Financial Markets

Dear Client, In addition to this abbreviated Weekly Report, I sent you a Special Report earlier today written by my colleague Mark McClellan of our monthly Bank Credit Analyst publication. Following up on many of the themes discussed in our latest Quarterly Strategy Outlook, Mark makes a convincing case that most of the factors that have suppressed global interest rates since the financial crisis could begin to unwind or even reverse over the coming years. Best regards, Peter Berezin, Chief Global Strategist Feature Davos Man Is Happy Chart 1Macron Leading Le Pen Populist forces have been in retreat of late. First came the Austrian presidential elections, which saw voters reject a populist right-wing challenger in favor of a former Green Party leader who pledged to be an "open-minded, liberal-minded, and above all a pro-European president." Then came the Dutch elections, where Prime Minister Mark Rutte won more seats than the maverick Geert Wilders. Last week the pound surged after U.K. Prime Minister Theresa May called for a fresh election. May's announcement was designed to expand the Conservative Party's majority, thus neutralizing the ability of a few hardline Tories to scuttle a Brexit deal. These uncompromising MPs would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. This week we have the results of the first round of the French presidential elections. Despite the media's absurd characterization of Emmanuel Macron as an "outsider," the former government minister was, in fact, the establishment's dream candidate: pro-business and fervently Europhile. Current polls show Macron beating Le Pen in a runoff by 21 points (Chart 1). Finally, on the other side of the Atlantic, Donald Trump has caved on most of his populist campaign pledges. He agreed to drop his requests that Congress pay for a border wall with Mexico and defund Planned Parenthood. The move is likely to avert an imminent government shutdown. In addition, Trump backed off his pledge to scrap NAFTA. This follows on the heels of his decision not to label China as a "currency manipulator," something he had promised to do during the campaign. And to top it all off, Trump released a one-page tax plan with all the goodies the Republican establishment has been craving: Lower corporate and personal tax rates and the abolition of the estate tax. Risk Assets Will Benefit... Not surprisingly, global equities have responded positively to these developments. The MSCI All-Country World Index hit a record high this week (Chart 2). A rebound in corporate earnings is helping to propel stocks higher. Our global earnings model points to further upside for profits over the coming months (Chart 3). Chart 2Global Equities At Record Highs Chart 3More Upside Ahead For Global Earnings The laggard remains the Treasury market. Trump's tax plan will add about $5 trillion to the national debt over the next decade above and beyond what the Congressional Budget Office is already projecting. Yet, the 10-year Treasury yield remains 30 basis points below where it was in early March. The market is pricing in just under two rate hikes over the next 12 months. This is below the Fed's guidance and our own expectations. We went short the January 2018 fed funds futures contract last week (Chart 4). Higher U.S. rate expectations should lead to a further widening of rate differentials between the U.S. and its trading partners (Chart 5). Mario Draghi underscored yesterday that the ECB has no plans to remove monetary stimulus anytime soon. If anything, rising inflation expectations in the euro area on the back of a firming economy could lead to lower real yields there, putting downward pressure on the euro. Chart 6 shows that the market expects real U.S. five-year yields to be only 11 basis points higher than in the euro area in 2022.1 That seems too low to us, given the euro area's bleak demographics and high debt levels. We continue to see EUR/USD reaching parity later this year. Chart 4The Market Is Lowballing The Fed Chart 5Higher U.S. Rate Expectations Will Lead To Further Widening Of Rate Differentials Chart 6The Vanishing Transatlantic Bond Spread ...But Populists Will Triumph In The End Steady growth and falling unemployment will reduce support for populist parties over the coming 12 months. This will help keep global equities in an uptrend. Beyond then, the clouds are likely to darken. We argued in our Q2 Strategy Outlook that global growth could begin to slow in the second half of next year.2 If that happens, support for mainstream political parties will fade. Structural forces will further bolster support for populist leaders. Chart 7 shows that Le Pen won the plurality of voters between the ages of 35 and 59. Young voters tilted towards Mélenchon, while older voters overwhelmingly went for Emmanuel Macron and François Fillon. If recent voting trends are any guide, the elderly of tomorrow will be more sympathetic to Le Pen than the elderly of today. Le Pen's populist message on the economy could resonate more with younger voters (indeed, Le Pen beat Macron among voters between the ages of 18 and 24). Chart 7Who Likes Le Pen? Meanwhile, worries about terrorism will undermine support for the establishment. There are 17,000 people on the French government's terrorist watch list, 2,000 of whom have fought in Syria and Iraq. Macron's feeble pledge to hire 10,000 additional police officers will do little to thwart future attacks. In the U.S., Trump's pivot towards the establishment wing of the Republican Party could prove to be short-lived. Most Republican voters have mixed feelings about Donald Trump the man. They voted for Trumpism, not Trump. Either Trump will start delivering on the promises that endeared him to blue-collar workers in states such as Ohio and Pennsylvania, or he will go down in flames in the next election. Bottom Line: Investors should overweight global equities in a balanced portfolio over the next 12 months, but look to reduce exposure in the second half of next year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Towards Parity," dated April 14, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Outlook: "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Dear Client, In addition to an abbreviated Weekly Report that you will receive later tonight, I am sending you this Special Report written by my colleague Mark McClellan of our monthly Bank Credit Analyst publication. Following up on many of the themes discussed in our latest Quarterly Strategy Outlook, Mark makes a convincing case that most of the factors that have suppressed global interest rates since the financial crisis could begin to unwind or even reverse over the coming years. Best regards, Peter Berezin, Chief Global Strategist Highlights The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. Feature In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart 1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart 1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart 2Global Shifts In The Saving And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart 2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart 3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart 3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart 3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart 4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart 2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart 5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart 6). The same is true, although to a lesser extent, in the emerging world. Chart 4Working-Age Population Ratios Have Peaked Chart 5Labor Share Of Income Has Dropped Chart 6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart 7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart 8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart 7Economic Integration And Falling Capital Goods Prices Chart 8Macro Impact Of Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart 9Working-Age Population To Shrink in G7 and China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart 9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart 10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart 10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart 11 presents the data for China and three of the major advanced economies. The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart 11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart 11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. Chart 11Income And Consumption By Age Cohort The results are shown in Chart 12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart 12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Chart 13Demographics And Capex Requirements Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart 13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart 14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart 15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart 14China's Savings Rates Have Peaked... Chart 15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: Table 1Key Secular Drivers The main points we made in this report are summarized in Table 1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook. Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart 16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Another way of looking at this is presented in Chart 17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart 16Market Expects Negative Short-Term Rates For A Long Time Chart 17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 It is true that observed household saving rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3, IMF World Economic Outlook (April 2017). 5 In other words, while the household saving rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e., savings across the household, government, and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014).

Special Report

Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by the global risk appetite, as approximated by corporate spreads, and commodity prices. Based on our timing model­s, the countertrend correction in the dollar is toward its tailend. Any additional weakness should be used to buy the greenback. The euro is now expensive based on our timing model. However, it could become slightly more expensive as markets continue to price in the euro area-friendly outcome of the first round of the French election. Feature In July 2016, in a Special Report titled "In Search Of A Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline, a sanity check if you will, to our regular analysis. In this report, we review the logic underpinning these intermediate-term models and provide a commentary on their most recent readings for the G10 currencies vis-à-vis the USD. UIP, Revisited The uncovered interest rate parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is the one that will make an investor indifferent between holding the bonds of country A or country B. This means that as interest rates rise in country A relative to country B, the currency of country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of country B (Chart 1). Chart 1Interest Rate Differentials Remain Useful ##br##Gauges For XR Determination There has long been a debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. Research by the Fed and the IMF suggest that incorporating longer-term rates to UIP models increases their accuracy.2 This informational advantage works whether policy rates are or aren't close to their lower bound.3 Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements do not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of investor indifference between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.4 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from each other. It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan comes to the front of the mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 2Over The Long Run, Real Rate ##br##Differentials Work Best Chart 3Real And Nominal Rates ##br##Can Be Different Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real, not nominal long-term rate differentials. Global Risk Aversion And Commodity Prices Chart 4The Dollar Benefits From Global Woes Global risk appetite is also a key factor to consider when trying to model exchange rates. Risk aversion shocks tend to lead to an appreciation in the dollar, which benefits from its status as the global reserve currency.5 Much literature has often focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power for the option-adjusted spreads on junk bonds (Chart 4). Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.6 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resource prices constitute a terms-of-trade-shock for them. However, this relationship holds up for the euro as well, something already documented by the ECB.7 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe: Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite: Proxied by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. Real rates differentials, junk spreads, and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a 3-9 month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). The U.S. Dollar Chart 5Dollar Fundamentals Strengthening... Chart 6...But Timing Could Be Better To Buy DXY To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss, and Swedish real rates weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. The FITM for the DXY has stabilized and is now slowly moving upward (Chart 5). The ITTM itself is even pointing upward, arguing that the dollar is at a neutral level and that its previous overshoot has now been corrected. However, historically, the DXY rarely stabilizes at its fair value, overshooting the mark instead. Based on historical behavior, the DXY is likely to undershoot its ITTM by another two percent or so before an ideal entry point to buy the USD emerges (Chart 6). Longer term, we continue to expect the dollar to stay on an upward trend. The U.S. neutral rate remains above that of Europe and Japan. Moreover, U.S. economic slack is dissipating much faster than in Europe, and the U.S. may already be in the process of hitting its own capacity constraints. This suggests that the Fed has much greater scope to normalize policy than the ECB. With the OIS curve pricing in a 25 basis point hike in the U.S. over the next 12 months, this will support the USD versus the euro. Japan, too, exhibits increasing signs of limited slack in its economy. However, with the BoJ committed to an inflation overshoot in order to upwardly shock moribund Japanese inflation expectations, we think that Japanese real rates will lag U.S. ones, putting significant upside on USD/JPY. The Euro Chart 7Euro Fundamentals Are Deteriorating Chart 8The Euro Is No Longer Cheap The FITM for EUR/USD has rolled over and is now pointing south, suggesting that fundamentals are moving against the euro (Chart 7). This reflects large rate differentials between the U.S. and the euro area, but also, the recent softness in some corners of the commodity complex. Last spring, the FITM did a good job forecasting the rebound in the euro, and the fact that it is flagging impeding euro weakness deserves to be highlighted. In terms of entering a short EUR/USD tactical bet, at the current juncture, the ITTM suggests an entry point is soon to emerge (Chart 8). Now that the dueling pair of the second round of the French election has been determined - Macron vs Le Pen - the euro was able to price out nightmare scenarios involving two Eurosceptic candidates. In fact, with the realization that Macron holds a 20% lead over Le Pen in second round polling, the market has begun to completely price out any euro-endangering outcome for the French election. This means that the euro is likely to move toward its historical premium to the ITTM before reverting toward its cyclical downtrend. Practically, this means that EUR/USD could run toward 1.11-1.12 before rolling over, something that may happen by May 8th. On a 12- to 18-months basis, we are comfortable with the current message from the FITM. The European economy may be growing above trend, but there remains enough slack in Europe that wage and core inflation dynamics are still very muted. This contrasts with the U.S. economy, where most indicators we track argue that wages and core inflation should gain some upward momentum this year. This means that rate differentials between the euro area and the U.S. are likely to underperform even what is priced into the relative interest rate curves. This should weigh on EUR/USD as the euro is not cheap enough to compensate for these economic dynamics. The Yen Chart 9A Dovish BoJ Will Weigh ##br##On Yen Fundamentals Chart 10The Yen Is No Longer ##br##Tactically Cheap The FITM model shows that the post-election rally in USD/JPY was overdone as the yen's fundamentals have stopped deteriorating after October 2016 (Chart 9). As we see the growing likelihood of a decreasing deflationary impulse in Japan, the strong dovish commitment of the Bank of Japan should pull Japanese real rates lower vis-à-vis their U.S. counterparts. This underpins why we remain cyclical bears on the yen. Tactically, based on the ITTM, it will soon be time to close our short USD/JPY trade. While the yen had massively undershot any rational anchor in the wake of the Trump electoral victory, this undervaluation appears to have vanished after the yen's sharp rebound (Chart 10). A small overshoot in the yen is likely, but unless one is already short USD/JPY, this move should not be chased. In fact, USD/JPY below 108 should be used as an opportunity to reverse yen longs and play what may prove to be a powerful USD/JPY rally. The British Pound Chart 11GBP: A Long-Term Bargain... Chart 12...But Upside Against USD Is Limited According to the FITM, the pound's fair value has been stable post-Brexit, but it is now beginning to point lower. However, despite this turn of events, GBP/USD is currently trading at such an exceptional discount to the FITM - courtesy of a heightened geopolitical risk premium - that this deterioration in fair value is unlikely to matter much (Chart 11). Nonetheless, the fact that fundamentals have a negative directional bias for cable is prompting us to express our tempered optimism toward the pound by shorting EUR/GBP instead of buying GBP/USD. At a tactical level, the ITTM suggests that GBP/USD could have a bit more upside. GBP/USD is at equilibrium based on our timing model, but undershoots tend to be compensated by subsequent overshoots (Chart 12). That being said, with the ITTM still pointing south - in line with the FITM - any further rebound in GBP/USD is likely to prove to be limited. GBP/USD beyond 1.33 should be used as an opportunity to sell cable. On a multi-year basis, GBP is quite cheap, not only on a PPP basis, but also when incorporating relative productivity dynamics. This means that while we have a positive dollar-bias over the next 12-18 months, our favorite non-USD currency is currently the GBP. The June 8th general election is likely to give Theresa May the parliamentary majority she needs to have a more comfortable negotiating position with the EU, helping her obtain more advantageous terms for the U.K., re-enforcing our positive long-term bias on the GBP. The Canadian Dollar Chart 13Oil And Spreads Are Working##br##Against The Loonie... Chart 14...And So Is##br## Wilbur Ross According to the FITM, the aggregate fundamentals have rolled over and are beginning to point directionally south for the loonie: Oil has lost momentum, and rate differentials are not particularly flattering for the CAD (Chart 13). That being said, the CAD has greatly lagged these same fundamentals, probably as investors have been pondering the potential negative implications for NAFTA and Canada of the Trump administration. Our ITTM suggests that with this handicap taken into account, the CAD may not be a short after all (Chart 14). However, because the CAD is more sensitive to the trend in the broad U.S. dollar and general commodity prices than anything else, we prefer to express a positive bias on the loonie by buying it against the AUD, a commodity currency that does not trade at the same discount to its ITTM. The Swiss Franc Chart 15Inflationary Dynamics Should##br## Continue To Weigh On The Franc Chart 16No Clear Timing##br## Signals Yet Even if flat for the past year or so, the directional fundamentals on the Swiss franc vis-à-vis the USD still seems to be in a long-term bear market (Chart 15). This simply highlights the fact that with the U.S. economy able to generate some inflationary dynamics while Switzerland continues to suffer from pronounced deflationary anchors, U.S. real rates have more room to move upward than Swiss ones. In terms of timing, the ITTM is in the neutral zone, suggesting that there is no particularly compelling reason to buy or short USD/CHF at the current juncture (Chart 16). The SNB is unofficially targeting a floor under EUR/CHF around 1.06 to tame the deflationary impulse in Switzerland. While the Swiss economy is improving, it is not yet strong enough to handle a removal of this policy. In all likelihood, this means that for the rest of 2017, USD/CHF will remain a near-perfect mirror image of EUR/USD. The Australian Dollar Chart 17Iron Ore Prices: From Friend To Foe Chart 18No Valuation Cushion For AUD AUD/USD has not been able to break above 0.77, and the reason simply is that the forces embedded in the FITM have sharply rolled over (Chart 17). Not only have commodity prices stopped appreciating - with iron prices, the most crucial determinant of Australia's terms of trade down 21% - but U.S. short rates and long rates have been going up relative to Australia. Most disturbing for Australia, unlike the CAD it does not possess any cushion when analyzed through the prism of our ITTM (Chart 18). This suggests that the deteriorating Australian fundamentals are likely to be directly translated into a lower AUD/USD. Moreover, historically, previous undershoots in the AUD were followed by an overshoot. We do not think this time is any different; but the dovish slant of the RBA and the drubbing received by iron ore prices suggest that if the AUD overshoots, it will be because it may not fall as fast as its fundamentals at first. If that is the case, we do expect a catch-up later this year. As previously mentioned, the relative dynamics between the Canadian and Australian ITTM suggest that investors in commodity currencies should short AUD/CAD. Moreover, on a longer-term basis, we also favor oil producers over metal ones. The supply dynamics in the oil market are much more favorable than for metals. Not only have many global oil producers cut down their output, our sister publication Commodity And Energy strategy expects the OPEC + Russia agreement to be extended for the rest of 2017.8 Meanwhile, metal production cutbacks have been much more timid. The New Zealand Dollar Chart 19NZD Suffers From ##br##Similar Ills As AUD... Chart 20...However Inflationary Backdrop##br## Is More Favorable The fundamentals for the New Zealand dollar have also rolled over after having pointed to a strong Kiwi since February 2016 (Chart 19). Interestingly, the rollover in the NZD FITM has not been as sharp as the rollover in the Australian Dollar's FITM. The ITTM does argue that as with the CAD, the NZD does have a healthy margin of maneuver before the deteriorating fundamentals become a bidding constraint (Chart 20). In fact, the recent NZD weakness may have exaggerated the underlying deterioration in NZ data. The recent stronger-than-expected inflation data may prompt investors to reconsider their very dovish take on the RBNZ. Our preferred fashion to take advantage of the NZD's discount to its ITTM is also against the AUD. Both currencies are very exposed to EM and China shocks, and both currencies display a similar beta to the USD. As such, it is very rare for the NZD to trade at a discount to the ITTM while the AUD is at equilibrium. With the New Zealand domestic economy in better shape than that of Australia, our bet is that both currencies will have to converge, which should weigh on AUD/NZD. The Norwegian Krone Chart 21NOK Fundamentals Have Worsened ##br##Even With Firm Oil Prices Chart 22Not A Good Time To##br## Buy The Krone Yet Like other currencies, the fundamentals for the Norwegian krone have begun to roll over. The sharpness of that turnaround is particularly striking when one considers that oil prices have remained resilient, despite their recent weakness (Chart 21). NOK has taken the cue from the FITM and has weakened in line with fundamentals. Is it time to lean against this weakness and buy the NOK now? We doubt it. The NOK may benefit against the USD if the euro overshoots in the wake of the French election. However, the NOK has yet to correct previous overshoots, and the fact that it currently trades in line with the ITTM suggests that it provides very little insulation against any further deterioration in its own fundamentals (Chart 22). In the longer term, we are more positive on the NOK. It is cheap based on long-term models that take into account Norway's stunning net international position of 203% of GDP. Moreover, the high inflation registered between 2015 and 2016 is now over as the pass-through from the weak trade-weighted krone between 2014 and 2015 is gone. This means that the PPP fair value of the NOK has stopped deteriorating. The Swedish Krona Chart 23Dollar Strength Has Dislodged ##br##The SEK From Fundamentals Chart 24Taking Momentum Into Account##br## The SEK Is Not Cheap The SEK continues to display one of the highest beta to the USD of all the G10 currencies. As a result, when the USD is strong, even if fundamentals do not warrant it, the SEK is especially weak. The rally in the USD in the second half of 2016 took an especially brutal toll on the krona, which has dissociated itself from its pure fundamentals. If the dollar follows the recent improvement in its own FITM, then SEK too will weaken despite its apparent undershoot (Chart 23). Now, however, the SEK's weakness will follow the deterioration in directional fundamentals. The timing model corroborates this picture. The ITTM takes into account the trend of USD/SEK, and when this is done, the undervaluation of the SEK disappears (Chart 24). Over the next three to nine months, we expect U.S. rates to have more upside relative to European ones than is currently priced in by markets. Therefore, we anticipate the USD to strengthen further, and as a corollary, the SEK will suffer especially strongly under these circumstances. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report, "Assessing Fair Value In FX Markets," dated February 26, 206, available at fes.bcaresearch.com and gis.bcaresearch.com 2 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound," Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 3 Michael T. Kiley (January 2013). 4 Please see Yin-Wong Cheung, and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 5 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016). 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016). 7 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach," Working Paper No.85, European Central Bank (November 2001). 8 Please see Commodity And Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Lean against depressed and euphoric interest rate expectations. The ECB will remove or fade the negative deposit rate, with an outside chance that it happens this year. The U.K. economy will determine the nature of Brexit - not the other way round. The snap General Election doesn't change anything. Expect an ongoing narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. Expect the following order of currency performance: euro first, pound second, dollar third. Expect the FTSE100 to outperform the Eurostoxx50. Feature The interplay between interest rate expectations - in the U.K., U.S. and euro area - is one of the most important factors in explaining what has happened, what is happening, and what will happen, to financial markets. Chart of the WeekBrexit Depression Has Unwound; ##br##Trump Euphoria Hasn't... Yet Interest rate expectations convincingly explain the movements in the U.S. T-bond/German bund yield spread, the U.S. T-bond/U.K. gilt yield spread, euro/dollar, and pound/dollar. Thereby, they also explain FTSE100/Eurostoxx50 relative performance which is just an (inverse) currency play. Chart I-2, Chart I-3, Chart I-4, Chart I-5 and Chart I-6 should leave readers in absolutely no doubt. Chart I-2Interest Rate Expectations Explain The ##br##T-Bond/German Bund Yield Spread Chart I-3Interest Rate Expectations Explain The##br## T-Bond/U.K. Gilt Yield Spread Chart I-4Interest Rate Expectations ##br##Explain Euro/Dollar Chart I-5Interest Rate Expectations##br## Explain Pound/Dollar Chart I-6Pound/Euro (Inversely) Explains ##br##FTSE100/Eurostoxx50 Lean Against Depressed And Euphoric Interest Rate Expectations Last year's shock victories for Brexit and Trump dramatically swung the market mood towards the U.K. and U.S. economies. After Brexit, the knee-jerk response was depression; after Trump, the knee-jerk response was euphoria. But extreme mood swings to depression and euphoria are rarely justified, and ultimately tend to unwind. Responding to last year's dramatic mood swings, U.K. and U.S. interest rate policy - both actual and expected - moved very sharply in opposite directions. Following the Brexit vote, the BoE cut the base rate by a quarter percent, and the rate expected two years out plunged by three quarters of a percent. In contrast, following the Trump victory, the Federal Reserve twice hiked the Fed funds rate by a quarter percent, and the rate expected two years out surged by more than a percent. Meanwhile, throughout all this activity, the ECB repo rate and deposit rate were anchored at zero and -0.4% respectively, and the interest rate expected two years out remained in negative territory. Fast forward to today, and the U.K. interest rate expected two years out has fully unwound the Brexit vote depression - the expected BoE policy rate two years out stands exactly where it stood before the EU Referendum. In contrast, the expected Fed policy rate two years out retains its Trump euphoria (Chart of the Week). Meanwhile, the expected ECB policy rate two years out remains anchored close to the realistic limit of negativity. To reiterate, the extreme market moods of depression and euphoria are rarely justified, and tend to unwind. On this basis, we can say that policy rate expectations in relative terms now have the scope to: Get less depressed in the euro area. Remain broadly unchanged in the U.K. Get less euphoric in the U.S.1 Hence, on a 12-month horizon, expect a continued narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. For currencies, expect the following order of performance: euro first, pound second, dollar third. And therefore, expect the FTSE100 to outperform the Eurostoxx50. Brexit: A Reductionist View Many millions of words have been written about Brexit, and we suspect that many millions more will be written. But true to our reductionist philosophy, we can reduce those millions of words to a single sentence. Brexit was, is, and always will be, about the trade-off between national sovereignty and access to the European single market. Irrespective of the vote to leave the EU and the start of the divorce proceedings, the full spectrum of possibilities in this trade-off is still open to the U.K. At one extreme the U.K. could get a full divorce, and thereby regain absolute national sovereignty in all areas including law and immigration. But in this full divorce, the EU27 would regard the U.K. as a complete outsider whose status is little different to say, Russia. At the other extreme, the U.K. could near enough replicate its current economic and political relationship with the EU27 in a 'pseudo-marriage'. Technically, the U.K. would be divorced, but practically, there would be only minor differences to being married. Although the U.K. would lose its official place at the EU top table, in all likelihood the EU27 would still listen to the British voice given the U.K.'s size and global standing. But in this pseudo-marriage the EU27 would exact a cost: the U.K. could not regain any national sovereignty. All points on the spectrum between a full divorce and a pseudo-marriage are now available to the U.K. The relationship that the U.K. ends up with depends on the trade-off that the British public - and therefore its political representatives in the government and parliament - will accept. In turn, this will depend on the evolution of the economy and standards of living. A strong economy will embolden the British public to want something close to a full divorce. Conversely, a weakening economy might be blamed, rightly or wrongly, on Brexit. In which case, public opinion would shift towards something closer to a pseudo-marriage. Therefore, the causality runs from the economy to Brexit, not from Brexit to the economy. The U.K. economy will determine where the U.K. ends up on the Brexit spectrum - at least, in terms of the initial deal. The snap General Election doesn't change anything. Nor is the General Election a game changer for the pound. The preceding section demonstrated that relative interest rate expectations - rather than Brexit per se - are driving the pound. We expect the BoE to remain relatively inactive because empirically, U.K. real consumption is hyper-sensitive (inversely) to inflation. When inflation is too high, real consumption growth is undermined, making it difficult to hike rates; and when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-7). This ties the hands of the BoE, and explains why the post EU Referendum emergency rate cut has been the BoE's only interest rate change since early 2009! Chart I-7Why The Bank Of England's Hands Are Tied While rate expectations can get less depressed in the euro area, and less euphoric in the U.S., they are likely to change least in the U.K. Hence, we like the pound less than the euro; but we like the pound more than the dollar. Role Playing On The ECB Governing Council We are writing ahead of the ECB policy meeting, but we do not anticipate any substantive announcements - given that we are only half way through the French Presidential Election. In the absence of major developments, the euro's strong recent advance might take a tactical breather. But what then? Some people argue that ECB policy should be based not on the aggregate euro area economy, but instead on the weaker links in the euro area economy. These arguments have some merit, as the ECB - unlike other central banks - has to contend with a permanent existential threat. On this basis, let's finish this week with a role playing exercise. Imagine you're on the ECB Governing Council, and the weak link that worries you is euro area bank fragility, particularly in some of the southern member states. Your own (ECB) analysis, illustrated in Chart I-8, shows that extreme accommodative monetary policy has had a negligible net impact on bank profitability. The QE component has probably been a mild net positive - admittedly, a flatter yield has dragged down banks' net interest margins; but it has also generated profits in banks' bond portfolios; and in so far as QE has boosted economic growth, it has reduced bank charge-offs. Chart I-8What Is The Point Of The ECB's Negative Deposit Rate? But the negative deposit rate - charging banks for excess liquidity - has been a clear drag on bank profitability. And there is little evidence that it has encouraged lending. What would you do? Even if the ECB is setting policy for the euro area weak links, the central bank's own analysis suggests that it should remove, or at least fade, the negative deposit rate. Our central expectation is for this to happen early next year, with an outside chance that it is even sooner. With expectations for ECB policy rates still anchored close to the realistic limit of negativity, the euro exchange rate has cyclical upside. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Assuming that the U.S. government does not approve inappropriate fiscal stimulus. Fractal Trading Model* This week's trade is to go long the FTSE100 versus the IBEX35 with a profit target and stop loss of 4%. 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-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 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

Special Report

The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The ##br##Saving And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Chart II-6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com.

Highlights Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. There are also some worrying signs in our global forward-looking growth indicators for 2018, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. first-quarter economic data. They also went too far in pricing out U.S. fiscal action. It is positive for risk assets that centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. Italian elections could be troublesome, but that is a story for next year. The fact that China finally appears willing to apply pressure to Pyongyang is good news. North Korea might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. Disappointing U.S. Q1 real GDP growth largely reflects weather and seasonal adjustment factors. The deceleration in bank credit growth is also temporary. The window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals remain constructive. Importantly, signs of improving pricing power in the U.S. corporate sector are finally emerging, which should allow margins to expand somewhat in the coming quarters. The bond rally has depressed yields to a level that makes fixed-income instruments highly vulnerable to a reversal of the factors that sparked the rally. Market expectations for the fed funds rate are far too benign. The ECB will announce the next tapering step later this year, and may remove the negative deposit rate. But the central bank will not be in a position to lift the refi rate for some time. Yield spreads will shift in a way that allows one last upleg in the U.S. dollar. The recent pullback in oil prices will not last, as OPEC and Russia manage global stockpiles lower this year. Feature Chart I-1Reflation Trades Returning? Traders and investors gave up on the global reflation story in early April, sending the 10-year U.S. Treasury yield below the year's trading range. Missile strikes, European elections and U.S. saber rattling regarding North Korea lifted the allure of safe havens such as government bonds (Chart I-1). At the same time, the Fed was unwilling to revise up the 'dot plot', doubts grew over the ability of the Trump Administration to deliver any stimulus and U.S. data releases disappointed. The major equity indexes held up well against the onslaught of bad news, but looked increasingly vulnerable as April wore on. The market gloom was overdone in our view, and it appears that financial markets have now returned to a 'risk on' phase. It is difficult to forecast the ebb and flow of geopolitical news so we cannot rule out another bout of risk aversion. Nonetheless, the global economic backdrop remains upbeat and tensions regarding North Korea have eased. President Trump also unveiled his Administration's tax reform plan, raising hopes of a fiscal boost to the economy. Moreover, investors have read too much into the distorted U.S. first quarter data, and our corporate pricing power indicators support our constructive earnings view in 2017. There are clouds hanging over the outlook for 2018, but the backdrop will favor risk assets for most of this year. Investors should remain overweight equities versus bonds and cash, and bullish the dollar. Geopolitics Weigh On Risk Tolerance President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. The fact that China finally appears willing to apply pressure to Pyongyang is good news. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. The safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances. Chart I-2Macron Appears Set For Victory Turning to Europe, investors breathed a sigh of relief following the first round of the French Presidential election. The pre-election polls turned out to be correct, and our Geopolitical Team has no reason to doubt the polls regarding the second round (Chart I-2). We expect Macron to sweep to victory on May 7 because Le Pen will struggle to get any voters from the candidates exiting the race. What should investors expect of a Macron presidency? A combination of President Macron and a right-leaning National Assembly should be able to accomplish some reforms. Several prominent center-right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister. This is positive for the markets as it means that French economic policy will be run by the center-right, with an ultra-Europhile as president. Over in the U.K., the big news in April was Prime Minister Theresa May's decision to hold a snap election, which reduces the risk of a "hard Brexit". The current slim 12-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories who would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservatives are able to increase their seats in Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. U.S. Fiscal Policy: Positive For 2017, But Long-Term Negative Chart I-3Long-Term U.S. Budget Pressures The drama will be no less interesting in Washington in the coming weeks. As we go to press, Congress is struggling to pass a bill to keep the U.S. government running through the end of fiscal year 2017 (the deadline is the end of April). We expect a deal will get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. Both events could see temporary safe-haven flows into Treasurys. However, markets may have gone too far in pricing-out tax cuts or fiscal stimulus. For example, high tax-rate companies have given back all of their post-election equity gains. Even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. "Dynamic scoring" will be used to support the argument that the tax cuts will self-funding through faster growth. We also expect that Trump will get his way on at least a modest amount of infrastructure spending. The so-called Trump trades may wither again in 2018, but we see a window this year in which the stock-to-bond total return ratio lifts as growth expectations rebound. Looking further ahead, it seems likely that the U.S. budget deficit is headed significantly higher. Health care and pension cost pressures related to population aging are well known (Chart I-3). A recent Special Report by BCA's Martin Barnes highlighted that "it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlement programs and preventing a massive rise in the budget deficit."1 There is simply not enough non-defense discretionary spending to cut. Larger U.S. Federal budget deficits could lead to a widening fiscal risk premium in Treasury yields, although that may take years to show up. Perhaps more importantly, the U.S. government sector will be a larger drain on the global pool of available savings in the coming years. We highlight in this month's Special Report, beginning on page 20, that there are several key macro inflection points under way that will temper the "global savings glut" and begin to place upward pressure on global bond yields. A Temporary Soft Patch Or Something Worse? The first quarter GDP report for the U.S. is due out as we go to press, and growth is widely expected to be quite weak. The retail sales and PCE consumer spending data have fed concerns that the U.S. economy is running out of gas, despite the surge in the survey data such as the ISM. We believe that growth fears are overdone. Financial markets should be accustomed to weak readings on first quarter GDP. Over the past 22 years, the first quarter has been the weakest of the four on 12 occasions, or 55% of the time. Second quarter GDP growth has been faster than Q1 growth 70% of the time. A large part of the depressed Q1 GDP growth rate and lackluster "hard data" readings likely reflect poor seasonal adjustment and weather distortions. The "soft" survey data are more consistent with the labor market. Aggregate hours worked managed to increase by 1.5% at an annualized rate in Q1. If GDP growth really was barely above zero, this would imply an outright decline in the level of labor productivity. Even in a world where structural productivity growth is lower than it was in the past, this strikes us as rather implausible. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have pulled back from their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in the weather-impacted "hard" data in May and June. What about the slowdown in commercial and industrial loan growth and corporate bond issuance late in 2016 and into early 2017? This is a worry, but it partly reflects the lagged effects of the contraction in capital spending in the energy patch. C&I loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that the defaults have waned, this process will soon go into reverse. Higher profits more recently have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 bn in issuance in Q1, the highest level on record (Chart I-4). The rest we chalk up to uncertainty surrounding the U.S. election. The recent spikes in the political uncertainty index correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November. There has been a close correlation between these spikes and the deceleration in C&I loan growth. CEOs are also holding back on capex in anticipation of new tax breaks from Congress. The good news is that bond issuance has rebounded strongly in January and February of this year (Chart I-5). The soft March U.S. CPI release also appeared to be quirky, showing a rare decline in the core price level in March (Chart I-6). However, the March reading followed two months of extremely strong gains and it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart I-4U.S. Bank Credit Slowdown Is Temporary Chart I-5U.S. Corporate Bond Issuance Is Rebounding Chart I-6U.S. Inflation: Sogginess Won't Last Global Economic Data Still Upbeat For the major industrialized economies as a group, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4½% in February on a year-over-year basis (Chart I-7). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession that was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart I-8). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the six months to March (Chart I-9). Chart I-7Global Pick-Up On Track Chart I-8Manufacturing Rebound Is Not About Energy Chart I-9U.S.: Non-Energy Production Surging The weak spot on the global data front has been capital goods orders (Chart I-7). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart I-7, third panel). Improving CEO sentiment, accelerating profit growth and activity surveys all suggest that capital goods orders will catch up in the coming months. That said, one risk to our positive capex outlook in the U.S. is that the Republicans fail to deliver on their promises. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital spending. As for China, the economic data are holding up well and deflationary pressures have eased. Fears of a debt crisis have also ebbed somewhat. That said, fiscal and monetary stimulus is fading and it is a worrying sign that money and credit growth have decelerated because they tend to lead production. Our China experts believe that growth will be solid in the first half of the year, but they would not be surprised to see a deceleration in real GDP growth in the second half that would weigh on commodity prices. Bond Market Vulnerable To Fed Re-Rating A rebound in the U.S. activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A May rate hike is unlikely, but we would not rule out June. The bond market is vulnerable to a re-rating of the path for the fed funds rate because only 45 basis points of tightening is priced for the next 12 months. This is far too low if growth rebounds as we expect. The FOMC also announced that it intends to start shrinking its balance sheet later this year by ceasing to reinvest both its MBS and Treasury holdings. Our bond strategists do not think this by itself will have much of an impact on Treasurys because yields will continue to be closely tied to realized inflation and the expected number of rate hikes during the next 12 months (Chart I-10). Fed policymakers are trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. It is a different story for mortgage-backed securities, however, where spreads will be pressured wider by the lack of Fed purchases. All four of our main forward-looking global economic indicators appear to have topped out, except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past (Chart I-11). Nonetheless, all four are still consistent with robust growth. They would have to weaken significantly before they warned of a sustained bond bull market. Chart I-10Shrinking Fed Balance Sheet: ##br##Bearish For Bonds? Chart I-11Leading Indicators: ##br##Some Worrying Signs The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is the most concerning at the moment. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The bottom line is that global bond yields have overshot on the downside: underlying U.S. growth is not as weak as the Q1 figures suggest; market expectations for the fed funds rate are too benign; the Republicans will push ahead with tax cuts and infrastructure spending; the global economy has healthy momentum, and the majority of the items on our Duration Checklist suggest that the bond bear market will resume; the ECB will announce another tapering of its asset purchase program this autumn, placing upward pressure on the term premium in bond yields across the major markets; and the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. We recommend keeping duration short of benchmarks within fixed-income portfolios. One Last Leg In The Dollar Bull Market Chart I-12ECB In No Hurry To Lift Rates While we see upside for the money market curve in the U.S., the same cannot be said in the Eurozone. The economic data have undoubtedly been robust. The composite PMI is booming and capital goods orders are in a clear uptrend. Led by gains in both manufacturing and services, the composite PMI rose from 56.4 in March to 56.7 in April, a six-year high. The current PMI reading is easily consistent with over 2.0% real GDP growth (Chart I-12). This compares favorably to the sub-1% estimates of trend growth in the euro area. Private sector credit growth reached 2½% earlier this year, the fastest pace since July 2009. Despite this good news, the ECB is in no rush to lift interest rates. The central bank will taper its asset purchase program further in 2018, but ECB President Draghi has made it clear that he will not raise the refi rate until well after all asset purchases have been completed, which probably will not be until late 2019 at the earliest (although the ECB could eliminate the negative deposit rate to ease the pressure on banks). Unemployment is still a problem in Spain and Italy, while core CPI inflation fell back to just 0.7% in March. The euro could strengthen further in the near term if Macron wins the second round of the French elections, easing euro break-up fears. Nonetheless, we expect the euro to trend lower on a medium-term horizon versus the dollar as rate expectations move further in favor of the greenback. Some real rate divergence is already priced into money and currency markets, but there is room for forward real spreads to widen further, possibly pushing the euro to parity versus the dollar before this cycle is over. We are also bullish the dollar versus the yen for similar reasons. On a broad trade-weighted basis, we still expect the dollar to rally by another 10%. Positive Signs For U.S. Corporate Pricing Power Chart I-13U.S. Corporations Gaining Pricing Power Turning to the equity market, it is still early days for Q1 U.S. earnings, but the results so far are positive for a pro-risk asset allocation. After a disappointing Q4, positive Q1 earnings surprises for the S&P 500 are on track to match their highest level in two years, with revenue surprises also materially higher than previous quarters. At the industry level, banks and capital goods companies stand out: the former registered an earnings beat of nearly 8%, and it was nearly 12% for the latter. We highlighted the positive 2017 outlook for U.S. corporate profits in our March 2017 Monthly Report. Earnings growth is in a catch-up phase following last year's profit recession, which was related to energy prices and a temporary slowdown in nominal GDP growth relative to aggregate labor costs. Proprietary indicators from our sister publication, the U.S. Equity Sectors Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart I-13). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly-based across industries (as shown by the diffusion index in the chart). As a side note, the Profit Proxy provides some evidence that recent softness in core CPI inflation will not last. Second, the upward march of wage growth appears to be taking a breather (Chart I-13). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching perpetually-optimistic bottom-up estimates for 2017 (Chart I-14). Many companies have supported per share profits in this expansion via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart I-15 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same is true for GDP. Chart I-14U.S. Profit Model Is Very Upbeat Chart I-15U.S. Corporate Finance Cycle Comparison Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity issuance since 2009, which includes the impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions (positive values shown in Chart I-15 represent net equity withdrawals). CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Nonetheless, buybacks have boosted EPS growth by almost 2% over the past year according to our proxy (Chart I-16). We expect this tailwind to continue given the positive reading from our Capital Structure Preference Indicator (third panel). Firms have a financial incentive to issue debt and buy back shares when the indicator is above zero. Stronger global growth should continue to power an acceleration in corporate earnings outside the U.S. over the remainder of the year. Chart I-17 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Our profit indicators remain constructive for the U.S., Eurozone and Japan. Chart I-16Incentive To Buy Back ##br##Stock Remains Strong Chart I-17Global Profit ##br##Growth On The Upswing It is disconcerting that the rally in oil prices has faltered in recent days as investors worry that increased U.S. shale production will thwart OPEC's plans to trim bloated inventories. A breakdown in oil prices could spark a major correction in the broader equity market. Indeed, commercial oil inventories finished the first quarter with a minimal draw. The aim of last year's agreement between OPEC and Russia to remove some 1.8mn b/d of oil production from the market in 2017 H1 was to get visible inventories down to five-year average levels. They are well short of that goal. Without trimming stockpiles to more normal levels, storage capacity remains too close to topping out, which raises the risk of another price collapse. This is an extremely high-risk scenario for states like Saudi Arabia, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. This is the reason why our commodity strategists expect the OPEC/Russia production cuts to be extended when OPEC meets on May 25. This will significantly raise the odds that OECD commercial oil stocks will be drawn down to more normal levels. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. Investment Conclusions Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. Admittedly, some of the U.S. data have been disappointing given the extremely upbeat survey numbers. There are also some worrying signs in our global forward-looking growth indicators, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. economic data in the first quarter. They also went too far in pricing out U.S. fiscal action. As for European political risk, centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. There are legitimate reasons to be concerned about the economic and profit outlook in 2018. Nonetheless, we believe that the window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals are constructive. The passage of market-friendly fiscal policies in the U.S. later in 2017 will be icing on the cake. Perhaps more importantly, we are finally seeing signs that pricing power in the U.S. corporate sector is improving, allowing margins to expand somewhat in the coming quarters. Our profit models remain upbeat for the major advanced economies and for China. It has been frustrating for those investors looking for an equity buying opportunity. Despite the surge in defensive assets such as gold and Treasurys, the major equity bourses did not correct by much. Value remains stretched in all of the risk asset classes. Nonetheless, investors should stay positioned for another upleg in the stock-to-bond total return ratio in the coming months. Perhaps the largest risk lies in the bond market. The rally has depressed yields to a level that makes bonds highly vulnerable to a reversal of the factors that sparked the rally. Within an underweight allocation to fixed-income in balanced portfolios, investors should overweight investment- and speculative-grade corporate bonds in the U.S. and U.K. We are more cautious on Eurozone corporates as the ECB's support for that sector will moderate. Looking ahead to next year, our bond strategists foresee a shift to underweight credit given the advanced nature of the releveraging cycle in the U.S. corporate sector. Our other recommendations include: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. in currency-hedged terms. Continue to favor defensive over cyclical equity sectors in the U.S. for now, but a shift may be required later this year. Overweight the dollar versus the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market. Recent underperformance is a buying opportunity. Value has improved and cyclical conditions favor small caps. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst April 27, 2017 Next Report: May 25, 2017 1 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies and Fantasies," dated April 5, 207, available at bca.bcaresearch.com II. Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The Saving ##br##And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Chart II-6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The modest correction in April did not improve equity valuation by much in any of the major markets. Our U.S. valuation metric is still hovering just below the +1 sigma mark, above which would signal extreme overvaluation. Measures such as the Shiller P/E ratio are flashing red on valuation, but our indicator takes into consideration 11 different valuation measures. Technically, the U.S. equity market still has upward momentum, while our Monetary indicator is neutral for stocks. The Speculation index indicates some froth, although our Composite Sentiment indicator has cooled off, suggesting that fewer investors are bullish. The U.S. net revisions ratio is hovering near zero, but it is bullish that the earnings surprise index jumped over the past month. First-quarter earnings season in the U.S. has got off to a good start, while the global earnings revisions ratio has moved into positive territory for the first time in six years (see the Overview section). Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little 'dry power' left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. April's rally in the U.S. bond market dragged valuation close to neutral. However, we believe that the market is underestimating the amount of Fed rate hikes that are likely over the next year. Now that oversold technical conditions have been absorbed, this opens the door the next upleg in yields. Bonds typically move into 'inexpensive' territory before the monetary cycle is over. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, the dollar has shifted down this year to meet support at the 200-day moving average and overbought conditions have largely, but not totally, been worked off. We still believe there is more upside for the dollar, despite lofty valuation readings, due to macro divergences. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China

Highlights China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Continued demand strength in DM will not prevent a relapse in EM/China growth. EM is much more leveraged to China than to DM. Higher bond yields in DM, a stronger U.S. dollar and weak China/EM domestic demand are bearish for commodities and EM risk assets. A new equity trade: short KOSPI / long Nikkei. Feature In our recent reports1 we have argued that China's growth is likely to relapse again in the second half of this year based on its aggregate credit and fiscal impulse. Chart I-1 illustrates that this impulse leads Korean, Taiwanese, Japanese, German and U.S. aggregate exports to China by six months, and this indicator is reinforcing the message that shipments from these economies to the mainland have peaked and will stumble. Consistently, the bottom panel of Chart I-1 reveals that Chinese imports of capital goods are set to decelerate significantly and probably contract anew by the end of this year or early 2018. If markets are forward looking, they should begin discounting a potential growth slump very soon. Chart I-2 demonstrates that there is a tight correlation between each of these countries' shipments to China and the mainland's credit and fiscal impulse. Chart I-1Chinese Imports To Relapse Chart I-2Exports To China To Weaken In this context, a relevant question is whether the expansion of U.S. and European imports will be sufficient to safeguard the recovery in EM and global trade as China's imports tumble. Our analysis substantiates that domestic demand strength in the U.S. and Europe will boost these economies but will likely not preclude another downturn in EM/Chinese growth and global trade. In brief, China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Our basis is that EM and China trade much more with one another, and as such the DM business cycle has become a less important driver. If DM demand holds up as China's imports tumble anew, EM share prices and currencies will underperform their DM counterparts. In this context, our negative view on EM is contingent on a deceleration in China's business cycle rather than a major relapse in DM domestic demand. In the near term, higher bond yields in DM due to strong domestic demand combined with weakness in EM/Chinese growth will reverse the EM rally. EM Is Much More Leveraged To China Than To DM Chart I-3EM Is Leveraged To China Much More Than DM Chart I-3 shows that the relative performance of EM versus DM stocks typically fluctuates with the relative import volume trend between China and DM. This supports our thesis that the EM world is much more leveraged to China than DM. The following considerations certify China's greater importance for EM economies compared to the U.S. and Europe: Table I-1 shows the share of exports going to China and to the U.S. for individual EM countries. The mean for exports to China is 14.6% of total, and 11.3% for shipments to the U.S. These numbers corroborate the fact that developing countries sell more to China than to the U.S. Chart I-4 is constructed using the numbers from Table I-1. It demonstrates that Korea, Taiwan, Chile and Peru are more exposed to China while India, Turkey, and the Philippines are more leveraged to the U.S. We did not include Mexico and central Europe in this chart because the former trades with the U.S. and the latter predominantly with European countries due to their geographical proximity. Table I-1Export To China And U.S. Chart I-4Exposure To China And Exposure To The U.S. Chinese demand is critical for commodities, particularly for industrial metals prices. China consumes 6-7-fold more industrial metals than the U.S. Unsurprisingly, the mainland's credit and fiscal impulse leads industrial metals prices (Chart I-5). At this moment, we are negative on both metals and oil prices, as we view the 2016 rally as a mean-reverting rally in a structural bear market. As commodities prices drop again, commodities-producing nations will suffer from a negative terms-of-trade shock. This is regardless of which countries they export commodities to. There is one global price for each commodity, and when it deflates commodity producing nations are the ones that get hurt - irrespective of whether they sell that commodity to China, the U.S., Europe or the rest of the world. Countries like Korea and Taiwan do not sell commodities, but their largest export destination is still China (Chart I-6). The latter accounts for 25% of Korean and 27% of Taiwanese exports Chart I-5China's Credit And Fiscal##br## Impulse And Industrial Metals Chart I-6Korea And Taiwan: The ##br##Composition Of Exports. Even if we assume that 30% of goods exported to China by Korea and Taiwan are assembled and then re-exported to other countries, the mainland's domestic absorption of Korean and Taiwanese goods is still considerable. Notably, the recovery in Korean, Taiwanese and Japanese exports has been driven more by China than the rest of the world (Chart I-7). Therefore, China's business cycle is also important for some non-commodity producing countries like Korea, Taiwan and others in Asia. China itself has become much more reliant on its credit origination and fiscal spending than on exports in general and exports to DM in particular (Chart I-8). Chart I-7Asia's Exports Recovery Has Largely ##br##Been Driven By China's Demand Chart I-8China Has Become Reliant ##br##On Stimulus Not Exports Finally, Table I-2 exhibits the product structure of Chinese imports. By and large, China imports three categories of goods: various commodities, capital goods and some luxury goods. All three are at risk of a slowdown because they are leveraged to the nation's credit cycle. Table I-2Composition Of Chinese Imports Bottom Line: China's imports are critical not only for commodity producers (Latin America, Russia, Africa, the Middle East and Indonesia) but also for non-commodity economies in Asia. Altogether this comprises most of the EM universe. EM/China's Importance In Global Trade EM/China account for much larger global trade flows than advanced economies. In short, global trade will relapse again if global shipments to China and the rest of the EM universe slump. EM including Chinese imports (but excluding the mainland's imports for re-exports) in U.S. dollars are equal to imports by the U.S., EU and Japan combined (Chart I-9). Chinese imports for processing - imports that are used to manufacture goods for exports - are excluded from the calculation of this chart. Only Chinese imports for domestic consumption are accounted for. Also, this EM aggregate excludes Mexico and central European countries because their manufacturing is intertwined with the ones in the U.S. and EU. Exports to EM countries account for 25%, 28% and 17% of German, Japanese and U.S. exports, respectively. As a share of GDP, exports to vulnerable EM economies stand at 2%, 5% and 5% of U.S., German and Japanese GDP, respectively (Chart I-10). Chart I-9EM Imports Are Equal To Combined##br## Imports Of U.S., EU And Japan Chart I-10Japan And Germany Are More ##br##Exposed To EM Than The U.S. Japan and Germany are much more vulnerable to an EM/China slowdown than the U.S. and the rest of Europe (Europe ex-Germany). China's exports are exposed more to EM than DM. Chart I-11 shows that 45% of Chinese exports are shipped to Asia ex-Japan, 18% to Latin America, Russia, the Middle East, Africa, Australia and Canada and only 18% to the U.S. and 16% to the EU. Capital spending in China and EM ex-China makes up 5% and 5% (together 10%) of global GDP in real terms (Chart I-12). By comparison, EU and U.S. capital expenditures are 5% and 4.5% of world GDP in real terms. Hence, EM and especially China's investment outlays are big enough to matter for the global economy. Chart I-11China Sells More To EM Than DM Chart I-12EM/China Capex Is Large As Chart I-1 indicates, China's imports of industrial goods will soon tumble. Capital goods imports for EM ex-China have revived, but as their bank loan growth slumps the recovery in capital goods imports is likely to be short lived. Bottom Line: Two-pronged trade flows between EM and China are considerable for their own economies as well as global trade flows. Continued demand strength in DM countries will not prevent a relapse in EM/China growth. Market Observations And Conclusions Our conviction is that China's imports are set to dwindle in the second half of this year. This is bearish for commodities producers and Asian economies selling to China. If markets are forward looking, they should begin discounting this now. Moreover, bank deleveraging in EM/China has further to run. Altogether, this leads us to maintain the strategy of underweighting EM risk assets relative to their DM counterparts, and maintaining a negative stance on EM in absolute terms. Furthermore, it appears the U.S. dollar and U.S. bond yields have recently bounced from their technical support levels, and odds are they will rise further (Chart I-13). DM bond yields will move higher for now before the EM/China slowdown becomes visible later this year. For the time being, rising U.S. bond yields and a stronger greenback (versus EM, Asian and commodities currencies) will weigh on EM risk assets. Remarkably, Chinese interest rates are rising and corporate bond prices are plunging as the People's Bank of China continues along a gradual tightening path (Chart I-14). Chart I-13The U.S. Dollar And U.S. Bond Yields To Rise Chart I-14China: Borrowing Costs Are Rising As long as economic data from China and DM remain positive, financial regulators in Beijing are determined to curb leverage and speculative activities in China's credit system. Higher interest rates and regulatory tightening amid the lingering credit bubble are bound to cause meaningful stress in China's financial system and lead to a deceleration in credit growth. EM risk assets are very complacent about this risk. Interestingly, the commodities currencies index - an equal-weighted average of the Australian, New Zealand and Canadian dollars - has already halted its rally and begun depreciating even versus safe-haven currencies like the Swiss franc (Chart I-15). Such poor showing by commodities currencies should be taken seriously because it has occurred at a time when the U.S. dollar has been soft and global share prices have been well bid. As such, we read this message from the commodities currencies as a harbinger of a major top in commodities prices and EM risk assets. There is no reason why EM ex-China currencies should diverge from the commodities currency index this time around (Chart I-16). Chart I-15Commodities Currencies Versus ##br##Safe-Haven Currency Chart I-16EM Currencies ##br##To Tumble In short, we are reiterating our bearish strategy on EM currencies and recommend shorting a basket of the following currencies: ZAR, TRY, BRL, CLP, COP, MYR and IDR versus the U.S. dollar or a basket of the U.S. dollar and the euro. The main risk to our downbeat view on EM risk assets is not EM/China fundamentals but the rally in DM share prices. That said, DM stocks and credit markets were well bid in 2012-2014 yet EM stocks and currencies did very poorly during that period. This could be repeated again in the next couple of months before fundamental problems/weaker growth in China/EM become evident and stem the rally in DM equities too, as occurred in 2015. A New Equity Trade: Short KOSPI / Long Nikkei We have identified a tactical opportunity for a relative equity trade: short Korean / long Japanese stocks, currency unhedged. The Korean won is overvalued versus the Japanese yen, according to the relative real effective exchange rate based on unit labor costs (Chart I-17). This will provide a competitive advantage to Japanese manufacturers and will dent performance of the KOSPI versus the Nikkei. Even though the won could still appreciate versus the yen, equity prices in Japan will still fare better than their Korean counterparts in common currency terms. Japan's more competitive positioning is also reflected in its manufacturing PMI, which is much stronger than Korea's (Chart I-18). This should lead to outperformance of Japanese manufacturers versus their Korean peers. Chart I-17The Korean Won Is Expensive ##br##Versus The Yen Chart I-18Manufacturing PMI: ##br##Korea And Japan Korea is much more exposed to China than Japan. Exports destined to China make up 25% and 18% of Korean and Japanese exports, respectively. In the meantime, combined exports to the U.S. and EU account for 22% of Korea's total exports and 31% of Japan's total exports (Chart I-19). Provided our view that China's growth will disappoint relative to U.S. and EU growth pans out, Japan is in better position than Korea. Japanese policymakers continue to be much more aggressive in reflating their economy than Korean policymakers. Bank loan growth is accelerating in Japan but is slowing in Korea, albeit from a higher level (Chart I-20). Finally, the technical profile of relative performance between Korean and Japanese share prices favors the latter (Chart I-21). Chart I-19Japan And Korea: Structure Of Exports Chart I-20Bank Loan Growth Is Stronger In Japan Than Korea Chart I-21Short KOSPI / Long Nikkei Bottom Line: Short KOSPI / long Nikkei, currency unhedged. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Reports titled, "A Time To Be Contrarian", dated April 5, 2017, "Signs Of An EM/China Growth Reversal", dated April 12, 2017 and "EM: The Beginning Of The End", dated April 19, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Overall Duration: The factors that have driven global bond yields lower over the past month are not sustainable. Maintain a below-benchmark duration exposure, with current yield levels looking attractive to add to underweight/short positions as we did last week. French Election: We got the market-friendly outcome in the French election that we were expecting. We are closing our recommended long 10-year France vs 10-year Germany Tactical Overlay trade after the post-election spread tightening, at a profit of 1.3%. Feature Investors breathed a sigh of relief yesterday, after the French presidential election produced the most market-friendly result - a Macron-Le Pen matchup in the May 7 run-off. Pre-election polling showed that the pro-Europe reformer Macron and his En Marche ("On The Move") party would easily trounce the anti-Europe populist Le Pen in a head-to-head showdown. That outcome would eliminate the possibility of a confidence-shattering "Frexit" along the lines of last year's U.K. vote that could stall the current global economic expansion. Elevated political risks in Europe, and geopolitical risks in Syria and North Korea, have been a factor driving volatility higher, and bond yields lower, in recent weeks. There have also been some data disappointments in the U.S. that have occurred at the same time (Chart of the Week). It is difficult to tell which factor has been more important for government bond markets. The fact that yields jumped worldwide yesterday after the French election result and, more importantly, the lack of any serious repricing in global equity and credit markets alongside the recent pop in volatility, suggests that bond markets are likely not sniffing out a sustained growth slowdown. Government bond yields remain too low relative to underlying economic and inflation trends, and we continue to recommend below-benchmark duration exposure and above-benchmark allocations to corporate credit versus government bonds (especially in the U.S.). Falling Bond Yields: Some Shifting Expectations, But Not A Change In Trend The recent decline in global bond yields began in mid-March. The move in most of the major markets was largely driven by falling inflation expectations, with real yields staying relatively stable, although in the U.S. the split was more 50/50. Importantly, both the nominal 10-year U.S. Treasury and German Bund yield are bouncing off the bottom of their upward sloping trend channels that started in early 2016 (Chart 2). Chart of the WeekA Series Of Unfortunate Events Chart 2Upward Trend In Yields Still Intact We see those upward trending channels as being the primary medium-term trend for bond yields. The recent pullback in yields has been the result of several individual factors that have occurred at the same time that are likely to reverse in the months ahead: Slower U.S. growth & inflation: The latest soft readings on U.S. retail sales and core CPI inflation are not consistent with the robust readings on business confidence and manufacturing activity, as well as the accelerating trend in U.S. corporate profit growth that our models expect will continue in the coming quarters (Chart 3). The latter is being driven by significant improvements in corporate pricing power that are helping boost profit margins, according to our equity strategists (bottom panel).1 We find it hard to believe that there can be a prolonged slowdown in the U.S. economy if earnings growth is accelerating and firms are not forced to cut back on hiring and investment to preserve profitability. The U.S. Overnight Index Swap (OIS) curve is now only discounting 38bps of rate increases over the next year, Treasuries look expensive as the Fed is likely to deliver at least 50bps worth of hikes by year-end and the large short positions in the Treasury market have been unwound (Chart 4). Chart 3The U.S. Economy Is Not Rolling Over Chart 4Treasuries Are Expensive & Positioning Is Now Long Softer U.S. wage inflation: Some of that boost to U.S. profit margins is also due to the recent slower pace of wage growth, which we do not expect to continue given the tightness in the U.S. labor market and the continued robust readings on labor demand indicators (Chart 5). We expect wage growth to begin ticking higher in the months ahead, as will overall U.S. inflation expectations which still appear too low. The Cleveland Fed Median CPI has been steady around 2.5%, which is where we expect headline CPI inflation to be if the Fed's inflation target of 2% on the PCE deflator is met.2 We see TIPS breakevens gravitating towards those levels in the coming months, driving longer-term U.S. Treasury yields higher. Setbacks on the Trump economic agenda: President Trump's failure to get health care reform passed in Congress was interpreted as a sign that the more pro-growth parts of his agenda, like tax reform and infrastructure spending, would also have difficulties getting implemented. We are not strong believers in the idea of a significant "Trump trade" impact on growth and bond yields, as the U.S. economy was already showing improvement before Trump won the presidency. Nonetheless, any delay in the fiscal easing that Trump promised during the campaign would act to dampen expectations for U.S. growth and Fed rate hikes on the margin, to the benefit of U.S. Treasuries. Trump announced that he will unveil his tax reform proposals this week, with Congressional hearings on the subject also set to begin. Our colleagues at BCA Geopolitical Strategy expect Trump to try and move quickly to get a deal done, especially after the initial failure on health care reform. The political risks for the Republicans are very real in next year's mid-term elections, with current polling pointing to large losses of seats that could return the House of Representatives to Democrat control. If the Republicans want to push through their reform agenda and try and boost growth heading into the 2018 midterms to try and avert a loss of the House, they cannot delay on tax reform this year. While the U.S. political situation is always a wild card, we do not think that "Trump trade" disappointment will be a factor weighing on Treasury yields over the rest of 2017. Lower oil prices: Some of the decline in the inflation expectations component of global bond yields can be attributed to the pullback in oil prices since late February. Our colleagues at BCA Commodity & Energy Strategy continue to have a bullish outlook on global oil prices, however, and view the recent dip as a buying opportunity.3 They expect Russia and Saudi Arabia to honor their agreement to remove 1.8mm barrels/day of production from the global oil market our by mid-2017, as visible inventory levels remain too high. Combined with stronger expected demand, our strategists expect oil prices to move toward the $60/bbl level by year-end (Chart 6). That move would boost help to raise inflation expectations, and bond yields, in the months ahead. Chart 5U.S. Inflation Expectations Still Too Low Chart 6Oil Prices Set To Move Higher Slower Euro Area inflation: Just like in the U.S., there was a pullback in Euro Area inflation expectations after the dip in realized inflation readings in March. While some cooling was expected simply from base effects related to swings in oil prices and the Euro, our headline CPI diffusion index indicates that an increasing majority of sectors are seeing accelerating price growth (Chart 7). If our commodity strategists are correct on the call for higher oil prices, we would expect to see some re-acceleration of Euro Area inflation, and more bear-steepening of Euro Area government bond yield curves, in the coming months. Especially if the European Central Bank (ECB) begins to send a signal about a tapering of its asset purchases - an outcome that is more likely if the polling data proves correct and Macron wins the French Presidency in two weeks, thus reducing the near-term political uncertainty in Europe. The ECB meets this week, and while we still think any shift in the ECB's tone is more likely at the June meeting (when a new set of economic projections will be produced), this will be the first opportunity for comments after the French election result. French Election Uncertainty: The pre-election rise in French risk premia fully unwound yesterday in a matter of hours (Chart 8). Implied volatilities on Euro Area equities and the EUR/USD exchange rate plunged, as did France sovereign CDS spreads. France-Germany government bond spreads tightened sharply as well, with the benchmark 10-year OAT-Bund spread declining -19bps from last Friday's closing levels. With Macron having a 20 point lead on Le Pen in a two-way race according to the latest opinion polls - which proved to be very accurate in the first round of voting - we think that current spread levels are consistent with a Macron victory on May 7. Chart 7Only A Brief Setback##br## In Euro Area Inflation Chart 8Taking Profit On Our Long France/Short ##br##Germany Spread Trade We do not expect much additional spread tightening if Macron does indeed win, especially if the ECB does begin to signal a tapering of bond purchases in 2018. That would result in wider risk premia across all European bond markets as valuations start to return to levels more in line with fundamentals. Given France's high sovereign debt levels and low productivity growth vis-à-vis Germany, we do not see the OAT-Bund spread returning to the pre-election lows if the ECB slows its bond buying. Thus, we are taking profits on the long France/Short Germany 10-year bond trade in our Tactical Overlay Portfolio, which we established back in early February when the spread was 76bps; 26bps higher than yesterday's close.4 Bottom Line: The factors that have driven global bond yields lower over the past month are not sustainable. Maintain a below-benchmark duration exposure, with current yield levels looking attractive to add to underweight/short positions as we did last week. We got the market-friendly outcome in the French election that we were expecting. We are closing our recommended long 10-year France vs 10-year Germany Tactical Overlay trade after the post-election spread tightening, at a profit of 1.3%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Pricing Power Comeback," dated April 24 2017, available at uses.bcaresearch.com 2 That assumes a difference between headline CPI and PCE deflator inflation in line with its historical average of around 50bps. 3 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017/H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20 2017, available at ces.bcaresearch.com 4 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds," dated February 7 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS: Although we still expect TIPS breakevens to widen as inflation rises, this week we review possible arguments for why breakevens might have shifted to a permanently lower post-crisis equilibrium. Remain overweight TIPS versus nominal Treasuries. Corporate Valuation: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Feature Chart 1Yields Lower Since March FOMC In last week's report we argued that recent bond market strength was caused by a politically-induced flight-to-quality. In particular, we noted that the term structure of implied equity volatility had inverted - investors were paying more to hedge equity positions over a 1-month horizon than over a 3-month horizon. But political tensions have eased somewhat during the past week. President Trump promised to unveil his administration's tax reform plan this Wednesday, and the first round of the French election resulted in centrist candidate Emmanuel Macron securing a significant advantage over far-right candidate Marine Le Pen. As a consequence, 1-month implied equity vol fell back below 3-month vol, and the bond rally ebbed with the 10-year Treasury yield edging up to 2.29% from 2.17% at this time last week. Nonetheless, bond yields are still far below the levels seen following the last FOMC meeting in mid-March. Since that meeting, the 10-year Treasury yield has fallen 27 bps, split between a 12 bps decline in the real yield and a 15 bps drop in the cost of inflation compensation (Chart 1). Real Yields Are Too Low As shown in the top panel of Chart 1, the 10-year real yield is tightly linked to the number of rate hikes discounted in the overnight index swap curve during the next 12 months. Further, the drop in both of these series since mid-March occurred alongside a string of economic data disappointments, as evidenced by the sharp fall in the Economic Surprise Index (Chart 2). Our assessment, however, is that the mean reversion in the surprise index represents excessively optimistic expectations rather than a trend change in the pace of U.S. growth. Chart 2Disappointments Are Discounted To test this theory, we looked at the New York Fed's Nowcast for Q1 GDP growth and noted that it has been revised lower from 2.96% (as of March 24) to 2.65% (as of April 20). We observed that the data releases responsible for the bulk of the downward revision were: Real consumer spending Retail sales and food services Import & Export growth Housing starts As can be seen in Chart 3, with the exception of real consumer spending, all of the other data disappointments represent small corrections from elevated levels. As for real consumer spending, we noted last week that the recent weakness is probably explained by problems with Q1 seasonal adjustments.1 Taking a step back, U.S. growth still appears to be on solid footing. The BCA Beige Book Monitor, introduced last week by our U.S. Investment Strategy service,2 scans the Federal Reserve's Beige Book3 for the words "strong" and "weak" (and their derivatives like stronger, weakened, etc...). The Monitor is the number of "strong" words less the number of "weak" words, and it has been an excellent coincident indicator of GDP growth since the mid-1990s (Chart 4). At present, the Beige Book Monitor is sending a robust signal for U.S. growth. Similarly, despite supposed weakness in housing starts and trade data, our preferred leading indicators point to continued strength in both the residential investment and net export components of GDP (Chart 4, bottom 2 panels). Chart 3What Weak Data? Chart 4Growth Still Looks Strong Bottom Line: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. We still expect the Fed will lift rates by at least 50 bps between now and the end of the year. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS Breakevens: How Far From Fair Value? As was mentioned above, the cost of 10-year inflation compensation has also declined since mid-March alongside some weakness in the headline non-seasonally adjusted Consumer Price Index (see Chart 1). Our Financial Model of TIPS Breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline to weakness in the stock-to-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to our model's fair value (Chart 5). The 10-year breakeven rate is still somewhat wide compared to our model's fair value, but much less so. We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. The fair value reading from our TIPS Financial Model should also trend gradually higher in this environment. Historically, core PCE inflation anchored around the Fed's 2% inflation target has corresponded with a 5y5y TIPS breakeven inflation rate in the range of 2.4% to 2.5% (current value 1.89%) and a 5y5y CPI swap rate between 2.8% and 2.9% (current value = 2.31%) (Chart 6). These remain our target levels for TIPS breakevens and CPI swaps, respectively. Chart 5TIPS Financial Model Chart 6Still Below Target However, we must also consider the possibility that these target ranges, based on the mid-2000s, may no longer be applicable. Put differently, it is possible that the market for inflation protection underwent a structural shift following the financial crisis and the appropriate level for long-maturity TIPS breakeven rates when core PCE is anchored around 2% might now be lower. A Structurally Lower Inflation Risk Premium? It is common to think of the 10-year TIPS breakeven inflation rate as: TIPS Breakeven Inflation = Inflation Expectations + Inflation Risk Premium The inflation risk premium is the extra return required by nominal bond investors to bear the risk that future inflation will differ from expected inflation. In theory, this premium can be influenced by uncertainty about the inflation outlook, but also by structural factors that make it more or less attractive to include TIPS in a portfolio. For example, any asset that is negatively correlated with equities is more valuable as a hedge in the context of an overall portfolio and investors should demand less of a risk premium to hold that asset. As one recent Fed paper4 noted, the correlation between long-maturity TIPS breakeven rates and equities has shifted from being negative in the 1980s to being sharply positive in recent years. This means that TIPS have become less valuable as a hedge against equity positions. All else equal, this should increase the yield that investors demand to hold TIPS and thus lower the TIPS breakeven inflation rate. We acknowledge the strong positive correlation between equities and TIPS breakevens, but are inclined to view it as more of a cyclical phenomenon. Chart 7 shows that the correlation between inflation expectations5 and equities was negative when inflation was above the Fed's 2% target in the 1980s and also that the correlation becomes more positive when the Fed eases and more negative when the Fed tightens (Chart 7, bottom panel). Chart 7Correlation Between Breakevens & Equities Is Cyclical In other words, when inflation is low the Fed has an incentive to maintain an accommodative monetary policy. It does not react strongly when inflation rises, and this supports increases in both inflation expectations and equity prices. However, when inflation becomes too high, the correlation between inflation expectations and equity prices shifts because higher inflation now signals a more rapid pace of Fed tightening which tends to depress equities. It therefore seems likely that the correlation between TIPS breakevens and equity prices will weaken as inflation rises and the Fed tightens policy. So we do not view this as a compelling reason for why TIPS breakevens might be permanently lower. Structural Limits To Arbitrage? A potentially more interesting line of argument comes from a 2010 paper by Fleckenstein, Longstaff and Lustig.6 In this paper, the authors document a persistent arbitrage opportunity between TIPS and nominal Treasury bonds. Investors can earn risk-free returns using inflation swaps and TIPS to replicate the cash flows from a nominal Treasury bond. The authors also find that this arbitrage opportunity biases TIPS breakeven rates lower, and that this bias worsens in times of increased financial market volatility. Chart 8Repo Market Less Efficient Specifically, the authors demonstrate that the size of the downward bias in TIPS breakevens increases as repo market fails trend higher. The rationale being that repo fails occur when market participants are unable to acquire specific Treasury collateral. This is taken as a signal that the supply of government bonds is constrained, which makes it more difficult to take advantage of the arbitrage between TIPS and nominal Treasuries. Interestingly, repo fails have been trending higher since the financial crisis as repo market activity has been reduced by strict post-crisis regulations (Chart 8). The case has been made that new regulations - specifically the Supplementary Leverage Ratio which forces dealer banks to set aside a fixed amount of capital for any assets they hold, regardless of riskiness - have caused dealers to shy away from low margin businesses such as making markets in repo.7 It is conceivable that reduced activity in the repo market has resulted in less available collateral and increased fails. If this is the new state of affairs, then it is possible that TIPS breakevens will be permanently lower in the post-crisis world because lack of liquidity in the repo market has reduced the attractiveness of arbitraging the difference between nominal and real yields. So far, we are reluctant to draw any sweeping conclusions from this analysis. In fact, if the Fed believes that the fair value for long-maturity TIPS breakevens is between 2.4% and 2.5%, then does the "limits to arbitrage" argument even matter? Also, Manmohan Singh of the IMF has argued that the act of the Fed unwinding its balance sheet would free up balance sheet space for dealer banks, mitigating some of the regulatory burden and leading to a more efficient repo market.8 If this is correct, then repo fails could decline as the Fed starts to let its balance sheet run down, a process that is likely to start later this year. For now, we consider the theory of a permanently lower equilibrium for TIPS breakevens a risk to our view that merits further research in the coming weeks. Corporate Bond Valuation Update With the release of the Moody's Default Report for March we were able to update our High-Yield Default-Adjusted Spread (Chart 9). Our Default-Adjusted Spread is equal to the average option-adjusted spread from the Bloomberg Barclays High-Yield index less a 12-month forecast of default losses. That 12-month forecast is based on Moody's baseline forecast for the speculative grade default rate and our own forecast of the recovery rate. Chart 9Default-Adjusted Spread Moody's data show that the speculative grade default rate was 4.7% for the 12 months ending in March, and the baseline forecast calls for it to fall to 3% during the next 12 months. Using this forecast we calculate that the current Default-Adjusted Spread is 228 bps. Our analysis shows that excess returns for both Investment Grade and High-Yield corporate bonds are usually positive unless the Default-Adjusted Spread is below 100 bps. The relationship between excess returns and the Default-Adjusted Spread for both Investment Grade and High-Yield corporates is shown graphically in Charts 10 & 11 and also in Tables 1 & 2. Chart 1012-Month Excess Investment Grade Returns ##br##Vs. Ex-Ante Default-Adjusted Spread (2003 - Present) Chart 1112-Month Excess High-Yield Returns Versus Ex-Ante ##br##Default-Adjusted Spread (2003-Present) Table 112-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Given our relatively optimistic outlook for U.S. growth, we tend to view current valuation levels as attractive and see scope for spread tightening during the next few months. However, the weakening state of corporate balance sheets means spreads are at risk once inflation starts to bite and monetary policy turns less accommodative, possibly as early as next year.9 Bottom Line: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Fade The Flight To Safety", dated April 18, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com 3 According to the Fed, the Beige Book provides "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." 4 Chen, Andrew Y., Eric C. Engstrom, and Olesya V. Grishchenko (2016). "Has the inflation risk premium fallen? Is it now negative?," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 4, 2016, http://dx.doi.org/10.17016/2380-7172.1720 5 In order to benefit from more back-data, in Chart 7 we use the Cleveland Fed's measure of inflation expectations rather than TIPS breakeven rates. Details about the Cleveland Fed's methodology can be found here: https://www.clevelandfed.org/en/our-research/indicators-and-data/inflation-expectations.aspx 6 Fleckenstein, Matthias, Francis A. Longstaff, and Hanno Lustig (2010). "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle", NBER Working Paper No. 16358. September 2010. JEL No. E6,G12,G14. http://www.nber.org/papers/w16358 7 https://www.forbes.com/sites/lbsbusinessstrategyreview/2016/03/11/why-are-big-banks-offering-less-liquidity-to-bond-markets/#64286f5729de 8 https://ftalphaville.ft.com/2017/04/24/2187716/guest-post-why-shrinking-the-fed-balance-sheet-may-have-an-easing-effect/ 9 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights It is difficult to judge how much of the recent unwind of the Trump Trades has been due to data disappointments versus rising geopolitical tensions. We do not believe that an attack on North Korea is imminent. Rather, U.S. military muscle-flexing is designed to force the rogue state to the negotiating table. On the economic front, the U.S. "hard" data have disappointed surveys in Q1. However, we believe this largely reflects weather and seasonal adjustment distortions. The Leading Economic Indicator and our new Beige Book Monitor support this view. Our profit growth model is very bullish for earnings this year, and is supported by our proxies for corporate pricing power. The latter is improving relative to wage growth recently, suggesting that there is more upside for margins this year. Returning cash to shareholders has not been particularly strong in this expansion relative to past expansions, contrary to popular belief. Nonetheless, buyback activity will continue to boost EPS growth by about 2 percentage points. Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. Feature Treasury yields fell to their lowest level last week since just after the U.S. Presidential election. The solid start to the Q1 earnings reporting season was not enough to offset the disappointing economic reports and geopolitical fears, leaving U.S. equity prices mostly lower on the week (Chart 1). We thought that the "hard" data would improve to meet the accelerating "soft" data, but that clearly didn't occur last week. Unusual weather in March may have been a factor. We will return to the outlook for the economy and corporate profits later in the report. Chart 1Q1 Growth Disappoints It is difficult to judge how much of the bond rally has been due to data disappointments versus rising geopolitical tensions. President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances.1 The market's political focus will likely turn back to Washington this week. Congress has until April 28 to pass a bill to keep the U.S. government running through the end of fiscal year 2017. Our Geopolitical Strategy Service continues to expect a deal to get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. While the negotiations surrounding both of events could weigh on Treasury yields in the near term, our view is that they are unlikely to prevent an uptrend in yields over the coming 6-12 months. As for North Korea, the safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. But, near term, this situation is a huge wildcard. We cannot rule out another wave of risk aversion in financial markets. As this week's publication goes to press, the results of the first round of the French presidential election are being tabulated. Please consult BCA's Daily Insight on Monday, April 24, 2017 for our first take on the election results. A Temporary Soft Patch Or Something Worse? In last week's report, we wrote that the weak readings from the "hard" economic data would soon catch up with the surging "soft" economic data. In fact, the opposite has occurred since mid-April. Is this the start of a prolonged weak patch in the U.S. economy? Or is the softness perhaps related to weather and poor seasonal adjustment? We favor the later explanation for now. The first quarter GDP report is due out this Friday, April 28. The Bloomberg consensus is looking for just a 1.2% gain in the quarter after the 2.1% increase in Q4 2016. The Atlanta Fed's "GDP Nowcast" puts Q1 GDP at just 0.5% (Chart 1). The New York Fed's "Nowcast" is at 2.7%. Both estimates have been moving consistently lower since early March, dragging down 10-year Treasury yields (with U.S. stock prices along for the ride). Financial markets should be used to weak readings on first quarter GDP by now. Between 1950 and 1996, Q1 GDP was the weakest quarter of the year in just 14 of 47 years, or 30% of the time (Table 1). Q2 growth was stronger than Q1 growth about half the time. This is just about what you would expect if the U.S. Bureau of Economic Analysis' (BEA) seasonal adjustment program was functioning properly. But something has gone awry since 1997, despite the government statisticians' recent attempts to correct the problem. Over the past 20 years, the first quarter has been the weakest GDP reading of the year 10 times, or 50% of the time, and Q2 GDP growth has been faster than Q1 growth 70% of the time. Table 1The Gap Between GDP Growth In Q1 And Q2 Has Widened In The Past 20 Years A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this anomaly are in the private investment and government consumption components of GDP. More specifically, the Cleveland Fed cites defense spending as the key driver of the weakness in Q1 GDP relative to other quarters. We'll expand on this theme in next week's U.S. Investment Strategy report, but for now our view remains that the weakness in U.S. economic growth is temporary. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have backed off of their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in weather-impacted "hard" data like retail sales, housing starts and industrial production. The April update of our Beige Book Monitor, which we introduced last week, confirms that the economy is stronger than the GDP data suggest (Chart 2). The Monitor is simply the difference between the percentage of "strong" versus "weak" descriptors for growth in the document. Chart 2BCA Beige Book Monitor Upbeat For Growth The Monitor edged higher in April to 65%, from 51% in the March reading. "Weather" was mentioned 18 times, after just 6 mentions in March. More than two thirds of the 18 mentions of weather in April cited it as having a negative impact on economic activity. This supports our view that weather had a non-negligible impact on the hard data in March. Thus, if the weather in the first three weeks of April persists into the final week of the month, the stage is set for a noticeable improvement in U.S. economic data released in May. All else equal, this should temper fears that the U.S. economic expansion has lost momentum, supporting stock prices and allowing the recent bond rally to unwind (depending on geopolitics). The soft March CPI also appeared to be quirky, revealing that the core measure actually contracted in March (Chart 3). We note, however, that the weak March reading followed two months of extremely strong gains. In addition, it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Our "inflation words" indicator based on the Beige Book remains in an uptrend (Chart 2). Chart 3Has U.S. Inflation Peaked? A rebound in the activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A rate hike in next month is unlikely, but we would not rule out June if the economic data firm as we expect. Positive Signs For U.S. Corporate Pricing Power Another 82 S&P 500 companies report first quarter results this week, making it the busiest week of the season. The consensus for Q1 earnings growth remains near 10% on a 4-quarter trailing basis. That forecast is likely to be met. We highlighted the positive 2017 outlook for U.S. corporate profits in the April 10, 2017 Weekly Report. The U.S. experienced a profit recession in 2016 that did not coincide with an economic recession. Oil prices were part of the story, but we have seen this pattern occur several time since the late 1990s; nominal GDP growth (a proxy for top line growth) decelerates temporarily relative to labor compensation growth. Margins get squeezed but, since the economy manages to avoid a recession, nominal GDP growth subsequently rebounds relative to labor compensation. This resulted in a 'catch up' phase when earnings-per-share growth accelerated sharply and equity returns were favorable. We believe that U.S. earnings are in the same type of catch-up phase now, which has been accentuated by the rebound in oil prices. Proprietary indicators from our sister publication, the U.S. Equity Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart 4). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly based across industries (as shown by the diffusion index in the chart). As a side note, the Proxy provides some evidence that softness in core CPI will not last. At the same time, the upward march of wage growth appears to be taking a breather (Chart 4). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching (perpetually optimistic) bottom-up estimates for 2017 (Chart 5). Chart 4Corporate Sector Gaining ##br##Some Pricing Power Chart 5Profit Model##br## Is Very Bullish Companies have supported per share profits in this expansion in part via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart 6 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same has been true for GDP growth. Chart 6Comparison Of Corporate Outlays Across Four Economic Expansion Phases Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity withdrawal since 2009, which includes the net impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions. Bottom Line: CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Buyback Tailwind To Continue How important are buybacks to EPS growth? Chart 7 (second panel) presents a rough proxy for the historical impact of equity withdrawal that is based on the S&P 500 divisor. It is the difference between EPS growth and growth in total dollar earnings. When the line is above zero, it means that EPS growth has been lifted above dollar earnings growth via equity withdrawals. Chart 7Buybacks Adding Almost ##br##2 Percentage Points To EPS Growth This proxy must be taken with a grain of salt due to the manner in which the divisor is calculated. Nonetheless, it suggests that buybacks have boosted EPS growth by 2 percentage points in the year to 2016Q4. We expect that buyback activity will continue to be a mild tailwind in the coming quarters given the positive reading from our Capital Structure Preference Indicator (Chart 7, third panel). This Indicator is defined as the equity risk premium minus the default adjusted high-yield corporate bond yield. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Bottom Line: Buybacks have not had an outsized impact on EPS growth in this cycle, but the good news is that this tailwind is likely to continue. Capitalization Strategy: Stick With Small Caps The relative performance of U.S. small vs large cap stocks surged following the November election, but has since retraced about two-thirds of its post-election gains and has recently been trading below its 200-day moving average. Small cap stocks have been one of several "Trump trades" that have waned over the past three months, but our view is that several positive tailwinds for small cap relative performance continue to warrant an overweight stance: Panel 1 of Chart 8 highlights that our cyclical capitalization indicator has moved sharply into positive territory following the election, and has remained positive despite the recent weakness in small cap relative performance. Small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (panel 2), which argues for a bullish stance given our overweight positions in U.S. equities versus bonds. Our relative valuation indicator for U.S. small caps has moved back towards neutral valuation territory, which is a significant change from the conditions that prevailed in the early part of the U.S. economic recovery. Chart 9 shows that the indicator was consistently elevated from 2009 until early-2015, but has since fallen back to zero. While relative prices have accounted for some of this adjustment, the relative (trailing) earnings trend for small cap stocks remains in an uptrend and has recently risen to an all-time high, despite a disappointing Q1. Chart 10 highlights one risk to the small cap trade that will be important to monitor. The chart shows the NFIB's outlook survey along with the percentage of respondents citing "red tape" as the most important problem facing their business. The consistent rise in concerns about red tape under the Obama administration, especially the strong rise that began in 2010, suggests that small firms have found elements of the Affordable Care Act to be particularly burdensome for their business. This suggests that a portion of the sharp rise in the outlook for small businesses following the election has occurred due to expectations that the ACA will be repealed, in turn implying that confidence may wither following the failure of the American Health Care Act (AHCA) to even be subjected to a vote in the House. Chart 8Beta And The Cycle Argue ##br##For Small Caps Chart 9Small Caps Are##br## No Longer Expensive Chart 10Watch The Change Of A "Trump Slump" ##br##In Small Business Sentiment While several planned policies of the Trump administration have indeed been delayed due to the failure of the AHCA, we remain of the view that a legislative agenda that at least appears to be pro-business remains in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation that we noted above. Bottom Line: Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. The failure of the AHCA may cause a near-term pullback in small business confidence, but we doubt that this will be sustained over the coming 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 2 "Lingering Residual Seasonality in GDP Growth," Federal Reserve Bank of Cleveland, March 28, 2017.