Europe

Highlights EUR/USD is in a blow off phase. Treasury secretary Mnuchin's comments added fuel to a fire already lit by worries of twin deficits and the inherent responsivity of the dollar to momentum. It is dangerous to short EUR/USD when momentum is so strong; while we expect EUR/USD to correct over the next three months, it is safer to short the euro against the yen. The rebound in Australia's national income will peter off, this will hurt inflows into the country. The RBA will not surprise markets to the upside in 2018. Most of the drivers of AUD/USD point south. Stay short the AUD against the CAD and NZD, shorting AUD/JPY is attractive. Feature By somewhat abandoning the "strong dollar policy" in Davos, U.S. Treasury Secretary Steve Mnuchin sent the dollar in yet another tailspin this week.1 The weakness was further compounded by the seeming lack of concern vis-à-vis the euro's strength expressed by European Central Bank President Mario Draghi during the European Central Bank's press conference in Frankfurt yesterday. Mnuchin's comments rightfully worried investors, as they echoed President Trump's own rhetoric from a year ago that a strong dollar was negative for the U.S. economy, at least in terms of trade competitiveness. However, it is important to remember that words are only words, and for these utterances to have any durable impact, they need to be backed by policy instruments. The 1985 Plaza Accord was able to drive down the dollar not just because finance ministers said that the greenback was too strong, but also because the Federal Reserve cut interest rates in half between July 1984 and October 1986. This drove 2-year yield differentials between the U.S. and Japan, the U.K., and Germany down by 454 bps, 630 bps and 407 bps, respectively. Compounding this punch, the USD was trading at prodigiously expensive levels in early 1985. Today, the Fed is not cutting interest rates, it is raising them. In fact, BCA expects at least three rate hikes this year. The current weakness in the dollar is also easing U.S. financial conditions further, which is giving more ammunition for the Fed to tighten policy. Meanwhile, President Draghi reiterated that the ECB was very unlikely to increase rates in 2018; thus rate differentials between the U.S. and the euro area are widening, not narrowing. There is also the nagging question of the twin deficit in the U.S. The Trump stimulus package is expected to increase the fiscal deficit, and also feed through to a higher current account deficit. We have sympathy for this view. While such a twin deficit was associated with a weakening USD at the beginning of the millennium, in the first half of the 1980s it was not. Thus a twin deficit is no guarantee of a weaker dollar. The behavior of the Fed is likely to once again dominate. In the early days of the millennium, the Greenspan Fed was easing policy aggressively. In the early 1980s, while the Fed was cutting rates, it was cutting rates at a slower pace than had been anticipated because it realized that President Ronald Reagan's tax cuts and increased military spending were inflationary. Volcker wanted to make sure inflation expectations would stay well anchored, and not spike up. It thus seems that once again, the behavior of U.S. inflation is paramount. If U.S. inflation picks up as we expect (Chart I-1), the dollar is likely to appreciate as the Fed will hike. If U.S. inflation stays moribund, the twin deficit will likely tank the dollar. What to do practically? We have posited that the expected terminal rate spread between the euro area and the U.S. has been the interest rate spread driving EUR/USD rate over the past 12 months. Yet, even by this metric, the move in the euro to 1.25 is out of bound, as the euro has completely diverged from the recent trends in terminal rate differentials (Chart I-2). This suggests the euro is vulnerable at current levels. Chart I-1U.S. Inflation Will Pick Up Chart I-2Mind The Gap! It is also important to remark that the dollar's weakness is generalized. Moreover, the dollar is oversold and likely to experience a rebound (Chart I-3). However, timing this rebound is a made harder by the nature of the greenback. As we highlighted in a Special Report in December, the U.S. dollar is one of the two currencies exhibiting the strongest response to momentum factors.2 This is because the dollar is a very important macro variable, which is both responsive to global growth but also a key input to global growth. As global growth strengthens, this tends to weigh on the USD, but the USD's weakness tends to also boost global growth, as it eases global financial conditions. This creates a strong feedback loop that favors momentum trades in the USD. Chart I-3The Time To Bet On A Rebound Is High The greenback is currently entangled in such dynamics. Global growth improved after China massively stimulated its economy in 2015 and early 2016, which hurt the dollar. The weakness in the dollar is now helping global growth, which further hurts the dollar. It is thus a mugs game trying to time a reversal in the USD. As a result, even if we think EUR/USD is likely to experience a sharp correction in the coming weeks, we prefer shorting EUR/JPY. EUR/JPY is expensive, and positioning is just as extreme. However, by shorting the euro against the yen, we are not as exposed to the dollar cycle, and if global growth were to weaken in response to increasing tightening in Chinese policy, the yen would benefit in this environment. As such, the risk-reward ratio for this trade is higher. Bottom Line: Mnuchin comments on the USD were only an excuse for the dollar to sell off. The true culprit for the dollar's weakness is the greenback's own extreme sensitivity to momentum. As a result, timing a dollar reversal is nearly impossible. Only once the dollar begins to turn around can we begin betting on a tactical USD rally, even if it dooms us to miss the early parts of the move. Shorting EUR/JPY continues to offer a more attractive risk-reward tradeoff than shorting EUR/USD. Feature: Hard Times Ahead For The AUD The Australian dollar has rallied by a stunning 18.3% since its February 2016 trough. Improvement in global trade, surging Chinese stimulus, the resurgence in commodity prices, the rally in EM stocks, and the fall in the U.S. dollar have all aligned to transform the AUD into a high flyer. Not only have these factors encouraged risk-taking, creating an environment that is helping high-beta Australian assets perform well, they also have had a direct positive outcome on the Australian balance of payments, thus creating real improvements in the AUD's fundamentals as well. With AUD/USD now back above the key 0.80 threshold, it is important for investors to ask themselves: Can the AUD continue on its upward trajectory or is it time to bet against it? While the short-term outlook remains clouded by the USD's downward momentum, the AUD is likely to weaken on a cyclical basis. Playing AUD weakness against the NZD, CAD, and JPY seems like safer bets at the current juncture. Australian Economic Developments Australia's real GDP growth has slowed from 2.8% in Q3 2016 to 2.2% in Q3 2017, and currently stands below the lows recorded in 2015. However, this hides some very significant improvements, as nominal GDP growth has surged - from 1.4% in Q3 2015 to 6.5% in Q3 2017 (Chart I-4). Consumption has not been the crucial source of variations in Australia's economic activity. Instead, the source of change has emanated from net exports, which have moved from slicing off nearly 2% to GDP growth in late 2015 to adding more than 3% in the most recent quarter. The fluctuations in Australian growth have in large part reflected the dynamics in commodities prices. Australia has undergone massive fluctuations in its terms-of-trade as iron ore, copper and coal prices experienced a bust, followed by a subsequent boom that has pushed base metals prices up by 76% since their nadir. These movements in commodity prices not only explain past gross domestic product performance, they also explain the swings in both national income and corporate profits (Chart I-5). Chart I-4Australian Growth Decomposition Chart I-5The Positive Shock: Commodities In response to the improvement in national income and profits since the winter of 2016, the basic balance of Australia has surged from a deficit of 3% of GDP to a surplus of 3% (Chart I-6). While higher commodities prices contributed to higher exports, lifting the current account, portfolio flows moved up by more than 4% of GDP. This was simply because the surge in Australian corporate profits also made investing in Australia much more attractive for investors around the world. This combination caused a lot of investors to buy Australian dollars in the process, generating a severe upward bias in favor of the AUD. But how these trends are likely to evolve remains uncertain. To begin with, the rate of change of the Reserve Bank of Australia's commodity index has already rolled over, plunging from a high of 47% six months ago to -1% today. The historical lead times of this variable on GDP, GNI and profits suggests that each of these three variables are set to decelerate meaningfully in the coming quarters. This could weigh on inflows into Australia. China too plays a key role. Exports to China were subtracting 0.5% from Australia's growth as of the end of 2016 and are now adding 1.5%. Swings in Chinese activity could amplify the impact of the rollover in commodities price inflation. In fact, the slowing Li Keqiang index already paints this exact picture (Chart I-7). The growth rate of railway freight, one of the index's components, has already collapsed from 20% in August 2017 to 1%, and iron ore stockpiles in Chinese ports are hitting record highs. The tightening of the monetary and fiscal screws in China are therefore likely to exert a negative impact on Australia's national income, and thus on inflows that have been so important in supporting the AUD. Chart I-6From Income Shock To ##br##Balance Of Payment Shock Chart I-7China's Boost Is Dissipating ##br##The Boost To Trade Is Dissipating But what about real economic activity? Here again, the picture does not shine particularly bright. Fiscal policy has been a drag on GDP since 2011, and 2018 will be no exception, as the fiscal thrust will be -0.3% of potential GDP (Chart I-8). A potential rollover in aggregate profits could limit corporate capex in 2018. Mining projects in Australia are expected to continue to decline as a share of GDP in 2018, thus mining capex will remain a drag on growth (Chart I-9). Moreover, imports of capital goods have been a leading indicator of Australian capex, and they too have rolled over after a recent surge, suggesting that non-mining capex growth will also experience limited upside. The Australian consumer is also unlikely to come and save the day. To begin with, the savings rate has additional upside. As net worth has increased, Australian households have curtailed their savings rate to 3% of disposable income (Chart I-10). Moreover, debt levels have increased significantly, rising to an eye-opening 200% of income. The problem is that Australian housing is now much overvalued (Chart I-11). While this does not guarantee a fall in house prices, it is highly unlikely that net worth will continue to increase at its heady pace. Thus, with high debt loads and a limited wealth effect, the probability is high that the savings rate will increase. Chart I-8Fiscal Policy: Still Contractionary ##br## Fiscal Policy Is Still A Drag Chart I-9Mining Capex##br## Still Falling Chart I-10Households Savings ##br##Rate Should Rise Put together, the Australian economy is unlikely to accelerate this year. As Chart I-12 illustrates, business confidence has been weakening throughout the year, new orders are at high levels but are rolling over, and real consumer spending has not been able to gain any traction - despite job growth reaching a 3.8% annual pace. Job growth is unlikely to accelerate from such high levels, limiting the potential for household income growth to undo the damage of a rising savings rate. Chart I-11House Price Gains Will Slow Chart I-12No Boost To Real GDP Growth Bottom Line: The Australian dollar has benefitted from a major nominal improvement in the economy. As terms of trade rebounded, so did nominal GDP, national income and profits. This caused a surge in inflows into the country. However, the best of the positive terms-of-trade shock is ebbing, and the slowdown in Chinese industrial activity also points to weakening national income growth. In terms of real activity, the Australian fiscal drag continues unabated, capex will not accelerate, and households are likely to increase their savings rate, which will weigh on consumption. While Australia is not on the verge of recession, it will not experience much of a boom either. But How Fast Can The RBA Hike Anyway? Chart I-13The RBA Is Limited By Economic Slack The RBA is also still facing a tough environment. On one hand, job creation was very robust in Australia last year, and core CPI has accelerated. However, wage growth remains depressed at 2%. Even more disturbing is the fact that Australian wages have decoupled from a reliable driver: exports to China (Chart I-13). This underscores the extremely large degree of slack present in the Australian labor market. As the middle panel of Chart I-13 displays, the underemployment rate remains near twenty five-year highs and is congruent with the current level of wage growth. Moreover, Australia's output gap is still -2% of GDP and is not expected to close until after 2020. Thus, the underemployment rate will continue to act as an anchor on policy (Chart I-13, bottom panel). The strength in the AUD since 2016 will play into these dynamics. The lack of traction on wages is likely to be compounded by the tightening in monetary conditions resulting from an expensive AUD. As such, we would expect core CPI to weaken again in the coming quarters, which will comfort the RBA that its dovish stance remains appropriate. Finally, the high indebtedness of Australian households along with the fact that house price appreciation has slowed also suggests that household balance sheets are not capable of withstanding much of an increase in interest rates right now. The RBA is unlikely to toy with such a deflationary risk while the output gap is still negative and labor utilization is so low. The market is currently pricing in 40 basis points of hikes in 2018. A hike in 2018 is possible, as the global economy has healed from its deflationary nadir of 2016, but the economic backdrop of Australia will not let the RBA test the waters more than once this year. We thus anticipate that the RBA will continue to lag the Bank of Canada and the Federal Reserve - two central banks we expect to raise rates three times in 2018. The RBA will also most likely lag behind the RBNZ. Bottom Line: The Australian economy is replete with excess capacity, which is limiting the ability of the RBA to push up its policy rate. Moreover, the elevated indebtedness of Australian households suggests the RBA is loath to generate a deflationary shock while the output gap is already negative. The RBA will therefore lag the Fed, the BoC and the RBNZ. Implications For The AUD AUD/USD is currently trading at a 15% premium to its purchasing power parity equilibrium versus the U.S. dollar, making it one of the rare currencies expensive against the still-pricey greenback (Chart I-14, top panel). Moreover, Australia's real effective exchange rate also trades above its long-term average (Chart I-14, bottom panel). While the AUD is not wildly expensive, its current premium to fair value does suggest it would not be immune to adverse cyclical dynamics. What do the cyclical drivers currently say about the AUD? As we have highlighted, Australian national income and profit growth are likely to decelerate sharply in 2018, which is likely to undo some of the improvement that has materialized in the basic balance and thus remove one of the key supports that has underpinned the AUD. In this optic, the fact that the AUD has been able to strengthen despite a significant deceleration in Australian exports of iron ore to China raises a yellow flag against the AUD's strength (Chart I-15). Chart I-14No Valuation Cushion In AUD Chart I-15AUD Disconnect However, when investors expect strong growth from EM economies, the AUD does well. Thus, if the outlook for EM growth remains healthy, current weaknesses in commodities shipments can be safely ignored. Under this framework, the recent sharp upgrade by global investors of long-term earnings growth of EM equities sheds light on the AUD's strength, despite slowing iron ore exports (Chart I-16). Yet, this growth expectation is now the highest on record. This suggests the expectation hurdles in EM are very elevated. Even if EM growth does not crater, any disappointment could leave the AUD in a