Financial Markets

Highlights Recommended Allocation The sweet spot of non-inflationary accelerating growth is likely to continue. European politics will fade as a risk, and Trump should still be able to get tax cuts through. We continue to be positive on risk assets on a one-year horizon, though returns are unlikely to be as good as in the past 12 months and there is a risk of the next recession arriving in 2019. Our portfolio tilts are generally pro-risk and pro-cyclical. We are overweight equities versus fixed income. We move overweight euro area equities, which should benefit from inexpensive valuations, higher beta and a falling political risk premium. Within fixed income, we prefer credit over government bonds, and raise high-yield debt to overweight on improved valuations. We expect the dollar to appreciate further, which makes us cautious on emerging market assets and industrial commodities. Feature Overview No Reasons To Turn Cautious Markets have paused for breath following the reflation trade that began a year ago and that was given an extra boost by the election of Donald Trump in November. Since the turn of the year, the dollar, U.S. 10-year Treasury yields, credit spreads and (to a degree) equities have all eased back a little (Chart 1). We don't think the risk-on rally is over, but the going will undoubtedly get tougher from here. The momentum of global growth cannot continue to rise at the same pace, with the Global PMI already at its highest level since 2011 (Chart 2). Global equities, therefore, are unlikely to return the 16% over the next 12 months, that they have over the past 12. Chart 1A Pause For Breath Chart 2Growth Momentum Must Slow From Here Nonetheless, we see nothing that is likely to stop risk assets continuing to outperform over the one-year horizon: Growth is likely to rise further. While the initial pick-up was in "soft" data such as consumer sentiment and business confidence, signs are emerging that "hard" data such as household spending and production are now also improving (Chart 3). Models developed by our colleagues on The Bank Credit Analyst indicate that real GDP growth in the U.S. this year will come in above 3% and in the euro area above 2% (Chart 4),1 compared to consensus forecasts of 2.2% and 1.6% respectively. Chart 3Hard Data Also Not Picking Up Chart 4GDP Growth Could Beat Consensus For now, this growth is unlikely to prove inflationary. In the U.S. the diffusion index for PCE inflation shows more prices in the basket falling than rising; in the eurozone, the rise to 2% in headline inflation in January was temporary, mainly because of higher oil prices, and core inflation remains at only 0.7%. The U.S. output gap will close soon, but the eurozone's is still deeply negative (Chart 5). We see the Fed raising rates twice more this year, in line with its dots, though it may have to accelerate the pace next year if the Trump administration succeeds in passing fiscal stimulus. The ECB, however, is unlikely to raise rates until 2019 and will taper asset purchases only slowly.2 Misplaced worries that it will tighten more quickly than this have recently dragged on European equities and strengthened the euro. We think the market is wrong to price out the probability of a tax cut in the U.S. just because of the Trump administration's failure to reform healthcare. Our Geopolitical strategists argue that Republicans in Congress (even the Freedom Caucus) are united behind the idea of cutting taxes, even if these are not funded by tax reforms or spending cuts (they can be justified on the grounds of "dynamic scoring").3 We see a cut in corporate and personal taxes passing before year-end to take effect in 2018. And Trump has not abandoned the idea of infrastructure spending. The market no longer expects any of this: the prices of stocks that would most benefit from lower corporate taxes or from government spending have reverted to their pre-election levels. European political risk is likely to wane. The market continues to worry about the possibility of Marine Le Pen winning the French Presidential election, as shown in the spread of OATs over Bunds (which has widened to 60-80 bp from 20 bp last summer). We think this very unlikely: polls show her consistently at least 20 points behind Emmanuel Macron in the second round of voting (Chart 6). While Italian politics remain a risk, the parliamentary election there is unlikely to take place until March 2018. Brexit is a threat to the U.K., but should have minimal impact on the eurozone. We retain, therefore, our pro-cyclical and pro-risk tilts on a 12-month time horizon. We have even added a little more beta to our recommended portfolio by raising high-yield bonds to overweight (since their valuations now look more attractive after a recent sell-off) and by going overweight eurozone stocks (paid for by notching down our double-overweight in U.S. stocks). The eurozone has consistently been a higher beta (Chart 7), more cyclical equity market than the U.S. and, once the political risks (at least temporarily) subside, should be able to outperform for a while. Chart 5Eurozone Output Gap Still Very Negative Chart 6Can Le Pen Really Win From Here? Chart 7Eurozone Is A High Beta Stock Market But we warn that the good times may not last for long. Tax cuts in the U.S. would add stimulus to an economy already at full capacity. The Fed might have to raise rates sharply next year (although the timing might depend on how President Trump tries to affect monetary policy, for example whom he appoints as Fed chair to replace Janet Yellen next February). U.S. recessions have typically come two or three years after the output gap turns positive (Chart 5). As Martin Barnes, BCA's chief economist, recently wrote,4 that may point to next recession arriving as soon as 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Chart 8Expensive, But Not At An Extreme Aren't You Worried About U.S. Equity Valuations? Valuation is a poor timing tool in the short term but, when it reaches extremes, it has historically added value. The valuation metrics we watch show that U.S. equities are expensive, but not at the extreme levels that have historically warranted an outright sell or underweight. First, according to MSCI, U.S. equities are currently trading at 24.4 times 12-month trailing earnings, and 25.7 times 10-year cyclically-adjusted earnings; both measures are about one standard deviation from their 10-year averages. Second, U.S. equities are trading at a premium to global equities, but the premium to the developed markets is in line with the 10-year average (Chart 8, panel 1), while the premium to emerging markets is about 1.5 standard deviations from the 10-year average (panel 2). Third, equities are cheap compared to fixed income: the earnings yield is still higher than the yields on both 10-year government bonds and investment grade corporate bonds, and the yield gaps are currently only slightly lower (more expensive) than their respective 10-year averages (panels 3 and 4). In the long run, the 10-year cyclically-adjusted PE (CAPE) has had relatively good forecasting power for 10 year forward returns. Currently, the regression indicates 143% (9.3% annualized) total returns over the next 10 years. This could be on the optimistic side given that we are no longer in an environment of declining bond yields and margins are elevated compared to the 1990s. That said, we have cut our U.S. equity overweight by half, partly due to valuation concerns. Is EM Debt Attractive? Chart 9Avoid EM Debt Emerging market debt has continued its run from last year, with sovereign and local currency debt providing YTD returns of 3% and 2% respectively. Over long periods, EM debt has displayed the ability to provide substantial returns while also providing robust diversification benefits to a 50/50 DM equity/bond portfolio, even more so than EM equities.5 However, over the cyclical horizon, we remain bearish on EM debt both in absolute terms and relative to global equities. EM fixed income markets have been able to defy deteriorating fundamentals for some time, but this is unsustainable. After years of leveraging, credit excesses will need to be unwound. Decelerating credit growth will be enough to dampen economic growth and damage emerging markets' ability to service their debt. Risks in EM sovereign debt markets are high. Historical returns have shown negative skewness and fat tails, suggesting high vulnerability to large downswings. This is particularly concerning given that yields are one standard deviation lower than their long-term average (Chart 9). While EM local currency debt is more fairly priced and has a more favorable risk/return profile than its sovereign debt counterpart, local currency debt returns are even more heavily influenced by their currencies. Above-trend growth in the U.S. leading to additional rate hikes, as well as rising U.S. bond yields and softer commodity prices will add further downward pressure to EM currencies. For EM dedicated investors, we suggest overweight positions in low beta/defensive markets. Regions that are less susceptible to currency weakness with high yields and low foreign funding requirements include Russia, India and Indonesia. How Will The Fed Shrink Its Balance Sheet, And Does It Matter? After the Fed's third rate hike, attention is turning to when it will begin to reduce its balance sheet. This has grown to $4.5 trillion, up from $900 billion before the Global Financial Crisis. Assets currently include $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-related securities. Since asset purchases ended in October 2014, the Fed has rolled over maturing bonds to maintain the size of the balance sheet. The FOMC statement last December committed to maintaining this policy "until normalization of the level of the federal funds rate is well under way". The market takes this to mean 1-1.5%, a level likely to be reached by year-end. The view of BCA's fixed income team6 is that the Fed will start by ceasing reinvestment of Agency bonds and mortgage-backed securities (MBS) in 2018, at the same time reducing excess bank reserves on the liability side of the balance sheet (Chart 10). This will worry markets to a degree and the Fed will need to be careful how it communicates the policy: for example what size it thinks its balance sheet should ultimately be. It may also need to skip a rate hike or two in the first months of the shrinkage. The MBS market is likely to suffer from the increased supply. But the only historical precedent - the BoJ's unwinding of its 2000-3 QE - is reassuring: this had no discernible effect on rates or the yen (Chart 11). Chart 10Fed Will Cut MBSs First Chart 11Nobody Noticed The BoJ Taper When Will ECB Taper? Chart 12Recovery Not Permanent Euro area growth is recovering and headline inflation has hit the ECB's 2% target (Chart 12). Investors are wondering how rapidly the ECB will taper its asset purchases and when it will raise rates. Our view is that the ECB will move only slowly. The pickup in inflation is mostly driven by the base effect and by the rise in energy prices. The failure of core inflation, which remains below 1%, to pick up appreciably suggests that underlying price pressures are weak. The current program has the ECB purchasing EUR 60 Bn of assets each month until December 2017. Markets have recently become more hawkish with regards to the likely path of policy: currently futures are pricing in the first hike only 19 months away versus an expectations in January of 44 months. We expect the ECB to remain more dovish than that, given weak underlying inflation, political uncertainty, and banking system troubles. We think the ECB will announce around September this year a taper of its asset purchases in 2018. However, it is not clear whether it will cut them to, say EUR 30 Bn a month, or whether it will reduce the amount steadily each month or quarter. But we don't see an interest rate hike soon, since the euro area economy is not expected to reach full employment until 2019. Ewald Novotny, president of the Austrian central bank, spooked markets by suggesting a hike before complete withdrawal of asset purchases but, in our view, that would will send a confusing signal to investors. Nowotny has long been hawkish and we think his view is untypical of ECB council members. If our analysis is correct, ECB policy should be positive for euro area equities and bearish for the euro over the next 12 months. Will REIT Underperformance Continue? Chart 13Underweight REITs Relative REIT performance has continued its downtrend, underperforming the broad index by 5% YTD. While valuations have become more attractive and rental income is still robust, we expect the decline to continue given unsupportive macro factors. We previously argued that real estate is in a sweet spot, where economic growth was sufficient to generate sustainable tenant demand without triggering a new supply cycle.7 This is no longer the case. Office completions increased substantially over the past quarter and apartment completions remain in an uptrend. As we expect growth to remain robust in the U.S., the likelihood is that these two trends remain in place. REIT relative performance peaked at the beginning of August, shortly after long-term interest rates bottomed. REITs have historically outperformed when yields are falling and inflation is low (Chart 13). However, long-term rates should continue to rise over the cyclical horizon, primarily due to higher inflation expectations. Additionally, REITs typically benefit from increasing central bank asset purchases, as increased liquidity and lower interest rates boost real estate values. With the Fed clearly in tightening mode and the strong likelihood of ECB tapering next year, slowing asset purchases will be a considerable headwind to REIT performance. Within REITs, we maintain our sector tilts. Continue to favor Industrials, which will benefit in a rising USD environment and provide considerable income. Maintain underweight position in Apartments, due to rising completions and a low absorption ratio. Additionally, we continue to favor trophy over non-trophy markets given more stable rent growth as well as geopolitical risks in Europe and potential Washington disappointments. Global Economy Overview: The global economy has continued to recover from its intra-cycle slowdown in late 2015 and early 2016. Economic surprise indexes have everywhere surprised significantly on the upside since mid-2016 (Chart 14, panel 1). Although "hard" data (consumption, production etc.) have lagged "soft" data (consumer sentiment, business confidence), the former also have begun to recover recently. Although there are few negative indicators, it will get harder to beat expectations. U.S.: Lead indicators continue to improve, with the manufacturing ISM at 57.7 and new orders at 65.1. Sentiment quickly turned bullish after the presidential election, and hard data has now started to follow, with personal consumption expenditure rising 4.7% year on year and capital goods orders (+2.7% YoY in February) growing for the first time since 2014. With steady wage growth, continuing employment improvements, and a likely pick-up in capex, we expect 2017 GDP growth to beat the current consensus expectations of 2.2%. For now inflation remains quiescent, with core PCE inflation stuck at around 1.8%, below the Fed's 2% target. Euro Area: Leading indicators, such as PMIs, have rebounded in Europe too (Chart 15), suggesting that the consensus 2017 GDP forecast of 1.6% is achievable. Inflation has picked up, with the headline CPI 2.0% for the Eurozone in January, but core inflation remains low at 0.7% and headline fell back to 1.5% in February. However, the recent slowdown in bank loan growth (new credit creation is 36% below the level six months ago) suggests that continuing weakness in the banking sector is likely to keep growth sluggish. Chart 14How Long Can Growth Continue To Surprise? Chart 15A Synchronized Global Growth Rebound Japan is a tale of two segments. International-oriented data have recovered, with IP up 3.7% (Chart 15, panel 2) and exports +5.4% year on year. But domestic demand remains weak: wages are rising only 0.5% YoY (despite a tight labor market), which is holding back household spending (-1.2% YoY in January). Core inflation has shown the first signs of picking up, but remains very low at 0.1% YoY. Emerging Markets: The effects of China's reflationary policies from early 2016 continue to boost activity (Chart 15, panel 3). But the excess liquidity they triggered worries the authorities, who have clamped down on real estate purchases and capital outflows, slowed fiscal spending, and tightened monetary policy. China will prioritize stability until the Party Congress in the fall, but the impact of reflation on commodity prices and on other emerging markets will fade. Interest rates: The Fed is likely to hike twice more this year in line with its "dot plot", unless inflation surprises significantly to the upside. This, plus an acceleration of nominal GDP growth to 4.5-5%, should push the 10-year bond yield above 3% by year end. The ECB will not be as hawkish as the market expects (futures markets indicate a rate hike by end-2018), since Mario Draghi expects headline inflation to fall back once the oil price stabilizes and is concerned about political risk especially in Italy. Consequently, rates are unlikely to rise as quickly as in the U.S. The Bank of Japan will keep its 0% yield target for 10-year JGB for the foreseeable future. Global Equities Global equities continued to make impressive gains in Q1 2017, after a strong 2016. The price appreciation since the low in February 2016 has been driven by both multiple expansion and earnings growth, roughly in equal proportion, as shown in Chart 16, panel 1. Chart 16Earnings Improving But Valuation Stretched Equity valuation is expensive by historical standards but, as an asset class, equities are still attractively valued compared to bonds (see the "What Our Clients Are Asking" section on page 6). In this "TINA" (There Is No Alternative) world, we remain overweight equities versus bonds. Within equities, we maintain our call of favoring DM equities versus EM equities despite of the 6% EM outperformance in Q1, which was supported by attractive valuations. About half of that outperformance came from the appreciation of EM currencies versus the USD. Our house view is that the USD will strengthen further versus the EM currencies. Within EM, we have been more positive on China and remain so on a 6-9 month horizon. The only adjustment we make now is to upgrade euro area equities to overweight by reducing half of our large overweight in the U.S. so that now we are equally overweight the U.S. and euro area (see details on the next page). In terms of global sector positioning, we maintain a pro-cyclical tilt. Our largest overweight in Healthcare panned out very well in Q1 but the overweight in Energy did not, due to the drop in oil prices. Our Energy strategists believe this was caused by one-off technical factors on the supply side, and argue that the oil price will soon revert to $55 a barrel. Euro Area Equities: A Cheaper Alternative To The U.S. Political risks related to elections in some eurozone countries are receding. The ECB is likely to maintain its easy monetary policies, while the Fed is on track to normalize interest rates in the U.S. We have had a large overweight of 6 percentage points (ppts) on U.S. equities while being neutral on the euro area. We upgrade the eurozone to overweight by 3 ppts, so that we are now equally overweight the U.S. and the euro area. The following are the reasons: First, the relative performance of total returns between eurozone and the U.S. equities is at its lowest since 1987. Since April 2015, when the most recent brief period of eurozone outperformance ended, eurozone equities have underperformed the U.S. by over 16% in common currency terms (Chart 17, panel 1), while the euro lost only about 4% versus the USD over the same period. Second, eurozone equities are trading at a 22% discount to the U.S., compared to the five-year average discount of 17% (panel 3). Third, eurozone equities have lower margins than the U.S., but the profit margin in the eurozone has been improving (panel 2). Lastly, the PMIs in the euro area have been improving (panel 4) and this improvement is faster than the global aggregate PMI (panel 5), which implies - based on the close correlation between PMIs and earnings growth - that profitability in the eurozone should improve at a faster pace than the global average. Sector Allocation: We have had a relatively pro-cyclical tilt in our global sector positioning, overweight three cyclical sectors (Energy, Industrials and Info Tech) plus Healthcare, while underweight three defensive sectors (Consumer Staples, Telecoms and Utilities) as well as Consumer Discretionary. We have been neutral on Financials and Materials. After very strong performance in 2016, cyclical sectors underperformed in Q1 2017 (Chart 18, panel 1). The underperformance of cyclicals versus defensives can be largely attributed to the polar-opposite performance of Energy and Healthcare (Chart 19). Going forward, we maintain our current sector positioning for the following reasons: Chart 17Earnings Growth At Lower Valuation Chart 18Maintain The Cyclical Tilt Chart 19Global Sector Performance First, Energy was the only sector which fell in Q1, largely due to the decline in oil prices. BCA's Energy and Commodity Strategy attributes the oil price weakness to inventory buildup related to the production rush before the OPEC agreement to cut production, and therefore expects the WTI oil price to return to the $50-55 range. Energy stocks should benefit once oil prices turn back up. Chart 20Relative Factor Performance Second, the relative profitability between cyclicals and defensives is underpinned by global economic conditions, as represented by the global PMI. The PMI is on track to recover further, which bodes well for the profit outlook for cyclicals versus defensives. Third, our pro-cyclical tilt in sector positioning is hedged by an overweight in Healthcare (a defensive sector) and underweight in Consumer Discretionary (a cyclical). Smart Beta Update: No Style Bet Q1 2017 saw some significant performance reversals in the five most enduring factors: quality, minimum volatility, momentum, value, and size (Chart 20, panels 2-6). Quality and Momentum performed the best, outperforming the global benchmark by over 200 bps in Q1. The star performer in 2016, the Value factor, performed the worst, underperforming by 190 bps. According to the findings in our Special Report,8 recent factor performance seems to be pricing in a "Goldilocks" environment in which growth is rising and inflation falling. We have shown that it is very difficult to time the shift in factor performance cycles and so have advocated an equal weight in the five factors (Chart 20, panel 1) for long-term investors. We reiterate this view. Government Bonds Maintain slight underweight duration. Our 2-factor model made up of global PMI and U.S. dollar sentiment indicates the current fair value of the 10-year Treasury yield is 2.4% (Chart 21). While this suggests bonds are currently correctly priced, we still expect that long-term yields will rise over a cyclical horizon. The long end should grind higher given improving growth, rising equity prices and renewed "animal spirits." Additionally, large net short positions have been unwound, allowing for another leg higher in yields. Overweight TIPS vs. Treasuries. Diffusion indexes for both PCE and CPI inflation shifted into negative territory, suggesting realized inflation will soften in the near term. Nevertheless, with headline and core CPI readings of 2.7% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 22). This trend should continue as a result of cost-push inflation driven by faster wage growth. Very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Euro area growth is stable, but expectations of a rate hike from the ECB are premature (Chart 23). While the central bank opened the door slightly to a less-accommodative policy stance, it is unlikely that the ECB will hike until full employment is reached. Our expectation is for a tapering of asset purchases to occur in 2018. Once tapering is complete, rate hikes will follow by approximately 6-12 months. The implication is upward pressure on European bond yields and wider spreads for peripheral government debt. Chart 2110-Year Treasury Fair Value Model Chart 22Inflation Has Bottomed Chart 23Will the ECB Hike Soon? Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 24). Over the last quarter, the indicator worsened, as profit margins, return-on-capital and liquidity declined. However, leverage did improve slightly. The trend toward weaker corporate health has been firmly established over the past 12 quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. The U.S. is in a self-reinforcing, low-inflation recovery. Economic growth should accelerate throughout 2017, with strong consumer spending, rising capex intentions, and still accommodative monetary policy. The potential sell-off from rate hikes this year should be fairly mild given that the market is already close to pricing in three. Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. Expect low but positive excess returns (Chart 25). Shift to overweight in high-yield debt. Our default model is showing improvement due to elevated interest coverage, a robust PMI reading, declining job cut announcements, softening lending standards and a rising sales/inventory ratio. The recent backup in yields has made junk bond valuations more attractive. The default adjusted spread, calculated by subtracting an ex-ante estimate of default losses from the average spread, is now approximately 220bps (Chart 26). Chart 24Balance Sheets Deteriorating Chart 25A Supportive Backdrop Chart 26High Yield: Valuations Becoming More Attractive Commodities Chart 27Upside To Resource Prices Limited Secular Perspective: Bearish A slowdown in Chinese activity, led by its transition to a services economy, coupled with unfavorable global demographics, will continue to constrain demand for commodities. This slack in demand coupled with excess capacity will continue to limit the upside in resource prices and prolong the commodities bear market which began in 2012 (Chart 27). Cyclical Perspective: Neutral Energy markets have moved from excess supply to excess demand, and so we remain positive on oil. But, with the impact of Chinese fiscal stimulus waning, excess supply in the metals market will persist, putting downward pressure on prices. Our divergent outlook for energy vs metals gives us an overall neutral view for commodities over the cyclical horizon. Energy: With a synchronized upturn in global growth and inflation, both OECD and non-OECD demand will remain strong. Following Saudi Arabia's production cuts, we expect the OPEC agreement to be honored by all members, including Russia. With strengthening demand and falling production, storage should draw through the year. We expect the oil-USD divergence to persist as improving fundamentals override the stronger dollar. Base Metals: With Chinese government spending slowing from 24% growth year on year in January 2016 to only 4%, the country's fiscal impulse has ended. Tightening in Chinese liquidity conditions have led to higher borrowing rates for the real estate sector, which is dampening its demand for materials. At the same time, inventories for key metals such as copper and steel have risen. We expect metals prices to correct over the coming months. Precious Metals: Gold has rallied 10% from last December, and another 4% following the Fed's March rate hike. These were responses to the dovish nature of the hike and continuing political risk. We expect the Fed to turn more hawkish in coming weeks, sending the dollar and real yields higher, thereby holding back the gold price from rising much further. Currencies Chart 28Return Of The Dollar USD: The last Fed meeting resulted in a dovish hike, as evidenced by the subsequent fall in the dollar. However, as the U.S. economy nears full employment, we expect a more hawkish tone from FOMC members in the coming weeks which will push the dollar up (Chart 28). The Fed continues to be data dependent, and sees the recent synchronized global upturn as an opportunity to deliver hikes in line with market expectations. Euro: As the economy stabilizes, as evidenced by rising headline inflation, stronger retail sales and improving PMI numbers, the ECB has opened the window for reducing monetary accommodation. However, since the economy is expected to reach full employment only in 2019, we expect rates to be kept low even after the tapering of ECB asset purchases starts next year. This will add further downward pressure on the euro. Yen: The Bank of Japan will continue its highly accommodative monetary policy, centered on its 0% yield target for 10-year government bonds, because Japanese growth and inflation is lagging the global upturn. Japan is benefitting from global growth, as seen in the improvement in its manufacturing PMI, but domestic demand remains weak as consumer confidence and retail sales stagnate. Continued downward pressure on relative interest rates will drive the only reliable source of inflation: a weaker yen. EM: A more hawkish Fed and rising bond yields will tighten global liquidity conditions, making it difficult for emerging nations that run current account deficits. The rising threat of protectionism could affect EM exports and create a new wave of deflationary pressure, forcing central banks to engineer currency devaluation. The fact that commodity prices have risen, yet EM currencies have remained weak, is a clear indications that EM fundamentals are weak. Alternatives Overweight private equity / underweight hedge funds. Leading indicators suggest that global growth continues to improve. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a boost to returns. Additionally, surveys suggest that managers are planning on increasing their allocation percentage toward private equity over the rest of the year. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 29). Overweight direct real estate / underweight commodity futures. Demand for commercial real estate (CRE) assets remains robust but the increase in completions is worrying. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 30). Overweight farmland & timberland / underweight structured products. The potential for trade wars, geopolitical risk in Europe and concerns over an equity market correction have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, the end of the 35-year bull market in bonds presents a substantial headwind. Structured products also tend to outperform during recessions, which is not our base case (Chart 31). Chart 29PE: Tied To Real Growth Chart 30Commodities: A Secular Bear Market Chart 31Structured Products Outperform In Recessions Risks To Our View Our pro-cyclical pro-risk tilts are based on the premise that global growth will remain strong over the next 12 months. We do not see many risks to this view: leading indicators suggest that consumption and capex are likely to continue to rebound. The one major indicator that suggests downside risk is loan growth. In the U.S., loans to firms have slowed to 5.4% from over 10% last summer, and in the euro area the meager pickup in corporate loan growth seems to have faltered (Chart 32). There may be some special factors: oil companies that borrowed in early 2016 when in difficulty no longer need to tap credit lines, and U.S. companies may be holding back to see details of tax cuts. But loan growth needs to be watched closely. More granularly, our country and sector preferences - in particular, our cautious views on Emerging Markets and industrial commodities - are based partly on the expectation that the U.S. dollar will appreciate further. If the global expansion remains highly synchronized (Chart 33) this might instigate all G7 central banks to tighten, allowing the Fed to raise rates without appreciating the dollar. However, we expect continuing divergences in growth and monetary policy to push the dollar up further. Finally, some indicators suggest that investors have become too positive on the outlook for stocks (Chart 34). Sentiment has in the past not been a reliable indicator of stock market peaks, but excess euphoria could trigger a short-term correction. Chart 32Why Is Bank Loan Growth Slowing? Chart 33Could Synchronized Growth Push Down USD? Chart 34Are Investors Too Euphoric? 1 Please see The Bank Credit Analyst, March 2017, page 33, available at bca.bcaresearch.com 2 Please see What Our Clients Are Asking: When Will The ECB Taper? on page 9 of this report for a full explanation of why we think this. 3 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 4 Please see BCA Special Report titled "Beware The 2019 Trump Recession", dated March 7, 2017, available at bca.bcaresearch.com 5 Please see Global Asset Allocation Strategy Special Report, "EM Asset Allocation: Is There Any Reason To Own Stocks?," dated November 27, 2012, available at gaa.bcaresearch.com. 6 Please see Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet," dated February 28, 2017, available at gfis.bcaresearch.com. 7 Please see Global Asset Allocation Strategy Special Report, "REITs Vs. Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. Recommended Asset Allocation Model Portfolio (USD Terms)

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of March 31, 2017. The model has not made significant changes compared to previous month as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, Level 2 model ( the allocation among the 11 non-U.S. DM countries) sharply outperformed its benchmark by 338 basis points (bps) in March, largely a result from the overweight of Spain and Italy versus underweight in Japan and Canada. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 27 bps in March due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 71 bps in March and by 117 bps since going live. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of March 31, 2017. Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance The momentum component has shifted Materials from overweight to underweight and Consumer Discretionary from underweight to overweight. The growth component has become less optimistic on global growth given the weakness in metals prices. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights With the labor market near full employment and the economy growing modestly, the U.S. economy is not in dire need of a "shot in the arm" from fiscal stimulus. Stocks may dip temporarily out of disappointment, but the economy will be fine even if Congress fails to boost infrastructure spending and/or cut taxes. Our view is that the market will adjust up expectations toward the Fed's view for 2018. The timing of this convergence will depend critically on the path of realized inflation and inflation expectations. If the 5-year, 5-year forward TIPS breakeven rate rises above a level that is consistent with the Fed's 2% inflation target. That would signal that investors fear the Fed is falling behind the inflation curve. Our view remains that U.S. equities will continue to outperform U.S. Treasury bond market in 2017, although that view is as much about the poor prospective returns in the bond market as it is about our bullish view on stocks. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. Feature With the labor market near full employment and the economy growing modestly, the U.S. economy is not in dire need of a "shot in the arm" from fiscal stimulus (Chart 1). The situation is very different from the early 1980s, early 2000s and during the aftermath of the collapse of Lehman Brothers in the fall of 2008. In early 2009, when the Congress and President Obama passed the $787 billion American Recovery and Reinvestment Act (ARRA), the economy was in the midst of the Great Recession and was still reeling from the collapse of Lehman Brothers and the freezing up of credit markets. Chart 1Trump Inheriting Best Economy For A New President In Decades Similarly, the economy was still struggling from the aftermath of the bursting of the technology, telecom and media bubble in 2000, when President Bush and an all-Republican Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. When President Reagan and a split Congress passed the Economic Recovery Tax Act (ERTA) in August 1981, the economy had entered the second recession in as many years. While the economic expansion since the end of the Great Recession has been sluggish, and has not benefited all Americans the same way, the U.S. economy today is in much better shape than any of the three periods listed above. Monetary policy remains stimulative, financial conditions are easy and none of our forward-looking indicators warn of an economic downturn. Longer term, many of the policy proposals rattling around the Trump Administration may help to boost productivity and, ultimately, growth over the coming years. These include: simplifying the tax code; reducing regulation; and enacting legislation to enhance the nation's infrastructure. In the short term, however, some of those proposals may create uncertainty and thereby spark an economic soft patch (for example, the "border adjustment tax" or repealing Obama Care without immediately replacing it). Nonetheless, our main point is that the U.S. economy doesn't need a shot in the arm from fiscal policy to "rescue it" as was the case in decades past. The bottom line is that stocks may dip temporarily out of disappointment, but the economy will be fine even if Congress fails to boost infrastructure spending and/or cut taxes. Resetting The Stage The odds of a recession this year remain low, as there are few excesses in the system that typically lead to economic downturns. Just because the economic expansion that began in mid-2009 will turn eight years old later this quarter, that doesn't mean that a recession is imminent. We will continue to carefully monitor the economy for signs that excesses are building. But for now, our view remains that modest economic growth will continue, even without a boost from fiscal stimulus. The market has long questioned the pace of Fed rate hikes contained in the FOMC's 'dot plot'. Expectations for 2017 have converged on two more quarter-point hikes this year (Chart 2). It's a different story for 2018 and 2019, where the Fed sees 3 more hikes in 2018 and 4 more in 2019, but the market is pricing in just 2 and 1. Our view is that the market will adjust up expectations toward the Fed's view for 2018. The timing of this convergence will depend critically on the path of realized inflation and inflation expectations. A Tale Of Two Halves Headline inflation is likely to remain elevated and above the Fed's 2% target in 1H 2017, before fading modestly in the second half of the year as we pass the anniversary of the low in oil prices. That may cause markets to temporarily roll back the outlook for Fed tightening in 2018. Nonetheless, a continuing upward march in wage growth will keep pressure on core PCE inflation. The FOMC will likely 'look through' any softening in the headline rate that is simply due to oil prices. Notably, service sector inflation, which accounts for 2/3 of CPI, has been accelerating for 7 years and is above 3% (Chart 3). Chart 2Connected In 2017 And Disconnected After Chart 3Service Inflation Accelerating Rising short-term interest rates should not be a major headwind for the equity market to the extent that it is reflective of robust growth rather than surging inflation. Inflation expectations are only creeping higher at the moment according to market-based measures (Chart 4). Risk assets could run into trouble if the 5-year, 5-year forward TIPS breakeven rate rises above a level that is consistent with the Fed's 2% inflation target, at 2.4-2.5%. That would signal that investors fear the Fed is falling behind the inflation curve and will have to crank up the pace of tightening. The so-called 'Trump trades' are under pressure following the failure to reform Obamacare, at a time when U.S. equity valuations are stretched and some measures of equity sentiment are elevated. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. A lack of progress on a meaningful tax package and infrastructure plan may well end up being the catalyst for the first U.S. equity market correction of more than 5% in the Trump era. Nonetheless, the lack of excesses in the economy, general agreement between the Fed and the market on the path of rates for this year and rising, but still modest, inflation are likely to make any pullback in U.S. stocks a buying opportunity for investors. In fact, one could argue that fiscal stimulus at this point in the cycle would truncate the expansion because the Fed would have to respond more aggressively if the stimulus boosted inflation pressures. Fed Chair Yellen has made this point in recent public appearances. The failure to pass a tax reform package might undermine the long-term productivity story, but it could actually extend the length of this expansion and the equity bull market by delaying aggressive Fed rate hikes. Our view remains that U.S. equities will continue to outperform the U.S. Treasury bond market in 2017, although that view is as much about the poor prospective returns in the bond market as it is about our bullish view on stocks (Chart 5). Chart 4Inflation Expectations##br## Well Contained Chart 5Equities Continue To ##br##Outperform Bonds This Year The remainder of this week's publication focuses on the forces behind the continuing drop in risk asset correlations, and the implications for a mean-reversion in the equity risk premium. Correlation, ERP And Hurdle Rates Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification (Chart 6). Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart 7). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.1 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. Chart 6Market Correlations Are Shifting Chart 7Market Correlation And The ERP A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart 8). But why was the ERP so elevated after 2007? The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.2 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.3 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart 9). Chart 8Modeling The Stock Price ##br##Correlation Within The S&P 500 Chart 9Capex Hurdle Rates ##br##Never Came Down J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.4 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. Chart 10Forward Multiple Scenarios The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart 10). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 2 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 3 Are Firms Underinvesting - And If So Why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 4 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016.

Highlights Portfolio Strategy A window has opened up for utilities outperformance. Upgrade to overweight on a short-term (1-3 month) view. Leading indicators of beverage sales have improved, heralding an upgrading in depressed expectations. Stay overweight. The pullback in consumer finance stocks appears to be contagion from the overall financial sector selloff than a reflection of deteriorating industry-specific fundamentals. Buy on weakness. Recent Changes S&P Utilities - Boost to overweight from neutral on a tactical basis. Table 1 Feature Our view remains that stocks are in a consolidation phase, waiting for economic/profit confirmation that earnings will grow into the latest valuation expansion. Thin equity market risk premia can be justified if the economy has embarked on an extended and strong non-inflationary growth path that will spawn robust corporate profitability. Chart 1A Second Half Squeeze? On this note, the third mini-economic up-cycle since the Great Recession has been underway since last year. The first two bursts of economic strength fizzled quickly, eventually requiring a new dose of stimulus to reinvigorate growth. The current up-cycle may have more legs given that the rest of the world is now participating and the U.S. economy at full employment, but it would be dangerous to become complacent. The stock-to-bond ratio has crested on a growth rate basis, and its mean reversion properties suggest that key macro gauges such as the ISM index may cool as the year progresses (Chart 1). Odds of growth-propelling fiscal stimulus, that equities have already bought and paid for, may now fade following Congress' failure to move on health care reform. Total bank credit growth is decelerating on a broad basis. Chart 1 shows that of the 8 major bank loan categories, only 1 has a positive credit impulse (the annual change in the 52-week rate of change), the other 7 are negative, i.e. it isn't simply C&I loan weakness driving the credit deceleration. Traditionally, credit and economic growth move together, so the current gap warrants close attention. Meanwhile, the reflationary impulse over the past 18 months from China is set to fade as the authorities tap the brakes, particularly in the housing market, which may throw a wrench into new construction. Chinese property prices have been especially correlated with global economic up-cycles. Real estate inflation downturns have been important global economic signals (Chart 1). Consequently, the second half of the year may 'feel' slower from a growth perspective and challenge the reflation hypothesis. Some trepidation about the durability/breadth of the economic expansion is becoming evident in internal market behavior. Our Intermediate Equity Indicator (IEI) has continued to weaken as breadth and participation thin (Chart 2). If the IEI drops below zero, the odds of a meaningful pullback will rise substantially. Keep in mind there is a lot of air between the S&P 500 index and its 40-week moving average. The number of S&P 500 groups with a positive 52-week rate of change has pulled back to post-Great Recession lows (Chart 2). Last week we showed a composite of relative industry and sector performance that also heralded a choppy period ahead for the broad averages. All of these factors suggest that a tactical consolidation needs time to play out, especially with first quarter reporting season fast approaching and optimism in the outlook bursting at the seams. While trading sentiment is not overly stretched, the truest measure of sentiment is asset valuations and expectations. On this front, our Global Economic Sentiment Index, which contrasts equity and government bond valuations in the major economies, has reached the 'extreme optimism' zone (Chart 3, middle panel). Such a reading does not automatically foretell of an imminent major equity peak, but reinforces that there is little margin for disappointment. Chart 2Deteriorating Internals Chart 3Early Signs Of Overconfidence? In addition, the trend in analyst earnings expectations is also consistent with an overriding theme of exuberance. Cyclical earnings estimates have tentatively peaked after a steep upgrade over the last few quarters, and are now sitting below 5-year growth expectations, suggesting overwhelming confidence in the longevity of the expansion. The last three times that cyclical (12-month) profit growth estimates diverged negatively from lofty long-term estimates was in 2000, 2007 and 2015 (Chart 3). Each episode coincided with ebullient global economic sentiment, and heralded market turbulence, with varying lags. The point is that when financial conditions tighten enough to undermine the cyclical growth outlook but fail to dent conviction in the long-term outlook, it is a signal of overconfidence. The good news is that financial conditions have remained historically easy and should only tighten gradually, such that the risk of a policy-induced slowdown is not acute. In sum, we expect the tactical consolidation phase to persist, especially if economic momentum cools. Exuberant expectations argue for a digestion phase, which should continue to broadly support defensive over cyclical sector positioning, a stance that has paid off nicely since late last year. We may look to selectively increase cyclical and financial sector exposure in the coming weeks if the U.S. dollar remains tame and inflation expectations perk back up, but for now, we are making a tactical addition to the defensive side of the ledger. Utilities Are Powering Up We booked sizable gains in the S&P utilities index and downgraded to neutral last summer, because of our view that bond yields were bottoming on the back of economic stabilization. Since then, relative performance collapsed by 20%, but it has recently started showing some signs of life. Is it time to re-enter this overweight position on a tactical basis? The short answer is yes. There are five reasons to buy utilities at the current juncture with a tactical (1-3 month) time horizon. A possible cooling in economic momentum will redirect capital into the sector. Last week we highlighted that the economically-sensitive transportation index may be heralding mean reversion in key activity gauges, such as the ISM manufacturing index (Chart 4). If the run of positive economic surprises reverses, utilities stocks should receive a sizeable relative performance boost. Transport stock underperformance typically means utility stock outperformance (Chart 4, bottom panel). A cycle-on-cycle analysis of relative utilities performance and the ISM manufacturing survey reveals that is pays to overweight utilities when the latter hits the current level. This has occurred seven times since the early 1990s, and the S&P utilities sector outperformed in the subsequent 3 and 6 months by an average of 3 and 5%, respectively. Only one period generated negative returns (Table 2). Chart 4Utilities Win When Transports Lose Table 2Contrary Alert: Buy Utilities Market-based inflation expectations have crested, aided by the dip in oil prices. Relative share prices have been inversely correlated with inflation expectations, owing to the link to long-dated Treasury yields. Importantly, the University of Michigan's survey inflation expectations, both short and long term, have been drifting lower signaling that the recent backup in CPI headline inflation will likely prove transitory (inflation expectations shown inverted, Chart 5). The flattening yield curve is also sending a tactical buy signal for utilities stocks (shown inverted, Chart 5). Natural gas prices are strengthening. Nat gas prices are the marginal price setter for non-regulated utilities, and the recent price spike has boosted utilities pricing power. Sell-side analysts have taken notice, aggressively ratcheting EPS numbers higher. Nevertheless, the relative EPS growth bar still remains low, signaling that a relative profit outperformance period looms (Chart 6). Chart 5External Support As... Chart 6... Earnings Recover One risk to our tactically bullish utilities view is stagnant electricity generation growth. However, if overall output growth recedes in the next quarter or two, then the non-cyclical power demand profile will shine through, offsetting low utility utilization rates in absolute terms. Bottom Line: There is scope for a playable relative performance rally in the coming one-to-three months. Boost the niche S&P utilities sector to overweight. Soft Drinks Are About To Pop Indiscriminate selling of all consumer staples immediately after the Trump victory restored value in a number of defensive consumer groups. They have stealthily outperformed for most of this year. Chart 7 shows a number of valuation yardsticks. Soft drink stocks are yielding more than both 10-year Treasurys and the broad market. Similarly, the relative P/S and P/E ratios have dipped comfortably below their respective historical means. From a technical standpoint, relative share price momentum has been pushed to a bearish extreme (Chart 7). Against this valuation and technical backdrop, any whiff of operating traction should trigger a playable outperformance phase. Industry pricing power has rebounded smartly, exiting the deflation zone (Chart 8). This firming in selling prices appears to be demand driven. Growth in relative consumer outlays on food and non-alcoholic beverages has improved. Actual industry sales growth has returned to positive territory and beverage output growth is outpacing other non-durable goods industries (Chart 8). While export trends have been a sore spot for beverage companies, the tide should soon turn. The greenback has depreciated versus emerging market (EM) currencies since mid-December, permitting EM central banks to ease monetary policy. That heralds a recovery in consumer goods exports and a reversal of negative translation FX effects (Chart 9, middle panel). Chart 7Cheap And Washed Out Chart 8Inflection Point Chart 9Export Drag Should Reverse The improvement in top-line leading indicators is particularly noteworthy given that cost inflation remains muted. Food input prices are contracting and ethylene prices, a primary packaging ingredient, are also deflating. With headcount under control (Chart 9, bottom panel), there is scope for margin expansion at a time when overall profit margins face a steady squeeze from rising wage inflation. This brightening backdrop, especially in relative terms, has not yet been embraced by the analyst community. Not only are earnings slated to trail the broad market by 7% in the coming year, but 5-year relative EPS growth has plummeted to all-time lows. Such pessimism is unwarranted. All of this implies that while recent beverage shipment growth has been soft, a recovery is likely as the year progresses. That will set the stage for a series of positive surprises, supporting share price outperformance. Bottom Line: The compellingly valued S&P soft drinks index has troughed and has a very attractive reward/risk profile. Were we not already overweight, we would lift exposure to above benchmark today. The ticker symbols for the stocks in the S&P soft drinks index are: BLBG: S5SOFD-KO, PEP, MNST, DPS. Consumer Finance: Cast Aside, But For No Good Reason Like all financials, consumer finance stocks have underperformed the broad market in recent weeks. High intra-financial sector correlations are understandable early in a corrective phase, especially given the magnitude of the initial post-election rally. However, as time passes, correlations should recede because significant discrepancies exist among industry profit drivers. For instance, any meaningful broad market correction could undermine capital markets activity via reduced appetite for new equity issues, less M&A activity and smaller trading fees, taking a bite out of investment banking profits. Elsewhere, banks have been riding hopes for higher net interest margins and an easing regulatory burden. However, without any corresponding improvement in credit growth they are now giving back those gains because bond yields have stalled, the yield curve has narrowed and expectations for deregulation are being watered down to a dilution of terms These factors justify the pullback in both banks and capital markets stocks, even if temporary. On the flipside, the consumer finance group has also been dragged down, even though leading indicators of profitability have continued to improve. As shown in past research, the credit card interest rate spread has low sensitivity to shifts in the yield curve. As such, receivables growth matters more to profits than the slope of the yield curve. Whether consumers embark on debt-financed consumption is heavily dependent on job security, debt-servicing costs, and household wealth. When consumer comfort rises, the personal savings rate tends to decline, indicating a greater propensity to spend. Household net worth has set a new all time high on the back of buoyant financial markets and recovery in house prices (Chart 10). Debt service payments remain historically depressed as a share of disposable income, underscoring that the means to re-leverage exist (Chart 10). Typically credit card charge-offs stay muted until well after debt servicing requirements hit a much higher level, either through reduced incomes or higher interest rates, or a combination of the two. At the moment, both are working in favor of credit quality, not against it. In fact, house prices have reaccelerated sharply in the past few months, which heralds share price outperformance (Chart 11, top panel). Moreover, the steady increase in housing starts bodes well for additional gains in outlays on durable goods, a positive omen for consumer credit demand. Chart 10Credit Quality Remains Strong Chart 11Bullish Leading Indicators The latter is already growing at a solid clip, in contrast with other lending categories such as C&I loan growth (Chart 11), which is weak and dragging down total bank credit. The surge in consumer income expectations points to an expanded appetite for debt (Chart 11). Consequently, the sell-off in the S&P consumer finance index should be treated as indiscriminate contagion from the rest of the financials sector rather than a reflection of deteriorating fundamentals. Recent value creation represents a buying opportunity. Bottom Line: Stick with a high-conviction overweight in the S&P consumer finance index. The ticker symbols for the stocks in the S&P consumer index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The locomotive of the U.S. economy, the consumer, remains supported by powerful tailwinds. The Fed will be able to tighten monetary policy relative to other central banks by a higher degree than the market appreciates. The dollar will rise further. Use this dip to buy more dollars. Being tactically long the yen is a hedge against growth disappointments. Set a stop-sell for AUD/NZD. Feature In June of last year, we wrote a piece titled "What Could Go Right?" arguing key changes in the global economy may have justified a more pro-risk stance for investors.1 The core of the argument was that markets were pricing in a lot of negatives, as the annual return of the global stock-to-bond ratio was deeply negative and could only fall further if a recession were to emerge. Moreover, as commodity prices were improving, we foresaw a waning of deflationary forces that had engulfed the world. This easing deflation would cause real rates to fall and economic activity in EM to rebound. Chart I-1Global Asset Prices: From Gloom To Glee Over the subsequent nine months, this scenario moved from the world of theories to being the reality for the global economy. Today, the annual return of the global stock-to-bond ratio is now the mirror image of last June (Chart I-1). Thus, for the stock-to-bond ratio to move higher, we need to explore where growth may come from. Moreover, we need to consider whether this growth is likely to help the dollar or help other currencies. The U.S. Is In Charge The U.S. economy continues to show the most promise. It is true that some signs do point to a weak Q1. Much noise has been made about the decline in commercial and industrial loans. We are more sanguine. To begin with, the Conference Board includes C&I loans in its list of lagging indicators, not leading ones. Additionally, C&I loans lag banks' lending standards, and, in fact, the weakness in this subsection of credit aggregates is the natural consequence of the 2015-2016 tightening in lending standards. Their recent easing points toward a rebound in C&I loans, as do core durable goods new orders (Chart I-2). What is more concerning is the slowdown in credit to households (Chart I-3). The U.S. economy is driven by household dynamics and the Conference Board does include consumer credit in its list of leading indicators. Moreover, the amount of MBS and ABS on primary dealers' balance sheets remains in a downtrend. This is worrisome because it suggests that the slowing accumulation of consumer debt on banks' balance sheet is genuine, and not a reflection of securitization (Chart I-4). Chart I-2C&I Loans##br## Will Pick Up Chart I-3However, Household Credit ##br##Dynamics Are A Worry Chart I-4Securitization Unlikely ##br##To Be The Culprit However, there are causes to minimize these concerns. Mainly, the drivers of household income and spending are still healthy. First, U.S. financial conditions remain easy, a phenomenon that tends to boost GDP growth in the following quarters, suggesting that national income will remain strong. Second, the outlook for employment in the U.S. remains robust. As Chart I-5 illustrates, the employment components of the ISM and the Philly Fed surveys both point to a pick-up in job creation. This further supports the notion that nominal household income will strengthen Third, our real disposable income indicator, based on various components of the NFIB survey, is showing that households should enjoy strong income growth in the coming months (Chart I-6). Moreover, despite the failure of the AHCA, Marko Papic, the head of BCA's Geopolitical Strategy service argues that it will be much easier for the GOP to implement tax cuts, especially geared toward the middle class, than it was to repudiate the much-maligned Obamacare.2 This could further help household disposable income. Chart I-5Job Growth Will Rebound Chart I-6Household Income: Highway Star Fourth, household liquid assets represent 270% of disposable income, the highest level in decades. Moreover, household debt-servicing costs are still near multi-generational lows, suggesting that households are in the best financial shape they have been in decades. And fifth, household confidence has surged to its highest levels since 2000, reflecting both the large increase in net worth created by surging asset values as well as the very low level of unemployment in the U.S. (Chart I-7). Thus, the decline in the savings rate from 6.2% in 2015 to 5.5% at present could deepen further, adding more impetus to transform income gains into consumption gains. At the worst, this development suggests that the household savings rate will not rise much. These factors all imply that household consumption will remain robust and may in fact accelerate in the coming quarters. Consequently, that capex too has upside. We have highlighted how capex intentions have risen substantially, and this has historically been a powerful leading indicator of capex itself.3 However, the financial press is replete with commentators reminding us that the positive global economic surprises have mostly been a reflection of "soft data" and that "hard data" has not followed through. Not only do we philosophically disagree with this statement - historically soft data does indeed lead hard data - but as Chart I-8 illustrates, core capital goods orders have risen quite sharply, mimicking the developments in retail sales. A combination of strong retail sales and strong orders tend to portend to a rise in capex. Chart I-7Happy Shiny People Chart I-8Capex Will Rebound These developments raise the likelihood that U.S. growth will power the global economy and that the Fed will be in a good position to make good on its intent to increase interest rates two more times this year. In fact, there is even a growing probability that the Fed will add another tool to its tightening arsenal: letting MBS run off, resulting in a contraction of its balance sheet. The combined tightening of two more hikes and a shrinking balance sheet will be much greater than any tightening emanating from an ECB taper. As we argued last week: Europe's inflation and wage backdrop remains icy cold, limiting how far the ECB can tighten monetary policy.4 While an environment of globally rising rates is normally negative for the yen, with the BoJ displaying and even easier bias than in the past, any increase in rates in the U.S. is likely to supercharge weaknesses in the yen, as the BoJ will put a lead on JGB yields and force them to remain subdued.5 As a result of these views, we remain very committed dollar bulls on a 12-18 months basis and recommend using the current dip in the dollar as a buying opportunity, especially on a trade-weighted basis. Bottom Line: While consumer loan growth has slowed - which could result in a poor Q1 U.S. growth number - the outlook for U.S. household income and consumption remains promising. This will also feed through to higher investment growth, clearing the Fed's path toward higher rates. This dip in the dollar should be used as an occasion to buy the greenback. But Why Still Long The Yen Tactically? This position has two purposes. First, we have been worried about dynamics in China that could cause a correction in EM markets.6 More recently, the decline in Chinese house-price appreciation has deepened, representing an ominous sign for the iron ore market (Chart I-9). Poor metal prices tend to represent a negative terms of trade shock and therefore an economic handicap for many large EM nations. Moreover, back in June, the improvement in Taiwanese IP was one of the factors that prompted us to highlight a potential improvement in the global economy. So was the uptrend in our boom/bust indicator. Today, not only is the boom/bust indicator losing steam, but Taiwanese IP has sharply rolled over (Chart I-10). While this is not a reason to worry about our bullish view on the U.S. economy, this could suggest that the global manufacturing upswing has seen its heyday, a development that is likely to weigh more heavily on EM economies than on the U.S. Any EM stress is likely to boost the yen's appeal, temporarily countering the BoJ's aggressive stance. Chart I-9Problems For Iron Ore Chart I-10Two Clouds For Global Growth Second, we do not want to be dogmatic on our U.S. growth view. As the top panel of Chart I-11 illustrates, increases in 2-year Treasury yields have tended to lead to decreases in U.S. inflation expectations. While we would argue that the U.S. economy is on a stronger footing to withstand higher rates than at any point since 2010, a policy mistake is not out of the scope of probabilities. If rising rates is indeed a policy mistake, a large risk-off event would be a very likely outcome, one that boosts the yen. Finally, as the middle and bottom panels of Chart I-11 shows, a fall in U.S. inflation expectations would also extract its toll on EM and cyclical plays, further reinforcing any disappointment out of China, and further adding shine to the yen. Our original target on USD/JPY was 110, we are moving it to 108. At this point, we will become sellers of the yen, unless we see signs that the global economy is entering a more dangerous path than originally anticipated. Additionally, investors looking to express a bearish view on EM may want to go short MXN/JPY (Chart I-12). The peso has massively rallied and is now at a crucial technical spot against the JPY. Moreover, while being short USD/JPY may be a dangerous move - after all, we are playing what amounts in our view to a countertrend bounce in the yen - if EM are at risk, these risks could be exacerbated by the tightening in financial conditions created by a higher dollar. Mexico, with its high external debt, representing nearly 70% of GDP, is particularly exposed to this problem. Also, MXN, with its high liquidity for an EM currency, is often a vehicle for investors to play EM weaknesses. Thus, shorting MXN/JPY could be a great hedge for investors with long EM exposures. Chart I-11Are We Out Of The Woods Yet? Chart I-12A Gauge And A Play Bottom Line: Being tactically long the yen in a portfolio offers two advantages. First, it is a direct play on any disappointment of investors in the EM space, and, second, it is also a hedge against the risks to our strong U.S. growth view. AUD/NZD: Not A Bargain It is often argued that AUD/NZD is a bargain as it trade 6% below its purchasing power parity rate. This may be a valid reason to buy this cross, but only for investors with extremely long investment horizons, as PPP deviations can take seven years to correct. In fact, following the recent rebound in AUD/NZD, we would be inclined to short this pair once again. On the international front, AUD/USD seems to be driven by the dynamic in Chinese nominal GDP growth. We doubt Chinese nominal GDP growth will accelerate much beyond Q1. As Chart I-13 illustrates, AUD/USD seems to have moved ahead of Chinese GDP, putting this currency at risk. We also can also interpret AUD/NZD as a vehicle to play the growth rebalancing in China. The AUD (iron ore, other metals, and coal) is a bet on industrial and investment growth while the NZD (dairy, meat, and wool) is a wager on the Chinese households. As China moves away from an investment-led growth model toward a more consumption-led growth model, AUD/NZD should underperform. A simple fair value model for this cross designed to capture these dynamics as well as the USD dynamics indicates that AUD/NZD is 8% overvalued (Chart I-14). Chart I-13AUD Prices In Chinese Optimism Chart I-14AUD/NZD Is Expensive Moreover, still with an eye firmly planted on China, AUD/NZD has tended to perform poorly when Chinese monetary conditions tighten. The recent upward move in the Chinese 7-day repo rate could be a harbinger of bad things to come for this cross. Relative domestic factors also temper any bullishness on AUD/NZD. Kiwi house prices are outperforming Aussie prices and New Zealand inflation is catching up to that of Australia's. Moreover, the RBA has been paying more attention to the poor state of the Australian labor market, while that of New Zealand remains very strong. These dynamics suggest that kiwi rates could rise relative to that of Australia (Chart I-15). More technically, investors are massively long the AUD relative to the NZD (Chart I-16). This usually is a good signal to bet against this pair. Chart I-15Domestic Conditions Favor##br## Higher NZ Rates Vs. Australia Chart I-16Speculators ##br##Are Bullish Bottom Line: Shorting AUD/NZD at current levels makes sense. Not only is it a way to take advantage of the desire by Chinese authorities to rebalance growth away from the Chinese industrial sector, the Kiwi economy is outperforming that of Australia, and too much negativity has been priced in for the RBNZ relative to the RBA. Finally investors are overly long the AUD relative to the NZD. Set up a stop-sell of AUD/NZD at 1.1100, with a target of 1.000 and a stop at 1.1330. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "What Could Go Right?", dated June 24, 2016 available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe", dated March 22, 2017 available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016 available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "JPY: Climbing To The Springboard Before The Dive", dated February 24, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The DXY displayed resilience this week: the third estimate for U.S. GDP in 2016Q4 outperformed expectations at 2.1%, after being revised up from 1.9%; consumer confidence increased to 125.6, the highest level since 2000; yet Initial jobless claims ticked in at 258,000, underperforming expectations of 248,000 but beating previous figures of 261,000. Another factor lifting the dollar were recent comments by Secretary of Transportation, Elaine Chao, who stated that Trump's $1 trillion infrastructure plan will be unveiled later this year. This could be considerably positive for U.S. economic growth as it will cover a large part of the economy: "transportation infrastructure, energy, water and potentially broadband and veterans hospitals as well." Although specifics were not disclosed, such stimulus in the face of tightening labor market could fan inflation. Under the assumption of a proactive Fed, this could translate into a strong dollar. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Last week's hawkish comments by ECB board member Ewald Nowotny drove the euro higher, while recent comments by Peter Praet confirmed that "a very substantial degree of monetary accommodation is still needed", which pushed the euro down. Promoting the euro's downside were Italian industrial sales and orders, which contracted at a monthly pace of 3.5% and 2.9% respectively, although annual rates remain positive. Article 50's invocation was another factor which contributed to volatility. How Brexit negotiations evolve will dictate movements in EUR/GBP for the foreseeable future. President Tusk's demeanor was also quite negative in his speech, focusing on minimizing "the costs for EU citizens, businesses and Member States". In other news, Portugal's Finance Minister Mario Centeno hinted at a possible upgrade to the growth forecast to around 2% from 1.5% as exports grew by 19% in January. As exports continue to be a key driver of growth for this country, this suggests a weaker euro is still needed to support growth in the periphery. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been mixed for Japan: Corporate services prices rose by 0.8% year-over-year, outperforming expectations. However, retail trade yearly growth deteriorated to 0.1% from 1% the previous month, underperforming expectations. Furthermore, manufacturing PMI fell to 52.6 from 53.3 the previous month. We are changing our tactical target for USD/JPY from 110 to 108. The decline in Chinese property prices as well as slowing inflation expectations in the U.S. might create a risk off environment that will affect carry currencies and will benefit the safe havens like the yen. On a cyclical basis, we remain yen bears, as recent sluggishness will only embolden BoJ policy makers to maintain their radical monetary stance. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 It's official: Theresa May has triggered Article 50. The pound reacted relatively positive to the event as both parties in the negotiations chose to start with the carrot rather than the stick: In her letter to the EU Theresa May stated that she hoped to enjoy a "deep and special" relationship with the European Union once Brexit is finalized. On the other side of the channel, Donald Tusk also pledged to work "closely" with their counterparts in London, and that he hoped that the U.K. will stay a close partner after Brexit. These developments are encouraging, as it shows that cooler heads might prevail at the end of the day. This rosier outlook in an environment where expectations for the Britain are still too pessimistic makes the pound a very attractive buy, particularly against the euro, despite the potential for short-term volatility as the stick will ineluctably come out. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 In an attempt to curb housing market euphoria, all four major banks - ANZ, CBA, NAB and Westpac - increased lending rates on investor and interest-only mortgages this month. Fitch Ratings reports that the tightening was done "ahead of probable regulatory tightening", as hinted frequently by the RBA. Rising wholesale funding costs due to tighter U.S. policy is also a motivating factor behind this. For the time being, the housing market risk will continue to be restricted through macroprudential policies rather than actual tightening by the central bank. Eventually risks related to record-high household debt will limit the capacity of the RBA to increase rates. On the brighter side, banks are well positioned with strong capital buffers and pre-impairment to profitability, with Fitch rating them 'Stable'. This means that risks may not lie with the banking sector, but that the consumer sector will be the key drag on growth. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 In the current environment, although we like to continue to be short the NZD against the yen, we are also shorting AUD/NZD once again. Beyond its uncorrelated nature, there are many reasons why this is an attractive cross to short: AUD/NZD tends to perform poorly when Chinese monetary conditions tighten. Therefore, the spike in Chinese repo rates could weigh on this cross. Furthermore, investors are very long the AUD relative to the NZD. This gives us confidence that this cross might be in overbought territory and that the 5.5% rally in AUD/NZD over the last 2 months may be exhausting itself. Finally, as we have mentioned before, domestic factors still favor the NZD, as kiwi house prices are rising at a faster pace than Aussie ones, which should put pressure on rate differentials. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD is displaying some strength on the back of stronger oil prices, outweighing the pressure from a stronger USD. As mentioned last week, the trend for USD/CAD is still negative in the short term, as corroborated by a negative MACD trend. The greenback's seasonal behavior is also generally negative in April, which could buoy the CAD in the next month. Nevertheless, at the Bank of Canada's meeting in two weeks, Poloz is likely to continue displaying a dovish rhetoric, limiting the CAD's resilience. Similar to Australia, risks lie with the consumer sector, which is burdened by a huge debt load. This gives another reason for Poloz to stay off hikes for the time being and concentrate instead on promoting the implementation of macroprudential policies to regulate lending standards and mitigate housing market risks. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF now hovers around 1.07, clearing the implied floor by the Swiss National Bank. Recent data have been positive: The Zew survey for economic expectations reached 29.6, up from 19.4 in February. It is now at the highest level in 3 years. The KOF leading indicator came at 107.6, above expectations. Although it does seem that the Swiss economy is still improving, the SNB will stay resolute in its intervention for the time being. Indeed, this was the message of SNB Governing Board Member Andrea Maechler, who asserted that there was no limit on their expansion of FX reserves, and that the Swiss franc was "strongly overvalued". We will continue to observe how the Swiss economy develops. However, for the time being the SNB is likely to keep its floor in place. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week, even in the face of a rally in oil prices. This has been in part due to a phenomenon that should continue in the next months: an appreciation of the U.S. dollar against EM and commodity currencies. Furthermore, domestic factors should continue to weigh on the krone, as employment continues to contract and inflation is receding due to the stabilization of the krone. Indeed, Governor Olsen signaled that the Norges bank will likely leave rates unchanged for "a good while" due to these developments. Furthermore, oil could be at risk as well, as the market is starting to doubt the Russian commitment to its deal with OPEC. This, coupled with a slowdown in EM, could prompt a down leg in oil, hurting the NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data came out strong: Retail sales annual growth remains unchanged at 2.7%; The producer price index grew at 7.5%; Consumer confidence for March was at 102.6, down from the previous 104.3. Interesting technical developments for the krona are pointing to further weakness. USD/SEK has rebounded from oversold levels and the MACD line is beginning to overtake the signal line. More importantly, the Coppock curve is rebounding, signifying a bullish trend. EUR/SEK is showing similar signs with the MACD pointing up and the Coppock curve rebounding. Interestingly, