Europe

Highlights Our base case outlook is unchanged. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, the cycle is well advanced and, given current valuations, the long-term outlook for returns in the major asset classes is far less appealing. The risk/reward balance is unfavorable. Investors should therefore separate strategy from forecast. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, which means that the FOMC will have to consider becoming outright restrictive in order to slow growth and raise the unemployment rate. The risks facing equities, EM assets and spread product will escalate at that point. The advanced stage in the cycle and our bias for capital preservation requires us to heed the recent warnings from our growth indicators and 'exit' timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. The implication is that we are tactically trimming risk asset exposure to benchmark. We expect to shift back to overweight once our indicators improve and/or the geopolitical tensions fade. This month we provide total return estimates for the major U.S. asset classes under our base case outlook and two alternative scenarios. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession in 2019. We also review the U.S. fiscal outlook, which is clearly unsustainable over the long-term. While we do not see a dollar crisis anytime soon, the prospect of large and sustained federal budget deficits supports the view that the dollar will continue on a long-term downtrend (although it is likely to buck the trend in the coming months). It also supports our view that the multi-decade Treasury bull market is over. U.S. consumers will not be particularly sensitive to rising borrowing rates, although there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Feature It was the summer of 2009. Risk assets were bombed out, investor sentiment was deeply depressed, business leaders were shell-shocked, the Fed was easing and some 'green shoots' of recovery were emerging. Plentiful economic slack also meant that there was a long potential runway for the economy and earnings to grow. Given that backdrop, it was appropriate to begin rebuilding risk portfolios and ride out any additional turbulence in the markets. Today's situation is almost the mirror image. The economic expansion is well advanced, there is little slack, the Fed is tightening, risk assets are expensive, and investor equity sentiment is frothy. The long-term outlook for returns in the major asset classes is underwhelming to say the least. Table I-1 updates the long-run return expectations we published in the 2018 BCA Outlook. Some technical adjustments make the numbers look a little better but, still, a balanced portfolio will deliver average returns over the long-term of only 3.8% and 1.8% in nominal and real terms, respectively. Table I-110-Year Asset Return Projections For stocks, the expected returns are poor by historical standards because we assume a mean-reversion in multiples and a decline in the profit share of total income. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or P-E ratios remain at historically high levels. Equities obviously would do better than our estimates in this case, but the point is that it is very hard to see returns in risk assets anywhere close to their 1982-2017 average over the long haul. On a two-year horizon, our base case outlook still sees decent equity returns. Nonetheless, the risk/reward balance has become quite unfavorable because the cycle is so advanced. It is therefore prudent to focus on capital preservation and be quicker to trim risk exposure when the outlook becomes cloudier. Losing Sleep Investors have cheered some easing in the perceived risk of a trade war in recent weeks. Nonetheless, a number of items have made us more nervous about the near term. First, our Equity Scorecard has dropped to one, well below the critical value of three that is consistent with positive equity returns historically (Chart I-1). Table I-2 updates our Exit Checklist of items that we believe are important for the equity allocation call. Five of the nine are now giving a 'sell' signal, pointing to at least a technical correction. Chart I-1Our Equity Scorecard Turned Negative Table I-2Exit Checklist For Risk Assets Moreover, we highlighted last month that global growth appears to be peaking (Chart I-2). Our Global Leading Economic Indicator is still bullish, but its diffusion index has plunged below zero. The Global ZEW index and our Boom/Bust indicator have fallen sharply and the global PMI index ticked down (albeit, from a high level). Industrial production in the major economies has eased. Korean and Taiwanese exports, which are a barometer of global industrial activity, have decelerated as well. Chart I-2Economic Indicators Have Softened While we expect global growth to remain at an above-trend pace for at least the next year, the peaking in some coincident and leading indicators is worrying nonetheless. Other items to keep investors up at night include the following: Loss Of Fed Put: With inflation likely to reach the Fed's target in the next couple of months, and policymakers worried about froth in markets, the FOMC will be less predisposed to ease at the first hint of economic softness (see below). Inflation Surge: There is a lot of uncertainty around estimates of the level of the unemployment rate that is consistent with rising wage and price pressures. Inflation could suddenly jump if unemployment is far below this critical level, leading to a blood bath in the bond market that would reverberate through all other assets. The fact that long-term inflation breakevens have surged along with the 10-year Treasury yield in the past couple of weeks is an ominous sign for risk assets. Neutral Rate: We agree with the Fed that the neutral fed funds rate is rising, but nobody knows exactly where it is at the moment. If the neutral rate is lower than the Fed believes, then the economy could suddenly stall as actual rates rise above the neutral level. Trade War: President Trump's popularity among Republican voters is rising, which gives him the ability to weather turbulence in the stock market while he 'gets tough' on trade. The fact that U.S. Treasury Secretary Mnuchin will visit China is a hopeful sign. Nonetheless, we do not believe that we have seen peak pessimism on trade because the President needs to placate his supporters in the mid-west that are in favor of protectionism. The summer months could be volatile as market confusion grows amidst a plethora of upcoming event risks.1 Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks (Bolton and Pompeo). Meanwhile, tensions in Syria are building with the potential for U.S. and Iranian forces to be directly implicated in a skirmish. Russia: Tensions between the West and Russia are also building again. Stroke Of Pen Risk: There is a rising probability that the current administration decides to up the regulatory pressure on Amazon. Other technology companies like Facebook and Google also face "stroke of pen" risks. On a positive note, first quarter earnings season is off to a good start in the U.S. Earnings have surprised to the upside by a wide margin, which is impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results to beat expectations. That said, a lot of good news is already discounted in the U.S. market. Chart I-3 highlights that bottom-up analysts' expected annual average EPS growth for the S&P 500 over the next five years has shot up to more than 15%, a level not seen since 1998! This is excessive even considering that the estimates include the impact of the tax cuts. History teaches that investors should be wary during periods of earnings euphoria. Chart I-3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Given these risks, market pricing and our checklist, we adjusted the tactical (3-month) House View recommendation on risk assets to benchmark in April. We see this shift as tactical, and expect to move back to overweight once our growth indicators bottom and the geopolitical situation calms down a little. Our base case outlook remains constructive for risk assets on a cyclical (6-12 month) view. Three Scenarios This month we consider two alternative scenarios to our base case outlook and provide estimates of how several key asset classes would perform between now and the end of 2019: Base Case: U.S. real GDP growth accelerates to 3.3% year-over-year by the end of 2018 on the back of fiscal stimulus and improving animal spirits in the corporate sector. Growth is expected to decelerate in 2019, but remain above trend. Profit margins are squeezed marginally by rising wage pressure. The recession we expect to occur in 2020 is beyond the horizon of this exercise. Optimistic Case: The multiplier effects of the fiscal stimulus could be larger than we are assuming if consumers decide to spend most of the tax windfall, and the corporate sector cranks up capital spending due to accelerated depreciation, the tax savings and repatriated overseas funds. We assume that real GDP growth is about a half percentage point higher than the base case in both 2018 and 2019. This is only modestly stronger than the base case because, given that the economy is already at full employment, the supply side of the economy will constrain growth. Even more margin pressure partially offsets stronger top line growth for corporations. Pessimistic Case: The fiscal multiplier effects turn out to be smaller than expected, compounded by the growth-sapping impact of a tariff war and a spike in oil prices due to tensions in the Middle East. The corporate and consumer sectors are more sensitive to rising interest rates than we thought (see below for more discussion of U.S. consumer vulnerabilities). Growth begins to slow toward the end of 2018, culminating in a recession in the second half of 2019. Margins are squeezed initially, but then rise as labor market slack opens up next year. This is more than offset, however, by declining corporate revenues. Chart I-4 presents the implications for S&P 500 EPS growth in the three scenarios, according to our top-down model. Four-quarter trailing profit growth comes in at a respectable 15% and 8½%, respectively, in 2018 and 2019 in our base case. The optimistic scenario would see impressive profit growth of 20% and 13%. Trailing EPS expands by 9% this year in the pessimistic case, but contracts by about the same amount next year. Chart I-4Three Scenarios For S&P 500 EPS Growth In order to use these EPS forecasts to estimate expected S&P 500 returns, we made assumptions regarding an appropriate 12-month forward P/E ratio (Table I-3). We also translated our trailing EPS forecasts into 12-month forward estimates based on historical cyclical patterns. The 12-month forward P/E ratio is 17 as we go to press (based on Standard and Poors figures). We assume the ratio is flat this year in the base case, before edging lower in 2019 due to rising interest rates. The forward P/E is assumed to edge up in the optimistic case in 2019, but then falls back in 2019 as rates rise. In the recession scenario, we conservatively assume that this ratio falls to 15 by the end of this year, and to 13 by the end of 2019. We incorporate a 2% dividend yield in all scenarios. Over the next two years, the S&P 500 delivers an 8% annual average return in our baseline, and 13% in the optimistic case. As would be expected, investors suffer painful losses of 13% this year and roughly 20% next year in the case of recession, as the drop in multiples magnifies the earnings contraction. Table I-4 presents total return estimates for the 10-year Treasury under the three scenarios. The bond will provide an average return of close to zero in our base case. It suffers heavy losses in 2018 if growth turns out to be stronger than we expect, because a faster acceleration in inflation would spark a sharp upward revision to the path of short-term rates. Long-term inflation expectations would rise as well. The 10-year yield finishes 2019 at 3.5% in the base case, and at 3.75% in the optimistic growth scenario. In contrast, total returns are hefty in the recession case as the 10-year yield drops back below 2%. Table I-3S&P 500 Return Scenarios Table I-410-year Treasury Return Scenarios We believe the risk/reward profile is less attractive for corporate bonds than it is for equities (Table I-5). Strong profit growth in the base and optimistic cases is positive for corporates, but this is offset by deteriorating financial ratios as interest rates rise in the context of high leverage ratios. We expect investment-grade (IG) spreads to widen modestly even in the base case, providing a small negative excess return. We see spreads moving sideways at best in our optimistic scenario, giving investors a small positive excess return of about 100 basis points. In the case of a recession, we could see the option-adjusted spread of the Barclay's IG index surging from 105 basis points today to 250 basis points. Excess returns would obviously be quite negative. Table I-5U.S. Investment Grade Corporate Bonds All of these projected returns are only meant to be suggestive because they depend importantly on several key assumptions. Still, we wanted to provide readers with a sense of the risks for returns around our base case outlook. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession. U.S. Fiscal Policy: Good And Bad News The probabilities attached to the baseline and optimistic scenarios are supported by the U.S. fiscal stimulus that is in the pipeline. The IMF estimates that the tax cuts and spending increases will provide a fiscal thrust of 0.8% in 2018 and 0.9% in 2019, not far from the estimates we presented last month (Chart I-5).2 This represents a powerful tailwind for growth for the next two years. We must turn to the Congressional Budget Office (CBO) projections to gauge the longer-term implications. On a positive note, the CBO revised up its estimate of the economy's long-run potential growth rate on account of the supply-side benefits of lower taxes and the immediate expensing of capital outlays. Faster growth over the long run, on its own, reduces the projected cumulative budget deficit over the 2018-2027 period by $1 trillion. However, this positive impact is swamped by the direct effect on the budget of the tax breaks and increased spending. The CBO estimates that the net effect of the fiscal adjustments will be a $1.7 trillion increase in the cumulative budget deficit over the next decade, relative to the previous baseline (Chart I-6). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart I-5U.S. Fiscal Stimulus Will Support Growth Chart I-6U.S. Federal Budget: A Lot More Red Ink The deficit situation begins to look better after 2020 because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which they extend the temporary provisions and grow the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 6% of GDP by 2022 and the federal debt-to-GDP ratio hits almost 110% of GDP in 2028. This is not a pretty picture and investors are wondering what it means for government bond yields and the dollar. We noted in the March 2018 Bank Credit Analyst that academic studies published before 2007 suggested that every percentage point rise in the government's debt-to-GDP ratio added roughly three basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade would lift the equilibrium long-term bond yields by 75 basis points. This estimated impact on yields should not be thought of as a default risk premium because there is no reason to default when the Fed can simply print money in the event of a funding crisis. Rather, a worsening fiscal situation could show up in higher long-term inflation expectations if investors were to lose confidence in the Fed's inflation target. Higher real yields could also come about through the 'crowding out' effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Deficits And The Dollar We discussed the potential debt fallout for the U.S. dollar from an economic perspective in the April 2018 Special Report. While the fiscal stimulus means that the U.S. twin deficits are set to worsen, the situation is not so dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding U.S. debt sustainability among international investors. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. Nonetheless, with President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. This month's Special Report beginning on page 22 examines this issue. There is no evidence at the moment that the U.S. dollar is losing any market share and we do not foresee any sudden shifts away from the U.S. dollar as a reserve currency. However, cracks are beginning to form, especially with regard to the RMB. We also believe that the euro is likely to benefit from a structural tailwind as global reserve managers increase the share of the euro in their reserves. A trade war would accelerate the diversification away from the dollar. Chart I-7Economic Slack: U.S./Eurozone Comparison The conclusions of this month's Special Report support those of last month's analysis; the dollar will continue on its long-term downtrend, although there is still room for a counter-trend rally this year. We do not see much upside against the yen in the near term, but we expect some of the euro's recent strength to be unwound. A debate is raging within the halls of the European Central Bank regarding the amount of Europe's economic slack. On this we side with President Draghi, who believes that there is still plenty of excess capacity in the labor market. The Eurozone's unemployment rate has reached the level of full employment as estimated by the OECD. However, Chart I-7 shows various measures of hidden unemployment, including discouraged workers and those that have been out of work for more than a year. In all cases, the Eurozone appears to be behind the U.S. in terms of getting back to full employment. This, along with the recent softening in some of the Eurozone's economic data, will keep the ECB wedded to low interest rates even as it terminates the asset purchase program this autumn. Long-dated forward rate differentials are beginning to move back in favor of the dollar relative to the Euro. Dollar strength will also be at the expense of most of the EM currencies. The Long-Term Consequences Of Government Debt While it is somewhat comforting that the U.S. twin-deficits are unlikely to spark financial panic in the short- to medium term, the U.S. and global debt situations are not without consequences. The latest IMF Fiscal Monitor again sounded the alarm over global debt levels, especially government paper. The Fund argues that debt sustainability becomes increasingly questionable once the general government debt/GDP ratio breaches 85%. The IMF points out that more than one-third of advanced economies had debt above 85% in 2017, three times more countries than in 2000. And this does not include the implicit liabilities linked to pension and health care spending. The good news is that the IMF expects that most of the major economies will see a reduction in their general government debt/GDP ratios between 2017 and 2023. The big exception is the U.S., where the average deficit is expected to far exceed the other major countries (Charts I-8A and I-8B). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019! Including all levels of government, the IMF estimates that the U.S. debt/GDP ratio will rise by about nine percentage points, to almost 117%, between 2017 and 2023. Chart I-8AIMF Projections (I) Chart I-8BIMF Projections (II) U.S. fiscal trends are clearly unsustainable in the long-term. Taxes will have to rise or entitlement programs will have to be slashed at some point. The question is whether Congress administers the required medicine willingly, or is forced to do so by rioting markets. We do not believe that the dollar's 'day of reckoning' will happen anytime soon, but growing angst over the U.S. fiscal outlook supports our view that the multi-decade Treasury bull market is over. In the near term, the main threat to the global bond market is a mini 'inflation scare' in the U.S. Fed Will Soon Reach 2% Goal Chart I-9Inflation May Soon Reach The Fed's Target The 10-year Treasury yield is testing the 3% support level as we go to press. In part, upward pressure on yields likely reflects some calming of tensions regarding global trade and the news that the U.S. will hold face-to-face discussions with North Korea. Moreover, long-term inflation expectations have been rising in most of the major countries. Investors appear to be waking up to how strong U.S. inflation has been in recent months, driven in part by an unwinding of base effects that temporarily depressed the annual inflation rate. U.S. core CPI inflation has already quickened from 1.8% in February to 2.1% in March (Chart I-9). This acceleration will also play out in the core PCE deflator, the Fed's preferred inflation metric. Even if the core PCE deflator rises only 0.1% month-over-month in March, year-over-year core PCE inflation will increase to 1.85%. This would be above Bloomberg and Fed estimates for the end of the year. If the core PCE deflator rises 0.2% m/m in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will almost reach the Fed's 2% target. The FOMC will not be alarmed even if inflation appears set to overshoot the 2% target. Nonetheless, Fed officials will be forced to adjust the communication language because they can no longer argue that "accommodative" monetary policy is still appropriate. In other words, policymakers will have to openly admit that policy will have to become outright restrictive. The Fed's "dot plot" could then be revised higher. The policy risks facing equities, EM assets and spread product will escalate once it becomes clear that the FOMC is actively targeting slower economic growth and a higher unemployment rate. As for Treasurys, the surge in the 10-year yield to 3% has been quick and we would not be surprised to see another consolidation period. Eventually, however, we expect the yield to reach 3.5% before the bear phase is over. How Vulnerable Are U.S. Households? The ultimate peak in U.S. yields will depend importantly on the economy's sensitivity to rising borrowing costs. Our research on excessive borrowing in recent months has focussed on the U.S. corporate sector. Next month we will review corporate vulnerabilities in the Eurozone. But what about U.S. consumers? Overall debt as a ratio to GDP or personal income has fallen back to pre-housing bubble levels, underscoring that the household sector has deleveraged impressively (Chart I-10). Household net worth has surpassed the pre-Lehman peak and our "wealth effect" proxy suggests that the rise in asset prices and recovery in home values provide a strong tailwind for spending (Chart I-11). The proxy likely overstates the size of the tailwind due to the lack of cash-out refinancing. Chart I-10U.S. Consumers Have Deleveraged Chart I-11'Wealth Effect' Is A Tailwind The financial obligation ratio (FOR) - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades (Chart I-12). Chart I-13 shows a broader measure of the burden that households face when paying for essentials; interest payments, food, medical care and energy. These are all expenses that are difficult to trim. Spending on essentials has increased over the past couple of years to a little under 42% of disposable income due to rising interest rates and a continuing uptrend in out-of-pocket medical care costs. However, the ratio is below the post-1980 average level and has only risen back to levels that existed in 2011/12. From this perspective, it is difficult to believe that rising gasoline prices will dominate the benefits of the tax cuts on household spending. Chart I-12Past The Peak Of U.S. Consumer Credit Quality Chart I-13Spending On Essentials Is Not Onerous The labor market is clearly supportive for consumer spending. Wage growth has been disappointing so far in this recover, and real personal disposable income has slowed over the past year. Nonetheless, the economy continues to produce new jobs at an impressive pace, unemployment claims are close to all-time lows, and households are feeling confident about their future income and job prospects. Some market pundits have pointed to the falling household savings rate as a warning sign that consumers are 'tapped out' (Chart I-14). We are less concerned. The savings rate tends to decline during economic expansions and rises almost exclusively during recessions. All else equal, one could make the case that U.S. households should save more over their lifetimes. Nonetheless, a falling savings rate is consistent with strong, not weak, economic activity. That said, some signs have emerged that not all consumer lending in recent years has been prudent. Bank and finance company loan delinquency rates are rising, especially for credit cards and autos (Chart I-15). While the FOR is still low, it is rising and it tends to lead bank loan delinquency rates (Chart I-12). These trends usually occur just prior to a recession. Chart I-14Savings Rate Falls During Expansions Chart I-15Some Signs Of Excessive Lending There has also been an alarming surge in credit card charge-off rates, which have reached recession levels among banks that are outside of the top 100 (Chart I-15, top panel). Anecdotal evidence suggests that large banks offered lush cash rewards and points to attract higher-quality customers. Smaller banks could not compete on cash rewards, and instead had to loosen credit requirements for card issuance. The deterioration in the credit-quality composition of these banks' loan portfolios helps to explain why delinquencies have increased despite a robust labor market. The Fed's senior loan officer survey shows that expected delinquencies and charge-offs are rising even among large banks. One risk is that, while overall credit growth has been weak in this expansion, it has been concentrated in lower-income households. However, the Fed's Survey of Consumer Finances does not flag a huge problem. Various measures of credit quality have not deteriorated for lower income households since 2007 (latest year available; Chart I-16). Chart I-16Credit Quality For Lower ##br##Income U.S. Households The bottom line is that there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Nonetheless, the backdrop for consumer health has not deteriorated to the point where the U.S. household sector will be ultra-sensitive to higher interest rates on a broad scale. Investment Conclusions Our base case outlook is unchanged this month. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, one must separate strategy from forecast at this point in the cycle. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, while rising energy and base metal prices add to the broader inflationary backdrop. Strong global oil demand growth and the OPEC/Russia production cuts are draining global oil inventories and supporting prices. Sanctions against Iran and/or Venezuela that further restrict supply could easily send oil prices to more than US$80/bbl this year. Investors should remain overweight energy plays. The implication is that the Fed may have to tighten into outright restrictive territory. The advanced stage in the cycle and our bias for capital preservation requires us to heed the warnings from our indicators and timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. Thus, we are tactically trimming risk asset exposure to benchmark until our indicators improve and/or geopolitical tensions fade. Investors should also be more cautious in their equity sector allocation for the very near term. We continue to favor Eurozone stocks over the U.S. (currency hedged), since the threat from monetary tightening is greater in the latter market and we expect the dollar to appreciate. We are neutral on the Nikkei because the risk of a rising yen offsets currently-strong EPS growth momentum. Stay short duration within global bond portfolios, and remain underweight the U.S., Canada and core Europe (currency hedged). Overweight Australia and the U.K. The Aussie economy will continue to underperform, and the U.K. economy will not allow the Bank of England to hike rates as much as is currently discounted. Mark McClellan Senior Vice President The Bank Credit Analyst April 26, 2018 Next Report: May 31, 2018 1 For a list of these events, see Table 2 in the BCA Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 2 The fiscal thrust is the change in the cyclically-adjusted budget balance as a share of GDP. It is a measure of the initial impetus to real GDP growth, but the actual impact on growth depends on fiscal "multipliers". II. Is King Dollar Facing Regicide? This month's Special Report is a joint effort by BCA's Geopolitical and Foreign Exchange strategists, along with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research). It is a companion piece to last month's Special Report, in which I discussed the short- and long-term outlook for the U.S. dollar from a purely economic perspective. This month's analysis takes a geopolitical perspective, focusing on the possibility that the U.S. dollar will lose its reserve currency status and weaken over the long term. I trust that you will find the Report as insightful as I did. Mark McClellan Reserve currencies are built on a geopolitical and macroeconomic foundation. For the U.S. Dollar, these foundations remain in place, but cracks are emerging. Relative decline in American power, combined with a loss of confidence in the "Washington Consensus" at home, are eroding the geopolitical foundations. Meanwhile, threats to globalization, a slower pace of petrodollar recycling, and stresses in the Eurodollar system are eroding the macroeconomic foundations. The Renminbi is not an alternative to King Dollar, but the euro remains a potential challenger in the coming interregnum years that will see the world transition from American hegemony... to something else. In the long run, we envision a multipolar currency regime to emerge alongside a multipolar geopolitical world order. In this report, BCA's Geopolitical and Foreign Exchange strategies join efforts with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research) to examine the conditions necessary for the decline of a reserve currency. Specifically, we seek to answer the question of whether the U.S. dollar is at the precipice of such a decline. With President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. After all, King Dollar has fallen by 9.7% since President Trump's inauguration on January 20, while alternatives of dubious value, such as a slew of cryptocurrencies, have seen a rally of epic proportions (Chart II-1). Professor Barry Eichengreen, a world-renowned international economics historian,1 has recently penned an insightful paper proposing a link between the robustness of military alliances and currency reserve status.2 According to the analysis, reserve currency status reflects both economic fundamentals - safety, liquidity, network effects, and economic conditions - and geopolitical fundamentals. In the case of close U.S. military allies, such as South Korea and Japan, the choice of the dollar as store of value is explained far more by the geopolitical links to the U.S., rather than the importance of the dollar for their economies. The authors warn that if the U.S. "withdraws from the world," the impact could be as large as an 80 basis points rise in the U.S. long-term interest rate. Intriguingly, some of what Professor Eichengreen posits could happen has already happened. For example, the share of foreign holdings of U.S. Treasuries by military allies has already declined by a whopping 25% (Chart II-2). And yet the demand for King Dollar assets was immediately picked up by non-military allies, proving the resiliency of greenback's status as the reserve currency. Chart II-1Is Trump Guilty Of Regicide? Chart II-2Geopolitics Is Not Driving ##br##Demand For Treasuries When it comes to global currency reserves, the U.S. dollar continues to command 63%, roughly the same level it has commanded since 2000 (Chart II-3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart II-4). The Chinese renminbi remains largely ignored as a global reserve currency and its use across markets and geographies appears to have declined since the imposition of full capital controls in October 2015 (Chart II-5). Chart II-3Dollar Remains King Chart II-4The Euro Is The Only Serious Competitor To King Dollar... Chart II-5...The Renminbi Is Not However, some cracks in the foundation are emerging. A recent IMF paper, penned by Camilo E. Tovar and Tania Mohd Nor,3 uses currency co-movements to determine which national currencies belong to a particular reserve currency bloc.4 Their work shows that the international monetary system has already transitioned from a bi-polar system - consisting of the greenback and the euro - to a multipolar one that includes the CNY (Chart II-6). However, the CNY's influence does not extend beyond the BRICS and is scant in East Asia, the geographical region that China already dominates in trade (Chart II-7), albeit not yet geopolitically (Map II-1). Chart II-6Renminbi Does Command A Large Currency 'Bloc'... Chart II-7...But Despite China's Dominance Of East Asia... Map II-1...Renminbi's 'Bloc' Is Not In Asia! Our conclusion is that the geopolitical and economic tailwinds behind the greenback's status as a global reserve currency are shifting into headwinds. This process, as we describe below, could increase the risk of a global dollar liquidity shortage, buoying the greenback in the short term. In the long term, however, a transition into a multipolar currency arrangement could rebalance some of the imbalances created by the collapse of the Bretton Woods System and is not necessarily to be feared. The Geopolitical Fundamentals Of A Reserve Currency Nothing lasts forever and the U.S. dollar will one day join a long list of former reserve currencies that includes the Ancient Greek drachma, the Roman aureus, the Byzantium solidus, the Florentine florin, the Dutch gulden, the Spanish dollar, and the pound sterling. All of the political entities that produced these reserve currencies have several factors in common. They were the geopolitical hegemons of their era, capable of controlling the most important trade routes, projecting both hard and soft power outside of their borders, and maintaining a stable economy that underpinned the purchasing power of their currency. Table II-1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table II-1Insights From History: What Makes A Reserve Currency? Geopolitical Power As Eichengreen posits, geopolitical fundamentals are essential for reserve currency status. Military power is necessary in order to defend one's national and commercial interests abroad, compel foreign powers to yield to those interests, and protect allies in exchange for their acquiescence to the hegemonic status quo. An important modern world example of such "gunboat diplomacy" was the 1974 agreement between the U.S. and Saudi Arabia.5 In exchange for dumping their petro-dollars into U.S. debt, Riyadh received an American commitment to keep the Saudi Kingdom safe from all threats, both regional (Iran) and global (the Soviet Union). It also received special permission to keep its purchases of U.S. Treasuries secret. Chart II-8The Exorbitant Privilege In One Chart As with all the empires surveyed in Table II-1, allies and vassal states were forced to use the hegemon's currency in their trade and investment transactions as a way of paying for the security blanket. To this day, there is no better way to explain the "exorbitant privilege" that the dollar commands. Chart II-8 illustrates that the U.S. enjoys positive net income despite a massively negative net international investment position. It is true that the U.S.'s foreign assets are skewed toward foreign direct investment and equities, investments that have higher rates of returns than the fixed-income liabilities the U.S. owes to the rest of the world. But the U.S.'s positive net income balance has been exacerbated by the willingness of foreigners to invest their assets into the U.S. for little compensation, something illustrated by the fact that between 1971 and 2007, the ex-post U.S. term premium has been toward the lower end of the G10. Additionally, as foreigners are also willing holders of U.S. physical cash, the U.S. government has been able to finance part of its budget deficit with instruments carrying no interest payments. This is what economists refer to as seigniorage, a subsidy to the U.S. government equivalent to around 0.2% of GDP per annum (or roughly $39.5 bn in 2017). In essence, American allies are paying for American hegemony through their investments in U.S. dollar assets, and this lets the U.S. live above its means. But ultimately, the quid pro quo is perhaps as much geopolitical as economic. There is one, non-negligible, cost for U.S. policymakers. The greenback tends to appreciate during periods of global economic stress due to its reserve currency status.6 This means that each time the U.S. needs a weak dollar to reflate its economy, the dollar moves in the opposite direction, adding deflationary pressures to an already weak domestic economy. Compared to the benefits, which offer the U.S. a steady-stream of seigniorage income and low-cost financing, the cost of reserve currency status is acceptable. Chart II-9U.S. Naval Strength Still Supreme... Economic Power Aside from brute force, an empire is built on commercial and trade links. There are two reasons for this. First, trade allows the empire to acquire raw materials to fuel its economy and technological advancement. Second, it also gives the "periphery" a role to play in the empire, a stake in the world system underpinned by the hegemonic core. This creates an entire layer of society in the periphery - the elites enriched by and entrenched in the Empire - with existential interest in the status quo. For the past five centuries, commercial dominance has been underpinned by naval dominance. As the Ottoman Empire and the Ming Dynasty closed off the overland routes in the fourteenth and fifteenth centuries, Europeans used technological innovation to avoid the off-limits Eurasian landmass and establish alternative - and exclusively naval - routes to commodities and new markets. This has propelled a succession of largely naval empires: Portuguese, Spanish, Dutch, French, British, and finally American. Several land-based powers tried to break through the nautical noose - Ottoman Turks, Sweden, Hapsburg Austria, Germany, and the Soviet Union - but were defeated by the superiority of naval-based power. Dominance of the seas allows the hegemonic core to unite disparate and far-flung regions through commerce and to call upon vast resources in case of a global conflict. Meanwhile, the hegemon can deny that commerce and those resources to land-locked challengers. This is how the British defeated Napoleon and how the U.S. and its allies won World War I and II. The U.S. remains the supreme naval power (Chart II-9). While China is building up its ability to push back against the U.S. navy in its regional seas (East and South China Seas), it will be decades before it is close to being able to project power across the world's oceans. While the former is necessary for becoming a regional hegemon, the latter is necessary for China to offer non-contiguous allies an alternative to American hegemony. Bottom Line: The foundation of a global reserve currency status is geopolitical fundamentals. The U.S. remains well-endowed in both. American Hegemony - From Tailwinds To Headwinds Chart II-10...But Overall Hegemony Is In Decline The U.S. is already facing a relative geopolitical decline due to the rise of major emerging markets like China (Chart II-10). This theme underpins BCA Geopolitical Strategy's view that the world has already transitioned from American hegemony to a multipolar arrangement.7 In absolute terms, the U.S. still retains the hard and soft power variables that have supported the USD's global reserve status and will continue to do so for the next decade (which is the maximum investment horizon of the vast majority of our clients). However, there are three imminent threats to the status quo that may accentuate global multipolarity: Populism: The global hegemon could decide to withdraw from distant entanglements and institutional arrangements. In the U.S., an isolationist narrative has emerged suggesting that America's status as the consumer and mercenary of last resort is unsustainable (Chart II-11). President Obama was elected on the promise of withdrawing from Iraq and Afghanistan; his administration also struck a major deal with Iran to reduce American exposure to the Middle East. Donald Trump won the presidency on an even more isolationist platform and he and several of his advisors have voiced such a view over the past 15 months. The appeal of isolationism could resurface as it is a potent political elixir based on a much deeper rejection of globalization among the American public than the policy establishment realized (Chart II-12). Chart II-11Trump Is Rebelling Against The Post-Cold War System Chart II-12Americans Are Rebelling Against The 'Washington Consensus' Return of the land-based empire: While the U.S. remains the preeminent naval power, its leadership in military prowess could be wasted through a suboptimal grand strategy. The U.S. has two geopolitical imperatives: dominate the world's oceans and ensure the disunity of the Eurasian landmass.8 Eurasia has sufficient natural resources (Russia), population (China), wealth (Europe), and geographical buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia would have no need for a navy as it would become a superpower by default. Why would America's European allies abandon their U.S. security blanket for an alliance with Russia and China? First, stranger shifts in alliance structure have occurred in the past.9 Second, because a mix of U.S. mercantilism and isolationism could push Europe into making independent geopolitical arrangements with its Eurasian peers, even if these arrangements were informal. The advent of the cyber realm: Finally, the advent of the Internet as a new realm of great power competition reduces the relative utility of hard power, such as a navy. Great empires of the past struggled when confronted with new arenas of conflict such as air and submarine. New technologies and new arenas can yield advantages in traditional battlefields. Today, the U.S. must compete for hegemony in space and cyber-space with China, Russia, and other rivals. In these mediums, the U.S. does not have as great of a head start as it has in naval competition. Bottom Line: The U.S. remains the preeminent global power. However, its status as a hegemon is in relative decline. Domestic populism, suboptimal grand strategy, and the advent of cyber and outer-space warfare could all accelerate this decline on the margin. The Economic Fundamentals Of U.S. Dollar Reserve Status One unique aspect of the U.S. dollar as a reserve currency is that it is a fiat currency, i.e. paper money limited in supply only by policy. Throughout human history, most dominant currency reserves were based on commodities that were rare or difficult to acquire, like silver or gold.10 When the U.S. dollar was decoupled from gold prices in 1971, it became the only recent example of a global reserve currency backed by nothing but faith (the pound was for most of its period of dominance backed by gold). Money serves three functions in the economy. It is a means of payment, a unit of account, and a store of value. The last comes into jeopardy when the reserve currency has to supply the world with more and more liquidity, also known as the "Triffin dilemma". By definition, as the global reserve currency, the USD has to be plentiful enough for the global economy and financial system to function adequately. The U.S. government must constantly supply dollars to this end. Chart II-13 illustrates the timeline of global dollar liquidity, which we define as the total U.S. monetary base in circulation (U.S. monetary base plus holdings of U.S. Treasury securities held in custody for foreign officials and international accounts). The world has seen an ever-expanding U.S. dollar monetary base since 1988. Only during periods where the price of money (i.e. the Federal funds rate) has increased, has the money creation process slowed. Now that the expansion of the global USD monetary base is slowing, overall dollar liquidity is as important as the price, if not more (Chart II-14). Chart II-13Global Dollar Liquidity... Chart II-14...Drives Global Asset Prices The constant increase of dollar liquidity has made the greenback the "lubricant" of today's global financial system. There are three major forces at work beneath this condition: Recycling of petrodollars into the global financial system; Globalization and the build-up of - mainly USD-denominated - FX reserves; Deregulation of the Eurodollar system.11 Petrodollars Commodity exporters, mainly oil producers, sell their products in exchange for U.S. dollars. In addition, most Middle Eastern producers recycle their profits into U.S. dollars due to the liquidity and depth of U.S. capital markets. By 1980, the majority of oil producers were trading in U.S. dollars and were similarly investing their surpluses into the U.S. financial system in the form of U.S. government debt securities. The growth in petrodollars has allowed the world's dollar monetary base to grow substantially. This was both enabled by direct issuance of U.S. debt securities funded by petrodollar purchases and also through the Eurodollar system whereby banks outside the U.S. held large deposits of surplus dollar earnings from Middle East oil producers. Globalization The contemporary wave of globalization began in the mid-1980s, when it became evident that the Soviet Union was in midst of a deep economic malaise. This prompted the new Soviet Premier Mikhail Gorbachev to launch perestroika ("restructuring") in 1985, throwing in the proverbial towel in the contest between a statist planned economy and a free market one. Alongside the rise in global trade, financial globalization rose at a very rapid pace as cross-border capital flows more than doubled as a percentage of global GDP from 1990 onward. In the U.S., the economic boom of the 1990s was the longest expansion in history, with growth averaging 4% during the period. The U.S. trade deficit ballooned, providing the world with large amounts of dollar liquidity in the process. The flipside of the massive current account deficit was the accumulation of FX reserves in Europe and Asia, largely denominated in U.S. dollars. These insensitive buyers of U.S. debt indirectly financed the U.S. trade deficit, and also indirectly fuelled the debt super cycle and asset inflation as the "savings glut" compressed the world's risk-free rate and term premium. In other words, financial globalization combined with excess international savings morphed into a global quid pro quo. The world economy needed liquidity to finance growth and capital investment. In a system where the greenback stood at the base of any liquidity build up, this meant that the world needed dollars to finance its development. The world was thus willing to finance the U.S. current account deficit at little cost. The Eurodollar System The Eurodollar system was originally a payment system introduced after World War II as a result of the Marshal Plan. Because global trade was dominated by the U.S. - the only country that retained the capacity to produce industrial goods - foreigners had to be able to access U.S. dollars where they were domiciled in order to buy capital goods. The U.S. current account deficit played a role in growing that Eurodollar market. While a lot of the dollars supplied to the rest of the world through the U.S. current account deficit ended up going back to the U.S. via its large capital account surplus, a significant portion remained in offshore jurisdictions, providing an important fuel for the Eurodollar markets. In fact, more than two-thirds of U.S.-dollar claims in the Eurodollar market can be traced back to U.S. entities. After this original impetus, the Eurodollar market grew by leaps and bounds amid a number of regulatory advantages introduced in the 1980s. These changes in regulations not only deepened the participation of European and Japanese banks in the offshore markets, it also allowed U.S. banks to shift capital to Europe, harvesting a lower cost of capital in the process.12 The next growth phase in the Eurodollar system came with the evolution of shadow banking, in which credit was created off balance sheet by lending out collateral more than once, thus enabling banks to obtain higher gearing. This process is known as "re-hypothecation." In the U.S. there was a limit to which banks were allowed to gear collateral, which was not the case in Europe. Hence, to take advantage of this regulatory leniency, global banks grew further through the offshore market, causing an additional expansion in the Eurodollar market.13 Ultimately, this implies that over the past 30 years, the growth of the Eurodollar system has mainly been a consequence of the architecture of the international financial system. Headwinds To Dollar Liquidity The forces contributing to the extraordinary growth in dollar liquidity have begun to fade. In brief: Protectionism and populism: A slowdown in global trade has occurred for a number of structural, non-geopolitical reasons, especially if one controls for the recovery of energy prices (Chart II-15).14 This slowdown implies a slower accumulation of international FX reserves and a reduction of the "savings glut." If protectionism were to compound the effects - by shrinking the U.S. trade deficit - the result for global dollar liquidity would be negative. The consequence would be a certain degree of "quantitative tightening" of global dollar liquidity. Energy prices: Despite the recovery in energy prices, oil producers continue to struggle to rein in their budget deficits. Deficits blew out during the high-spending era buoyed by high oil prices (Chart II-16). Today, oil producing countries have less oil revenues to spend on the Treasury market, as their cash is needed at home. Meanwhile, the U.S. is slowly moving towards partial energy independence, further shrinking its trade deficit. Chart II-15Global Trade Growth Has Moderated Chart II-16Petrodollars Are Scarce Eurodollar system: The monetary "plumbing" has become clogged since 2014 after the Fed stopped growing its balance sheet and sweeping Basel III bank regulations took effect. The cost of acquiring U.S. dollars in Eurodollar markets currently stands at a premium. This extra cost cannot be arbitraged away due to the restrictive capital rules imposed under Basel III, which have raised the cost of capital for banks. This can be seen in the persistent widening of USD cross-currency basis-swap spreads and more recently, in the rise of the Libor-OIS spread (Chart II-17). The introduction of interest on excess reserves by the Federal Reserve is further draining dollars from the Eurodollar system. The velocity of dollar usage in international markets is unlikely to return to the pace experienced from 1995 to 2008, when the shadow banking system grew rapidly. To complicate matters, dollar-denominated debt issued outside of the U.S. by non-U.S. entities such as banks, governments, and non-financial corporations has grown substantially. This could exacerbate the scramble for dollars in case of a global shortage. For example, the stock of outstanding dollar debt issued by foreign nonfinancial corporations currently stands at US$10 trillion (Chart II-18). Chart II-17Mounting Stress In The Eurodollar System Chart II-18Foreign Dollar Debt Is At $10 Trillion Why is the Eurodollar system so important? Today is the first time in the world's history that this much debt has been accumulated in the global reserve currency outside of the country that issues that currency. The Eurodollar system is thus a key source of liquidity for global borrowers. It is also necessary to ensure that these borrowers can access U.S. dollars when the time comes to repay their USD-denominated obligations. The U.S. trade deficit is effectively the source of the growth of the monetary base in the Eurodollar system, and the stock of dollar-denominated debt issued by non-U.S. entities is the world's broad money supply. With the money multiplier in the offshore USD markets having fallen in response to the regulatory tightening that followed the Great Financial Crisis, broad USD money supply in the Eurodollar system will be hyper sensitive to any decline in the U.S. current account deficit. Less global imbalances would therefore result in a further increase in USD funding costs in the international system, and potentially into a stronger U.S. dollar as well, making this dollar debt very expensive to repay. This raises the likelihood of a massive short-squeeze in favour of the U.S. dollar, challenging the current downward trajectory in the U.S. dollar, at least in the short term. Another consequence of a higher cost of sourcing U.S. dollars in the Eurodollar market tends to be rising FX volatility (Chart II-19). An increase in FX volatility should represent a potent headwinds for carry trades. This, in turn, will hurt liquidity conditions in EM economies. Hence, EM growth may be another casualty of problems in the Eurodollar system. Chart II-19Eurodollar Stress Produces FX Volatility Thus, the risks associated with U.S. protectionism go well beyond the risks to global trade. If severe enough, protectionism can threaten the plumbing system of the global economy. Bottom Line: The global economy has been supplied with dollar-based liquidity through the Eurodollar market. At the base of this edifice stands the U.S. trade-deficit, which was then magnified by the issuance of U.S. dollar-denominated debt by non-U.S. entities. This system is becoming increasingly tenuous as Basel III regulations have increased the cost of capital for global money-center banks, resulting in a downward force on the money multiplier in the offshore dollar funding system. In this environment, the risk to the system created by protectionism rises. If Trump and his administration can indeed scale back the size of the U.S. trade deficit, not only will the growth of the U.S. dollar monetary base be broken, but since the monetary multiplier of the Eurodollar system is also impaired, the capacity of the system to provide the dollars needed to fund all the liabilities it has created will decline. This could result in a serious rise in dollar funding costs as well as a tightening of global liquidity that will hurt global growth and result in a dollar short squeeze. This implied precarious situation raises one obvious question: Could we see the emergence of another reserve asset to complement the dollar, alleviating global liquidity risk? If Something Cannot Go On Forever, It Will Stop A global shortage of dollars is not imminent but could result from the forces described above. Even so, it is unlikely that the U.S. dollar faces any sudden end to its role as the leading global reserve currency. However, the world is unlikely to abide by a system that limits its growth potential either. The demise of the Bretton Woods system is important to keep in mind. The Bretton Woods system tied the supply of global liquidity to the supply of U.S. dollars. Initially this was not a problem as the U.S. ran a trade surplus. But it became a significant issue when the rest of the world began to question the U.S. commitment to honouring the $35/oz price commitment amidst domestic profligacy and money printing. Ultimately, the system broke down for this very reason. The strength of the global economy, along with the size of the U.S. current account deficit, was creating too many offshore dollars. Either the global money supply had to shrink, or gold had to be revalued against the dollar. The unpegging of the dollar from gold effectively resulted in the latter. However, the 1971 Smithsonian Agreement that replaced the gold standard with a dollar standard retained the dollar's hegemony. There was simply no alternative at the time. Today, it is unlikely that the global economy will stand idle in the face of a potentially sharp tightening of global liquidity conditions. We posit that this rising dollar funding costs will be the most important factor to decrease the importance of the dollar in the global financial system. Since the demand for the USD as a reserve currency is linked to its use as a liability by banks and financial systems outside of the U.S., if the USD gets downgraded as a source of financing by global banks, the demand for the greenback in global reserves will decline.15 As the share of dollars in foreign reserve coffers decreases, the dollar will likely depreciate over time as it will stop benefiting from the return-inelastic demand from reserve managers. Profit-motivated private investors will demand higher expected returns on dollar assets in order to finance the U.S. current account deficit. Despite this important negative, the dollar will still be the most important reserve asset in the world for many decades. After all, the decline of the pound as the global reserve asset in the interwar period was a gradual affair. Nonetheless, the share of reserves concentrated in USD assets as well as the share of international liabilities issued in USD will decrease, potentially a lot quicker than is thought possible. Chart II-20Reserve Currency Status ##br##Can Diminish Quickly For example, Eichengreen has shown that the pound sterling's share of non-gold global currency reserves fell from 63% in 1899 to 48% in 1913, just 14 years later (Chart II-20). It is instructive that this pre-World War I era coincides with today's multipolar geopolitical context. It similarly featured the decline of a status quo power (the U.K.) and the emergence of a rising challenger (the German Empire). What are the alternatives to the dollar? Obviously, the euro will have a role in this play. The euro today only represents 20% of global reserve assets, and considering the size of the Euro Area economy as well as the depth of its capital markets, the euro's place in global reserves has room to increase. In fact, the share of euros in global reserves is 15% smaller than that of the combined continental European national currencies in 1990 (see Chart II-4 on page 25). The CNY can also expect to see its share of international reserves increase. While China does not have the same capital-market depth as the Euro Area, it is gaining wider currency. The One Belt One Road project is causing many international projects to be financed in CNY and China's economic and military heft is still growing fairly rapidly. Nevertheless, China's closed capital account continues to weigh against the CNY's position. As Chart II-21 illustrates, there is a relationship between a country's share of international global payments and inward foreign investment. Essentially, investors want to know that they can do something (buy and sell goods and services) with the currency that they use to settle their payments. In particular, they want to know that they can use the currency in the economy that issues it. As long as it keeps its capital account closed, China will fail to transform the CNY into a reserve currency. Chart II-21A Reserve Currency With A Closed Capital Account? Forget About It! This means that for at least the next five years, the renminbi's internationalization will be limited. If U.S. protectionism is severe enough, China's economic transition is less likely to be orderly and capital account liberalization could be delayed further. In terms of investment implications, this suggests that for the coming decade, the euro is likely to benefit from a structural tailwind as global reserve managers increase their share of euro reserves. The key metric that investors should follow to gauge whether or not the euro is becoming a more important source of global liquidity is not just the share of euros in global reserves, but also the amount of foreign-currency debt issued in euros by non-euro area entities in the international markets. In all likelihood, before the world transitions toward a unit of account other than the USD, tensions will grow severe, as they did in the late 1960s. It is hard to know when these tensions will become evident. This past winter, the USD basis-swap spread began to widen along with the Libor-OIS spread, but while the Libor-OIS spread remains wide, basis-swap spreads have normalized. Nonetheless, by the end of this cycle, we would expect a liquidity event to cause stress in global carry trades and EM assets. It is important that investors keep a close eye on basis-swap and Libor-OIS spreads to gauge this risk (Chart II-22). Chart II-22Are We Nearing A Global Liquidity Event? Additionally, the more protectionist the U.S. becomes, the larger the diversification away from the dollar by both global reserve managers and international bond issuers could become. This is because of two reasons: First, if the U.S. actually manages to pare down its trade deficit, this will accentuate the decline in the supply of base money in the international system. Second, rising trade protectionism out of the White House gives the world the impression that economic mismanagement is taking hold of the U.S., raising the spectre of stagflation. Finally, the next global reserve asset does not have to be a currency. After all, for millennia, that role was fulfilled by commodities such as gold, silver, or copper. Thus, another asset may emerge to fill this gap. At this point in time it is not clear which asset this may be. Bottom Line: A severe liquidity-tightening caused by a scarcity of U.S. dollars would create market tumult around the world. We worry that such a risk is growing. However, it is hard to envision the global economy falling to its knees. Instead, the global system will likely do what it has done many times before: evolve. This evolution will most likely result in new tools being used to increase the global monetary base. At the current juncture, our best bet is that it will be the euro, which will hurt the USD's exchange rate at the margin on a secular basis. This brings up the very important question of whether the euro is politically viable. We have turned to this question many times over the past seven years. Our high conviction view is still that the euro will survive over the foreseeable time horizon.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist Mathieu Savary, Vice President Foreign Exchange Strategy Mehul Daya Consulting Editor Neels Heyneke Consulting Editor 1 And an erstwhile member of BCA's Research Advisory Board. 2 Please see Eichengreen, Barry et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org. 3 Please see Tovar, Camillo and Tania Mohd Nor, 2018 "Reserve Currency Blocks: A Changing International Monetary System?," IMF Working Paper WP/18/20, Washington D.C. 4 The authors are essentially examining the extent to which national currencies are anchored to a particular reserve currency. 5 Please see David Shapiro, The Hidden Hand Of American Hegemony: Petrodollar Recycling And International Markets, New York: Columbia University Press. Also, Andrea Wong, "The Untold Story Behind Saudi Arabia's 41-Year Secret Debt," The Independent, dated June 1, 2016, available at independent.co.uk. 6 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," February 1, 2017, available at gps.bcaresearch.com. 9 Entente cordiale being particularly shocking at the time it was formalized in 1904. Other examples of ideologically heterodox alliances include the USSR's alliance first with Nazi Germany and then with Democratic America during World War II; the notorious alliance of Catholic France with Muslim Turks against its Christian neighbors throughout the seventeenth and eighteenth centuries; or Greek alliances with the Carthaginians against Rome in the third century BC. 10 Another exception to this rule was the Yuan Dynasty, established by Mongol ruler Kublai Khan, which issued fiat money made from mulberry bark. In fact, the mulberry trees in the courtyard at the Bank of England serve as a reminder of the origins of fiat money. 11 Eurodollar system simply refers to U.S. dollars that are outside the U.S. 12 Firstly, the absence of Regulation Q in offshore markets meant that regulatory arbitrage was possible, i.e. there was no ceiling imposed on interest rates on deposits at non-U.S. banks. Then, in the late 1990s, the Eurodollar system had another jump start with the amendment to Regulation D, which meant that non-U.S. banks were exempted from reserve requirements. 13 European banks specifically, but also U.S. banks with European branches, were aggressive buyers/funders of exotic derivatives products, such as CDO, MBS, SIVS. Most of these activities were off-balance sheet and took place in the Eurodollar system because a number of regulatory arbitrages existed. This is one of the main reasons that the Federal Reserve's bailout programs were largely focused towards foreign banks. The Fed's swap lines were heavily used by foreign central banks in order to clean up the operations of their own financial institutions. 14 Please see BCA Global Investment Strategy Special Report, "Why Has Global Trade Slowed?," dated January 29, 2016, available at gis.bcaresearch.com 15 Shah, Nihar, "Foreign Dollar Reserves and Financial Stability," December 2015, Harvard University. 16 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011; "No Apocalypse Now?," dated October 31, 2011; "The Draghi 'Bait And Switch," dated January 9, 2013; "Europe: The Euro And (Geo)politics," dated February 11, 2015; "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016; "After BREXIT, N-EXIT?," dated July 13, 2016; "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017. III. Indicators And Reference Charts A key divergence has emerged between the U.S. corporate earnings data and our equity-related indicators. The divergence supports our tactical cautiousness on risk assets. Forward earnings have soared on the back of the U.S. tax cuts and upgrades to the growth outlook. Earnings are beating expectations by a wide margin so far in the Q1 earnings season, which is reflected in very elevated levels for the net revisions ratio and net earnings surprises. However, the S&P 500 has failed to gain any altitude on the back of the positive earnings news, in part because bond yields have jumped. Our Monetary Indicator moved further into bearish territory, and our Equity Technical indicator is below its 9-month moving average and is threatening to break below the zero line (which would be another negative signal). Valuation has improved marginally, but is still stretched, according to our Composite Valuation Indicator. Our Speculation Indicator does not suggest that market frothiness has waned at all, although sentiment has fallen back to neutral level. It is also worrying that our U.S. Willingness-to-Pay indicator took a sharp turn for the worse in April. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Finally, our Revealed Preference Indicator (RPI) for stocks flashed a 'sell' signal in April. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. As for bonds, oversold conditions have emerged but valuation has not yet reached one standard deviation, the threshold for undervaluation. This suggests that there is more upside potential for Treasury yields. The U.S. dollar broke out of its recent tight trading range to the upside in April, although this has only resulted in an unwinding of oversold conditions according to our Composite Technical Indicator. The dollar is expensive on a PPP basis, but we still expect the dollar to rally near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Global corporate bond markets have seen both ups and downs so far in 2018. Credit spreads in the developed markets and emerging markets, both for investment grade (IG) and lower quality credit tiers, tightened in January. This was followed by a sharp widening of spreads in the two months after the "VIX spike" in early February. Spreads have begun narrowing again in April, but remain above levels that began the year in all major countries with one notable exception - U.S. high-yield. Feature The volatility in corporate credit is a reflection of the growing list of investor worries, coming at a time when yields and spreads still remain near historically low levels in almost all markets. Topping that list is the fear that low unemployment and rising inflation rates will force the major central banks to maintain a more hawkish (or, at least, less dovish) policy bias in the medium term, even with the global economy losing some upside momentum so far this year after a robust 2017. Add in other concerns over U.S. trade policy (i.e. tariffs), U.S. fiscal policy (i.e. wider deficits, more U.S. Treasury issuance) and even signs of potential stresses in global funding markets (i.e. wider LIBOR-OIS spreads), and it is no surprise that more uncertain investors have become less comfortable with the risks stemming from credit exposure. This can be seen in the volatility of mutual fund and ETF flows into riskier bond categories like U.S. high-yield (HY), which saw a whopping -$19.8bn in outflows in Q1/2018, but has already seen +$3.8bn in inflows in April - possibly in response to the surprisingly strong results seen in Q1 U.S. corporate earnings reports.1 Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. In this CHM Chartbook, we introduce new country coverage to our CHM universe, adding a bottom-up measure for Japan and both top-down and bottom-up CHMs for Canada. After these new additions, we now have CHMs covering 92% of the Barclays Bloomberg Global Corporate Bond Index universe, based on country market capitalization weightings. The broad conclusion from the latest readings on our CHMs is that global credit quality has enjoyed a cyclical improvement in response to the coordinated growth seen in 2017, but with important geographical differences (Chart 1): Chart 1Global Corporates: Now Supported##BR##By Growth, Not Central Banks Credit quality in the U.S. has improved on the back of the solid performance of U.S. profits over the past year, but high leverage and low interest coverage suggest corporates are highly vulnerable to any slowing in economic growth Underlying credit quality in euro area corporates remains supported by low interest rates and the easy money policies of the European Central Bank (ECB), but the CHMs are trending in the wrong direction due to poor profitability metrics - most notably, a very depressed return on capital - and rising leverage among core European issuers U.K. corporate health continues to benefit from a very robust short-term liquidity position, although sluggish profitability and weak interest coverage suggest potential medium-term problems beneath the surface Japanese corporates are in good shape, enjoying strong interest coverage and low leverage, although absolute levels of profitability remain much lower than the other countries in our CHM universe Canadian corporate health has enjoyed some modest cyclical improvement, but low absolute levels on profitability and interest coverage, combined with high leverage, point to underlying risks. Looking ahead, the tailwinds that have supported corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds. Inflation expectations are moving higher in most countries, fueled by low unemployment rates and rising oil prices. This is most evident in the U.S., where the additional boost to growth from fiscal stimulus will keep the Fed on its rate hiking path over the next year. A mild inflation upturn is also visible in the euro area and Japan, where the ECB and Bank of Japan (BoJ) are already contributing to a less favorable liquidity backdrop for corporates by reducing the pace of their asset purchases. That trend is projected to continue over the next year, to the detriment of credit market returns that have been boosted by those unusual monetary policies (see the bottom panel of Chart 1). At some point within the 6-12 months, more hawkish central banks will act to slow global economic growth, triggering a more fundamental underperformance of corporates versus government bonds. For now, the backdrop remains supportive, but the clock is ticking as the end of this credit cycle draws closer. U.S. Corporate Health Monitors: A Cyclical Improvement, But Underlying Problems Persist Our top-down CHM for the U.S. has been flashing "deteriorating health" for fourteen consecutive quarters dating back to the middle of 2014 (Chart 2). Yet there has been a modest cyclical improvement seen in many of the individual CHM ratios over the past couple of years - most importantly, return on capital and profit margins - helping push the top-down level to close to the zero line. It is important to note that, due to delays in the reporting of the data used in the top-down U.S. CHM, the latest reading is only from the 4th quarter of 2017.2 A move into "improving health" territory in the 1st quarter of 2018 would require additional increases in cyclical profitability measures. This will be difficult to achieve with U.S. economic growth cooling off a bit in the first three months of 2018 (although the enactment of the Trump corporate tax cuts will likely help support the after-tax measure of margins used in the top-down CHM as 2018 progresses). From a longer-term perspective, the fact that the top-down CHM return on capital metric is well off the post-crisis peak is a disturbing development, given that non-financial corporate profit margins have been stable over the same period. This suggests a more fundamental problem with weak U.S. productivity growth and lower internal rates of return on marginal investments for companies, which is a longer-term concern for U.S. corporate health when the economic growth backdrop becomes less friendly. The bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4) have also both improved, with the HY indicator sitting right at the zero line. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term problems of high leverage and low returns on capital are not going away. In particular, HY interest and debt coverage remains near multi-decade lows. Chart 2Top-Down U.S. CHM:##BR##A Cyclical Pause Of A Structural Deterioration Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##A Bit Better, But Still Deteriorating What is rather worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of debt has now expanded to a point where the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to increase significantly or the U.S. experiences a major economic downturn. Interest costs would rise while earnings deteriorate, which would push interest coverage to historic lows, as was discussed in a recent report from our flagship Bank Credit Analyst service.3 For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after U.S. inflation expectations rise to levels consistent with the Fed's inflation target (i.e. when both the 5-year/5-year forward U.S. TIPS breakeven and the outright 10-year TIPS breakevens reach 2.4-2.5%). This will give the Fed confidence to follow through on its rate hike projections, pushing the funds rate to restrictive levels. In turn, that will dampen future corporate profit expectations and raise risk premiums on U.S. corporate bonds. With those breakevens now sitting at the highest point in four years (2.19%), that tipping point for credit markets is drawing nearer. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##A Strong Cyclical Improvement Chart 5The Beginning Of The End Of##BR##The U.S. Credit Cycle Euro Corporate Health Monitors: Getting Better Thanks To The Economy & The ECB Our top-down Euro Area CHM remains in "improving health" territory, as it has for the entire period since the 2008 crisis. The trend in the indicator has been steadily worsening since 2015, however, and the top-down CHM now sits just below the zero line (Chart 6). The steady deterioration of the top-down CHM is due to declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity and interest coverage, which are being supported by the easy money policies of the ECB (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Compared to the top-down CHMs we have constructed for other countries, there is an even longer lag on data availability from euro area government statisticians. Our top-down euro area CHM is only available to the 3rd quarter of 2017 and, therefore, does not reflect the strong performance of the euro area economy at the end of last year. Our bottom-up versions of the euro area CHMs for IG (Chart 7) and HY (Chart 8), which are based on individual earnings data that is more timely, both show that corporate health continued to improve at the end of 2017. Return on capital for euro area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, similar to the level in the bottom-up U.S. IG CHM but higher than the equivalent measures in our U.K., Japan and Canada CHMs. Both interest coverage and liquidity ratios for euro area IG are also close to U.S. IG levels. The euro area HY CHM is also showing improvement though declining leverage, although these results should be interpreted with caution as the sample size is relatively small. Chart 6Top-Down Euro Area CHM:##BR##Health Improving At A Diminishing Rate Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Steady Improvement Within the Euro Area, our bottom-up CHMs show that the gap has closed between issuers from the core countries versus those in the periphery, but all still remain in the "improving health" zone. (Chart 9). Return on capital, interest coverage and debt coverage are higher in the core, while liquidity is better in the periphery despite more highly levered balance sheets. Chart 8Bottom-Up Euro Area High-Yield CHMs:##BR##Steady Improvement As Leverage Declines Chart 9Bottom-Up Euro Area IG CHMs:##BR##Core Vs. Periphery While all of our euro area CHMs are indicating healthier balance sheets, that fact is already discounted in the low yields and tight spreads for both IG and HY issuers (Chart 10). Euro area corporates are also benefitting from the supportive bid of the ECB, which buys credit as part of its asset purchase program. We expect the ECB to fully taper its government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. That would be a scenario that could be keep euro area credit spreads tight, although the momentum in the euro area economy will likely be the more important driver of credit valuations. If the soft patch in growth seen in the first few months of 2018 continues in the coming months, euro area credit spreads would likely widen, although by less than if the ECB was not buying corporates. We have preferred to own U.S. corporates over Euro Area equivalents for much of the past year. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although that has not yet flowed through into any meaningful outperformance of U.S. IG and HY corporates. Chart 10European Credit:##BR##Spreads & Yields Have Bottomed Out Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: Still No Major Causes For Concern The top-down U.K. CHM remains firmly in the "improving health" zone, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital remains near 20-year lows around 6%, however, mirroring levels seen in this ratio in the CHMs for other countries. Profit margins remain at 20%, near the middle of the historical range. U.K. credit has benefitted from highly stimulative monetary policy settings by the Bank of England (BoE) - especially after the 2016 Brexit shock when the central bank not only lowered policy rates, but announced bond buying programs for both Gilts and U.K. corporates. The BoE has begun to take back some of that monetary easing by raising rates 50bps since last November. However, we remain skeptical that the central bank will be able to deliver much additional tightening over the rest of 2018 given sluggish growth, falling realized inflation and lingering Brexit uncertainties weighing on business confidence. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet both yields and spreads have been drifting higher in recent months, mirroring the trends seen in other global corporate bond markets (Chart 13). It is difficult to paint a scenario of renewed outperformance of U.K. credit versus Gilts without a fresh catalyst like accelerating growth or monetary easing. Yet the combination of accommodative monetary policy with a solid credit backdrop leads us to maintain a neutral recommendation on U.K. corporate debt. Chart 12U.K. Top-Down CHM:##BR##Steady Improvement Chart 13U.K. Credit: Yields & Spreads##BR##Are Drifting Higher Japan Corporate Health Monitor: A Small, But Very Healthy, Market We introduced our Japan CHM in a recent Weekly Report.4 We only have a bottom-up version of the indicator at the moment, as there is not the same consistency of top-down data sources as are available in other countries. Furthermore, the Japanese corporate bond market is small, as companies have historically chosen to borrow money (when needed) through bank loans and not bond issuance. This means that we have a much more limited amount of data available with which to build a Japan CHM, which covers only 43 companies and only goes back to 2006. The Japan CHM has been in "improving health" territory for the past decade, driven by very healthy liquidity levels and rising return on capital and interest coverage (Chart 14). While the trend in the latter two ratios differs from what is shown in all CHMs for other countries, it is noteworthy that Japan's return on capital has risen to a "high" level (6%) that is similar to the current historically low levels in the U.S. and Europe. The comparison is even less flattering when looking at profit margins, which have been steadily improving over the past five years but are only around 6% - less than half the levels seen in the bottom-up IG CHMs for the U.S. and Europe. Turning to the corporate spread, it has slightly widened in 2018, but by a far smaller amount than seen in other corporate bond markets (Chart 15). We have shown that Japanese corporate spreads are highly correlated to the level of the yen. The direct effect is obvious, as a stronger yen will hurt the competitiveness and profitability of the exporter-heavy Japanese non-financial corporate sector. Yet a strong yen is also a reflection of the market's belief in the next move by the BoJ with regards to Japanese monetary policy. On the front, we continue to expect the BoJ to maintain a very dovish policy stance, with no change in the central bank's interest rate targets (both for short-term interest rates and the 10yr JGB yield). The bigger issue will be if the current softness in the Japanese economic data turns into a broader trend, which would damage corporate profits and likely result in some widening of Japanese credit spreads.  Chart 14Japan Bottom-Up CHM:##BR##Very Healthy Chart 15Japanese Corporates##BR##Will Continue To Outperform JGBs Canada Corporate Health Monitor: In Good Shape On A Cyclical Basis In this CHM Chartbook, we are introducing new CHMs for Canada. Like Japan, this is another relatively small market. Canadian corporates represent a slightly larger share of the Bloomberg Barclays Global Investment Grade Corporate Bond Index (5%) than Japan (3%). The average credit rating of the Canadian corporate bond index is A2/A3, which is higher quality than that of the U.S. IG index with but with similar credit spreads over their respective government bonds. However, due to the lack of liquidity and market accessibility, Canadian corporates are considered a niche market that has not gained much attention from global investors. We created both a top-down and bottom-up version of the Canada CHM. For the bottom-up CHM, we gathered data on 85 companies from both the Bloomberg Canadian dollar-denominated IG and HY indices. We combined IG and HY bonds into one set of data given the small sample sizes of each category, which also allows us to compare it to the top-down Canadian CHM that does not distinguish by credit quality. Both Canadian CHMs are firmly in the "improving health" territory (Chart 16). Unsurprisingly, these CHMs have shown a reasonably strong correlation to oil prices, which are a key driver of the Canadian economy through the energy sector. This can be seen in the deterioration in the CHMs after global oil prices collapsed in 2014/15, and the subsequent improvement as oil prices have recovered over the past couple of years. Going through the individual CHM components, leverage has been steadily rising and currently sits around 100%. While Canada's problems with high household debt levels are well known, the Bank for International Settlements (BIS) noted in its March 2018 Quarterly Review that high Canadian corporate leverage could also pose a future problem for the Canadian economy.5 Among the other CHM ratios, return on capital and profit margin have fallen for nearly a decade, although there has been some moderate improvement of late thanks to higher oil prices. Debt coverage and interest coverage are also showing some very moderate recovery due to low interest rates - a trend also observed in other countries where central banks have maintained easy monetary policy. Canadian corporate bond valuations are not cheap at the moment, with the index spread around decade-lows of 100bps (Chart 17). BCA's commodity strategists expect global oil prices to continue climbing over the next year, which should support Canadian corporate valuations versus government bonds given past correlations. We also expect the Bank of Canada to continue to slowly raise interest rates over the next year, as well, mimicking moves we also anticipate from the U.S. Federal Reserve. Given the cyclical signs of improving corporate health from our Canadian CHMs, and our bearish views on Canadian government bonds, we are upgrading our recommended allocation on Canadian corporates to overweight while downgrading governments. This is strictly a carry trade, however, as we do not anticipate spreads narrowing much from current levels. Chart 16Canada CHMs:##BR##Cyclical Improvements, Structural Problems Chart 17Canadian Corporates:##BR##No Cyclical Case For Spread Widening Yet Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.6 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Table 1Definitions Of Ratios##BR##That Go Into The CHMs Appendix Chart 1We Now Have CHM Coverage For 92% Of##BR##The Developed Market Corporate Bond Universe 1 http://lipperalpha.financial.thomsonreuters.com/2018/04/high-yield-bond-funds-attract-investor-attention/ 2 The majority of data used in the top-down U.S. CHM comes from the Federal Reserve's quarterly Financial Accounts Of The United States Z1 release (formerly known as the Flow of Funds), which is typically published in the third month following the end of a quarter. Thus, those data inputs for Q1/2018 will not be available until June. 3 Please see Section II of the March 2018 edition of The Bank Credit Analyst, available at bca.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 5 https://www.bis.org/publ/qtrpdf/r_qt1803.htm 6 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, Alongside this week's report we are also sending you a fascinating short Special Report written by Jennifer Lacombe of our Global ETF Strategy sister service. The report, which demonstrates the use of ETF flows as a leading indicator of FX trends, points to downside for the EUR/USD and GBP/USD this year. I trust you find the piece informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A debate over slack is raging within the ECB. We tend to side with President Draghi, and believe there is more labor market slack in the euro area than suggested by the OECD's measures. Arguing in favor of this case is the presence of hidden labor market slack, the paucity of wage gains, even in Germany, and the potential for NAIRU to decline in many large economies. With global and European growth slowing, this will limit how hawkish the ECB can be in the short term, and thus limits the euro's gains in 2018. However, on a long-term basis, the presence of slack today argues that the euro area's potential GDP is higher than if there were no slack, and therefore policy rates and the euro have more long-term upside. Feature The recent release of the European Central Bank's account of its March policy meeting was very revealing. The ECB is currently torn between two camps: one believing there is little slack in the euro area labor market, and the other, led by ECB President Mario Draghi and chief economist Peter Praet, arguing that the continent's job market is still replete with excess capacity. This debate has enormous implications for the path of the euro. If there is no slack left in the euro area, this would point to an immediate need for higher rates and a higher euro, but it would also suggest the scope for the terminal policy rate in Europe to rise is limited. The long-term upside in the euro would therefore also be small. If there is still a large amount of slack in the euro area labor market, this implies that policy rates do not have much scope to rise over the next 18 months, and that the euro will find it difficult to appreciate much over this time frame. However, it also suggests that the potential growth rate of the euro area is higher than would otherwise be the case and that terminal policy rates can rise more in the long-run - implying that on a long-term basis the euro still has meaningful upside. We side in the latter camp. Chart I-1No Slack In Europe? Hidden Labor Market Slack... The question of slack in the euro area has been ignited by a simple reality: both the OECD's measure of the European output gap and the difference between the official unemployment rate and the equilibrium unemployment rate calculated by the OECD (NAIRU) are close to zero (Chart I-1). This observation would vindicate the desire of some ECB members to increase rates sooner than later, since the absence of an unemployment gap should lead to both higher wages and higher inflation. But before making too prompt a judgment, the U.S.'s recent experience is illuminating. Only now that the unemployment rate is 0.5% below NAIRU are U.S. wages and core inflation showing some signs of life (Chart I-2). In the U.S., we observed that while the headline unemployment rate has been consistent with accelerating wages as early as in 2015, discouraged workers back then represented 0.4% of the working age population, and were in fact willing participants in the job market. Only now that this number has fallen back to 0.27% - levels associated with full-employment in the previous business cycle - are employment costs perking up. There is little reason to believe that the eurozone economy is very different from the U.S. in this respect. In fact, the euro area suffered a double-dip recession, the second leg of which ended only in 2013, suggesting Europe suffered a severe enough shock to also fall victim to the symptoms of hidden labor market slack. A simple comparison helps illustrates that Europe is likely to still be experiencing labor market slack. Chart I-3 shows various measures of total and hidden labor market slack in the U.S. and the euro area. To begin with, despite a sharp rise in the female participation rate, the euro area's employment-to-population ratio for prime-age workers is not only well below the level that currently prevails in the U.S., it is also below its 2008 peak by a greater extent than is the case on the other side of the Atlantic. This suggests there is greater total labor market slack in Europe than in the U.S. Additionally, discouraged workers and long-term unemployment remain much closer to post-crisis highs in the euro area than in the U.S. In the latter, these ratios have mostly normalized close to levels consistent with full employment. Chart I-2The U.S. Experience WIth##br## Hidden Labor Market Slack Chart I-3The Euro Area Still Has ##br##Plenty Hidden Slack Looking at some euro area-specific variables also dispels the idea that the European job market is near full employment and about to generate inflation: The ECB's labor underutilization measure1 still shows a high level of slack, especially in the European periphery (Chart I-4). Another problem for Europe is irregular work contracts. Europe, like Japan, is plagued with a dual labor market. On one hand, permanent employees are still protected by generous employment laws. On the other hand, employees under temporary work contracts are not. In Japan, this same disparity has been blamed for keeping wages down, as temporary employees are often willing to switch to positions offering the protection of regular job contracts for no wage increases. These workers are a form of hidden labor-market slack. Temporary employment in Europe remains at elevated levels, and contract work represents a record share of employment in Italy and France (Chart I-5), suggesting the same disease present in Japan also lingers in vast swaths of the European economy. Chart I-4The ECB's Metrics Also Show ##br##Elevated Labor Underutilization Chart I-5A Dual Labor Market Weighs ##br##On Wage Growth Labor reforms could also be creating labor market slack in Europe. As Chart I-6 shows, after Germany implemented its Hartz IV labor reforms in 2004, NAIRU collapsed. Spain, which has implemented equally draconian measures, could also witness its own equilibrium unemployment rate trend sharply lower over the coming years (Chart I-6, bottom panel). In France, timid reforms were implemented during the Hollande presidency, but President Macron is pushing an agenda of deep job market reforms. While Italy remains a laggard and its current political miasma offers little hope, the reality remains that much of Europe could also be experiencing a decline in NAIRU like Germany did last decade. Even Germany shows limited signs of an overheating labor market, despite an unemployment rate of 5.3%, the lowest reading ever in re-unified Germany: not only have German wages been unable to advance at a faster pace than the experience of the past 15 years, recent quarters have seen a slowdown in wage growth (Chart I-7). The presence of slack in the rest of Europe therefore appears to be limiting wage pressures even in that booming economy. Chart I-6The Impact Of Labor Reforms##br## On Full Employment Chart I-7No Wage Growth##br## In Germany Bottom Line: The euro area is likely to be under the same spell as the U.S. was a few years ago. Traditional metrics portend a labor market at full employment, but broader measures in fact highlight that there is still plentiful slack. Additionally, the implementation of labor market reforms in key European economies in recent years could imply that Europe's NAIRU is lower than the OECD's estimate and may further decline in coming years. ... And Slowing Global Growth It is one thing for Europe to be experiencing hidden labor market slack, but if growth is set to accelerate further, this would mean that this slack could nonetheless dissipate fast enough to allow for a more hawkish ECB in the short run. However, this is not the case. The European economy is very sensitive to global growth gyrations, and signs are accumulating that the global synchronized boom is petering out. As we have already highlighted, the diffusion index of the OECD global leading economic indicator has plummeted well below the boom/bust line, pointing to a sharp slowdown in the LEI itself (Chart I-8, top panel). EM carry trades have been underperforming, which normally leads a slowdown in global industrial activity (Chart I-8, middle panel). Additionally, Japanese export growth is decelerating sharply (Chart I-8, bottom panel). In a previous report we attributed major responsibility for this slowdown to monetary, fiscal and regulatory tightening in China. Europe is not immune to this malaise. European exports growth and foreign orders are all slowing sharply, but interestingly domestic factors are also at play. As the top panel of Chart I-9 illustrates, the European credit impulse is now contracting, suggesting domestic demand is set to slow. In fact, this has already begun as the growth of German domestic manufacturing orders is in negative territory (Chart 9, bottom panel). Chart I-8Global Growth Is Slowing Clouds##br## Hanging Over Global Growth Chart I-9Euro Area Domestic##br## Growth Is Flagging No matter the source, the end result for Europe is the same: the torrid pace of European growth is set to slow, not accelerate. Not only have European economic surprises fallen precipitously (Chart I-10, top panel), but the Ifo survey - a key bellwether of German activity - has also peaked. Moreover, the Sentix survey points to a sharp slowdown in the manufacturing PMIs (Chart I-10, bottom panel). Because there is slack in the European economy and growth is set to slow, there is a good reason for the Draghi-led ECB to remain very cautious in the coming quarters before sounding hawkish. As a result, the euro faces strong headwinds over the next six months or so, especially as the Federal Reserve faces milder handicaps than the ECB: U.S. economic slack has dissipated and U.S. inflation is rising. These inflationary pressures could even intensify thanks to U.S. President Donald Trump's late-cycle fiscal stimulus. Relative growth dynamics also support the dollar this year as euro area industrial production is already lagging behind the U.S. (Chart I-11). This trend is set to continue for the coming quarters because the U.S. economy is less exposed to a global growth slowdown and U.S. households' are experiencing sharply accelerating disposable income growth, a support for domestic demand. Chart I-10Weakening European ##br##Growth Outlook Chart I-11European Growth Will ##br##Underperform The U.S. Further Bottom Line: Not only is there still slack in the euro area labor market, global growth is showing signs of a slowdown. This is likely to have a deleterious impact on European growth as the eurozone credit impulse is already contracting. As a result, European growth is likely to lag that of the U.S., an economy where there is no more slack, and where inflation is perking up. This combination represents a potent headwind for the euro over the next six months or so. The Euro Cyclical Bull Market Is Far From Over The combination of slowing global growth and labor market slack in the euro area suggests the euro may depreciate by six to eight cents over the next six months, but it does not sound the death knell of the euro's cyclical rally. To the contrary, the presence of slack in Europe suggests the euro still has significant cyclical upside. Historically, the euro performs well when the U.S. business cycle enters the last two years of expansion (Chart I-12). This is because European growth begins to outperform U.S. growth in the late stages of the economic cycle, allowing investors to upgrade their assessment of the path of long-term monetary policy in the euro area relative to the U.S. This time an additional impetus could emerge. If there is more slack in the euro area than traditional unemployment metrics imply, the euro area's potential GDP is also higher than these traditional metrics would submit - i.e. trend growth in Europe could be higher than once thought. The impact of labor market reforms in France and Spain further bolster this possibility. A consequence of a higher trend growth rate would also be a higher than originally assessed level for euro area neutral interest rates, or the so-called r-star. The European five-year forward 1-month OIS could therefore have significant upside from current levels (Chart I-13, top panel). This would also imply that expected rates in Europe have room to increase versus the U.S., lifting the euro in the process (Chart I-13, bottom panel). Chart I-12The Euro Rallies Late##br## In The Business Cycle Chart I-13European Slack Today Means ##br##Higher Rates Tomorrow Bottom Line: The presence of slack in Europe suggests that its potential GDP is higher than once thought. Hence, Europe could still have a few more years of robust growth in front of her. The following paradox ensues: if the presence of slack limits the upside for European interest rates today, it also suggests that European policy rates can rise much more in the future than if there was no slack today. Therefore, while this limits the capacity of the euro to rise further this year, the euro cyclical bull market has much more upside than if there was no slack in Europe today. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This underutilization measure is based on the number of unemployed and underemployed, those available to work but not seeking a job and those seeking a job but not available for one. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was decent: Retail sales ex. Autos increased at a 0.2% monthly pace, in line with expectations; Housing starts and building permits both beat expectations, coming in at 1.319 million and 1.354 million, respectively; Industrial production grew by 0.5% at a monthly pace, beating expectations; Capacity utilization also increased to 78%; Continuing and initial jobless claims both came out higher than expected; U.S. data continues to generally beat expectations, especially when contrasted with European data, representing a sharp reversal from last year's environment. The yield curve has flattened which has weighed on the greenback preventing the USD from rallying despite an outperforming U.S. economy. Report Links: U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data has been disappointing: German Wholesale price index increased by only 1.2%, less than the expected 1.5%; European industrial production grew at a 2.9% yearly pace, less than expectations of 3.8%; The ZEW Economic Sentiment and Current Situation Survey for Germany disappointed; European headline inflation disappointed, coming in at 1.3%, while core was in line with expectations of 1%. Signs of a slowdown are now emerging in European data, however the euro has yet to follow. The euro area's leading economic indicator is rolling over, suggesting that cyclical factors could drag the euro down in the coming months. The waning of inflationary pressures across the euro area is likely prompt a dovish tone in upcoming ECB communications, which will induce a downward revision in rate expectations by investors. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Exports yearly growth underperformed expectations, coming in at 2.1%. Moreover, imports yearly growth also surprised to the downside, coming in at -0.6%. Finally industrial production yearly growth also disappointed, coming in at 1.6%. USD/JPY has remained relatively flat this week. Overall, we expect that the yen will continue to appreciate, as global geopolitical risks are on the rise and a potential slowdown in China's growth could will likely lead to a pick-up in FX market volatility. On the other hand, the yen remains at risk in the long term, given that economic data continues to underperform due to the strong yen and Japan's great exposure to global growth. This means that the BoJ will have to keep policy easy in order to support the economy. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Headline inflation underperformed expectations, coming in at 2.5%. Moreover, core inflation also surprised negatively, coming in at 2.3%. Retail prices yearly growth also underperformed, coming in at 3.3%. However, the ILO unemployment rate surprised positively, coming in at 4.2%. After being up nearly 1.4% this week, GBP/USD fell more than a percentage point following the disappointing inflation numbers. Overall, the data follows our prediction from a couple of weeks ago: inflation in the U.K. is set to decline substantially despite a tightening labor market. This is because inflation in the U.K. is mainly driven by previous currency movements. Therefore, given the steep appreciation of the pound since 2017, prices will likely fall, causing the hawkishly-priced BOE to tighten less than expected, hurting the pound in the process. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Aussie has traded in a wave pattern against the greenback since the beginning of 2016. This week, AUD once again rebounded off the trough of the wave, catalyzed by higher prices in the metals space. Recent announcements by Anglo-Australian group BHP Billiton about curtailing production forecasts provided a boost to iron ore prices. This was coupled with the PBOC's decision to cut banks' reserve requirements which is raising the specter of a potential reflation wave in China. While, for now, external factors are proving to be positive for the Antipodean economy and its currency, the domestic story remains the same: labor market slack, high debt loads, and not enough wage inflation. Recent employment figures confirm this reality: employment grew by only 4,900, driven by a decline in full-time employment of 19,900. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The food price index month-on-month growth came in at 1%. Meanwhile, headline inflation came in at 1.1%, in line with expectations. NZD/USD has fallen by nearly 1.3% this week. Overall, we expect that the NZD will suffer in the current environment of rising volatility and geopolitical risks. Moreover, on a long term basis, the kiwi continues to be at risk, given that the new populist government is set to decrease immigration and implement a dual mandate for the RBNZ; both factors would lower the real neutral rate. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 This year's disappointing first quarter GDP growth of 1.7% QoQ growth was regarded as an important factor in the BoC's decision this week to hold interest rates unchanged. The statement recognized the weaker housing market and flailing exports as the two culprits in this development. Bank officials denoted the tight capacity utilization as a constraint to further export growth, stating that growth will not be sufficient "to recover the ground lost during recent quarters". While this was an overall dovish policy statement, the Bank still continues to see robust growth going forward, revising their 2019 growth forecast from 1.6% to 2.1%. Importantly, this revision widened the output gap as the potential growth rate was revised higher. In terms of monetary policy, investors still predict two more rate hikes this year, bringing the benchmark rate to 1.75%, which is still below the Bank's estimated neutral rate of 2.5% - 3.5%. This means that if NAFTA is not abrogated in any major way - our base case scenario for the current negotiations - there is still plenty of upside for Canadian rates, and therefore, the CAD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has gone up by 1% this week. Overall, we continue to believe that the franc will continue to depreciate on a cyclical basis, given that Swiss inflationary pressures remain too weak and economic activity is still highly dependent on the easy monetary conditions brought about by the weak franc and low rates. Therefore, the SNB will remain very dovishly enclined in order to keep an appreciating franc from hurting the economy. Moreover, the Swiss franc continues to be expensive, putting further downward pressure on this currency. On a tactical basis however, this cross could have some downside in an environment of rising volatility and rising geopolitical risk. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week. We continue to be negative on the krone against the U.S. dollar, even in an environment of rising oil prices. This is because this cross is more correlated to real rate differential than it is to crude. Therefore, in an environment where the Fed hikes more than expected, real rates should move in favor of the U.S., helping USD/NOK in the process. That being said, the krone will likely outperform other commodity currencies like the AUD, as oil has a relatively lower beta than industrial metals to global growth and Chinese economic activity. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 A slight economic slowdown is still being felt in the Scandinavian economy. As leading economic indicators in both Sweden and the euro area roll over, disinflationary winds continue to batter Swedish shores. As a result, EUR/SEK continues to trade at lofty levels, especially as global investors remain nervous about the risks of a global trade war. The Swedish yield curve has flattened 53 bps since January highs, which is one of the most severe moves in the G-10. It seems that Stefan Ingves' extreme dovishness is again being taken seriously by investors, especially as core CPI is at a mere 1.5%, despite CPIF clocking in at 2%. This core measure and global reflation will need to pick up for Ingves to change his view. While the SEK is cheap, and thus have limited downside from current levels, this economic backdrop suggests it is still risky for short-term investors to buy the SEK. Long-term players, however, should use current weaknesses as a buying opportunity. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights EUR/USD will eventually drift up to the ECB calculated equilibrium range of 1.30-1.35. Tactical short NOK/AUD. Tactical long SEK/GBP. On a six month horizon, stay underweight Basic Materials and Financials and own some government bonds. The overall equity market will lack any sustained direction. Sell any sharp rallies and buy any sharp dips. Feature We have seen the shape of things to come. Norway has just lowered its inflation target from 2.5 to 2.0 per cent. This follows years of failure to achieve the higher target (Chart of the Week). More important, Norway's Royal Decree on Monetary Policy emphasizes flexibility: Inflation targeting shall be forward-looking and flexible so that it can contribute to high and stable output and employment and to counteracting the build-up of financial imbalances. Norway follows hot on the heels of Sweden. Last September, the Riksbank also added flexibility to its inflation mandate. The inflation target remains 2 per cent but the central bank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." We applaud the Riksbank for its honesty, but we would go a step further. It is near impossible to sustain an arbitrary point target, like 2 per cent (Chart I-2). Chart of the WeekNorway Has Given Up On##br## Its 2.5% Inflation Target Chart I-2Sweden Has Also Struggled To ##br##Achieve Its Inflation Target One Per Cent And Two Per Cent Are Indistinguishable In 1979, Daniel Kahneman and Amos Tversky formalized a new branch of behavioural finance called Prospect Theory, which would ultimately win Kahneman the Nobel Prize for Economics. One of the key findings of Prospect Theory is that the human brain is incapable of distinguishing between very small numbers. In the case of inflation, very few people can really distinguish between an inflation rate of, say, 1 per cent and a rate of 2 per cent. For most people, anything within a range of around 0-2 per cent is indistinguishably perceived as 'negligible inflation'. Since prices rising at 1 per cent or 2 per cent are indistinguishable to most people, Prospect Theory finds that it is near impossible for monetary policy to fine tune inflation expectations - and therefore inflation itself - to a point-target like 2 per cent (Chart I-3). Chart I-3Mission Impossible: 2% Inflation The good news - as we are seeing in Scandinavia - is that central banks are creating, or already have in place, a degree of flexibility and tolerance in their inflation mandates: the Swiss National Bank targets an inflation range of 0-2 per cent; the BoE has a variation band of 1-3 per cent; the Fed has a dual mandate of price stability and maximizing employment;1 New Zealand's government recently asked its Reserve Bank to balance its inflation goal with another aimed at employment; and the BoJ keeps extending the timeframe which it needs to achieve 2 per cent inflation. One of the original reasons for the 2 per cent inflation target has disappeared. To counter a recession, central banks wanted the freedom to take real interest rates to around -2 per cent. With the lower bound of nominal interest rates thought to be zero, this implied an inflation target of 2 per cent. However, we now know that the lower bound of nominal rates is not zero, it is somewhere close to -1 per cent. On this basis, the 2 per cent inflation target should become 1 per cent. All of which makes the ECB's fixation on a 2 per cent point-target for inflation look positively antediluvian. The ECB treaty defines 'price stability' as its single mandate, but the precise definition of price stability is up to the central bank. Given the powerful findings of Prospect Theory, and the general direction of travel of all the other central banks, it is only a matter of time before the ECB interprets or creates more flexibility in its mandate too. Small Differences In Central Bank Mandates Amplify To Huge Moves In Currencies Are we just splitting hairs in pointing out small differences in central bank mandates? No, Prospect Theory finds that people cannot distinguish between inflation rates within a 0-2 per cent range. Yet, for central banks, there can be a huge difference between 0 per cent, 1 per cent and 2 per cent. Hence, within this range, small differences in central bank mandates and definitions of inflation can amplify to huge differences in monetary policies. As we highlighted last week in Where President Trump Is Right About Europe, core consumer prices in the euro area and the U.S. - measured on a like-for-like basis - have increased at a near identical rate over the long term (Chart I-4) and the short term.2 In the euro area, consumer prices exclude the consumption costs of owner-occupied housing; in the U.S. they include it. But both can't be right. Either owner-occupied housing should be excluded from the price basket, and U.S. inflation is running lower than we think; or owner-occupied housing should be included, and euro area inflation is running higher than we think. In 2014, like-for-like inflation was running at exactly the same rate in the two economies (Chart I-5). Yet the small differences in central bank mandates and definitions of inflation led to diametrically opposite policies: ultra-accommodation from the ECB and tightening from the Fed. The upshot is that the EUR/USD exchange rate has seen huge swings: from 1.39 to 1.03 and then back up to 1.24 today. To repeat, like-for-like inflation was not, and is not, that different. Which makes the huge moves in the currency markets highly undesirable and highly unnecessary (Chart I-6). Chart I-4The Euro Area And U.S. Have Experienced ##br##The Same Like-For-Like Core CPI Inflation Chart I-5In 2014, The Euro Area And U.S. Had The ##br##Same Like-For-Like Core CPI Inflation... Chart I-6...Yet Monetary Policy Went In Opposite ##br##Directions And EUR/USD Had Huge Swings In the medium term, we expect the ECB will have no choice but to interpret or create more flexibility in its price stability mandate. If the ECB reaction function becomes less differentiated from its peers, EUR/USD will eventually drift up to the ECB calculated equilibrium range of 1.30-1.35. Returning to Norway, the recent rally in the NOK is overdone. Lowering the inflation target from 2.5 per cent to 2.0 per cent does create the scope for tighter (or at least, less loose) policy than was previously expected. But our tried and tested indicator of excessive groupthink suggests that the currency may have overpriced the pace of change (Chart I-7). Play this through a tactical short in NOK/AUD. Chart I-7The Recent Rally In The NOK Is Overdone In Sweden, the same indicator of excessive groupthink suggests that the recent sell-off in the SEK is also overdone (see page 7). Play this through a tactical long in SEK/GBP. Distinguish Catalysts From Causes Finally, a quick comment on the equity market's struggles this year. To explain these struggles, it would be easy to fixate on the news stories that are dominating the international headlines. But it is always important to distinguish catalysts from causes. When a tree loses its foliage in the autumn, a day of strong winds is the catalyst, it is not the cause. The underlying cause is that the autumn leaves are fragile and due to fall anyway. Likewise, for the market's struggles, trade war skirmishes and missile attacks in Syria are simply catalysts, they are not the cause. The underlying cause is that risk-assets were fragile and due a setback. On price to sales, world equities are as highly valued as at the peak of the dot com bubble (Chart I-8). Meanwhile, global economic growth has entered a mini-deceleration phase which we expect to continue at least into the summer months. In such mini-downswings, bond yields tend to be capped, or even trace down. And cyclical sectors such as Basic Materials and Financials always underperform (Chart I-9). Therefore, on a six-month horizon, own some government bonds and stay underweight Basic Materials and Financials. Chart I-8World Equities As Highly Valued As ##br##At The Peak Of The Dot Com Bubble... Chart I-9...And Global Growth Is Entering##br## A Mini-Downswing The overall equity market will meet both resistance and support. A mini-deceleration in growth implies downside to economic surprises. Against this, if bond yields stabilise or trace down, it will underpin all valuations. Taken together, this suggests that the overall equity market will lack any sustained direction. Sell any sharp rallies and buy any sharp dips. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Some people even argue that the Fed has a triple mandate which includes financial stability. 2 Please see the European Investment Strategy Weekly Report 'Where President Trump Is Right About Europe' April 12, 2018 available at eis.bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's trade recommendation is long SEK/GBP. The profit target is 3% with a symmetrical 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 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights U.S. Treasury Curve: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation expectations and longer-term Treasury yields in the next 3-6 months. UST-Bund Spread Update: Stay in our recommended 10yr UST-Bund spread widening trade. as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. Global IG Corporate Sector Allocation: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. Feature The unpredictable, and at times unruly, behavior of financial markets over the first few months of 2018 has been exhausting for investors. A calm January was followed by the early February volatility spike and, more recently, huge intraday swings based on the ebb and flow of news on U.S. trade and foreign policy. Yet when looking at the year-to-date returns for various asset classes, the numbers do not seem unusually alarming given the amount of surrounding noise. Chart of the WeekA Long Road Back From The VIX Spike The S&P 500 index is only down -0.7%, while both equities in both the euro area and emerging markets (EM) equities are up +1.8% and +1.1%, respectively (using MSCI data in U.S. dollar terms). Credit markets are also delivering rather boring performance so far in 2018, from U.S. high-yield (+1.2% excess return over government debt) to euro area investment grade and EM hard currency corporates (both with an -0.1% excess return in U.S. dollar terms). Admittedly, these numbers look far less flattering considering the robust rally in risk assets in January. Yet the year-to-date returns simply do not line up with our impression of how investors' feel about how this year has gone so far. The perception is much gloomier than the actual outcome. Right now, markets are looking for guidance and direction and finding little of both. A big problem is that global bond yields, most notably in the U.S., have not fallen much from the highs for the year - even with global growth clearly losing some steam in the first quarter of 2018. The reason? Global inflation is in a mild cyclical upswing, a product of persistently tight labor markets and rising oil prices (Chart of the Week). The "leadership" in government bond markets has shifted away from accelerating global growth and an upward repricing of future central bank tightening, to rising inflation and unchanged monetary policy expectations. The notion of central bankers not being friendly to the markets remains our key theme for this year. We continue to expect that policymakers will not respond to the latest softer patch of economic data and will focus more on the reacceleration of inflation. This is especially true with risk assets stabilizing and volatility measures like the U.S. VIX index continuing to drift lower and, more importantly, the "volatility of volatility" (as measured by the VVIX index) now back to the levels that prevailed before the early February volatility spike (bottom panel). Although as BCA's strategists discussed at our View Meeting yesterday, volatility can quickly return with a vengeance given softer global growth momentum, and with the geopolitical calendar heating up next month (the U.S. government must make its final decision on the China trade tariffs and investment restrictions).1 This led the group to downgrade our recommended global equity exposure and upgrade our global bond exposure on a tactical (0-3 months) basis, although our more medium-term cyclical allocations (6-12 months) were unchanged (overweight stocks versus bonds). From the point of view of global bond markets, we may now be in period of mild "stagflation" with softening growth and rising inflation. We remain of the view that the former is temporary and the latter is not. This backdrop will keep global bond yields under upward pressure for at least the next few months, with better expected performance of corporate debt over governments - albeit with the potential for higher volatility given more elevated geopolitical risks. What Next For The U.S. Treasury Curve? The Treasury curve flattened to a new cyclical low last week, with the spread between 2-year and 10-year bonds now sitting at 45bps. On the surface, this flattening seems consistent with a Fed that is maintaining a "cautiously hawkish" message and that its rate hike plans for 2018 are unchanged despite more volatile financial markets. Chart 2This UST Curve Flattening Is Different What makes this current episode different from other bouts of Treasury curve flattening over the past five years, however, is the starting point for the absolute of bond yields. According to our two-factor valuation model for the 10-year Treasury yield, yields are now just a touch above fair value, which is currently 2.78%. That yield valuation was at least +25bps before the previous flattening episodes between 2014 and 2017 (Chart 2). That distinction is critical in differentiating a bull flattener from a bear flattener. Simply put, longer-dated Treasuries are not yet cheap enough to suggest that investors should extend duration risk to benefit from any additional curve flattening from here. In fact, we see a greater risk that Treasury curve re-steepens a bit from here, as there is more room for longer-term inflation expectations to move higher than there is for the front-end of the curve to reprice an even more hawkish Fed. The recent softening of cyclical global economic data has been occurring while realized inflation rates have been slowly rising from depressed levels (Chart 3). Yet in the U.S., the slowing of growth seen in the first quarter of the year remains very modest compared to that seen in Europe or Japan, while core inflation rates (for both the CPI index and the PCE deflator) have accelerated back to 2%. The Atlanta Fed's GDPNow forecasting model is calling for Q1/2018 growth of 1.9%, while the New York Fed's Nowcast model is predicting Q1 growth of 2.8%. While both forecasts are a deceleration from the 3% rates seen in the previous three quarters in 2017, neither is below U.S. potential GDP growth, which the U.S. Congressional Budget Office now estimates to be 1.9%. Even in China, where the economy had been slowing as policymakers have aimed to tighten monetary policy and slow credit growth, cyclical indicators such as the Li Keqiang index (the preferred indicator of our China strategists) have shown a bit of a rebound of late. Right now, underlying U.S. growth and inflation momentum are still pointing towards the Fed delivering on its current projection of an additional 50bps of rate hikes in 2018, taking the funds rate to 2.25%, with even a chance of an additional hike if inflation continues to accelerate. This is essentially fully priced with a 2-year Treasury yield just under 2.4%, however, and the real funds rate is now at neutral according to measures like the Fed's r-star. Therefore, additional flattening pressures from the front end of the curve are unlikely unless the Fed is willing to signal a faster pace of rate hikes than currently laid out in its economic projections (the "dots"). At the same time, the 10-year TIPS inflation breakeven remains 25-35bps below the 2.4-2.5% range that would be consistent with the market expecting U.S. inflation to sustainably return to the Fed's 2% inflation target on the headline PCE deflator. Hence, a steeper Treasury curve is far more likely than a flatter Treasury curve from current levels. Where could this view go wrong? Perhaps the Trump administration's trade skirmishes with China could broaden into a full-on trade war that could cause deeper damage to U.S. equities, dampen growth expectations and drive longer-term yields lower. Coming at a time when there is a significant short position in the U.S. Treasury market, this could look similar to the prolonged bull-flattening seen in 2015-16. During that episode, duration exposure flipped from a big net short to very net long according to measures like the J.P. Morgan Duration Survey (Chart 4, top panel), while the market priced out all expected Fed rate hikes (2nd panel). However, that also occurred alongside a 50bp decline in inflation expectations (3rd panel) and a big deceleration of U.S. growth (bottom panel), both related to a weakening global economy and collapsing oil prices. It is uncertain if the current U.S.-China trade skirmish would have an equivalent impact on both the U.S. economy and the Treasury curve, especially given a starting point of stronger global growth a far more positive demand/supply balance in world oil markets. Chart 3A Whiff Of Stagflation? Chart 42018 Is Not 2015/16 In sum, we are sticking to our view that the Treasury curve is more likely to bear-steepen through higher longer-term yields than flatten bearishly through more discounted Fed hikes or flatten bullishly through much weaker growth and inflation. We continue to recommend a below-benchmark duration stance in the U.S., within an underweight allocation in a currency-hedged global government bond portfolio. We are also are sticking with our tactical trade of staying short the 10-year U.S. Treasury versus the 10-year German Bund, even with the spread now looking a bit too wide on our fundamentals-based valuation model (Chart 5). The unrelenting string of disappointing economic data in the euro area has already resulted in a far more cautious tone from European Central Bank (ECB) officials regarding the potential for quick rate hikes after the expected end of the asset purchase program at the end of this year. The gap between the U.S. and euro area data surprise indices has proven to be a good directional indicator for the Treasury-Bund spread (Chart 6, bottom panel). Given our views on the potential for renewed bear-steepening in the Treasury curve, which is unlikely to be matched in the German curve in the next 3-6 months, we see no reason to take profits yet on our spread trade. Chart 5UST-Bund Spread Now A Bit Too Wide... Chart 6...But Too Soon For Spread Tightening Bottom Line: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation and longer-term Treasury yields in the next 3-6 months. Stay in our recommended 10-year Treasury-Bund spread widening trade, as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. A Brief (And Belated) Performance Update For Our Corporate Bond Sector Allocations It has been some time (August 2017) since we last published a performance update for our investment grade (IG) corporate sector allocations for the U.S., euro area and U.K. As a reminder, those allocations come from our relative value model, which is designed to measure the valuation of each individual sector compared to the overall Barclays Bloomberg corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all the other sectors in each region, as a function of the sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and the fair value OAS is our valuation metric from the model for each region. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 14. We also show the duration-times-spread (DTS) for each sector in those tables, using that as our primary way to measure the volatility of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. Chart 7Performance Of Our IG Sector Allocations We then apply individual sector weights based on the model output and our desired level of overall spread risk that we wish to take in our recommended credit portfolio. At our last update in August 2017, we made a decision to keep the overall (weighted) DTS of our sector tilts roughly equal to the overall IG corporate DTS for each region. With credit spreads looking tight at the time, credit spread curves flat relative to history, and with the Fed in the midst of a tightening cycle, we did not see a case for taking aggressive spread risk (i.e. having a high aggregate DTS) in the portfolio. The performance of our latest sector recommendations since our last update in August 2017, and in the first quarter of 2018, are shown in Chart 7. We show both the total return and excess return of each sector versus duration-matched government bonds. Since that last review, our U.K. sector allocations have performed the best, delivering an additional 12bps of total return and 10bps of excess return versus the U.K. IG corporate index. Our euro area corporate allocations have added 2bps of total return and 3bps of excess return, while our U.S. allocations have modestly underperformed both on total return (-1bp) and excess return. We also show the performance numbers for just the first quarter of 2018 in Chart 7, and we will present the return numbers on this quarterly basis in the future as part of our regular model bond portfolio performance reviews. The sector allocations offered a modest underperformance in Q1 2018, with -5bps of total return and -8bps of excess return coming mostly from euro area and U.K. allocations. The U.S. allocations actually outperformed by +3bps on a total return basis in Q1. The return numbers for our U.S. sector allocations can be found in Table 1. Since our last update in August, the best performing sectors (in excess return terms) for our U.S. portfolio allocation were the overweights to all Energy sub-sectors (+35bps combined), Cable & Satellite (+4bps) and Banks (+4bps). Of those names, only the Independent Energy sub-sector delivered a positive excess return (+3bps) in Q1 2018. Table 1U.S. Investment Grade Performance The return numbers for our euro area sector allocations can be found in Table 2. Since our last update in August, the best performing sectors (in excess return terms) for our euro area portfolio allocation were the overweights to Financials (+35bps, coming mainly from Banks, Senior Debt and Insurance) and Integrated Energy (+13bps). Those overweights also delivered small positive excess returns (+3bps and +1bps, respectively) in Q1 2018. The return numbers for our U.K. sector allocations can be found in Table 3. Since our last update, the best performing sector (in excess return terms) was the overweight to Financials (+6bps, coming mostly from Banks). Looking ahead, credit spread curves remain very flat by historical standards (Chart 8), which suggests there is not enough spread compensation for extending credit risk to lower quality tiers. Thus, we are sticking with keeping our target DTS for our combined sector allocations equal to that of the overall IG index for each region. We will update our sector allocations in an upcoming Weekly Report. Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Chart 8Credit Quality Curves Remain Very Flat Bottom Line: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. We continue to recommend a cautious approach to sector allocation, targeting index levels of spread risk (in aggregate) in the U.S. euro area and U.K. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Appendix Appendix Chart 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The ECB admits that its policy is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. 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. It follows that the 10% undervaluation of the euro will eventually correct. And German consumer services will structurally outperform the consumer goods exporters. Feature Let's begin with some facts, which are difficult to dispute. Fact 1: The euro area is running a €400 billion trade surplus with the rest of the world, equivalent to 4% of euro area GDP. €300 billion of this surplus resides in Germany.1 Fact 2: The trade surplus is a direct result of the undervaluation of the euro (Chart of the Week). This we know, because the surplus has evolved as a perfect mirror image of the euro's undervaluation as calculated by the ECB itself. The central bank admits that the euro is undervalued by around 10%2 (Chart I-2). Chart of the WeekThe Euro Area's Huge Trade Surplus Is Due To The Undervalued Euro Chart I-2The Euro Is Undervalued By 10% Fact 3: The substantial undervaluation of the euro is the unavoidable result of the of the ECB's extreme experiment with bond buying and zero and negative interest rates. This we know, because the euro's 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 and Chart I-4). Chart I-3The Euro Is Undervalued Because Of The ##br##ECB's Ultra-Accommodative Policy Chart I-4The Euro Has Tracked Expected##br## Relative Monetary Policy Nevertheless, a reasonable riposte to facts 1-3 is that the ECB does not target the euro exchange rate. The ECB sets policy to achieve its price stability mandate, which it defines as an inflation rate of "below, but close to, 2%", the same definition as the Federal Reserve uses. Given that the ECB is further from its price stability mandate than the Fed is, the ECB has to set much more accommodative policy. And there the story might end. 2% Inflation In The Euro Area Is Different To 2% Inflation In The U.S. Except that the story has a twist. The price stability mandates of the ECB and Fed appear very similar, but they are not. The ECB mandate is much harder to achieve, because of two further facts. Fact 4: The definitions of consumer prices in the euro area and the U.S. are quite different. The euro area's Harmonized Index of Consumer Prices (HICP) excludes the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes it at a very substantial 25% weight. The omission of owner-occupied housing costs - which consistently tend to rise faster than other prices - makes it much more difficult for overall inflation to reach 2%. Indeed, excluding shelter, core inflation in the U.S. today is running at 1.2%, the same rate as in the euro area (Chart I-5 and Chart I-6). Chart I-5Core Inflation Is Higher##br## In The United States... Chart I-6...But On A Like-For-Like Basis, Core Inflation##br## Is Not Higher In The United States Fact 5: The ECB has a single mandate of price stability, whereas the Fed has a dual mandate of price stability and maximizing employment. Some people even argue that the Fed has a triple mandate which includes financial stability. The point is that for Fed policy, price stability is only one of several considerations, creating flexibility; whereas for ECB policy, price stability is the only consideration, creating inflexibility. Nevertheless, a reasonable riposte to facts 4-5 is that we must just accept that the ECB and Fed operate within different frameworks. If the ECB's framework necessitates ultra-accommodative monetary policy today, then so be it. And there the story might end. Why Should Americans Pay For European Integration? Except that the story has another twist. The ECB framework wasn't always what it is today. Fact 6: On May 8 2003, the ECB changed its definition of price stability from "inflation below 2%" to "inflation below, but close to, 2%". Thereby, the addition of three small words transformed the flexibility of a 0-2% inflation range to the inflexibility of a 2% point target. Why did the ECB change its objective and make it so much more difficult? Here is the answer, straight from the horse's mouth: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%" - Mario Draghi So there you have it - the ECB admits that it changed its objective to ease the integration burden on weaker euro area economies. The undisputed consequence is structurally easier monetary policy than would be the case without the integration burden. The ECB also admits that an unavoidable result is a structurally undervalued euro, meaning a substantial competitive advantage for the euro area versus its major trading partners, including the United States. To which President Trump might rightly ask: why should American competitiveness shoulder the burden for European integration? Trump's crosshairs may be trained on Germany, which is running the largest export surplus. But he should redirect his focus to the ECB. The majority of German export hyper-competitiveness is no fault of Germany, it is due to the structural undervaluation of the euro (Chart I-7). Moreover, while an undervalued euro benefits exporters, it hurts euro area household real incomes by raising the prices of dollar-denominated energy and food imports, whose demand is inelastic. German households are also deeply unhappy about the negligible interest on their savings. Chart I-7The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Way Forward, And Some Investment Considerations Ultra-accommodative policy was not the game changer that is sometimes claimed. The euro area's strong recovery started more than a year before the ECB even mooted its extreme accommodation. The turning point came in 2013 when euro area banks stopped aggressively de-levering their balance sheets ahead of the bank stress test (Chart I-8). Chart I-8The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering Mario Draghi admits that policy today is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The ECB has a legal obligation to achieve price stability as its sole objective, but the precise definition of price stability is up to the central bank. To reintroduce some flexibility, it has two options: 'cross-sectional' flexibility, by reintroducing an inflation target range; or 'longitudinal' flexibility by a more relaxed interpretation of the 'medium term' timeframe required to achieve its point target. Of these two options, we expect a gradual move to greater longitudinal flexibility, especially as 'medium term' is already open to considerable interpretation. This will create three structural investment opportunities. 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. It follows that the 10% undervaluation of the euro - as calculated by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually corrects, the decade-long outperformance of consumer goods exporters versus consumer services will reverse, especially in Germany (Chart I-9 and Chart I-10). Overweight German consumer services versus consumer goods exporters. Chart I-9Consumer Services Have ##br##Underperformed In Europe... Chart I-10...But Are Starting To Turn ##br##Around In Germany Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Q4 2017 at an annualised rate. 2 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* This week, we note that the rally in the Spanish 10-year government bond is extended and ripe for a countertrend reversal. Implement this as a pair-trade: short the Spanish 10-year bond, long the German 10-year bund. The profit target and symmetrical stop-loss is 1%. Lever up to increase potential return. We are also pleased to report that our short Helsinki OMX / long Eurostoxx600 trade achieved its 3% profit target and is now closed. This leaves five open trades. 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 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##Br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Trade wars have captured investors' imaginations, but slowing global growth is a more immediate risk for both asset prices and exchange rates. As reflationary forces ebb, slow global growth will help the dollar stage a rally. EUR/USD and GBP/USD could decline over the next two quarters. We are selling EUR/CHF. The AUD has more downside. It is too early to close short AUD/NZD or AUD/JPY. Short EUR/CAD with a first target at 1.44. Feature The growing trade skirmish between China and the U.S. has been blamed for much of the movements in risk assets this year. We do not deny that this has been a very important factor determining the price action of all assets globally; after all, market participants are trying to price in the probability that global supply chains as we currently know them will be forever impaired. If this were to happen, global growth and profits would suffer considerably. This warrants a risk premium, one that is currently being estimated by the market.1 As we have written in recent weeks, this will be a stop-and-go pattern, and behind-the-scene negotiations between China and the U.S. will remain intense until June, when the U.S. tariffs are in fact implemented. However, trade wars are not the only force impacting asset returns today. Global asset prices are also slowly adjusting to a world where reflation is ebbing and where growth may be dipping from its heightened state. This week, we examine the role of liquidity and how it is affecting growth,2 and the implications for various currency pairs. From Reflation To Less Growth Through most of 2016 and 2017, risk assets, EM plays, commodity prices and growth greatly benefited from a wave of global reflation implemented by monetary and fiscal authorities around the world in the wake of a market meltdown that culminated in January 2016. A great victim of this reflationary effort was the U.S. dollar. Once global growth and inflation perked up, the dollar sold off. The U.S. economy is not as levered to global growth as the rest of the world is, thus investors were attracted by greater shift in expected returns outside the U.S. than in the U.S. But how is this reflation story faring today? Global monetary policy is not as supportive as it once was as central banks are not adding to global base money as forcefully as before. For example, the Federal Reserve has begun the rundown of its balance sheet, and the real fed funds rate is closing in on the Laubach-Williams estimate of the neutral rate; the European Central Bank has begun tapering it asset purchases, the European shadow policy rate has increased by 400 basis points; and the Bank of Japan has not hit its JGB target of JPY80 trillion of purchases since mid-2016. Even the Swiss National Bank has not seen any increase in its sight deposits since mid-2017. We like to use excess money growth to measure the impact of these changes in base money growth. Excess money supply growth is measured as the difference between broad money supply growth and money demand as approximated by loan growth. As base money and deposits become scarcer in the banking system relative to the pool of existing loans, the liquidity position of commercial banks deteriorates. This deprives them of the necessary fuel to generate further loan growth down the road. Chart I-1 not only shows that excess money in the U.S., euro area and Japan has been decelerating sharply in recent months, but also that this decline points toward slowing global industrial activity, widening junk spreads and decline EM stock prices. Beyond quantity-based measures of liquidity, price-based measures are sending a similar signal. The widening in the LIBOR-OIS spread has now been well documented. It is true that technical factors such as the issuance of T-bills by the Treasury and the progressive move away from LIBOR as a key benchmark for the pricing of loans partly explain this phenomenon. However, this development is now spreading outside the U.S., with Australia in particular experiencing some especially sharp widening in the spread between deposit rates and the OIS. In fact, the LIBOR-OIS spread for the G-10 as a whole is now at its widest since 2012 (Chart I-2). This also portends a situation where liquidity is becoming scarcer than it once was. Chart I-1Deteriorating Liquidity Conditions Chart I-2Price Of Liquidity Is Increasing Growth is responding to these dynamics, and the softening in PMIs around the world was in full display this week. Interestingly, two bellwethers of global growth are showing especially clear signs of a slowing.3 In Korea, exports have greatly decelerated, industrial production is contracting and PMIs are well below 50 (Chart I-3). Taiwan is also showing some signs of weakness, as exports and export orders are both slowing sharply (Chart I-4). Chart I-3Korea: A Key Global Bellweather Is Slowing Chart I-4Taiwan Echoes Korea's Message This message is also being relayed by the Japanese economy. Japan's exports to Asia have been slowing sharply as well. As Chart I-5 illustrates, weak Japanese shipments to Asia correlate closely with a weak AUD/JPY, weak EM stock prices and widening junk spreads, suggesting that these specific shipments capture systematic developments behind global growth. Key growth-sensitive currencies are flashing a similar signal. As the top panel of Chart I-6 shows, NZD/JPY has historically rolled over and declined ahead of recessions, growth slowdowns or EM crashes. It has clearly weakened for eight months now. Meanwhile, the bottom panel of Chart I-6 shows the Swedish krona versus the euro. This cross is also a good leading indicator of global growth, and it is clearly pointing south. Chart I-5Japanese Exports Point To A Malaise Chart I-6NZD/JPY And EUR/SEK: Confirming The Risks Finally, one of our favorite gauges to measure the impact of reflation has substantially weakened: the combination of global growth and inflation surprises. This indicator clearly shows that after a massive upsurge in reflationary forces over the past two years, reflation is now waning (Chart I-7). Chart I-7Economic Surprises Are Declining If reflation is about pushing growth and prices upward, removing stimulus could have the opposite impact. While it is clear that global growth is slowing, what about inflation? We do not think that global inflation is set to slow significantly: global growth is unlikely to move back below trend, and the U.S. is experiencing increasingly potent domestic inflationary pressures supercharged by fiscal profligacy. That being said, the uptrend in global inflation is nonetheless set to flatten for now as our Global Inflation Diffusion Index based on consumer and producer prices across 27 economies has begun to fall, which normally points to lower global headline and core consumer prices (Chart I-8). Bottom Line: The market's attention has been captured by the dramatic flare-up in trade tensions between the U.S. and China, but a more imminent risk has been garnering less press: the decline of reflation. China sent the first salvo on this front; DM central banks have also slowly been either tightening outright or not expanding monetary aggregates as aggressively as before. As a result, global liquidity is tightening and global growth is slowing. Global inflation is also set to decelerate as well, suggesting the decline in economic activity will not be a real phenomenon only, but a nominal one as well. Key Currency Market Implications One of the key implications of lower global growth and ebbing inflationary pressures is likely to be a stronger dollar. As Chart I-9 illustrates, when our Global Inflation Diffusion Index declines and global inflationary pressures ebb, the dollar tends to strengthen. This makes sense: the dollar does best when global growth weakens, inflation slows and commodity prices soften. This time around, the case for a few quarters of dollar strength may be even better defined. U.S. inflation is unlikely to decelerate as much as non-U.S. inflation as U.S. capacity utilization is tighter, the U.S. labor market is at full employment and America is receiving an extraordinarily large amount of fiscal stimulus at this late stage of the business cycle. Chart I-8No Acceleration For Now In Global Inflation Chart I-9Ebbing Inflationary Pressures Will Help The Dollar Technical considerations suggest the dollar is well placed to take advantage of these dynamics. On a short-term basis, both our intermediate-term oscillator and 13-week rate-of-change measures have formed positive divergences with the DXY itself (Chart I-10). While the pattern does not look as bullish as the one registered in 2014, it evokes deep similarities with the 2011 formation. On a longer-term basis, the dollar is massively oversold, as measured by the 52-week rate of change measure. It is true that it managed to stay at similarly oversold levels for nearly a year in 2003, but back then the dollar was much more expensive than today: the U.S. current account deficit was 4.4% of GDP versus 2.4% today and the basic balance of payments deficit was at 3% of GDP versus 2% today (Chart I-11). It is reasonable that with these stronger fundamentals, the dollar will not need to hit as oversold levels as back then before staging a significant rebound. Chart I-10Positive Divergences For The Greenback Chart I-11Dollar Technicals And Valuations: 2003 Vs. Today With global growth slowing, especially in Asia, it is easy to paint a picture where the dollar only strengthens against EM and commodity currencies - the currencies most exposed to both global growth and this specific geographic area. However, while we do see downside in USD/JPY, we expect the greenback to rally against the euro toward EUR/USD 1.15. Our model for EUR/USD shows that the euro is trading 10% above its fair value determined by real rate differentials, the relative slope of yield curves and the price of copper relative to lumber (Chart I-12). In fact, since Europe is more levered to global economic activity than the U.S., these drivers are likely to deteriorate a bit further for the remainder of 2018. Chart I-12EUR/USD Is Vulnerable GBP/USD also looks set to experience a period of weakness against the greenback. Historically, GBP/USD and EUR/USD have been correlated. This is a simple reflection of the fact that the U.K. has a deeper economic relationship with the euro area than the U.S., and thus benefits from the same economic impulses as the eurozone. Chart I-13GBP/USD: ##br##Extremely Overbought Some pound-specific factors will also play against GBP/USD. As we argued last week, the British domestic economy is rather weak; this week's construction PMI confirmed this assessment.4 Additionally, the British basic balance of payments is in deficit anew. This is not only a reflection of the U.K.'s current account deficit of 4% of GDP, it also reflects the fact that FDI into the U.K. has been melting in response to uncertainty surrounding Brexit. This means the U.K. is dependent upon global liquidity to finance this large deficit. An environment where global growth is set to decelerate and where global liquidity is tightening will make it more expensive to finance this large hole. The fastest means to increase expected returns on British assets to attract foreigners' funds is to depreciate the pound today. Finally, the GBP's annual momentum has hit levels consistent with a reversal in cable (Chart I-13). Staying in Europe, another pair is currently interesting and devoid of taking on any USD risk: EUR/CHF. While we think EUR/CHF has more upside over the remainder of the economic cycle,5 this is unlikely to be the case in the second and third quarters of 2018. The Swiss franc tends to outperform the euro when reflationary forces retreat, when global growth slows and when FX volatility increases - all views we espouse for the coming quarters. Moreover, Switzerland's current account and basic balance-of-payment surpluses are 6.5% of GDP and 11.5% of GDP greater than that of the euro area, providing further attraction in a growth soft spot. Finally, EUR/CHF is massively overbought right now, pointing to heightened vulnerability to the economic risks highlighted above (Chart I-14). We are opening a short EUR/CHF trade this week. In the same vein, we remain bearish EUR/JPY. Finally, in previous reports, we highlighted the AUD as being the currency most at risk from any downshift in global growth.6 Despite its recent weakness, we think the AUD is likely to remain very vulnerable. We have been short AUD/NZD since last October, and we do believe this pair will retest 1.04 before forming a base. Australia is experiencing even less inflationary pressures than New Zealand, and is more exposed to slower global industrial production than its neighbor. Technically, AUD/NZD still has some downside. As Chart I-15 illustrates, the 13-week rate of change measure for AUD/NZD has not yet hit the kind of depressed levels associated with complete capitulation. In fact, the recent breakdown in momentum points toward such capitulation as being imminent. AUD/JPY too is not yet oversold enough to be a buy, especially in the context of slowing global growth. Thus, we continue to recommend investors stay short this pair. Chart I-14Technical Indicators Confirm ##br##The Fundamental Vulnerability Of EUR/CHF Chart I-15AUD/NZD Has A Little Bit More Downside Bottom Line: Ebbing reflationary forces suggest the trade-weighted dollar is likely to rally over the coming months. We do see upside for the USD against EM and commodity currencies, but against European currencies as well. Only the yen is anticipated to buck this trend. Within the commodity-currency complex, we foresee that the AUD will suffer the most, and the CAD the least. Within the European currency complex, we are selling EUR/CHF. We are not selling EUR/USD as we are already long the DXY. A Cyclical Opportunity To Sell EUR/CAD This trade is an attractive means to bet on global growth slowing, especially relative to the U.S. As we have argued, U.S. financial conditions have eased relative to the rest of the world, the U.S. is enjoying large injections of fiscal stimulus and it is less exposed to declining global growth. As a result, we anticipate the outperformance of the U.S. ISM to continue relative to global PMIs. Historically, this is an environment where EUR/CAD tends to depreciate (Chart I-16). This is because while 75% of Canadian exports go to the U.S., only 13% of euro area exports end up there. Thus, Canada is much more exposed to the U.S. business cycle than Europe, who is exposed to the rest of the world's. Domestic factor also argues in favor of shorting EUR/CAD. Canadian core inflation is in an uptrend, and at 2% is at the Bank of Canada's target. European core inflation meanwhile only stands at 1%. Moreover, Canada's unemployment's rate is already 0.5% below equilibrium, while the euro area's is 0.4% above such equilibrium (Chart I-17). Thus, European wages and service sector inflation is likely to continue to lag behind Canada's. As a result, we continue to expect the BoC to keep hiking in line with the Fed, or another three times this year. The same cannot be said for the ECB. Chart I-16EUR/CAD: A Play Global Vs. U.S. Growth Chart I-17No Slack In Canada, Plenty In Europe Making the trade even more attractive, EUR/CAD is currently trading at a premium on many metrics. First, our augmented interest rate parity models show that the EUR/CAD trades anywhere between 10-15% above fair value (Chart I-18).7 Relative productivity trends have been a reliable long-term indicator of the path for EUR/CAD. On this metric as well, EUR/CAD is trading at a significant 9% premium (Chart I-19). Finally, EUR/CAD has tended to trend in an inverse relationship with oil prices. Today, it is well above levels implied by various oil prices (Chart I-20). Chart I-18EUR/CAD Trades At A Premium To Rate Differentials... Chart I-19...At A Premium To Relative Productivity... In our view, a key factor explains these discounts: Fears regarding the future of the North American Free Trade Agreement. An abandonment of NAFTA would hurt Canadian growth and prompt the BoC to be much more dovish than we anticipate. However, while there will be some small tweaks to NAFTA, the probability of a major overhaul that deeply affects the North American supply chain has declined, as Canada and Mexico are being exempted from steel and aluminum tariffs and as the White House has softened its stance on the U.S. content of Canadian auto exports back to the U.S. Our Geopolitical team assesses that the probability of a major NAFTA overhaul has declined from 50% to less than 20%, especially as Trump now has bigger fish to fry with China. As a result of these improvements in negotiations, EUR/CAD is potentially set to decline toward 1.44 over the rest of 2018, especially as our oil strategists continue to expect Brent prices to average US$74/bbl this year. Meanwhile, the ratio of copper prices to oil prices, which has been a decent early directional indicator for this cross, suggests the timing is ripe to bet against euro/CAD (Chart I-21), especially as slowing global growth will further weigh on copper relative to oil. Chart I-20...And A Premium To Oil Chart I-21Where Copper-To-Oil Goes, So Does EUR/CAD Bottom Line: An attractive means to bet on slowing global growth while benefiting from the impact of the U.S.'s fiscal stimulus is to short EUR/CAD. Not only is this cross a play on the differential between international and U.S. growth, it is also currently trading at a large premium on various metrics. Dissipating risks that NAFTA will be abrogated in a major way are providing an attractive cyclical entry point to short EUR/CAD, with an initial target of 1.44. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Analyst haarisa@bcaresearch.com 1 For more analysis on trade wars and the current China/U.S. spat, please see Foreign Exchange Strategy Weekly Report, "Are Tariffs Good or Bad For The Dollar?" dated March 9, 2018, available at fes.bcaresearch.com as well as the Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 2 We have already gone over the role of China at length to explain the global growth slowdown. For detailed discussions on the topic, Please see Foreign Exchange Strategy Weekly Report, "The Return Of Macro Volatility", dated March 16, 2018, available at fes.bcaresearch.com. 3 For more indicators pointing toward slower global growth, Please see Foreign Exchange Strategy Weekly Report, "Canaries In the Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017 and "Canaries In the Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "Do not Get Flat-Footed By Politics", dated March 30, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Special Report, "The SNB Doesn't Want Switzerland To Become Japan", dated March 23, 2018, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Weekly Report, "From Davos To Sydney, With a Pit Stop in Frankfurt", dated January 26, 2018, available at fes.bcaresearch.com. 7 EUR/CAD trades 15% above a fair value model, that does not encapsulate the trend in the cross. If the recent cross is taken into account through a model that incorporates mean-reversion, EUR/CAD trades at a more modest 10% above its fair value. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: ISM Manufacturing came in slightly weaker than expected at 59.3; However, ISM Prices Paid was a very strong number, 78.1, up from the previous 74.2; Services PMI and Non-Manufacturing ISM also disappointed expectations; The trade balance in February fell to US$ -57.6 bn; Initial jobless claims, however, came in much higher than expected at 242,000. The dollar is now up more than 2% from its February lows. This has been driven by slowing global growth, particularly in Korean and Taiwanese trade data. The greenback should fare well in this environment. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: German retail sales disappointed, growing at a 0.7% monthly pace and a 1.3% annual pace; German Manufacturing PMI came in slightly lower than expected at 58.2; European unemployment dropped to 8.5% as expected; Headline inflation improved to 1.4% also as expected, but core inflation came in weaker than expected at 1%. The euro is set to experience a period of correction as inflation in the Eurozone remains weak and global growth is slowing, as Asian economic data increasingly shows. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth outperformed despite coming in at -2.6%. The Nikkei manufacturing PMI surprised on the strong side, coming in at 53.1 However, the Markit Services PMI underperformed expectations coming in at 50.9. USD/JPY has been relatively flat this week. Overall, we expect that the yen will continue to strengthen, given that the market will continue to be rattled by the increasing a weakening in global growth. This risk off environment should benefit the yen. However, given the slowdown in Japanese economic data, the BoJ will eventually have to intervene to make sure that the rise in the yen does not derail the economic recovery and particularly, its inflation objective. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit Manufacturing PMI outperformed expectations, coming in at 55.1. It also increased slightly from last month's reading. However PMI construction underperformed expectations substantially, coming in at 47. This is the lowest level in more than 2 years. GBP/USD has been relatively flat this week. Overall the latest construction PMI number confirms our analysis: the uncertainty caused by Brexit is weighing heavily on Britain's housing market. This weakness in the housing sector, coupled with a strong pound, will likely limit how high British interest rates can go. Therefore GBP/USD has downside on a tactical basis. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: The RBA's Commodity Index in SDR terms contracted by 2.1% annually, much more than the expected 0.1% contraction; Building permits contracted on a monthly basis at a rate of 6.2%, while also contracting at a 3.1% pace in annual terms; However, retail sales did pick up in monthly terms at a rate of 0.6%. At the monetary policy meeting on Tuesday, Governor Philip Lowe referenced the increase in short-term funding costs that have spilled over from the U.S. into foreign markets owing to higher volatility, particularly in Australia. An escalation of a trade war will also prove to be very damaging for the Australian economy, which is a large export-based and commodity-dependent nation. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. Overall we expect this cross to weaken going forward, given that New Zealand is one of the most open economies in the G10, and thus, it stands to risks the most from both an increasing risk of trade wars and slowing global growth. Moreover, there are also some negative aspects of New Zealand on a more structural basis, as the neutral rate is set to be lowered. This is because the populist government is looking to lower immigration while also implementing a dual mandate for the central bank. All of these factors will cause the kiwi to suffer on a long term basis. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was mixed: Manufacturing PMI came in line with expectations of 55.7; Exports and Imports for February came in at CAD 45.94 bn and CAD 48.63 bn, respectively, sinking the trade balance to CAD -2.69 bn. The CAD received a fillip on Tuesday as President Trump hopes to conclude preliminary negotiations for NAFTA by the end of next week. While the outcome for these negotiations remains uncertain, the Canadian economy is still in great shape, with a tight labor market, high wage growth and a closing output gap. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation outperformed expectations, coming in at 0.8%. Real retail sales yearly growth outperformed expectations, coming in at -0.2%. However, the SVME PMI underperformed expectations, coming in at 60.3. EUR/CHF has been relatively flat this week. Overall, we expect EUR/CHF to have further upside on a long-term basis. The Swiss economy is still weak and inflationary pressures are tepid. This means that any further appreciation by the franc will weigh heavily on the SNB's goals. While for now EUR/CHF could suffer as global growth declines, the SNB will fight this trend in order for them to achieve their inflation target. Thus, any rally in the CHF will prove temporary. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week. Overall, the krone should outperform most other commodity currencies given that oil should perform better than the rest of the commodity complex in the current environment. While all commodities would be affected by a possible slowdown in global growth and Chinese industrial production, oil will probably hold up the best given that advanced economies consume a greater proportion of oil than they do of other commodities, making oil less sensitive to gyrations in global industrial activity than metals. Moreover, the supply backdrop for oil remains more favorable than that of other commodities thanks to OPEC and Russia's production restrains. All of these developments should help the NOK outperform currencies like the NZD and the AUD. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data was disappointing: Manufacturing PM came in at 55.9, below last month's 59.9; New Orders increased annually only by 1.3% compared to 8.7% in January; Industrial production contracted in monthly terms by 0.5%, and grew annually by 5.7%, but it was still a deceleration relative to the previous 7.7% reading. The SEK has been weakening because of three factors: the talk of trade wars, the slowdown in the global manufacturing sector, and Sweden's housing bubble. While these risks are very real, Sweden's favorable macro backdrop of a cheap currency, a high basic balance of payments surplus and an economy operating above capacity mean that inflation will pick up meaningfully. This will prompt the SEK to rally once global growth can find its floor. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature Japan's economic experience in the post bubble era is often described as a fate to avoid at all costs. We would like to turn this common notion on its head. Rather than something to avoid, Japan's post bubble experience is a fate that other major economies should actively try to emulate, at least in parts. This report focusses on three specific lessons for European investors. Japan's so-called 'lost decades' describe the weak growth in its nominal GDP since the mid-1990s. But this emphasis on aggregate nominal income is grossly misleading. Standards of living do not depend on nominal GDP. What matters is real GDP per head combined with the absence of extreme income inequality. Real income must grow and this growth must benefit the majority, rather than a small minority. Since the late 1990s, the growth in Japan's real GDP per head has outperformed every other major economy (Chart Of The Week). And unlike other major economies, income inequality in Japan has not increased, remaining amongst the lowest in the developed world (Chart I-2). This is not surprising. Credit booms inflate bubbles in financial assets, which exacerbate income and wealth inequalities. Chart Of The WeekJapan Has Outperformed Everybody Chart I-2Income Inequality In Japan Has Not Increased Admittedly, the government has been running persistent deficits, but this is to counterbalance private sector de-levering. Total indebtedness as a share of GDP has not been rising. In the post credit boom era, Japan's real growth has come entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Unlike the unsustainable growth that is fuelled by credit booms and asset bubbles, real growth that comes from productivity improvements is sustainable. Genuine Price Stability: Something To Celebrate, Not Fear Japanese consumer prices are at the same level today as they were in 1992, meaning that Japan has experienced genuine price stability for two and a half decades (Chart I-3). But this is neither new, nor alarming - Britain enjoyed genuine price stability for two and a half centuries! At the height of the British Empire in 1914, consumer prices were little different to where they stood at the end of the English Civil War in 1651 (Chart I-4). Chart I-3Japan Has Experienced Genuine Price ##br## Stability For Two And A Half Decades... Chart I-4...But Britain Experienced Genuine Price Stability For Two And A Half Centuries! Nevertheless, central banks continue with the deception that price stability means an inflation rate of 2%. This is clearly nonsense. Think about it - if prices rise by 2% a year, then your money will lose a quarter of its purchasing power every decade. And after a typical working life, your money will have lost two-thirds of its value.1 How exactly does that qualify as price stability?2 Still, we frequently hear a strong counterargument - in a highly indebted economy, inflation and growth in nominal GDP do matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% rather than at zero; and nominal GDP growth at 3.5% rather than at 1.5%. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point target. As we explained a while back in The Case Against Helicopters, inflation is a non-linear phenomenon which is extremely difficult, if not impossible, to point target.3 Look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. Chart I-5The Money Multiplier Is Non-Linear M is non-linear because the commercial banking system money multiplier - the ratio of loans to bank reserves - is non-linear. At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible (Chart I-5). Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At this point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. What is the Japanese lesson for Europeans? Simply that just like the BoJ, the ECB will keep moving the 2% inflation goalpost further and further into the future, as it realises the impossibility of achieving and sustaining the 2% point target. So even with inflation in the 1-2% channel, the ECB will create a loophole to exit NIRP and ZIRP very soon after it exits QE. This will structurally support the euro. Do Not Own Banks For The Long Term (Or Now) Japanese financial sector profits stand at less than half their peak level in 1990. For euro area financial sector profits which peaked in 2007, the interesting thing is that they are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth through the next 17 years (Chart I-6). Chart I-6Euro Area Financial Profits May Experience No Sustained Growth In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage - the amount of equity held against the balance sheet. More stringent European regulation will make this a headwind too. Banks will have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin - the difference between rates received on loans and rates paid on deposits, effectively a function of the yield curve slope. However, this is a cyclical driver, and as explained last week in Market Turbulence: What Lies Ahead? this driver is unlikely to be positive in the coming months.4 What is the Japanese lesson for Europeans? Simply that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play during periodic strong countertrend rallies, albeit now is not the time for such a cyclical play. A Surge In Female Participation Chart I-7Sales Of Personal Products Have Boomed Over the past twenty years, Japanese sales of skin cosmetics and beauty products have almost tripled (Chart I-7). This has helped the personal products sector to outperform very strongly. The personal products sector is dominated by female spending. So it is significant that in 1995, the Japanese government introduced a raft of policies to encourage women to join the labour force: paid maternity leave, subsidised childcare, and paid parental leave for both parents. Today in Japan, both mothers and fathers can take more than a year of paid parental leave at an average rate of 60% of earnings. The policies had their desired effect. The proportion of Japanese women in the labour force has surged from 57% to 67%, while the male labour participation rate has held at 85%. Therefore, all of the growth in the Japanese labour force through the past twenty years has come from women. Europe tells a similar tale. Through the past couple of decades, parental leave policies have become steadily more generous. Unsurprisingly, the proportion of European women in the labour force has also surged from 57% to 67%, while the male labour participation rate has held at 78%. So just as in Japan, all of the growth in European labour force participation through the past twenty years has come from women (Chart I-8). But for the ultimate end-point in the European trend, look to the Scandinavian countries which have had generous parental leave policies since the 1970s. As a result, labour force participation for Swedish women is almost identical to that for men: 80% versus 83%. If the EU eventually reaches the Scandinavian end-point, it would mean another 20 million women in the EU labour force. What is the Japanese lesson for Europeans? While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled. Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17-year lag (Chart I-9). If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years. Stay overweight the European personal products sector. Chart I-8A Surge In Female Participation Chart I-9Personal Products Profits Set To Grow Very Strongly Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming you work for 50 years. 2 Admittedly, measured inflation probably overstates true inflation. However, estimates put this measurement error at no more than 0.3-0.5 percentage points. 3 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5 2016 and available at eis.bcaresearch.com 4 Please see the European Investment Strategy Weekly Report 'Market Turbulence: What Lies Ahead?' published on March 29 2018 and available at eis.bcaresearch.com Fractal Trading Model* This week’s trade recommendation is to go long the Australian dollar versus the Norwegian krone. The profit target is 2% with a symmetrical 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 * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

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

Highlights Recommended Allocation Due to the boost from U.S. fiscal stimulus, we do not expect recession until 2020. Despite some signs that growth is peaking, global economic fundamentals remain robust. Markets have wobbled because of the risk of trade war and rising inflation. We think neither likely to derail growth. Not one of our recession indicators is yet sending a warning signal. We are late cycle and volatility is likely to remain high (particularly if the trade war intensifies). But, given strong earnings growth and three further Fed rate hikes this year, we expect global equities to beat bonds over the next 12 months. Except for particularly risk-averse investors, who care mostly about capital preservation, we continue to recommend overweights in risk assets. We are overweight equities (especially euro area and Japan), cyclical equity sectors such as financials and industrials, credit (especially cross-overs and high-yield), and return-enhancing alternative assets such as private equity. Feature Overview Stimulus Trumps Tariffs Risk assets have been choppy so far this year, with global equities flat in the first quarter and the stock-to-bond ratio turning down (Chart 1). Markets were battered by worries about a trade war, signs of growth peaking, a rise in inflation, and bad news from the tech sector. This late in the cycle, with stock market valuations stretched and investors skittish about what might go wrong, we expect volatility to stay high. But the global economy remains robust - and will be boosted by U.S. fiscal stimulus - earnings are growing strongly, and the usual signs of recession and equity bear markets are absent. Though the going will be bumpy over coming quarters, we continue to expect risk assets to outperform at least through the end of this year. U.S. tariffs on steel and aluminum and the threat of $50 billion of tariffs on Chinese imports so far represent a trade skirmish, not a trade war. The amounts pale by comparison with the positive impact coming though from U.S. tax cuts, increased fiscal spending, and repatriation (Chart 2). In history, fights over trade have rarely had a serious impact on growth. They flared up frequently in the 1980s, which was a period of strong economic growth. Even the infamous Smoot-Hawley tariff increase of 1930 is now viewed by most economic historians as having played only a minor role in the collapse of trade during the Great Depression.1 Of course, trade war could escalate. China, as the biggest part of the U.S. trade deficit, is the White House's clear target (Chart 3). Japan in the 1980s, an ally of the U.S., agreed to voluntary exports restraints and to relocate production to the U.S. But China is a global rival.2 Chart 1A Tricky Quarter Chart 2Stimulus Tops Tariffs Chart 3China Is The Target For now, we expect the impact to be limited since some degree of compromise is the most likely outcome. President Trump sees the stock market as his Key Performance Indicator and would be likely to back off if stocks fell sharply. China knows that it has the most to lose in a prolonged fight. It might suit Xi Jinping's reformist agenda to boost consumption, cut excess capacity, and allow the RMB to appreciate modestly. While the U.S. has some justification for arguing that China's investment rules are unfair, China can also argue that it has made significant progress in recent years in reducing its dependence on exports, its current account surplus, and the undervaluation of its currency (Chart 4). But jitters will continue for a while. May could be a particularly tricky month, with the Iran sanctions waiver expiring on May 12, and the 60-day consultation period for China tariffs ending on May 21. Investors should expect that volatility, which in early January was remarkably low in all asset classes, should stay significantly higher until the end of this cycle (Chart 5). Chart 4...But Has Reduced Dependence On Exports Chart 5Volatility Likely To Stay High? Meanwhile, economic fundamentals generally remain strong. The Global Manufacturing PMI has dipped slightly from its cycle-high level in December, with recent currency strength causing some softness in the euro area and Japan (Chart 6). But the diffusion index shows that only three out of the 48 countries currently have PMIs below 50 (Egypt, Indonesia and South Africa). Consensus forecasts expect 2018 global GDP growth to come in at around 3.3%, similar to last year, and as yet show no signs of faltering (Chart 7). On the back of this, BCA's models suggest that global earnings growth will continue to grow at a double-digit pace for at least the rest of this year (Chart 8). Despite the strong growth, we see U.S. inflation picking up only steadily towards the Fed's 2% target.3 Jerome Powell in his first congressional testimony and press conference as Fed Chair showed no rush to accelerate the pace of rate hikes. We think the Fed is likely to hike four times, not three, but the market should not find this unduly hard to digest, as long as it is against a background of robust growth. Chart 6Dip In Growth Momentum? Chart 7Economists' Forecasts Not Faltering Chart 8Earnings Still Growing Strongly For the past year, we have highlighted a number of simple indicators we are watching carefully that have previously been reliable indicators of recessions and equity bear markets. Several have started to move in the wrong direction, but none is yet flashing a warning signal (Table 1, Chart 9). Table 1What To Watch For Chart 9No Warnings Flashing Here In February, BCA pushed out its forecast of the next recession to 2020, on the back of the U.S. fiscal stimulus. That would suggest turning more cautious on risk assets towards the end of this year - at which time some of these indicators may be flashing. But, until then we continue to recommend - except for the most risk-averse investors who care mainly about capital preservation and not about maximizing quarterly performance - an overweight allocation to risk assets. Garry Evans, Senior Vice President garry@bcaresearch.com Chart 10Not A Full Blown Trade War... For Now! What Our Clients Are Asking What Are The Implications Of U.S. Tariffs? Following recent announcements of tariffs on steel and aluminum and possible broad-based tariffs on Chinese imports, investors have started to worry about the future of global trade. But these moves should be no surprise since President Trump is merely delivering on electoral promises. From a macro-perspective, here are the key implications of rising trade barriers: An all-out trade war would certainly hurt U.S. growth, but a minor skirmish would have little impact. The U.S. is the advanced economy least exposed to global trade, which makes it harder for nations to retaliate. Running a large trade deficit, with imports from China representing 2.7% of GDP whereas exports to China are just 1.0% of U.S. GDP, gives the U.S. considerable leverage in negotiations. Additionally, the majority of Chinese imports from the U.S. are agricultural products, making it harder for China to retaliate with tariffs since these would raise prices for Chinese consumers (Chart 10). On the other hand, U.S. trade partners also have a case. With trade growth trailing output growth, other nations will be less willing to give in to U.S. threats. Additionally, unlike the Cold War era, when the U.S. had a greater influence on Europe and Japan, the world is moving toward a more multipolar structure. However, we do not believe nations will retaliate by dumping U.S. Treasuries, as that would deliver the U.S.'s desired end result of a weaker dollar. Chart 11Rising Wages Are The Missing Factor Finally, if tariffs lead to a smaller trade deficit and firms start to move production back to the U.S., aggregate demand will increase. And, given a positive output gap in the U.S., the Fed would be forced to turn more hawkish, ultimately forcing the dollar up. Equity markets do not like tariffs, and bonds will follow the path that real growth and inflation take. How the situation will develop depends on whether Trump embraces America's traditional transatlantic alliance with Europe and harnesses it for the trade war against China. If he does so, the combined forces of the U.S. and Europe will likely force China to concede. But if Trump goes it alone, a prolonged U.S.-China trade war could turn into a significant risk to global growth. How Quickly Will U.S. Inflation Rise? The equity sell-off in early February was triggered by a slightly higher-than-expected average hourly earnings number. In recent meetings, we find that clients, who last year argued that the structural pressures would keep inflation depressed ("the Philips Curve is dead"), now worry that it will quickly exceed 2%. And it is true that the three-month rate of change of core CPI has jumped recently (Chart 11, panel 1). Investors are clearly skittish about the risk of higher inflation, which would push the Fed to accelerate the pace of rate hikes. We continue to argue that core PCE inflation (the Fed's main measure) will rise slowly to 2% over the next 12 months, but we do not see it accelerating dramatically. Inflation tends to lag GDP growth by around 18 months and the pickup in growth from Q2 last year should start to feed through. This will be magnified by the 8% weakness in the US dollar over the past 12 months, which has already pushed up import prices by 2% YoY. What is missing, however, is wage pressure. Average hourly earnings are growing only at 2.6% YoY. We find that wage growth tends to lag profits by around 24 months (panel 2) and, since profits moved sideways for close to two years until Q2 last year, it may be a few quarters yet before companies feel confident enough to raise wages. Note, too, that wages have been weak compared to profits in this cycle. This is likely partly because of automation, but also because the participation rate for the core working population continues to recover towards its 2007 level, indicating there is more slack in the labor market than the headline unemployment data suggest (panel 3). Should Investors Still Own Junk Bonds? Chart 12Credit Cycle Still On The current late stage of the economic cycle has investors worried about the credit cycle and the outlook for corporate credit, in particular high-yield bonds. The number-one concern is stretched valuations. Spreads are close to all-time lows, which means investors should not expect significant capital gain. However, spreads can stay low for extended periods, especially in the late stages of the credit cycle. Junk bonds are a carry trade at this point, and investors can continue to pick up carry before a sustained period of spread widening sets in (Chart 12). A flattening yield curve is bad for junk returns, as it signals monetary policy is too restrictive. But, as inflation continues to trend higher, the curve is likely to steepen while allowing the Fed to deliver rate hikes close to its median projection. The key risk is a scenario in which inflation falters, but the Fed continues to hike. In this case a risk-off episode in credit markets would be likely, but this would be a buying opportunity and not the end of the cycle. Corporate balance-sheets have weakened, and logically investors should demand greater compensation to hold high-yield bonds. But spreads have diverged from this measure since early 2016. However, we expect improvements in corporate health since the outlook for profit growth is strong. However, a great deal of bond issuance has been used for share buybacks. If capital structures have less of an equity cushion, then recovery rates are likely to be lower when defaults do start to rise. Cross-asset volatility has returned. But credit spreads have remained calm thanks to accommodative monetary policy and easing bank lending standards. Also, stricter post-crisis bank capital regulations have mitigated the risk. Finally, the growing presence of open-ended junk bond funds and ETFs increases the risk that, once spreads start to widen, they will widen much more quickly than they would have otherwise. Who Should Invest In Hedged Foreign Government Bonds? In a recently published Special Report,4 we found that hedged foreign government bonds are a good source of diversification for bond portfolios. Hedging not only reduces the volatility of the foreign bonds, it reduces it so much that the risk-adjusted return ratio has significantly improved for investors with home currency in USD, GBP, AUD, NZD, CAD and EUR (Table 2). This is true across different time periods for most fixed income investors other than those in Japan, as shown in Chart 13. Table 2Domestic And Foreign Government Risk Return Profile (December 1999 - January 2018) Chart 13Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time So the answer depends on investors' objectives and constraints: If investors are comfortable with the volatility in their local aggregate bond indexes, which are already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K. and Canada are better off investing a large portion overseas. Global Economy Overview: Global growth remains robust, though momentum has slowed slightly in recent weeks. No recession is likely before 2020 at the earliest due to strong U.S. fiscal stimulus. Inflation will slowly rise towards central bank targets but there is little reason to expect it to accelerate dramatically, and so we see no need for aggressive monetary tightening. U.S.: Short-term, growth looks to have softened, with the Citigroup Economic Surprise Index turning down (Chart 14, top panel), and the regional Fed NowCasts for Q1 GDP growth pointing to 2.4%-2.7%. However, growth over the next two years should be boosted by the recent tax cuts and government spending increases, which we estimate will push up GDP growth by 0.8% in 2018 and 1.3% in 2019. Wages should start to rise from their current sluggish levels (average hourly earnings only up 2.6% YoY) given the tight labor market, which should boost consumption. Capex (panel 5) is likely to continue to recover due to tax cuts and a high level of businesses confidence. Euro Area: Growth has been steady in recent quarters, with Q4 GDP rising 2.5% QoQ annualized. However, lead indicators such as the PMI (Chart 15, top panel) have rolled over, probably because of the strong euro (up 6.2% in trade-weighted terms over the past 12 months). The effect has yet to be seen in exports, which continue to grow strongly, 6.2% YoY in February, but earnings results for Q4 surprised much less on the upside in the euro area than in the U.S. Chart 14Growth Robust, But Momentum Slowing Chart 15Strong Currencies Denting EU And Japanese Growth Japan: As an export-oriented, cyclical economy, Japan has also benefitted from better global conditions, with GDP rising by 1.6% QoQ annualized in Q4. However, like Europe, the stronger currency has begun to dent the external sector, with industrial production and the leading index slowing (Chart 15, panel 2). However, more encouraging signs are appearing domestically: retail sales rose by 2.5% YoY in January and part-time wages are up 2.0% YoY. As a result, inflation is finally emerging, with CPI (excluding food and energy) up 0.3% YoY. Emerging Markets: China's growth remains steady, with the Caixin PMI at 51 (panel 3). However, credit and money supply growth continue to point to a slowdown in coming months. This may be evident when March data (unaffected by the shifting timing of Chinese New Year) becomes available. Elsewhere in EM, growth has picked up moderately: Q4 GDP growth came in at an annualized rate of 7.2% in India, 3.0% in Korea, and even 2.1% in Brazil and 1.8% in Russia. Interest rates: A modest rise in inflation expectations (panel 4) has led to a rise in long-term rates, with the U.S. 10-year yield rising from 2.5% to almost 3% during Q1 before slipping back a little. We expect the Fed to hike four times this year, and think this will push up the 10-year Treasury yield to 3.3-3.5% by year-end. The ECB continues to emphasize that it will move only slowly to raise rates after halting asset purchases later this year, and we think the market has correctly priced the timing of the first hike for Q4 2019. We see no reason why the BoJ will end its Yield Curve Control policy, with inflation still well below the 2% target. Chart 16Cautiously Optimistic Global Equities Tip-Toeing Through The Late Cycle. Global equities experienced widespread corrections in the first quarter after a very strong start in January gave way to fear of rising inflation in the U.S., fear of slowing growth in China, and fear of rising geopolitical tensions globally. The return of macro volatility was so violent that it pushed the VIX to high readings not seen since 2015. Granted, a background of stretched valuations, complacency, and the "fear of missing out" also contributed to the market correction. The healthy correction of global equities from the high in late January has seen valuations contracting as earnings continued to grow at strong pace (Chart 16). BCA's house view is that global growth may be peaking, but should remain strong and above trend, underpinning decent earnings growth for the next 9-12 months. As such, we retain our pro-cyclical tilts in global equity allocations, overweight cyclical sectors and underweight defensive sectors; overweight high-beta DM markets (Japan and euro area); neutral on the U.S. and Canada; and underweight EM and Australia, the markets that would suffer most from a deceleration in Chinese growth. However, we are late in the cycle and valuations remain stretched by historical standards despite the recent correction. With macro volatility returning, investors should be very conscious of potential risks that could derail the uptrend in equities. For investors with higher aversion to risk, we suggest raising cash by selling into strength or dialing down the overweight of cyclicals vs defensives. Anatomy Of EM/DM Outperformance Since their low in early 2016, EM equities have outperformed DM in total return terms by more than 20%, of which 262 bps came in the first quarter of 2018, despite the rising volatility in all asset classes recently. As show in Chart 17, the outperformance of EM over DM has been dominated by three sectors: Technology, Financials and Energy. In the two-year period ending December 2017, over half of the EM outperformance came from the Tech sector, followed by Financials and Energy, accounting for 32% and 14% respectively. In Q1 2018, however, Tech's contribution dropped sharply to 0.3%, while Financials and Energy shot up to 51% and 33% respectively. Even though Energy is a relatively small sector, accounting for 6-7% of benchmark weights in both EM and DM, the diverging performance between EM and DM Energy sectors has played an important role in the EM outperformance. In the two years ending December 2017, EM Energy outperformed its DM counterpart by 32%, the same magnitude as the Tech sector (Table 3). In Q1 2018, EM Energy gained 7.6% while DM Energy suffered a 5.2% decline, resulting in a staggering 13% outperformance (Table 4). Chart 17Sector Contributions To EM/DM Outperformance Table 3Two-Year Performance Attribution* (December 2015 - December 2017) Table 4Q1/2018 Attribution* (December 2015 - December 2017) Country-wise, Brazil and China led the outperformance, helped by the Brazilian real's 30% appreciation against the U.S. dollar. BCA's EM Strategy believes that Brazilian equities and the real will both weaken given the country's weak governance and poor fiscal profile. Chart 18Style Performance We are neutral on Tech globally, and the general reliance of EM equities on Chinese growth, and the high leverage in EM do not bode well for EM equities. Remain underweight EM vs. DM. A Sector Approach To Style Year to date, the equal-weighted multi-factor portfolio has outperformed the global benchmark slightly, largely driven by the strong outperformance of Momentum and Quality, while Value and Minimum Volatility (MinVol) have underperformed (Chart 18, top three panels). This is in line with our previous regime analysis that indicated rising growth and inflation is a good environment for Momentum and Quality, but a bad one for Min Vol.5 As we have argued before, we prefer sector positioning to style positioning because 1) the major style tilts such as Value/Growth, Min Vol and Small Cap/Large Cap have seen significant sector shifts over time, and 2) sector selection offers more flexibility. As shown in Chart 18 (bottom three panels), the relative performance of Min Vol is a mirror image of Cyclicals vs Defensives, while Value/Growth is highly correlated with Cyclicals/Defensives. In a Special Report,6 we elaborated in-depth that sector selection is a better alternative to size selection, especially in the U.S. We maintain our neutral view on styles, and continue to favor Cyclicals versus Defensives. Given that we are at the late stage of the business cycle, investors with lower risk tolerance may consider gradually dialing down exposure to cyclical tilts. For stock pickers, this would mean favoring stocks with low volatility, high quality and strong momentum. Government Bonds Maintain Slight Underweight On Duration. Despite rising volatility due to changes in inflation expectations and uncertain developments in geopolitics, the investment backdrop has been evolving in line with our 2018 Strategy Outlook. Global growth continues at a strong pace (Chart 19) and our U.S. Bond Strategy has increased its yield forecast to the range of 3.3-3.6%, from 2.80-3.25% previously, reflecting both a higher real yield and higher inflation expectations. The U.S. 10-year Treasury yield increased by 34 bps in Q1 to 2.74%, still lower than our fair value estimate, implying that there is still upside risk for global bond yields. As such, investors should continue to underweight duration in global government bonds. Favor Linkers Vs. Nominal Bonds. The base case forecast from our U.S. Bond Strategy is that the U.S. TIPS breakeven will rise to 2.3-2.5% around the time that U.S. core PCE reaches the Fed's 2% target rate, likely sometime in 2H 2018. Compared to the current level of 2.05, this means the 10-year TIPS has upside of 25-45 bps, an important source of relative return in the low-return fixed income space (Chart 20). Maintain overweight TIPS vs. nominal bonds. In terms of relative value, however, TIPS are no longer cheap. For those who have not moved to overweight TIPS, we suggest "buying TIPS on dips". In addition, inflation-linked bonds (ILBs) in Australia and Japan are still very attractive vs. their respective nominal bonds (Chart 20, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Chart 19Further Upside In Bond Yields Chart 20Favor Inflation linkers Corporate Bonds We continue to favor both investment grade and high-yield corporate bonds within the fixed-income category. High-yield spreads barely reacted to the sell-offs in equities in February and March (Chart 21). We see credit spreads as a useful indicator of recessions and equity bear markets and so the fact that they did not rise suggests no broad-based risk aversion. Moreover, this resilience comes despite significant outflows from high-yield ETFs, $4.4 billion year-to-date, almost completely reversing the inflows over the previous three quarters. We still find spreads in this space attractive. BCA estimates the default-adjusted spread is still around 250 basis points (assuming default losses of 1.3% over the coming 12 months) which, while not cheap, is less overvalued than other fixed-income categories (Chart 22). Investment grade spreads, however, have widened in recent weeks (Chart 21), with the rise concentrated in the highest-quality credits. This is most likely because investors see little value in these securities. We keep our overweight but we focus on cross-over credits and sectors where valuations are still reasonable, for example energy, airlines and insurance companies. Excessive leverage remains a concern for corporate bond losses in the next recession. BCA's Corporate Health Monitor (Chart 23) has improved in recent quarters, mostly due to stronger profitability. But the deterioration in interest coverage ratios in recent years makes companies vulnerable to higher rates. We estimate that a 100 basis point increase in interest rates across the corporate curve would lead to a drop in the ratio of EBITDA to interest expenses from 4.0 to 2.5.7 Sectors such as Materials, Technology, Consumer Discretionary and Energy appear especially at risk.8 Chart 21IG Spreads Have Widened, But Not HY Chart 22Junk Bonds Still Offer Some Value Chart 23Leverage Is A Worry For The Next Recession Commodities Chart 24OPEC Agreements Hold The Key Energy (Overweight): Demand/supply fundamentals have been driving prices in crude oil markets (Chart 24). Fundamentals remain favorable as strong global demand is keeping the market in physical deficit. However, the outlook for demand has turned cloudy as the market may start to price in the possibility of a trade war which would dent growth. Also, threats of renewed sanctions against Iran and deeper ones against Venezuela could potentially disrupt supply sufficiently to push up the crude price. Given rising uncertainties with the demand and supply outlook, we expect increased volatility in the crude price. We maintain our forecasts for the average 2018 prices for Brent and WTI at $74 and $70 respectively. Industrial Metals (Neutral): As President Trump moves ahead with protectionist policies, markets are being spooked by the possibility of a trade war. Looking past the noise, since China remains the largest source of demand, price action will follow domestic Chinese market fundamentals which are a function of how authorities handle a possible growth slowdown. The possibility of global trade disruptions, coupled with a recovery in the U.S. dollar, suggests increased price volatility. We are particularly negative on zinc. Spanish zinc has been flooding into China, depressing physical premiums and causing inventory accumulation (Chart 24, panel 3). Precious Metals (Neutral): Rising trade protectionism, geopolitical tensions, and diverging monetary policy will be sources of increased market volatility for the rest of the year. When equity markets went through a minor correction earlier this year, gold outperformed global equities by 6%. However, rising interest rates and a potentially stronger U.S. dollar are two headwinds for the gold price. We continue to recommend gold as a safe haven asset against unexpected market volatility and inflation surprises (Chart 24, panel 4). Currencies Chart 25Dollar Will Stage A Recovery Rally U.S. Dollar: Following its 7% depreciation last year, the greenback is flat year to date. A positive output gap and strong inflation readings are giving the Fed enough reasons not to fall behind the curve. Secondly, the proposed fiscal stimulus is likely to increase the U.S.'s twin deficits which has historically been bullish for the currency, as long as it is accompanied by rising real rates. Finally, speculative positions in the dollar are net short, which means any positive surprises will be bullish for the currency. We expect the U.S. dollar to stage a recovery rally in the coming months (Chart 25, panel 1). Carry Trades: Cross-asset class volatility is making a strong comeback. Carry trades fare poorly in volatile FX markets. High-yielding EM currencies like the BRL, TRY, and ZAR will underperform, whereas low yielding safe-haven funding currencies like the Swiss franc and Japanese yen, in countries with outsized net international investment positions, will be the winners. Finally, the return of volatility could hurt global economic sentiment and possibly weigh on growth-sensitive currencies like the KRW, AUD and NZD (Chart 25, panel 2). Euro: Analyzing the euro's strength, we see a 9% divergence in performance between the EUR/USD pair and the trade-weighted euro. Global synchronized growth was driven predominantly by a recovery in manufacturing which benefited the euro area more than the U.S. Also looking at history, the euro tends to appreciate relative to USD in the last two years of economic upswings driven by strong growth. Finally, the recent divergence in relative interest rates is a clear sign that other fundamental factors, such as the current account balance, have been exerting pressure. Sentiment and positioning remain extremely euro bullish, hence any disappointment with economic data will force a correction (Chart 25, panel 3). GBP: Since 2017, the pound has strengthened by over 16% vs. USD. An appreciating currency has dented inflation readings, thereby limiting the pass-through effects via the Bank of England hiking rates. A hurdle to further appreciation is negative growth in real disposable income and declining household confidence. Finally, weak FDI inflows will hurt the U.K.'s basic balance. Since the BoE will find it difficult to tighten policy much, we expect a correction in the next few months (Chart 25, panel 4). Alternatives Investors have been increasing their allocation to alternatives, pushing AUM to a record $7.7 trillion. We continue to recommend allocations through three different buckets: 1) among return enhancers, we favor private equity vs hedge funds; 2) favor direct real estate vs. commodity futures in inflation hedges; 3) favor farmland & timberland vs. structured products as volatility dampeners. But alternatives have a few challenges that require special consideration. Private Equity: Key drivers of returns have changed. In the past, managers were able to succeed by "buying low/selling high". But today, investors need to pick general partners (GPs) who can identify attractive targets and effect strategic and operational improvements. $1.7 trillion of dry powder. Global buyout value grew by 19% in 2017, but deal count grew by only 2%. High valuations multiples, stiff competition, and an uncertain macro outlook will force funds to be selective. Competition from corporate buyers. GPs are fighting with large corporations looking for growth through acquisition. Private equity's share of overall M&A activity globally declined in 2017 for the fourth year running. Competition for targets is boosting entry multiples in the middle-market segment. Hedge Funds: Net exposure for long/short managers has remained static over market cycles, which means investors pay too much for market exposure. But if we see market rotation or increased dispersion of single stock returns, this hedge fund group will benefit. Discretionary macro will benefit from differing growth outlooks, idiosyncratic events, and local rate cycles. Also, potential for more dispersion in the large-cap space and at the index level will benefit systematic macro. Event-driven funds have been hurt by deal-spread volatility as shareholder opposition, anti-trust concerns and political issues led to deal delays. But we continue to favor short-term special situations in less-followed markets such as Asia. Real Estate: After strong growth in capital values, driven by low rates and cap rate compression, investors need to focus on income-driven total returns. Additionally, income returns do not vary across markets nearly as much as capital value growth. Increase focus on core strategies. Look for properties in prime locations with long and stable lease contracts. Investors can also consider loans made to high-quality borrowers which are secured against properties with stable cash flows. Private Debt: With ultra-low yields, private debt offers attractive risk-adjusted return, diversification, and a potential cash flow profile ideal for institutional investors. However, it is critical to source a differentiated pipeline of opportunities. Infrastructure debt, with a long expected useful life, can provide effective duration for liability matching. Risk-adjusted returns can be enhanced by directly sourcing and structuring. Risks To Our View We see the risks to our main scenario (strong growth continuing through 2019, moderate inflation, late cycle volatility, and rising geopolitical risks) as balanced. There are a number of obvious downside risks, including an escalating trade war, a sharp upside surprise to inflation, and the Fed turning more hawkish (perhaps in an attempt to demonstrate its independence if President Trump pressures it not to raise rates). Among the risks less appreciated by investors is a slowdown in China. Leading indicators of the Chinese economy, particularly money supply and credit growth, continue to slow (Chart 26). Xi Jinping's recent senior appointments suggests he is serious about structural reform, which would mean accepting slower growth in the short-term to put China on a sounder long-term growth path. Linked to this, we also think investors are insufficiently concerned about the impact of rising rates on emerging market borrowers. If, as we expect, U.S. long rates rise to close to 3.5% over the next year and the dollar strengthens, the $3.5 trillion of foreign-currency borrowing by EM borrowers could become a burden (Chart 27). Chart 26What If China Slows? Chart 27Highed Indebted EM Borrowers Are A Risk Chart 28Presidents Like Markets To Rise Upside risk centers on a continuation of strong growth and dovish central banks. We may be underestimating the impact of U.S. fiscal policy. Our assumption that it will peter out in 2020 may be wrong, if President Trump goes for further stimulus ahead of the presidential election - the third and fourth years of presidential cycles are usually the best for stocks (Chart 28). Wages may stay low because of automation. In the face of this the Fed may stay dovish: it already shows some signs of allowing an overshoot of its 2% inflation target, to balance the six years that it missed it to the downside. All this could produce a stock market meltup, similar to 1999. 1 See, for example, Clashing Over Commerce: A History of U.S. Trade Policy, Douglas J, Irwin, Chicago 2017, chapter 8. 2 For an analysis of the geopolitical implications, please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 27, 2018. 3 Please see the What Our Clients Are Asking: How Quickly Will U.S. Inflation Rise? on page 8 of this Quarterly Portfolio Outlook for the reasons why this is our view. 4 Please see Global Asset Allocation Special Report, "Why Invest In Foreign Government Bonds?" dated March 12, 2018 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?" dated July 8, 2016, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation Special Report, "Small Cap Outperformance: Fact Or Myth?" dated April 7, 2017, available at gaa.bcaresearch.com 7 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 8 Please see also What Our Clients Are Asking: Should Investors Still Own Junk Bonds, on page 9 of this Quarterly Update, for more analysis of this asset class. 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