vulnerable position. The rollover in the annual performance of EM/JPY carry trades point to a growing risk of such disappointments.3 Financial markets are also sending interesting signals. Australian equities are underperforming global indices in local currency terms, suggesting the growth outlook for Australia is weakening relative to the rest of the world. These developments are true even when financial stocks are removed from the equation. Moreover, AUD/USD has historically traded in line with the relative performance between Australian and U.S. equities. Not only is the AUD currently quite above the level implied by the relative stock performance, but also the underperformance of Aussie stocks is deepening. This is another poor omen for AUD/USD (Chart I-17). Chart I-16Investors Love EM, ##br##This Helps The Aussie Chart I-17Listen To Equities If stocks are sending a message regarding the path of the Australian economy vis-à-vis the U.S., and thus about the outlook for AUD/USD, so are various key drivers of policy. First, AUD/USD normally broadly tracks the gap in the five-year moving average of nominal GDP growth between Australia and the U.S. This growth differential is moving in the opposite direction of AUD/USD, and based on the IMF's forecast, it is only expected to widen. AUD/USD has also been responsive to the relative utilization of labor, as measured by the spreads between the U.S.'s U-6 unemployment rate and Australia's labor underemployment measure (Chart I-18). Currently, this spread is not ratifying the rally in AUD/USD - and is pointing toward a much more hawkish Fed than RBA. This too paints a somber picture for the Aussie. This picture is echoed by the trend in Australia's employment-to-population ratio for prime age workers relative to the U.S. Again, Australia's large labor market excess supply points to a weaker AUD (Chart I-19, top panel). What's more, Australia's employment-to-population ratio is set to fall further vis-à-vis the U.S. This relative labor utilization measure has tracked the share of investment as a percent of Chinese GDP. This is because the investment-heavy period of development that China has undergone over the past 30 years has been very commodities intensive, forcing full labor utilization in Australia. However, based on the IMF's forecast, the role of investment in the Chinese economy is set to decline further (Chart I-19, bottom panel). Chart I-18Labor Market Slack Points To Weak AUD Chart I-19Labor Market And China Additionally, Xi Jinping's reforms are about decreasing pollution and leverage while increasing the role of consumption and services in the economy. This points to a risk of an even greater fall in the share of capex in China's economy. This would deepen the decline in labor utilization in Australia relative to the U.S., and thus increase downside risk for the AUD. Another risk emanates from U.S. financial markets themselves. The AUD tends to perform well when volatility in financial markets is on the decline, or at very low levels. This describes the current state of financial markets. On the other hand, a higher VIX is associated with a declining AUD. The VIX's current low level is not enough to flash an imminent sell signal, but the risk of a spike in risk aversion increases significantly if the spot VIX is low and the VIX futures curve is "too flat." Since there is a strong inverse relationship between the VIX futures curve slope and the spot VIX, the curve is "too flat" when its steepness is below the degree implied by the line of best fit linking the slope to spot VIX. As Chart I-20 shows, when the slope of the VIX is below this implied fair value, the subsequent 12 months of returns in the AUD/USD have been negative 84% of the time. The current reading in this relationship suggests that the AUD could depreciate by a large amount over the coming year. Chart I-20Flat VIX Term Structure = Lower AUD In 12 Months Bottom Line: Australia's national income growth is set to decline, and the RBA is unlikely to increase rates more than is currently priced into the curve. Moreover, the Australian dollar is trading on the expensive side. These factors point to vulnerability for the AUD. Moreover, key variables are suggesting this vulnerability could materialize into actual weakness: investors are pricing in too much growth in the EM space, Australian equities point to growth underperformance, labor market utilization measures suggest relative policy will hurt the AUD, China's long-term policy tilt is becoming increasingly AUD-negative, and any spike in asset volatility would hurt the Aussie. Strategy Considerations The arguments highlighted above all point to a weakening AUD. However, the picture is never that clear-cut. In fact, there is one major risk to our view: commodities prices and the USD itself. As Chart I-21 illustrates, commodities prices have a stronger inverse relationship with the USD than they have a positive link to Chinese economic conditions. Thus, if the greenback were to weaken further, the AUD could delay its moment of reckoning even further. This suggests that playing AUD weakness on its crosses, while potentially less rewarding, is a safer strategy. Our long-term valuation models continue to highlight the positive risk/reward tradeoff to shorting AUD/NZD: Not only is the New Zealand economy less exposed to shifting away from investment in the Chinese economy, AUD/NZD is trading at valuation levels that are historically followed by periods of pronounced weakness (Chart I-22). Moreover, the Kiwi economy is displaying a much higher level of resource utilization than Australia, suggesting there is more scope for the RBNZ to increase rates than there is for the RBA. Chart I-21Risk To The View: The Weak USD Chart I-22Improve Your Reward To Risk: Short AUD/NZD The same can be said about AUD/CAD. AUD/CAD also trades at a significant premium to its fair value. As we argued two weeks ago, like New Zealand, labor and capacity utilization in Canada are both very tight, thus we foresee three BoC rate hikes this year, which is at least two more than we anticipate in Australia. Additionally, our commodity strategists continue to like energy more than they like metals. Thus, terms-of-trade dynamics will play in favor of the CAD. That being said, this trade is much more correlated with the movements in AUD/USD than the AUD/NZD bet is. Shorting AUD/JPY is also an attractive trade right now. AUD/JPY is trading at a 30% premium to purchasing power parity, and the risk represented by a potential removal of over-exuberance currently evident in the pricing of growth in EM markets would likely be amplified in this cross. Additionally, as we highlighted two weeks ago, the risk of a tactical rally in the JPY is growing significantly. Bottom Line: The outlook is negative for AUD/USD, but if the USD's bear market can gather force from current levels, this would dampen the attractiveness of shorting the Aussie. While potentially less profitable but also considerably less risky, shorting AUD/NZD and AUD/CAD remain attractive expressions of our negative AUD bias. We also like going short AUD/JPY as it plays both on our positive tactical view on the JPY and on the risks of a slowdown in EM earnings growth expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Even if he somewhat retracted his comments later during the day. 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: The Chicago Fed National Activity Index underperformed expectations of 0.44, coming in at 0.27; The Richmond Fed Manufacturing Index came in at 14, well below the expected 19; Manufacturing PMI came in at 55.5, above the consensus of 55; Existing Home Sales contracted by 3.6% on a monthly pace; New Home Sales contracted by 9.3% on a monthly pace; Continuing jobless claims underperformed at 1.937 million, while initial jobless claims outperformed expectations at 233,000. The greenback has experienced notable downside this week owing to a slew of disappointing data and significant technical breakdowns. Treasury Secretary Steven Mnuchin's comments concerning a weaker dollar being beneficial for growth only added fuel to the fire. We have a neutral view on the greenback against the euro as emerging inflation in the U.S. later in the year should help alleviate some of the gains in the euro. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 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 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data this week was stellar: German Current Situations and Economic Sentiment ZEW Surveys came in at 95.2 and 20.14, outperforming the expected 89.8 and 17.8; Overall euro area Economic Sentiment ZEW Survey came in at 31.8, outperforming the expected 29.7; European consumer confidence also beat expectations of 0.6, coming in at 1.3; German IFO Business Climate and Current Assessment outperformed expectations, while the Expectations survey underperformed; German Gfk Consumer Confidence came in at 11, also surpassing expectations of 10.8. Mario Draghi affirmed his positive outlook on European growth and inflation. However, we believe that the most recent move to 1.25 is unsustainable as the euro continues to decouple from relative terminal rates. We believe that signs of weakening global growth should translate into a weaker euro in the short term. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Even if they decelerated relative to the previous month, imports yearly growth surprised to the upside, coming in at 14.9%. Moreover, the Nikkei Manufacturing PMI also outperformed expectations, coming in at 54.4. The All Industry Activity Index month-on-month growth also outperformed, coming in at 1%. However, exports yearly growth, surprised to the downside, coming in at 9.3%. The Bank of Japan left the reference rate unchanged at -0.1%. In their Outlook for Economic Activity and Prices, the BoJ stated that it expects inflation to reach the 2% target by 2019. Moreover, the committee highlighted that the output gap will move further into positive territory in 2018 and 2019. Overall, we expect for the yen to appreciate in coming months, particularly against the Euro, given that financial conditions have tightened much more in Europe than in Japan. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales and retail sales ex-fuel yearly growth both underperformed expectations, coming in at 1.4% and 1.3% respectively. Both of these measures also declined relatively to last month. Moreover, the claimant count change surprised negatively, coming in at 8.6 thousand. However, average earnings excluding bonus yearly growth outperformed expectations, coming in at 2.4%. This number also increased from 2.3% last month. GBP/USD has surged by almost 4% this week, partly due to the fall in the dollar. However the pound has also rallied against the euro, with EUR/GBP falling by almost 2%. Overall, the ability for the BoE to raise rates relative to other central banks will be limited, as the strengthening currency should create a drag on inflation and the economy displays underlying weaknesses. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian dollar has benefitted from last year's stellar growth period, now above the crucial 0.80 level. Slowing Chinese industrial activity and a domestic fiscal drag will handicap Australian growth this year. We believe the AUD is expensive amongst various metrics and the RBA is unlikely to hike any time soon given the negative output gap. Additionally, substantial labor market slack remains as the concentration of employment has been in part-time growth. We believe markets are overpricing hikes at 40 bps, and the AUD will suffer once this becomes priced in. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data In New Zealand has been mixed: The ANZ Activity Outlook was unchanged from last month, coming in at 15.6%. However, headline inflation surprised to the downside, coming in at 1.6%. It also declined significantly from last month's 1.9% value. Intraday, the kiwi fell by almost 1.5% following the weak inflation number. However even amid this drop NZD/USD has rallied by almost 1% this week, as the dollar has weakened to its lowest level in 3 years. Overall, we are positive on this cross relatively to the AUD, given that Australia is more sensitive to a slowdown in China than New Zealand. However, the New Zealand dollar will likely have downside against the yen. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was mixed: Wholesale sales monthly growth missed expectations of 1%, coming in at 0.7%; Headline retail sales missed expectations of 0.7%, coming in only at 0.2% on a monthly basis; Core retail sales (ex. Autos) outperformed the expected 0.8% greatly, coming in at 1.6% month-on-month; We remain bullish on CAD as strong employment and higher wages will augur well for inflation this year. Higher oil prices will continue to power the Canadian economy and help close the output gap in line with expectations. The Bank will therefore continue to tighten policy. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen this week by almost 0.5% even as the euro has rallied. Nevertheless, as long as the SNB continues with its ultra-dovish monetary stance, upside for the franc is limited, as the Swiss National Bank will continue to intervene in the currency markets. Indeed, on Monday SNB president Thomas Jordan once again reiterated that he believed that the franc was "Highly Valued". As of now, while inflation is slowly picking up, wage growth and house price growth are too anemic for the SNB to have a significant change in their monetary stance. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated by 2.2% this week, as it has been struck by a double whammy of higher oil prices and a very weak dollar. Meanwhile, on Wednesday, the Norges Bank decided to keep its key interest rate unchanged at 0.25%. The bank decided that monetary policy should stay accommodative for the foreseeable future, as inflation is likely to stay under target. Furthermore they stated that inflation, the economy, and the currency were evolving according to their December 2017 expectations. Overall, we expect the krone to appreciate relative to the Canadian dollar, as the BoC is fully priced this year, while the Norwegian interest rates could still have some upside amid rising oil prices. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 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 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden was mixed: Consumer confidence decreased to 107.2 from 107.7, under expectations of 107.4; The unemployment rate increased to 6% from 5.8%, but beat expectations of 6.1%; Producer prices increased in December at a 1.6% monthly pace, and a 2.3% yearly pace. The SEK has appreciated noticeably given the recent hawkish comments by Riksbank officials about the policy path. While the consensus does seem to be changing in the Bank, we remain cautious given Ingves' dovish leanings. SEK could weaken against EUR for the rest of the year given Europe's stellar growth momentum. Report Links: 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 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report co-authored by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst, and Brian Piccioni of Technology Sector Strategy. Mark and Brian argue that the deflationary impact of robot automation will not prevent inflation from rising as the labor market tightens. I hope you will find their report interesting and informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Our cyclically overweight stance on global equities/underweight stance on bonds is working. Stick with it. U.S. Treasury Secretary Mnuchin's comments about the dollar are unlikely to have any lasting effects. EUR/USD has decoupled from terminal rate expectations since the start of this year. Tactical trade recommendation: Go short EUR/USD while simultaneously going long 30-year U.S. Treasurys/short 30-year German bunds. Feature Global Equities Enter A Blow-Off Phase Valuations do not matter on the way up, but they sure do matter on the way down. Once the market reaches that Wile E. Coyote moment - the one where the poor sap runs off the cliff, pauses in mid-air, looks down, and sees the ground below - all hell will break loose. On every valuation measure, U.S. stocks, and increasingly global stocks, have become very expensive (Chart 1). Chart 1AU.S. Stocks Are Expensive... Chart 1B...While Global Stocks Are Getting There That moment, however, is unlikely to arrive until the global economy and earnings growth begin to stall out. As we have argued in past reports, this probably will not happen until late next year. Historically, it has not paid to get defensive until six months before the start of a recession (Table 1). This suggests that stocks could continue to rally right through 2018. Beep beep. Table 1Too Soon To Get Out Granted, the timing of our recession call could turn out to be wrong, which is why we are watching a wide number of leading variables for signs that a slowdown is around the corner (Chart 2). In the U.S., these include credit spreads, the slope of the yield curve, financial conditions, business and consumer confidence, ISM new orders minus inventories, building permits, core capital goods orders, and initial unemployment claims. We have consolidated these variables and dozens of others into our MacroQuant model. The model is still pointing to a reasonably rosy cyclical outlook for stocks (Chart 3). Chart 2Leading Cyclical Data Still Strong Chart 3Cyclical Outlook For Stocks Is Still Rosy The Dollar Takes A Pounding While our cyclical bullish view on stocks and bearish view on bonds has paid off this year, our expectation that the dollar would recoup some of last year's losses has not worked out. Time will tell if December 2016 marked the beginning of a secular dollar bear market. The dollar tends to suffer when global growth accelerates. This happened last year. The dollar also tends to weaken when the composition of growth shifts away from the United States. That also happened in 2017. The remainder of this year could be different. We expect global growth to remain solidly above-trend in 2018, but ease from the torrid pace of 2017. This is already being foreshadowed by the decline in our Global LEI diffusion index to below 50%, a slowdown in Korean and Taiwanese exports, a deceleration in the Chinese Li Keqiang Index, and the loss of momentum in EM carry trades (Chart 4). Meanwhile, the composition of global growth should shift back in favor of the U.S. The fact that the U.S. Economic Surprise index has recovered in recent months relative to other economies suggests that this reversal of fortunes is already underway (Chart 5). The end result for asset markets could be slightly reminiscent of the late 1990s, a period when both equities and the dollar rallied. Chart 4Global Growth Will Remain Above-Trend ##br##But Ease From Blistering Pace Chart 5Composition Of Global Growth Will Shift ##br##Back In Favor Of The U.S. Talk Is Cheap Chart 6Trade-Weighted Dollar No Longer Pricey We do not put much weight on the remarks concerning the dollar made by Treasury Secretary Steven Mnuchin at Davos this week. While Mnuchin did say that "obviously a weaker dollar is good for us as it relates to trade and opportunities," he added that "longer term, the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and it continues to be the primary currency in terms of the reserve currency." More importantly, history suggests that verbal interventions in currency markets are only effective beyond the near term when backed by a supporting change in monetary policy. Many people remember the success that then-Treasury Secretary James Baker had in driving down the dollar following the Plaza Accord in 1985, but what is often forgotten is that the Federal Reserve steadily cut rates from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year interest rate differential fell by 454 bps against Japan, 630 bps against the U.K., and 407 bps against Germany over this period. It is also worth noting that the Fed's real broad trade-weighted dollar index is now 27% below its 1985 peak and 3% below its long-term average (Chart 6). This makes any effort to talk down the dollar all the more difficult. ECB Sending Mixed Messages About The Euro Chart 7Market Has Brought Forward ECB Rate Hikes ECB officials continue to send mixed messages about the resurgent euro. Earlier this month, ECB Vice President Vitor Constâncio and Bank of France Governor François Villeroy both expressed concern about the euro's strength, as did Ewald Nowotny, the fairly hawkish President of Austria's central bank. In contrast, Mario Draghi refused to wade into the debate during yesterday's press conference. The lack of angst in his tone sent the euro higher. Draghi's reluctance to say anything concrete about the euro was partly motivated by the desire to avoid the sort of "beggar thy neighbor" criticism that greeted Mnuchin's remarks. Like other central banks, the ECB gives a lot of weight to financial conditions in setting monetary policy. A stronger currency has tightened euro area financial conditions. This is something that must concern the ECB, at least behind closed doors. Ultimately, any effort by the ECB to knock down the euro will only work if it convinces the market to soften its expectations about the future pace of rate hikes. The likelihood of such an outcome is certainly higher now than it was in 2016. Our "months to hike" measure for the ECB has plummeted from over 60 months in mid-2016 to 19 today (Chart 7). Given that the ECB has made it clear that it intends to delay raising rates for some time after asset purchases end later this year, it is hard to see the central bank hiking rates before the summer of 2019. That is not far from where market pricing now stands. In contrast, if euro area growth were to surprise meaningfully on the downside or if core inflation in the peripheral economies continues to fall - it is already close to zero in Italy - the ECB could be forced to bide its time longer than the market currently expects. A Safer Way To Short EUR/USD Chart 8EUR/USD And Rate Decoupling ##br##Will Not Last Long Still, the euro has a lot going for it. Unlike the U.S., the euro area is running a current account surplus. This means the region does not need to attract foreign capital for there to be excess demand for euros. All it needs to do is keep net capital outflows roughly below 3% of GDP. The ability of the euro area to retain and attract fresh capital has become easier as political risk has ebbed and the ECB's pledge to do "whatever it takes" to preserve the euro has solidified. The euro's share of global central bank reserves currently stands at 20%, well below the 60% share enjoyed by the U.S. dollar. If capital continues to gravitate towards the region, the euro could strengthen further. All this makes shorting the euro a risky bet. With that in mind, investors should consider hedging short EUR/USD positions by wagering that the terminal rate spread between the euro area and the U.S. will narrow. Chart 8 shows that the spread in expected policy rates ten years out has decoupled from EUR/USD since the start of the year. The same is true for the 30-year spread between Treasurys and bunds - another good proxy for the terminal rate spread. While spreads have widened in favor of the dollar, the greenback has nonetheless plunged. Such decoupling rarely lasts long, which makes this a highly attractive trade. With that in mind, we are going short EUR/USD as a tactical trade while hedging the risk of a stronger euro by going long 30-year Treasurys/short 30-year bunds (a bet on further spread compression). Given that the first leg of the trade is more volatile than the second, we are scaling up the latter by a factor of 1.5. We will aim to close the trade for a gain of 5% (EUR/USD of about 1.18), assuming no change in the current spread of 160 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity Chart II-10U.S.: Unit Labor Costs Vs. Robot Density In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density Chart II-16Japan: Where Is The Flood Of Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators 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 One of the biggest mistakes in finance is to equate risk with volatility. The correct measure of risk is the negative skew in payoff distributions. If 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. This would be the point at which to scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Feature It is the crucial question that all investors should ask at all times. What is the relative risk of the two major asset classes - bonds and equities - and are their relative return prospects commensurate with the relative risk? Chart of the WeekBelow A 2% Yield, 10-Year Bonds Are Riskier Than Equities But first, there is an even more fundamental question: what do we mean by risk? Conventional wisdom says that the risk of an investment is captured by its volatility. Indeed, through instruments such as the VIX futures and currency volatility options, volatility has become a multi-trillion dollar asset-class in its own right. Therefore, volatility must measure the risk of an investment, right? Wrong. The Biggest Mistake In Finance As a measure of risk, volatility is clearly wrong. Volatility regards price gains in exactly the same way as it regards price losses. But investors don't mind gains, they only mind losses! Consider an investment whose price moves alternately sideways and sharply higher. The maths would say that the returns have high volatility, implying that the investment is very risky. In truth though, the investment is highly desirable and 'risk-free' - because its price never declines. At our recent New York conference, Nobel Laureate Daniel Kahneman warned that one of the biggest mistakes in finance is to equate risk with volatility. After decades of empirical and theoretical studies - which culminated in the 2002 Nobel Prize for Economics - Kahneman proved that investors are not concerned about the symmetrical fluctuations in investment returns. Instead, they are concerned about the asymmetry - or skew - in payoff distributions. Kahneman explained the underlying psychology. "People are limited in their ability to comprehend and evaluate extreme probabilities, so highly unlikely events are overweighted." If the payoff distribution is symmetric, the overweighting of unlikely events in the loss tail and the gain tail exactly cancels out. But if the distribution is asymmetric, the longer tail determines the perceived attractiveness of the payoff. Where the longer tail is on the gain side, the distribution is said to have positive skew (Figure I-1). The classic example is a lottery. When people play the lottery, their loss is limited to the ticket price, but their gain could be tens of millions. People perceive the positive skew as attractive because they overweight the minuscule probability of becoming a millionaire. As a result, they overpay for the lottery ticket versus its expected value. Where the longer tail is on the loss side, the distribution is said to have negative skew (Figure I-2). This is like a lottery in reverse. The gain size is relatively limited, but the loss could be very large. People perceive the negative skew as unattractive because they overweight the probability of a large loss. As a result, they demand overpayment to take it on. Figure I-1People Like Positive Skew Figure I-2People Dislike Negative Skew For investments with negative skew, this overpayment takes the form of an excess return demanded from the market - a 'risk premium' - versus investments with less negative skew. Are Bonds A Greater Risk Than Equities? We are now in a position to tackle the question in the title. To determine whether bonds are riskier than equities or vice-versa, we must compare the skews of their return profiles.1 The important point is that for a bond, the skew of its return profile changes with its yield. At yields above 2.5%, 10-year bond returns show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, returns start to exhibit negative skew (Chart I-2). And at yields below 1%, the negative skew becomes extreme. Chart I-2Bond Risk Increases At ##br##Low Bond Yields Chart I-3Equity Risk Does Not Increase At##br## Low Bond Yields The reason is obvious. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Close to this lower bound for yields, bond mathematics necessarily creates a negatively skewed return profile. Simply put, prices have little upside, but they have a lot of downside! Chart I-4A 40Bps Rise In Yields Would Make Global ##br##Bonds Riskier Than Equities Turning to equities, the empirical evidence shows that equity returns always exhibit negative skew. Worst losses are typically around 1.5 times the size of best gains (Chart I-3). But the negative skew of equity returns is largely independent of the bond yield. The upshot is that there is a crossover bond yield below which the negative skew on 10-year bonds exceeds that on equities. This crossover bond yield is around 2%. In negative skew terms, we can say that at a 10-year bond yield below 2%, 10-year bonds are riskier than equities. And at a yield above 2%, equities are riskier than 10-year bonds (Chart of the Week). So in negative skew terms, 10-year bonds are riskier investments than equities in Europe and in Japan. But equities are riskier investments than 10-year bonds in the United States. Still, given that developed financial markets tend to move en masse, the relationship that is most significant is the aggregate one. At a global level, 10-year bond yields are 40bps below the crossover yield at which equities become riskier than bonds (Chart I-4). QE Distorted The Relative Valuation Of Equities Versus Bonds Which segues us neatly to today's ECB monetary policy meeting. Many people, worried about the end of QE, point out that the $10 trillion of bonds that the 'big four'2 central banks have bought is not far short of the size of the euro area economy. However, in the context of a global fixed income market of $220 trillion,3 $10 trillion of buying is small change. For the $220 trillion global bond and bank loan complex, the much more significant driver of yields has been the expected path of policy interest rates. As ECB Chief Economist Peter Praet put it, serial QE has been nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Chart I-5A Promise To Keep The Policy Rate Ultra-Low ##br##Pulls Down Bond Yields Central bankers know that QE depressed bond yields by signalling an extended period of ultra-low interest rates (Chart I-5). They also know that if the prospective return on bonds drops, so must the prospective return on competing investments such as equities. Thereby, the absolute valuations of bonds and equities both rise. However, one largely overlooked impact of QE - even by central bankers - has been the effect on the relative valuation of equities versus bonds. To repeat, when 10-year bond yields drop below 2%, their return distribution becomes more negatively skewed than that for equities. But if bonds become riskier investments, the 'risk premium' (excess return) on equities must disappear. Meaning equity valuations and prices get a second boost, compressing the prospective 10-year equity return to become 'bond-like'. Is this the case? Unlike for 10-year bonds, we do not know the 10-year prospective return from equities with certainty. However, we can get a good estimate from today's starting valuation. But which valuation metric to use? We are cautious of using profit based metrics as these will be flattered by the advanced position in the business cycle as well as the structural uptrend in profit margins. Instead, at an aggregate level, world equity market capitalisation to world GDP has been an excellent predictor of the prospective 10-year return on world equities. Today, this valuation metric is at the same level as in 2000 and 2007, and implies a prospective return of less than 2% a year (Chart I-6). Chart I-6World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Nevertheless, while the global 10-year bond yield stays below 2%, this is a sustainable valuation for equities. Effectively, equities and bonds are offering broadly similar negative skews, and therefore should offer broadly similar prospective returns. However, if 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. Though not there yet, this would be the point when we would scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 One simple way to quantify this skew is to find an extended period of time in which the price ended where it started, and then to calculate the period's worst 3-month loss as a multiple of the best 3-month gain. We define skew = -ln(worst 3-month loss / best 3-month gain) using log returns for 3-month loss and 3-month gain. 2 The Federal Reserve, ECB, Bank of Japan and Bank of England. 3 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. Fractal Trading Model* This week's trade is to position for an underperformance of the Japanese energy sector (led by JXTG Holdings And Inpex) versus the overall Japanese market. This is a longer trade than normal with a maximum duration of 26 weeks. Set a profit-target at 8% 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-7 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 Global Duration Strategy: Global bond yields continue to move higher, driven by rising inflation expectations and falling investor risk aversion. With global interest rates still not at levels that will restrict growth or draw capital away from booming equity markets, the path of least resistance for yields remains upward. Maintain a below-benchmark overall portfolio duration stance, with a bearish curve steepening bias in the U.S. and core Europe. U.K. Gilts: The momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. Stay overweight Gilts. Feature Revisiting Our Duration Strategy After The Rise In Yields Global government bond markets have started 2018 in a grumpy mood. The price return on the overall Barclays Global Treasury index is already down -0.6% so far in January, and yields are up for almost every country and maturity bucket within the developed market universe. Only longer-dated Peripheral European debt (Italy, Spain, Portugal, even Greece) has seen lower yields month-to-date, as the powerful growth upturn in the Euro Area has resulted in sovereign credit upgrades and narrowing spreads to core European bonds. The global sell-off has been led by the U.S., with the benchmark 10-year U.S. Treasury yield climbing all the way to 2.66% last week, already surpassing the 2016 high seen last March. Rising inflation expectations are the biggest culprit, with the 10-year TIPS breakeven rate climbing to 2.07%, the highest level since 2014. Chart of the WeekNo Good News For Bonds Right Now The relentless surge in global stock markets - driven by faster worldwide economic growth and an absence of volatility - is also helping fuel the bearishness in government bond markets. The economic growth momentum is showing no signs of abating. The IMF just raised its global growth forecast for both 2018 and 2019 to 3.9% in both years - the fastest pace since 2011 - largely because of the impact of the U.S. tax cuts but also because of much faster expected growth in Europe.1 The IMF noted that "the cyclical rebound could prove stronger in the near term as the pickup in activity and easier financial conditions reinforce each other." We could not agree more. With robust growth pushing a majority of economies to operate beyond full employment, and with financial conditions remaining highly accommodative, global bond markets are now pricing in both higher inflation expectations and less accommodative monetary policy (Chart of the Week). While we only expect actual rate increases in the U.S. and Canada in 2018, the pressures on global central banks to respond to the coordinated growth upturn with hawkish talk will keep government bond markets on the defensive - especially if global inflation rates are moving up at the same time. Diminishing demand for government bonds from recently reliable sources may also act to push up yields in the months ahead. A reduced pace of asset purchases from the European Central Bank (ECB) and Bank of Japan (BoJ), combined with the Fed reducing the reinvestments of its maturing Treasury holdings, means that the private sector must now absorb a greater share of bond issuance, on the margin. In the U.S. in particular, the biggest swing factor for the Treasury market could end up being the retail investor. Households have been notably risk-averse in the years since the Great Financial Crisis, keeping relatively high allocations to fixed income and relatively low allocations to equities after suffering such steep losses in the 2008 crash. Those attitudes are changing, however, with the U.S. equity market continuing to hit new all-time highs amid increased media coverage of the rally (as well as the bullish Tweets from the White House taking credit for it). The latest University of Michigan U.S. consumer confidence survey showed that the expected probability of another year of rising stock prices is now at the highest level (66%) in the fifteen years that question was asked. U.S. investment advisors are also very optimistic, with the Investors' Intelligence bull/bear ratio back to the highest level since 1987! (Chart 2) Yet actual equity returns over the past three years have lagged those seen during periods of elevated investor sentiment, like in 1987, 2005 and 2014 (Chart 2). What is missing now is a big surge of retail investor money into equities that can fuel the next leg of the equity rally, particularly through mutual funds and ETFs. Chart 2The Bond-Bearish Equity Party##BR##Is Just Getting Started This is starting to happen. The rolling 12-month total of net flows into U.S. equity mutual funds and ETFs is about to accelerate into positive territory for the first time since 2012, according to data from the Investment Company Institute (3rd panel). This could soon pose a problem for U.S. bond markets as, since 2008, there has been a reliable negative correlation between U.S. retail flows into equity funds and flows into fixed income funds, especially at major turning points (bottom panel). For example, after that 2012 bottom in net equity flows, the rolling total of net flows into bond funds collapsed from over $400bn to zero in a span of 18 months, with the vast majority of the outflow from bonds going into equities. An exodus of U.S. retail investors from fixed income would be a major problem for bond markets, especially at a time when net Treasury issuance is expected to increase due to wider fiscal deficits and the Fed will be buying fewer bonds as it begins to unwind its massive balance sheet. Other buyers like commercial banks and global reserve fund managers can pick up some of the slack if the retail bid fades from U.S. Treasuries. However, in an environment of strong global growth, rising inflation and more hawkish central banks, it may require higher yields to entice those buyers to ramp up their allocations. In the near-term, the next wave of global bond-bearish news will have to come from upside surprises in inflation, not growth. The Citi Global Economic Data Surprise index - which has historically correlated with swings in global bond yields - is now at elevated levels which should raise the odds of data disappointments as growth expectations get revised up (Chart 3). The Citi Global Inflation Data Surprise index, however, remains just below zero after last year's plunge, but is showing signs of stabilizing (bottom panel). U.S. inflation is already starting to bottom out, but Euro Area core inflation has been underwhelming of late. It will likely take a rise in the latter to trigger the next move higher in global yields, as the market will begin to more aggressively price in less accommodative monetary policy from the ECB. For now, U.S. Treasuries are driving the path of yields, with the "leadership" of the bond bear market expected to switch to Europe later on in 2018. In terms of our recommend duration strategy and country allocations, we are sticking with our current positions which are finally beginning to move in favor of our forecasts (Chart 4): Chart 3The Next Leg Higher In Global Yields##BR##Must Be Driven By Inflation Surprises Chart 4Our Recommended##BR##Country & Curve Allocations Underweights to countries where we expect central banks to hike rates (U.S., Canada) or more openly discuss a tapering of asset purchases (Germany, France). Overweights to countries where we expect no change in policy rates (U.K., Australia) or only modest changes to asset purchase programs (Japan). Positioning for steeper yield curves in countries where growth is strong, economies are at or beyond full employment, but where inflation expectations remain far enough below central bank targets to prevent policymakers from turning more hawkish faster than expected (U.S., Germany, Japan). Bottom Line: Global bond yields continue to move higher, driven by rising inflation expectations and falling investor risk aversion. With global interest rates still not at levels that will restrict growth or draw capital away from booming equity markets, the path of least resistance for yields remains upward. Maintain a below-benchmark overall portfolio duration stance, with a bearish curve steepening bias in the U.S. and core Europe. U.K. Gilts: The BoE's Hands Are Tied In our final report of 2017, we updated our recommended allocations in our Model Bond Portfolio based on the key views stemming from the 2018 BCA Outlook.2 We upgraded our country allocation to U.K. Gilts to overweight, primarily as a "defensive" position within a portfolio positioned for an expected rise in global bond yields. That may sound surprising given the current elevated level of inflation and low unemployment rate in the U.K. Yet our view is based on the notion that the Bank of England (BoE) will have a very difficult time trying to raise interest rates at all in 2018 when other major global central banks are likely to take a more hawkish turn. The main reason that the BoE will be unable to do much on the interest rate front is that the U.K. economy is likely to slow in the coming quarters. The OECD leading economic indicator is decelerating steadily, and is pointing to a real GDP growth rate below 2% in 2018 (Chart 5). The updated IMF forecast for the U.K. calls for growth to only reach 1.5% in both 2018 and 2019. The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumption growth has already been slowing since early 2017, driven by diminishing consumer confidence (Chart 6, top panel). High realized inflation which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (3rd panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing down on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 5U.K. Growth Set To Slow Chart 6The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The December 2017 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide house prices came in at 1.1% and 2.5% respectively (Chart 7, top panel). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) survey has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -54% in November 2017. U.K. homeowners have had to take a lot of hits over the past couple of years. A 2016 hike in the stamp duty for second homes and buy-to-let properties prompted a plunge in more "speculative" property transactions. The squeeze on real household incomes that has damaged consumer spending has also made homes less affordable, even with very low mortgage rates. Most importantly, the 2016 Brexit vote and subsequent uncertainty over the U.K.'s future relationship with Europe has placed an enormous cloud over housing demand - both from potential reduced immigration to the U.K. and businesses and jobs potentially relocating to European Union countries. The Brexit uncertainty is also weighing on U.K. business investment spending. U.K. capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017, and is even lower in real terms (Chart 8, top panel). Capex is generally import-intensive, and the rise in import costs due to the depreciation of the Pound after the 2016 Brexit vote raised the cost of investment. Chart 7No Growth In##BR##U.K. Housing Chart 8Brexit Gloom Trumps Export##BR##Boom For U.K. Companies This explains why U.K. capital spending has lagged even with manufacturing indicators in decent shape, such as the Confederation of British Industry (CBI) survey which shows the highest readings on total industrial orders and export orders since 1988 and 1995, respectively (2nd panel). Yet non-financial credit growth stalled out in the latter half of 2017, while the CBI survey of business optimism has turned into negative territory. Brexit uncertainties are clearly trumping strong export demand, thus U.K. capital investment is likely to remain sluggish in 2018 even with robust global growth. With U.K. economic growth likely to slow in 2018, the lingering problem of high inflation should start to fade. Already, both headline and core CPI inflation have stabilized, with the latter actually drifting a touch lower in the latter half of 2017 (Chart 9). The small gap between the two can be explained by the rise in global oil prices seen over the past year. The impact of oil on U.K. inflation expectations is relatively modest compared to other countries with much lower realized inflation rates, as we discussed in last week's Weekly Report.3 What is far more relevant is the path of British pound. The 16% plunge in the trade-weighted sterling index after the 2016 Brexit vote was a major reason why U.K. realized inflation blew through the BoE's 2% target last year. The currency has since stabilized at a depressed level and traded in a relatively narrow range in 2017. The trade-weighted index is now 3% above year-ago-levels, which should help U.K. inflation rates drift lower in the next 6-12 months - especially if U.K. growth underwhelms at the same time. Already, the more stable currency has allowed the inflation rates of import prices and producer prices to fall sharply last year (bottom panel), which should soon start to feed through into overall inflation rates. Lower realized inflation would be a welcome boost for the spending power of U.K. households and businesses, but will likely be dwarfed by the impact of oil prices in the near term. More importantly, the slowing momentum of economic growth, now fueled more by Brexit uncertainty than high inflation, will limit the BoE's ability to continue normalizing the very low level of U.K. interest rates. Our 12-month U.K. discounter shows that markets are pricing in 25bps of rate hikes over the next twelve months (Chart 10). The forward path of interest rates shown in the U.K. Overnight Index Swaps curve suggests that the hike could come by October. That is unlikely to happen given the slump in leading economic indicators, and peaking in currency-fueled inflation, currently underway. Chart 9Currency-Fueled U.K. Inflation Is Peaking Out Chart 10Stay Overweight U.K. Gilts A stand-pat BoE, combined with more stable and potentially falling U.K. inflation, will limit the ability for U.K. Gilt yields to rise by as much as we are expecting in the U.S., and even core Europe, over the next 6-12 months. Gilts have become a relative safe haven within a global bond bear market in the developed markets, with a yield beta of around 0.5 to U.S. Treasuries and German government bonds. This has already allowed Gilts to outperform the Barclays Global Treasury index (in currency-hedged terms) since the most recent cyclical low in global bond yields last September (bottom panel). We continue to expect Gilts to outperform in 2018. Stay overweight. Bottom Line: The momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. Stay overweight Gilts. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 http://www.imf.org/en/Publications/WEO/Issues/2018/01/11/world-economic-outlook-update-january-2018 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Allocation In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Importance Of Oil", dated January 16th 2018, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Trade #1: Go Short The December 2018 Fed Funds Futures Contract. The trade has gained 64 bps since we initiated it. We are lifting the stop to 60 bps and targeting a profit of 75 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities. The trade is up 13.1%. We are targeting a profit of 15%, and are tightening the stop further to 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts. The trade is up 0.7%. We see this as a multi-year trade with significant upside potential. The unwinding of heavy short positions could cause the yen to strengthen temporarily. The euro is vulnerable to negative growth surprises. A retracement of some of its recent gains is likely. Feature Looking Back, Thinking Forward I had the pleasure of speaking at BCA's Annual Investment Conference held in New York on September 27th of last year where I offered three "tantalizing" trade ideas. Chart 1 reviews their performance. They were the following: Trade #1: Go Short The December 2018 Fed Funds Futures Contract We argued last summer that U.S. growth was likely to accelerate, taking rate expectations higher. That has indeed happened. Aggregate hours worked rose by 2.5% in Q4 over the previous quarter. Assuming that productivity increased by 1.5% in Q4 - equal to the pace recorded in Q3 - real GDP probably increased by nearly 4%. A variety of leading indicators point to continued above-trend growth in the months ahead (Chart 2). Chart 1Three Tantalizing Trades: ##br##An Update Chart 2Leading Indicators Pointing ##br##To Above-Trend U.S. Growth We think the Fed will raise rates four times this year, one more hike than projected by the dots and roughly 35 bps more in tightening than implied by current market expectations. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. We have been saying for a while that above-trend growth will take the unemployment rate down to a 49-year low of 3.5% by the end of this year. If the unemployment rate falls this much, the Fed will probably turn more hawkish. Stronger inflation numbers should also give the Fed confidence to keep raising rates once per quarter. Core inflation surprised on the upside in December. We expect this trend to continue in the coming months, as the ISM manufacturing index, the New York Fed's Inflation Gauge, and our own proprietary pipeline inflation index are already foreshadowing (Chart 3). Chart 3U.S. Inflation ##br##Should Accelerate Chart 4A Pick-Up In Wage Growth ##br##Would Put Upward Pressure On Service Inflation As we noted two weeks ago,1 service sector inflation should get a lift from faster wage growth this year (Chart 4). Goods inflation should also rise on the back of higher oil prices and the lagged effects of a weaker dollar (Chart 5). In addition, health care inflation is likely to pick up from its current depressed level, especially if the Congressional Budget Office is correct that insurance premiums will rise due to the elimination of the individual mandate (Chart 6). Housing inflation will moderate, but this is unlikely to stymie the Fed's tightening plans since excessively low interest rates could lead to even more overbuilding in the increasingly vulnerable commercial real estate sector. Chart 5Higher Oil Prices And A Weaker Dollar ##br##Are A Tailwind For Inflation Chart 6Health Care Inflation ##br##Should Move Higher Granted, four rate hikes equal four opportunities to defer raising rates. It is easy to imagine scenarios where the Fed stands pat, but hard to conjure scenarios where the Fed has to raise rates five times or more this year. Thus, the risk to our four-hike view is to the downside. As such, we will be looking to take profits of 75 bps on the trade, and are putting in a stop of 60 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities Capital spending tends to accelerate in the late innings of business-cycle expansions. We are in such a phase now, as evidenced by capital goods orders, capex intention surveys, and our global capex model (Chart 7). Increased capital spending will benefit industrial companies. Conversely, rising bond yields will hurt rate-sensitive utilities. Valuations in the industrial sector have gotten stretched, but are not at extreme levels (Chart 8). Based on enterprise value-to-EBITDA, industrials are still only slightly more expensive than utilities compared to their post-1990 average. Chart 7Capex Is Shifting Into ##br##Higher Gear Chart 8Industrial Stocks: Valuations Are Stretched, ##br## But Not Yet Extreme While we do think global growth will slow this year from the heady pace of 2017, it should remain firmly above-trend. A bigger-than-expected slowdown - especially if it is concentrated in China - would undoubtedly hurt industrials. A stronger dollar could also be a headwind. Thus, we are keeping this trade on a short leash, with a target of 15% and a stop of 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The Japanese economy is on fire. Growth almost reached 2% in 2017 and leading indicators suggest a solid start to 2018 (Chart 9). The unemployment rate has fallen to 2.7%, a full point below 2007 levels. The ratio of job openings-to-applicants has surpassed its bubble peak. The Tankan Employment Conditions Index is pointing to an exceptionally tight labor market. Wages excluding overtime pay are rising at the fastest pace in twenty years (Chart 10). Chart 9Japanese Growth Momentum Is Positive Chart 10Signs Of A Tight Labor Market Inflation is low but is starting to edge up. The most recent release surprised on the upside. Inflation expectations moved higher on the news, benefiting our long Japanese 10-year CPI swap trade recommendation (Chart 11). A simple scatterplot between the unemployment rate and core inflation suggests the Phillips curve remains intact in Japan -- amazingly, it even looks like Japan (Chart 12)! Chart 11Inflation Expectations Have Edged Higher Chart 12The Phillips Curve In Japan Looks Like Japan Still, with core inflation excluding food and energy running at only 0.3%, there is a long way to go before inflation reaches the BoJ's target -- and even longer if the BoJ honours its promise to generate a meaningful overshoot to compensate for the below-target inflation of prior years. This suggests the BoJ will not meaningfully water down its Yield Curve Control regime anytime soon. As such, five-year yields are likely to stay put while yields with maturities in excess of ten years should move higher. Our "tantalizing trade" being short 20-year JGBs versus their 5-year counterparts still has a long way to run. Too Risky To Short The Yen The exceptionally strong correlation between USD/JPY and U.S. Treasury yields has broken down this year (Chart 13). Had the relationship held, the yen would have actually weakened against the dollar. Still, we are reluctant to get too bearish on the yen (Chart 14). The yen real effective exchange rate is close to multi-decade lows. Positioning on the currency is heavily short. The current account surplus has mushroomed from close to zero in 2014 to 4% of GDP at present. And even if the BoJ keeps the Yield Curve Control regime in place, investors may still anticipate its demise, leading to a temporary bout of yen strength. Chart 13Strong Correlation Is Broken Chart 14Too Risky To Short The Yen What's Propping Up The Euro? The euro has been on a tear since last week, egged on by the ECB minutes, which hinted at a faster pace of monetary normalization. Growing confidence that Angela Merkel will be able to form a grand coalition also helped the common currency, along with hopes that the new government will loosen the fiscal purse strings. The euro is often thought of as the "anti-dollar." And sure enough, the euro's strength has been reflected in a broad-based decline in the dollar index in recent days. BCA's Global Investment Strategy service went long the dollar on October 31, 2014. We "doubled up" on this call in the fall of 2016, controversially arguing that "Trump will win and the dollar will rally." Obviously, in retrospect, I should have rung the register and declared victory on our long dollar view when I had the chance. EUR/USD fell to 1.04 on December 2016, within striking distance of our parity target. Bullish dollar sentiment had reached unsustainably lofty levels. That was the time to sell the greenback. But hubris got the best of me. While our other currency trade recommendations have delivered net gains of 11% since the start of 2017, the long DXY trade has stuck out like a sore thumb. Hindsight is 20/20. The key question is what to do today. EUR/USD is still trading below the level it was at when we went long the DXY. Relative to the IMF's Purchasing Power Parity exchange rate of 1.32, the euro is 7% undervalued. That said, PPP exchange rates may not be a reliable benchmark in this case. Given current market expectations, EUR/USD would need to strengthen to 1.41 over the next ten years just to cover the carry cost of being short the dollar. Even assuming lower inflation in the euro area, that would still leave the euro trading above its long-term fair value. It is possible, of course, that rate differentials will narrow further, but the scope for this is more limited than it might appear. The market currently expects policy rates ten years out to be 95 basis points higher in the U.S., down from a spread of nearly 180 basis points in late December (Chart 15). Given that euro area inflation expectations are 40-to-50 bps lower than in the U.S., this implies a real spread of about 50 bps - broadly in line with our estimate of the real neutral rate gap between the two regions. Ultimately, the fate of the euro in 2018 will rest on the same question that drove the currency in 2017: Will euro area growth surprise on the upside, prompting investors to price in a faster pace of monetary normalization? The bar for success is certainly higher at present. Chart 16 shows that euro area consensus growth estimates have risen significantly since the start of last year. The expected lift-off date for policy rates has also shifted in by more than a year to mid-2019. Considering that Jens Weidmann stated earlier this week that he thinks current market pricing is broadly consistent with when the ECB expects to hike rates, there is little scope for the lift-off date to move forward. Chart 15Little Scope For Rate Differentials ##br## To Narrow Further Chart 16Euro Area Growth Estimates Have Been Revised Up ##br##Since The Start Of 2017 Meanwhile, financial conditions have tightened significantly in the euro area relative to the U.S., the euro area credit impulse has turned negative, and the U.S. economic surprise index has jumped above that of the euro area (Chart 17). Euro area inflation has also dipped. Especially worrying is that core inflation in Italy has fallen back to a near record-low of 0.4% (Chart 18). How is Italy supposed to navigate its way out of its debt trap if nominal growth stays this weak? On top of all that, long speculative euro positions have soared to record-high levels (Chart 19). Given the choice of betting whether EUR/USD will first hit 1.30 or 1.15, we would go with the latter. If our bet turns out to be correct, we will use that opportunity to shift to neutral on the dollar. Chart 17The Euro Is Vulnerable ##br##To Negative Growth Surprises Chart 18Euro Area Core Inflation ##br##Has Dipped Chart 19Euro Positioning: From Deeply Short ##br##To Record Long Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The euro is in a cyclical bull market. It is supported by attractive valuations, improving balance of payments dynamics, declining political risk, potential shifts in reserves preferences, and a re-rating of the European terminal rate. This positive cyclical backdrop hides a more treacherous short-term outlook. EUR/USD is vulnerable because ECB members are increasingly worried, the European periphery is displaying early strains, European inflation will slow versus the U.S., global industrial activity may experience a mini down cycle, and sentiment measures are massively stretched. Short EUR/JPY for now, and use any move in EUR/USD to 1.15 or lower to buy this pair. Feature The euro has undergone a major paradigm shift over the course of the past 16 months. In December 2016, the euro was trading near parity, and expectations were uniform that it would fall well below that threshold. The narrative was simple: Europe was turning Japanese, with inflation forever moribund; also, Europe was succumbing to the siren call of nationalism and populism, which meant the euro was bound to break up within the next five years. Meanwhile, the U.S. was on the rebound. Core consumer price inflation was above 2.2%, and U.S. President Donald Trump was set to massively stimulate the American economy, giving a free hand for the Federal Reserve to hike to its heart's content. Today, the picture could not be more different. Investors expect the European Central Bank's first hike to materialize in the summer of 2019, European growth is stellar, and European inflation is not low enough to warrant emergency-level policy rates. As a result, not only is EUR/USD trading above 1.20, but consensus forecasts increasingly see the euro trading into the 1.25 to 1.30 zone by year end. Is EUR/USD at 1.22 a buying or a selling opportunity? Short-term risks are currently elevated for the euro, but a move toward 1.15 would represent a buying opportunity, as the cyclical bear market in the euro is over. The Long-Term Bull Case A crucial long-term positive factor for the euro is that it is cheap. EUR/USD currently trades at a 10% discount to its purchasing-power-parity equilibrium, even after a nearly 17% rally since its December 2016 low. Encapsulating this concept, the real effective exchange rate for the euro remains well below equilibrium (Chart I-1). Additionally, our fundamental long-term fair value model pegs the euro as being almost 1-sigma undervalued. The euro area's balance of payment is also very favorable. It is well known among the investment community that the euro area sports a surplus of 3.5% of GDP, but significant changes are also materializing in the capital account. Portfolios outflows out of the euro area have begun to decrease, as equity inflows are rising and bond outflows are becoming smaller. Moreover, the euro area basic balance is moving into positive territory, which historically has been a precursor to sustainable euro rallies (Chart I-2). The supply of euro for international markets is therefore decreasing. Additionally, the euro area's net international investment position (NIIP), which was as low as -17% of GDP in 2014, will likely move into positive territory toward the end of the year. The NIIP has historically been a strong driver of long-term exchange rate moves.1 Chart I-1The Euro Is Still Cheap Chart I-2The European Balance Of Payments Has Improved Politics too have been moving in the right direction. Euro skepticism is not taking hold in the euro area: Last year's French election was a vivid demonstration that "more Europe" is not electoral poison. Even the Italian elections this coming March may not land much of a blow to the European project: The Five Star Movement is rapidly softening its anti-euro rhetoric, and support for centrist parties is strengthening (Chart I-3). Moreover, a German move toward a grand coalition means Angela Merkel's CDU is very likely to be governing along with a pro-euro SPD, whose campaign theme was "MEGA": Make Europe Great Again. Already, Germany is lending a listening ear to some of Macron's integrationist proposals, and fiscal stimulus could well be in the pipeline. Long-term reserves diversification is also in the euro's favor. A headline last week suggested that China would unload some of its vast holdings of Treasurys. This leak was soon condemned as "Fake News" by China's State Administration of Foreign Exchange. However, while the news clearly lacked substance, the reality remains that despite the euro area and the U.S. being similarly sized economies, the euro only represents 20% of allocated global reserves, compared to 65% for the greenback. The greater depth and liquidity of U.S. bond markets contributes to this discrepancy, but the ECB's bond buying, by creating a scarcity of euro denominated securities, has exacerbated the disparity. This latter handicap for the euro will end sometime next fall, and if Europe's integrates further, European bond markets will increasingly become alternatives to U.S. ones. A rebalancing of reserves would principally help the euro by hurting the U.S. dollar: It will become more tenuous for the U.S. to achieve a positive international income balance while sporting a NIIP of -40% of GDP if official international demand for dollars falls (Chart I-4). Chart I-3Italian Centrists Are Gaining Ground Chart I-4The USD Needs Its Reserve Status Finally, the terminal rates differential between the U.S. and the euro area remains well above its long-term average of 110 basis points. Thus, there is scope for a normalization of European terminal rates relative to the U.S. on a long-term basis (Chart I-5). However, an average is only a number. What forces could cause the terminal rate spread between the euro area and the U.S. to normalize over the coming years? European policy is currently very loose when compared to the U.S., which will enable the ECB to play catchup over the coming years. To make this judgment, we look at broad money supply in excess of money demand. Because money demand is an unobserved variable, we have to estimate it. Economic theory argues it should be a positive function of economic activity, wealth and uncertainty. Therefore, to get a sense of what money demand may be, we regress the real broad money aggregates of various countries on uncertainty indices and real wealth.2 The difference between real broad money supply numbers and these estimates represent excess money supply. If a country's excess money is being generated today, it ends up stimulating future economic activity and inflation. This increase in expected nominal growth should contribute to lifting expected interest rates at the long end of the yield curve - i.e. expected terminal rates. As Chart I-6 shows, the stock of excess money supply in the U.S. has stopped growing since 2015. However, it is currently exploding in the euro area as European commercial banks are regaining their health and lending again. The money supply dynamics in Europe signal that the easy policy of the ECB is finally bearing fruit. And as the bottom panel of Chart I-6 illustrates, when European excess money supply increases relative to the U.S., as is currently the case, EUR/USD experiences cyclical rallies.3 This counterinituitive result exists because previous ECB easing is bearing fruits, European asset returns are rising, and economic activity is increasing. As a result, the European terminal rate now has more scope to rise vis-à-vis the U.S. The steepening of the German yield curve relative to the Treasury curve only confirms this message (Chart I-7). Chart I-5The U.S. Terminal Rate Has Room To Fall##br## Against That Of Europe Chart I-6European Excess##br## Money Is Surging Chart I-7Listen To Yield ##br##Curves The five forces described above imply that the euro's move from 1.03 to 1.21 was the first salvo in what is likely to be a long cyclical bull market that could end up driving the euro above 1.40 over many years. However, these factors provide little insight regarding the euro's path over the next three to six months. Bottom Line: The euro is likely to have embarked on a cyclical bull market at the beginning of 2017. Five factors support this judgment: The euro is cheap, the European balance-of-payment backdrop is favorable, political winds in the euro area remain favorable to further European integration, global foreign exchange reserves are very underweight the euro, and the spread between U.S. and euro area expected terminal rates remains well above its long-term average, and has scope to narrow. Murkier Short-Term Outlook While the long-term outlook is very favorable for the euro, the shorter-term outlook is much more clouded. First, the chorus of complaints against the euro's strength is growing among European central bankers. In recent days, not only have Vitor Constâncio and Francois Villeroy voiced concerns over the euro's recent strength, but so has Ewald Nowotny, the rather hawkish Austrian central banker. Additionally, Bundesbank President Jens Weidmann stated that the market should not anticipate a rate hike before the summer of 2019, suggesting he would not want to see a more aggressive rate pricing than what is currently at play (Chart I-8). Second, the less competitive and more fragile European periphery is already showing early signs that the sharp appreciation in the euro is causing some pain. Peripheral equities have begun to underperform the stocks of core euro area nations, and are also sharply underperforming U.S. equities. This phenomenon tends to be associated with a weakening euro. Moreover, peripheral inflation excluding food and energy has already weakened to 1.3% from a high of 2% in February last year, the consequence of a tightening in financial conditions (Chart I-9). Chart I-8ECB Doesn't Want This To Change Chart I-9Peripheral Core Inflation In Free Fall Third, the economic environment points to underperformance of aggregate European inflation relative to the U.S. A fall in the gap between euro area and U.S. inflation tends to be associated with short-term gyrations in EUR/USD (Chart I-10). This is because a fall in relative inflation against the euro area causes investors to temporarily tweak the perceived path of future policy differentials. Over the course of 2018, U.S. inflation is set to increase. A simple model based on U.S. capacity utilization and the velocity of money shows that U.S. core CPI could hit 2.1% (Chart I-11). While this model has done a good job picking the turning points in U.S. core inflation, it has consistently overestimated inflation since 2013. Correcting for this bias, the model still forecasts a significant pick-up in inflation to 1.8% (Chart I-11, bottom panel). Chart I-10Higher European Inflation Equals Higher Euro Chart I-11A U.S. Inflation Pick Up Is Coming The same cannot be said for euro area inflation. Not only is the European periphery already feeling the pain caused by the euro's strength, but also we have entered the window of time where the previous tightening in euro area financial conditions vis-à-vis the U.S. puts a brake on euro area relative inflation.4 Moreover, the diffusion index of the components of the euro area core CPI index has been below 50% for four months in a row now. Historically, this has been associated with a fall in core CPI. Fourth, over the past year or so, EUR/USD has traded in line with risk assets. The euro area has benefited from EM growth improvement, which has lifted all corners of the global economy levered to the global industrial cycle. As a result, as investors become increasingly bullish on industrial metals, EM assets or momentum plays, so they have of the euro.5 However, clouds are slowly forming over the global economy, at the very least pointing to a mini-cycle downturn. For one, Chinese producer prices have rolled over, and Chinese import growth has significantly underperformed expectations in recent months, slowing to a 5% pace from a 20% pace as recently as September 2017. Essentially, industrial activity has slowed in response to a tightening in Chinese monetary conditions. This slowdown is already beginning to impact various corners of the globe: Korean and Taiwanese export growth continues to decelerate; BCA's Global LEIs Diffusion Index is well below the 50% mark, which normally precedes slowdowns in the global LEI itself; Our boom/bust and global growth indicators have slowed further - two precursors to global industrial production decelerations. Our global economic and financial A/D line, which tallies 100 pro-cyclical variables, has also rolled over sharply, another early warning sign for the global economy (Chart I-12). Finally, as we highlighted in December, EM/JPY carry trades, a canary for the global economy, have lost momentum - a signal that has normally preceded a slowdown in global industrial activity.6 All these signals only confirm the "Yellow Flags" we highlighted last October.7 In an environment where complacency is rampant and assets levered to growth are priced for perfection, this is worrisome. The euro's recent elevated correlation to such risk assets, along with the fact that the gap between European and U.S. core inflation is itself led by Chinese PPI, suggests that the euro is tactically vulnerable. Fifth, from a technical perspective speculators have never been this long the euro, which represents a significant danger as the euro is trading at a sharp premium to its short-term interest rate driver (Chart I-13). Moreover, risk-reversals for EUR/USD point to heightened susceptibility of a selloff if the bad omen on global growth and European inflation come to fruition (Chart I-14). Chart I-12Rising Risks For Global Growth Chart I-13The Euro Is Vulnerable Chart I-14Risk Reversals Point To Euro Downside This short-term picture suggests that the probability of a move in EUR/USD toward 1.15 is growing over the course of the next three to six months. Bottom Line: While the cyclical picture for the euro is bright, the short-term snapshot is much more dangerous. Not only are an increasing number of ECB officials weighing in on the impact of the euro's recent rally, but the European periphery is showing growing signs that the euro rally has indeed taken a bite. Additionally, European inflation is set to underperform U.S. inflation, and the global economic cycle could enter a short burst of disappointment. Finally, investors are not positioned for such developments, increasing the likelihood of a downward move in the euro. What To Do? Caught between a cyclically propitious backdrop and a tactically dangerous environment, EUR/USD presents a riddle for FX investors right now. The odds of a euro correction over the next three to six months are substantially greater than 50%. But as we highlighted last week, instead of taking a direct bet on EUR/USD, we recommend investors short EUR/JPY. Shorting EUR/JPY is an even cleaner way to take advantage of the cloudy weather building over the global economy.8 Moreover, in recent years, EUR/JPY has fallen when the 52-week rate-of-change of momentum trades began to weaken (Chart I-15). This highly mean-reverting indicator is currently in the 96th percentile of its distribution for the past 25 years, suggesting an imminent rollover. Additionally, EUR/JPY tends to perform well when the LIBOR-OIS spread widens. Today, the three-month FRA-OIS spread has been widening, even as the end-of-year dollar funding shortage has passed (Chart I-16). These kinds of dynamics point to a potential drying out in global liquidity, a phenomenon which historically hurts risk assets, especially when they are as frothy as they are now. This should once again hurt EUR/JPY. Chart I-15EUR/JPY And Momentum Stocks Chart I-16Funding Stresses Point To A Fall In EUR/JPY Thus, shorting EUR/JPY is our highest conviction trade for the next six months or so. If, as we foresee, EUR/USD weakens during the first half of 2018, we will look to buy this pair. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets" dated February 26, 2016 available at fes.bcaresearch.com 2 We do not include real GDP in the models because since wealth is affected by GDP, they are two co-integrated variables, which creates strong multi-collinearity in the regressions. Of the two variables, real wealth was the stronger explanatory variable. 3 While the focus of this report is on the euro, the relationship between relative excess money supply and currency performances works across many exchange rates. We will develop this theme over the coming weeks. 4 Please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets" dated February 26, 2016 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Euro: Risk On Or Risk Off" dated November 17, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "A Cold Snap Doesn't Make A Winter" dated January 5, 2018 available at fes.bcaresearch.com 7 Please see Foreign Exchange Strategy Weekly Report, "The Best Of Possible Worlds?" dated October 6, 2017 available at fes.bcaresearch.com 8 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data out of the U.S. was strong this week: Industrial production increased by 0.9% on a monthly pace; Capacity utilization increased to 77.9% from 77.2%; Continuing jobless claims increased to 1.952 million from 1.876 million, beating expectations of 1.9 million; Initial jobless claims however decreased to 220K from 261K, beating expectations of 250K. We continue to expect the Fed to hike more than is priced by the market. A tightening labor market will eventually feed inflationary pressures, causing upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 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 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was decent: German CPI came in unchanged and at expectations, at 1.6%; European headline and core CPI also remained unchanged and at consensus, coming in at 1.4% and 1.1% respectively. However, the euro seems to be losing momentum his week. Comments by ECB board members such as Ewald Nowotny, Vitor Constâncio, and Francois Villeroy, all pointed to issues with the euro's sharp rise, and how they "don't reflect changes in fundamentals". Additionally, relapsing inflation data in the peripheries shows that the strength in the euro is beginning to cause strains and may even negatively affect the ECB's mandate. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Domestic corporate goods year on year inflation underperformed expectations, coming in at 3.1%. It also decreased substantially from November. Moreover, the Eco Watchers Survey for current conditions underperformed expectations, coming in at 53.9. It also decreased from the November reading. However, machinery orders yearly growth outperformed expectations substantially, coming in at 4.1%. USD/JPY is relatively flat from last week. Overall we expect upside to the yen to be limited against the U.S. dollar, given that bond yields are set to go up in the U.S. That being said, the yen has upside against the euro, as financial conditions have eased significantly in Japan relatively to the euro area. This should cause rate expectations in Japan to improve relative to those of Europe's, pushing EUR/JPY lower. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The DCLG House Price Index yearly growth outperformed expectations, coming in at 5.1%. However, core consumer price inflation underperformed expectations, coming in at 2.5%. It also decreased from the 2.7% reading of November. Moreover, headline inflation came in line with expectations at 3%. This also marks the first decrease in inflation in the U.K. since July 2017. Lifted by the USD's weakness, cable has now reached the pre-Brexit low 1.38 hit in February 2016. However, GBP has been experiencing a downtrend versus the euro since last September Overall, we continue to be skeptical of the ability of the BoE to raise interest rates meaningfully. Thus, we would fade any further rally from GBP/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was strong this week: Home loans grew at a 2.1% annual pace in November, higher than the expected -0.2%; Employment grew by 34.7K, beating expectations of 9K. The part-time component increased by 19.5K, while the full-time component grew by 15.1K; The participation rate increased to 65.7% from 65.5%; Unemployment rate increased to 5.5% from 5.4%. Foreign exchange traders lifted the AUD further this week. While the headline employment data remains stellar, the heavy concentration part-time job creation means that overall labor utilization measures is staying low. This will cap wage and inflationary pressures, especially as the AUD is once again expensive, further exacerbating deflationary pressures. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: The month-on-month growth of food prices declined from -0.4% to -0.8%. Moreover, Electronic Card retail sales yearly growth slowed from 4.3% to 3.3%. Finally the ANZ Commodity Price Index year on year growth declined from -0.9% to -2.2%. The New Zealand Dollar has surges by almost 3% year to data against the U.S. dollar. This has been largely due to the depreciation of the greenback itself, as global growth continues to beat forecast. On a short term basis we are positive on the NZD relative to the AUD, as Chinese tightening should weigh more on Australia than New Zealand. However, the new populist government in New Zealand worsens the outlook of the kiwi on a long term basis. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Movements in the petrocurrency were muted following the 'dovish hike' by the Bank of Canada. Numerous factors were highlighted to justify the rate hike to 1.25%, such as: strong employment growth; higher wages; robust consumption; and exceptional GDP growth in 2017. While the Bank's Business Outlook Survey suggests the labor market is tightening due to labor shortages, the BoC underplayed this factor, pointing to much more muted overall labor utilization metrics. The BoC also noted the expected decline in the contribution of housing and consumption to growth this year due to higher mortgage and borrowing rates. While the economy is firing on all fronts, the spread between the West Canada Select and West Texas Intermediate oil prices continues to widen due to a lack of pipeline capacity to ship the oil out of Canada. According to the Bank, these bottlenecks should be temporary, which means that the CAD could catch up to oil later. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 On Tuesday, Thomas Jordan, the president of the SNB once again reiterated that the franc is still "highly valued", and thus interest rates need to stay low so as to prevent the franc from appreciating. Moreover, he emphasized that while expansionary monetary policy was necessary, it was important to not wait too long to normalize rates. Overall, we believe that the SNB will want to see sustained inflation at relatively high levels to justify an exit from their radical monetary policy. In the meantime the Swiss Central bank will stay accommodative, and thus, EUR/CHF is likely to have limited downside. If the mini down cycle takes hold of the global economy, this would temporarily weigh on EUR/CHF. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone continued to appreciate this week, and is now UP 3.3% year-to-date. The krone has been helped mostly by the surge in oil prices and by the fall in the dollar. Overall, we are bullish on this cross against the CAD, as there are 60 basis points of hiked priced in the Canadian curve, even after this week's hike. In the meantime, there are only 21 basis points in the Norwegian curve. We believe this spread is too high, and thus, that the krone should appreciate against the Canadian dollar. Moreover, further downside in EUR/NOK is limited, given that near 70 dollars, there is not much room for oil prices to go up. Thus, we are closing our EUR/NOK trade with a 3.40% gain but keep our long NOK/SEK call in place. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 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 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 In a recent speech in Uppsala, Sweden, Deputy Governor Henry Ohlsson reminded the audience of his view from the December meeting that it would have reasonable to hike rates in "early 2018". He pointed to Sweden's robust economic performance, highlighting population growth, migration into cities, and higher real wages. Inflation has also been on target since mid-2017. This assessment is in line with our view of the economy, however Governor Ingves consistently supported a strong dovish tone which undermined our view. Now that the ECB has begun tapering, the consensus within the Riksbank seems to also be shifting. Falling house prices need to be monitored closely, especially when one keeps in mind Governor Ingves dovish inclinations. Report Links: 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 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Our new pecking order for currencies is: yen first, euro second, pound third, dollar fourth. Long-term (real) interest rate differentials are the dominant driver of currencies right now. EUR/USD should continue to trend higher to around 1.30. Equity investors should prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50. Underweight Basic Materials equities versus Healthcare equities on a 6-9 month horizon. Feature Nine months ago, our report Euro First, Pound Second, Dollar Third 1 encapsulated our recommended pecking order for the three major currencies. Subsequent performance has fully justified the title. The euro has appreciated by 6% versus the pound, and by 13% versus the U.S. dollar (Chart I-2). Today we are tweaking our currency pecking order: yen first, euro second, pound third, dollar fourth. Chart of the WeekHigher Euro Area Inflation Has Strengthened The Euro Chart I-2Euro First, Pound Second, Dollar Third The Euro Has Moved The 'Right' Way, The Yen Has Moved The 'Wrong' Way The Chart of the Week illustrates an excellent explanation for the euro/dollar exchange rate. It shows euro area versus U.S. core inflation differentials, and provides a great rule of thumb. If the euro area's core inflation were underperforming by 2% vis-à-vis the U.S., EUR/USD should stand at 1.00. But thereafter, every half-percent of euro area inflation catch-up strengthens the euro by 10 cents. At the start of 2017, our thesis was that the underperformance of euro area inflation by almost 2% - and the associated EUR/USD rate near 1.00 - was an anomaly. And that core inflation in the euro area would converge with that in the U.S. Which it duly has. Still, if the euro area's inflation underperformance vis-à-vis the U.S. converges to its long run average of half a percent, EUR/USD should continue to trend higher to around 1.30. One equity market implication is to prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50 (Chart I-3). The puzzle is that for the yen, the same inflation relationship has worked the 'wrong' way. Through the past ten years, every half-percent of Japanese core inflation catch-up has weakened the yen by around 10 yen (Chart I-4). To complicate the puzzle, the relationship for the yen used to work the 'right' way. Through 1999-2008, every half-percent of Japanese inflation catch-up strengthened the yen by around 10 yen (Chart I-5). Chart I-3A Stronger Euro Favours The Euro Stoxx ##br##Over The Euro Stoxx 50 Chart I-4Through 2008-17 Higher Japanese##br## Inflation Weakened The Yen... Chart I-5...But Through 1999-2007 Higher Japanese##br## Inflation Strengthened The Yen! So higher relative inflation in the euro area has driven the euro up; whereas higher relative inflation in Japan has driven the yen down, but previously used to drive the yen up! How can we explain the puzzle? The answer is to think in terms of both inflation and its impact on long-term interest rate expectations. What Are The Drivers Of Currencies? Foreign exchange demand serves one of four broad purposes: To buy foreign exchange reserves. To buy foreign goods and services. To buy long-term investments denominated in a foreign currency, also known as foreign direct investment (FDI) To buy shorter-term financial investments like bonds and equities denominated in that currency, also known as portfolio flows.2 Of these four components, the demand for foreign exchange reserves tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.3 The net foreign demand for euro area goods and services and FDI are also not particularly volatile. Which means that the usual swing-factor in foreign exchange demand is portfolio flows (Chart I-6), and especially fixed income portfolio flows. Chart I-6Portfolio Flows Are The Swing Factor In Foreign Exchange Demand What causes swings in fixed income portfolio flows? The answer is expected changes in real interest rates. Fixed income investors gravitate to the bonds with the highest real yield adjusted for likely currency losses or hedging costs. So when the expected real interest rate in the euro area rises relative to that in the U.S., euro bonds becomes de facto relatively more attractive. Meaning that international fixed income investors will shift into euro bonds until the flow pushes up EUR/USD to make the currency valuation symmetrically less attractive. At this new higher level for EUR/USD, the fixed income portfolio flow will stop because a new equilibrium has been established. International investors now have more upside from the more attractive bonds, but symmetrically less upside from the less attractive currency valuation - and the two factors cancel out. Furthermore, at major turning points in monetary policy, the main issue for the largest fixed income investors is not the exact pattern of short-term interest rate changes. Whether the Fed hikes in March, June and December or whether the ECB hikes next year is largely irrelevant. The big issue centres on the so-called real terminal rate: the average real interest rate over the very long term. Solving The Currency Puzzle Let's now return to our currency puzzle. If core inflation increases, but the expected terminal interest rate increases more, it means that the expected real terminal rate will also increase - causing the exchange rate to rise. This is what tends to happen in the euro area versus U.S. comparison, and explains why the relationship between relative core inflation and EUR/USD movements works the 'right' way. In effect, the nominal terminal rate is the driving factor for the currency. It is also what tended to happen in Japan before 2008 (Chart I-7), and explains why the relationship between relative core inflation and the yen also used to work the 'right' way. However, if core inflation increases, and the expected terminal interest rate increases less, it means that the expected real terminal rate will decrease - causing the exchange rate to fall. Since 2008, this is what has happened in Japan (Chart I-8). The expected nominal terminal rate has gone into stasis, so higher core inflation has pulled down the real terminal rate. Which explains why the relationship between relative core inflation and the yen has worked the 'wrong' way. The key question is what happens next? Will the expected terminal rate in the euro area go into stasis, as it did in Japan? Almost certainly no. The euro area's expected terminal rate has already risen by over 0.5% in the past year (Chart I-9). Chart I-7Expectations For Japan's Terminal ##br##Rate Used To Fluctuate... Chart I-8...But After 2008, Expectations For Japan's ##br## Terminal Rate Have Gone Into Stasis Chart I-9The Terminal Interest Rate Differential##br## Is Driving EUR/USD More plausibly, the expected terminal rate in Japan could come out of its stasis. With every other major central bank backing away from ultra-accommodation, and Japanese growth and inflation now looking little different from other G10 economies, is it realistic - or indeed feasible - for the Bank of Japan to maintain its extreme policy? The slightest hint from the Bank of Japan that it is following other central banks out of its ultra-accommodation would cause the expected terminal rate - and the yen - to gap (up) sharply. On this basis, the one major currency that we would short the euro against is the Japanese yen. The Global Mini-Upswing Is Losing Steam Finally and briefly, an update to our 'mini-cycle' framework for global growth. Last week in The Cobweb Theory And Market Cycles, we explained the existence of these mini-cycles, and argued that the current mini-upswing - which started last May - is getting long in the tooth. Right on cue, the latest credit data out of both China and the U.S. show that their 6-month credit impulses are losing steam (Chart I-10). The implication is that global growth will experience a mini-downswing during the first half of 2018. In all of the last five such mini-downswings, cyclical sectors ended up underperforming defensive sectors (Chart I-11). Accordingly, on a 6-9 month horizon, equity investors should underweight Basic Materials versus Healthcare. Chart I-106-Month Credit Impulses Have Rolled##br## Over In The U.S. And China Chart I-11Expect A Mini-Downswing: Underweight ##br##Basic Materials Vs. Healthcare Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Euro First, Pound Second, Dollar Third' published on April 27 2017 and available at eis.bcaresearch.com 2 In this discussion, portfolio flows include short-term speculative flows. 3 For example, when the Swiss National Bank broke the franc's peg to the euro, it just stopped buying euro reserves. Fractal Trading Model* There are no new trades this week, leaving two open positions. 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-12 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 The Japanese economy is booming. This is allowing the BoJ to move away from its QQE (Quantitive and Qualitative Easing) program. However, the YCC (Yield Curve Control) program will stay in place for the foreseeable future as inflation remains a direct function of financial conditions. Because yen positioning and valuations are so skewed, this could result in a yen rally, especially against the Euro. Short EUR/JPY. Like the Fed, the BoC will hike rates three times this year. However, the market already discounts more hikes in Canada than the U.S. We remain neutral USD/CAD. However, CAD will experience downside against the NOK. Short CAD/NOK. Feature Chart I-1JPY Vs. Bonds: The Divorce Something fascinating happened to USD/JPY in recent months: it began to decouple from U.S. bond yields (Chart I-1). To a large degree, this break in relationship reflected the dollar's own weakness, as the dollar index fell by 10% in 2017. But as weak as the dollar may have been last year, it has actually been flat since September 7. Another culprit behind the yen's decoupling from bond yields has been that as the European Central Bank announced the end of its own asset purchases program, the Bank of Japan has been seen as the next in line to diminish its purchases. On January 8th, the BoJ began moving in that direction, as it started to curtail its buying of long-dated JGBs. Since that day, not only have global bonds sold off, but the yen has regained vigor as well. We believe the yen bear market is not over, but a playable rally against the euro is likely to emerge. The Sun Is Rising The BoJ is justified in wanting to remove some policy stimulus. The Japanese economy is firing on all cylinders, and the improvement seems broad-based. Consumer confidence, buoyed by rising asset prices and an unemployment rate at 23-year lows, is hitting record highs (Chart I-2). This will continue to support real household spending, which is now growing at a nearly 2% pace after contracting steadily from 2015 to early 2017. Another support for household spending comes from the wage front. Contractual wages are already growing at their fastest pace since 2006, and wages excluding overtime pay are expanding at rates not seen since 1998 (Chart I-3). Moreover, the openings-to-applicant ratio is at its highest level since 1974. This increases the likelihood that Prime Minister Shinzo Abe's arm-wrestling with corporate Japan to increase wages will bear fruit, and that the upcoming spring wage negotiation will generate accelerating gains. Chart I-2Japanese Households Feel Ebullient Chart I-3Wage Growth Has Picked Up Business confidence is also surging. The Japanese manufacturing PMI number is elevated by Japanese standards, currently at 54, and small business confidence points toward an acceleration in industrial production (Chart I-4). Financial markets validate this picture as well. The surge in the Nikkei has grabbed the imagination of investors, but even more impressive has been the strength in small-cap equities, which have outperformed their large-cap counterparts by 17% since 2015 (Chart I-5). This development has coincided with a pick-up in credit growth, and is also normally associated with a robust growth outlook. The GDP model developed by our sister publication, The Bank Credit Analyst, encapsulates these various phenomena, and forecasts that Japanese real GDP growth could hit an annual rate of 3% in the first half of 2018 (Chart I-6). Thus, it would seem that the Japanese economy will continue to gain momentum. Chart I-4Japanese Companies Are Also##br## Feeling The Good Vibes Chart I-5Small Caps Point To##br## A Bright Outlook Chart I-6Japanese Growth ##br##Has Momentum But what underpins these improvements? First, the fiscal thrust in Japan has changed. Fiscal policy was a drag in Japan from 2012 to 2016, creating an average brake on economic activity of 0.6% of GDP per year. However, in 2017, fiscal policy eased to add 0.2% to GDP. Second, Japan has greatly benefited from the rebound in EM growth. According to the IMF, a 1% growth shock in EM affects Japanese growth by 50 basis points - nearly five times more than the effect of the same shock on the U.S. economy. This is because 43% of Japanese exports are shipped to EM economies. Third, the impact of EM activity on Japan is amplified by the countercyclical nature of the JPY. As global and EM growth expands more vigorous, the yen weakens, which eases Japanese financial conditions. This phenomenon was in full display last year, as financial conditions eased by a full standard deviation over the past 16 months. These developments are what have laid the ground for better growth and the change in the BoJ's tone. Bottom Line: Japan is doing very well. Consumers and businesses are upbeat, spending is on the rise and GDP is forecasted to accelerate even further. Easing fiscal belt-tightening, stronger EM economies, and the softening financial conditions are the factors behind these improvements. The BoJ is taking notice. How Far Can The BoJ Go? The BoJ had been itching to move policy for a few months now. In November 2017, BoJ Governor Haruhiko Kuroda was making noise about the concept of the "reversal rate." The reversal rate is the interest rate below which additional interest rate cuts become contractionary for economic activity. This is because below this level, lower rates hurt bank interest margins to such a degree that commercial banks start curtailing their lending to the private sector. The reason why the BoJ was getting more vocal about the reversal rate was because this rate is inversely related to the amount of securities held on commercial banks' balance sheets. If commercial banks hold plenty of government bonds, as interest rates fall to very low levels, the value of these securities increases, offsetting the negative impact of lower interest rate margins. The problem in Japan is that as the BoJ mopped up more JGBs than was issued by the government, and therefore the bond holdings of banks were dwindling at an alarming rate (Chart I-7). This meant that the reversal rate was rising, implying that the BoJ had less control over policy. When inflation surprised to the upside in December, financial markets reacted violently. While Japanese nominal yields did not budge much, Japanese inflation expectations surged, which prompted a collapse in Japanese real rates (Chart I-8). This produced a de facto easing in Japanese monetary conditions, creating the perfect cover for the BoJ to adjust its asset purchases: any negative impact from tweaking bond purchases would be mitigated and the BoJ, according to its view, would not lose control of financial conditions because of a falling reversal rate. Despite this shift in policy action and rhetoric, we do not yet foresee the end of the Yield Curve Control program. Inflation excluding food and energy only stands at a paltry 0.3%, still well below the BoJ's 2% target or even 1% - a level that is likely to result in a more real removal of easing. Additionally, the BoJ is in somewhat of a bind. It is true that the economy is doing much better, but this does not really help explain inflation dynamics. Japanese capacity utilization only explains 3% of the movements in Japanese core inflation; global utilization, only 10%; and inflation leads credit creation in Japan. Instead, the best factor to explain Japanese inflation has been financial conditions (FCIs). In no other country do FCIs explain inflation dynamics as much as they do in Japan. The recent movements in Japanese inflation are fully consistent with how Japanese FCIs have evolved since 2010. Based on this relationship, CPI excluding food and energy should likely peak at 0.7% in June 2018 (Chart I-9). Chart I-7Japanese Reversal Rate##br## Is Falling Because Of QQE Chart I-8Sudden Pick Up In##br## Inflation Expectations Chart I-9Inflation Is Picking Up Because##br## Financial Conditions Eased However, if the BoJ removes accommodation too fast, the yen would rally and financial conditions would tighten sharply. In all likelihood, inflation would weaken substantially, nullifying the very reason to tighten policy in the first place. These very dynamics point to a continuation of YCC for at least the next 12 to 18 months. Bottom Line: Japan will soon fully do away with its QQE program. However, this is not indicative of a removal of yield curve controls. This is not only because Japanese inflation is extremely far off from the BoJ's target, but also because Japan's inflation rate is hyper-sensitive to financial conditions. Therefore, any tightening in financial conditions created by a stronger yen - the likely market response of tighter policy - will cause inflation to collapse, nullifying the very need for tighter policy. Investment Implications USD/JPY is expensive, trading 16% above the fair value implied by purchasing power parity. Additionally, the yen is supported by a generous current account surplus of 4% of GDP. Moreover, global investors have been underweighting duration. This phenomenon tends to be negative for the yen. When investors are as underweight duration as they are currently, the yen becomes more likely to rally (Chart I-10). It is true that in 2014, investors were as negative on bonds as they are today, but USD/JPY sold off. This was because back then, the BoJ announced an increase to its asset purchase program. Today, the BoJ is moving toward ditching its QQE program, which is likely to prompt a short-covering rally. Now, the key question for investors is what currency should be sold against the yen. We posit the euro is an interesting alternative to the USD. EUR/JPY is exceptionally expensive at present. On a long-term basis, EUR/JPY is trading well outside its normal range on a purchasing-power-parity basis (Chart I-11). Moreover, while USD/JPY is mildly expensive according to metrics that incorporate rate differentials and risk appetite, EUR/USD is very dear based on a similar comparison. The implication is that EUR/JPY is trading at an exceptionally demanding level in terms of short-term valuations (Chart I-12). Hence, tactically, the timing is becoming increasingly ripe to short this cross Chart I-10Duration Positioning Points To Upside Risk For The Yen Chart I-11EUR/JPY Is Expensive Chart I-12Tactical Risk For EUR/JPY . Further arguing in favor of shorting EUR/JPY instead of USD/JPY are relative financial conditions. Euro area financial conditions have tightened much more than U.S. financial conditions relative to Japan's (Chart I-13). As a consequence, even when adjusting for sector biases, European stocks are currently underperforming Japanese equities by a greater margin than the underperformance of U.S. equities. This highlights that Japan's relative economic outlook burns brighter when compared to the euro area than when compared to the U.S. This also means that the yen has more room to rally against the euro than the USD. Finally, relative positioning between the euro and the yen is also exceptionally skewed. As Chart I-14 illustrates, when speculators are simultaneously long the euro and short the yen, EUR/JPY tends to experience subsequent corrections. Chart I-13Euro Area FCIs Tightened ##br##More Than U.S. Ones Chart I-14Skewed Positioning##br## In EUR The aforementioned factors point to a potentially large yen rally, but the durability of this rally is likely to be limited. The BoJ will only be dropping a QQE program that it had already only half-implemented in recent months, as bond purchases were well below its JPY80 trillion-yen objective. The BoJ is still committed to its YCC program for the foreseeable future. Only a rejection of this program will create a durable support for the yen. In the meanwhile, as any yen rally will tighten financial conditions and hurt inflation, any yen rally is to be rented rather than owned, as terminal policy rates in Japan still have little scope to rise. Bottom Line: Ditching QQE is likely to result in a yen rally. Such a rally is likely to be most pronounced against the euro as valuations, positioning, and financial conditions are especially exacerbated when compared to the European currency. To be clear, the yen rally is likely to be a countertrend move, as a strong yen will exert serious deflationary pressures on Japan, which means the BoJ's YCC program will remain firmly in place. We are shorting EUR/JPY at 133.79. CAD: Stuck Between The BoC And NAFTA Chart I-15Canada Will Experience Rising Wages Canada:##br## Inflationary Conditions Emerging The Bank of Canada (BoC) is meeting next week and the odds are rising that it will lift policy rates this month. The Canadian economy is very strong too, led by the domestic sector. Real consumer spending is growing at its fastest pace in nearly 10 years, the unemployment rate is at 40-year lows, and capex is recovering after having been decimated by the collapse in oil prices from 2014 to 2016. Thanks to this backdrop, the Canadian economy is hitting its own capacity constraints. The BoC estimates that the Canadian output gap has closed. Moreover, the recent Business Outlook Survey confirms this message: A record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints, and the growing number and intensity of labor shortages points to a tight labor market (Chart I-15). Tight capacity and higher wages will support the already-visible rebound in core inflation, which has already reached 1.8%. As a result, we expect the BoC to tighten rates as much as the Federal Reserve this year. However, the impact of this development on the CAD might be limited. Investors are already pricing in more hikes in Canada than in the U.S. over the next 12 months - 82 basis points versus 60 basis points, respectively. Moreover, speculators are once again very long the loonie, implying an elevated hurdle for strong economic data to actually lift CAD further. Moreover, NAFTA remains a major risk for Canada. As Marko Papic, our Chief Geopolitical Strategist, wrote in a November Special Report, President Trump does have uninhibited power when it comes to abrogating NAFTA (Table I-I).1 If NAFTA were to collapse, Canada would most likely ultimately revert to the still-preferential Canada-U.S. Free Trade Agreement. Thus, the impact on Canada-U.S. trade would likely be temporary. However, the brunt of the pain should be felt in Canadian capex spending. The high degree of uncertainty associated with unwinding NAFTA would cause companies to abandon expansion plans in Canada, and prompt them to expand their North American capacity directly in the U.S., thereby bypassing the regulatory risk created in the supply chain. This would dampen the future growth profile of Canada. Table I-1Trump Faces Few Constraints On Trade Oil is unlikely to fill the void for CAD. At near US$70/bbl, Brent has hit our Commodity and Energy strategists' target. OPEC 2.0 will be unwilling to accommodate much higher prices, as this would incentivize shale producers to expand capacity, recreating the supply glut dynamics that existed prior to the 2014 crash. Additionally, the West Canada Select benchmark, the oil price most relevant for Canada, remains at a substantial discount to WTI and Brent. This is because there is not enough pipeline capacity to ship oil outside of Alberta. Canada is drowning in its own oil. This situation is not about to change. Chart I-16CAD/NOK Is Stretched Based on this combination, we are neutral USD/CAD on a 12-month basis, even if a move back to 1.29 is likely over the coming weeks. However, while Canadian oil is trading at a discount, the CAD has performed better than the NOK, the other petrocurrency in the G10 space. This suggests that shorting CAD/NOK may be a cleaner way to play the risks inherent to the Canadian dollar. First, the Canadian dollar is very expensive relative to the Norwegian krone right now, trading 11% above its purchasing-power-parity rate (Chart I-16). Even when adjusting for other factors like productivity and commodity prices, CAD is trading at its largest premium to the NOK since 1994. This represents a risk for CAD/NOK as the loonie is exposed to trade policy risks, while the nokkie is not. Second, the balance-of-payments picture remains highly favorable for the NOK. Norway runs a current account surplus of 5.5% while Canada runs a deficit of 2.8%. Additionally, Norway sports a Net International Investment position (NIIPs) of 210% of GDP, the largest in the G10. Strong NIIPs are associated with rising real effective exchange rates. Third, while the Canadian economy's momentum is well known by investors - this is the reason why they are so long the CAD and expecting so many hikes from the BoC - the positives in Norway are being ignored. Norway's leading economic indicator is still rising, and Norwegian industrial production and real GDP growth are accelerating. Fourth, the Norges Bank is responding to weakness in the NOK. At its December meeting, it adjusted its tone, as the NOK is easing monetary conditions too much in the eyes of the Norwegian central bank. This suggests the 25-basis-point hike currently expected out of Norway could be too low. It also highlights that the exceptional 60-basis-point gap between Canada and Norway in terms of expected 12-month rate hikes is also likely to normalize. Finally, CAD/NOK is trading toward the top of both its long-term and near-term historical trading ranges. While positioning on the CAD is now quite extended on the long side, speculators are short the NOK, according to Norges Bank data. Thus, with NAFTA in question, a fully priced BoC outlook, and the unlikelihood that the WCS-Brent discount narrows, risks are skewed toward a lower CAD/NOK going forward. Bottom Line: The Canadian economy is booming. This means the BoC will keep pace with the Fed and increase rates at least thrice this year. However, markets are already discounting more hikes in Canada than they are in the U.S. Moreover, oil prices have limited upside from here, and the WCS benchmark will continue to trade at a deep discount to Brent. Thus, while USD/CAD has limited upside, it has limited downside as well. However, CAD/NOK faces plenty of downside risks from current levels. We are shorting this cross this week, with an entry point at 6.398. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism" dated November 10, 2017, available at gis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Nonfarm payrolls surprised to the downside, coming in at 148 thousand. Moreover, labor force participation rate surprised to the downside, coming in at 62.7%. ISM non-manufacturing PMI also underperformed expectations, coming in at 55.9. However, consumer credit change outperformed expectations, coming in at 27.95 billion dollars. The dollar began the week on a strong, which ultimately dissipated, on relatively hawkish ECB minutes and policy tweaks in Japan. Overall, we expect the market to continue to price the fed dot plot, putting upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 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 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been positive: Core inflation outperformed expectations, coming in at 1.1%. Moreover, the economic sentiment indicator also outperformed expectations, coming in at 116. Retail sale yearly growth also surprised to the upside, coming in at 2.8%. Finally, the unemployment rate declined from 8.8% to 8.7% In spite of the positive data the euro has fallen this weekThe Euro begun the week on the weak side but surged in the wake of the ECB's hawkish minutes. This has happened due to the surge in rate expectations in the U.S., as the market has continued to price in the fed. Overall, we expect to see downside in EUR/JPY as the BoJ has more room to back off its ultra-dovish policy than the ECB. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Labor Cash earnings yearly growth outperformed expectations, coming in at 0.9%. They also increased relative to October. However consumer confidence surprised to the downside, coming in at 44.7 and declining from the previous month. The yen has been surging this week, with USD/JPY falling by 1.7%. This was caused because the BoJ signaled that they would reduce their buying of long dated bonds. The market interpret this as a signal that the BoJ will start exiting from its ultra-dovish monetary policy. These developments should continue to provide upside to the JPY, particularly against the Euro. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production yearly growth outperformed expectations, coming in at 2.5%. Moreover, manufacturing production yearly growth also surprised to the upside, coming in at 3.5%. However, Halifax House Prices yearly growth underperformed expectations, coming in at 2.7% as the month-on-month growth contracted by 0.6%. The pound has been flat, this week against the dollar, while it has lost about 1% against the euro. Overall, the BoE is limited in the capacity to raise rates meaningfully. Moreover, inflation should start to ease following the rate hike and the rise in the pound. This will put downward pressure on the pound. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Building permits yearly growth outperformed expectations, coming in at 17.2%. However, the trade balance in November surprised to the downside, coming in at -628 million. It also decreased from -302 million one month earlier. AUD/USD has been flat this week, however AUD/NZD has fallen by roughly 1%. While it is true that global growth continues to be strong, key indicators like Korean and Taiwanese export growth have rolled over. Moreover money supply growth in China continues to decrease. All of this points to a temporary slowdown in Chinese industrial activity, which would lead to weakness in AUD/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has rallied by nearly 5% since the start of the year, as global growth continues to stay robust. Overall, we expect that the NZD will continue to outperform the AUD this year, as New Zealand is less sensitive to a tightening in financial conditions than Australia. However on a longer time horizon, the upside for the Kiwi is limited, as the new populist government has not only vowed to decrease immigration into the country, but also for the RBNZ to have a dual mandate. Both of these policies will depress the neutral rate in New Zealand, and consequently put downward pressure on the kiwi. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mostly positive: The unemployment rate surprised positively, as it declined to 5.7% from 5.9% Moreover, net change in employment also outperformed expectations, coming in at 78.6 thousand. Housing starts yearly growth also outperformed expectations, coming in at 217 thousand. However, the Ivey Purchasing Manager Index underperformed, coming in at 60.4. USD/CAD jumped on Tuesday following reports that Trump will exit the NAFTA accord. Overall we believe that the Canadian dollar will have limited upside from here on out, as the market is now pricing in more hikes in Canada than in the U.S. This weakness could be taken advantage of by shorting CAD/NOK, as this cross is much overvalued according to multiple metrics. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: Headline inflation came in line with expectations, at 0.8%, meanwhile month on month inflation surprised to the upside, coming in at 0%. The unemployment rate also came in line with expectations, at a very low level, coming in at 3%. Finally, retail sales yearly growth surprised to the upside substantially, coming in at -0.2%, compared to 2.6% last month. EUR/CHF has stayed relatively flat since last week. Overall, we expect limited upside in the franc. As the SNB will stay active in the foreign exchange market. In order for the SNB to change its policy, inflation in Switzerland will have to stay at a high level for a considerable amount of time. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Headline inflation outperformed expectations, coming in at 1.6%. Moreover core inflation also surprised to the upside, coming in at 1.4% However, manufacturing output growth underperformed expectations, coming in at 0.3% USD/NOK is down by roughly 0.7%, as oil prices continue to approach the 70 dollar mark. Nevertheless, we believe that the upside for USD/NOK is limited from here, as the market will start pricing in more rate hikes from the Fed. That being said, investors willing to bet on more oil strength could short EUR/NOK. Report Links: 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 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 After falling precipitously at the end of 2017, USD/SEK has been relatively flat this year. Overall, while Stefan Ingves continues to be very dovish, he conceded in the latest minutes that a change in monetary policy is getting closer. Meanwhile, Deputy Governor Jansson stated that while he supports to continue with asset purchases, to keep the repo rate unchanged would be "difficult to digest". Investors willing to bet on a slowdown in the Euro area caused by tightening financial conditions could short EUR/SEK. Report Links: 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 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Chart 15...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades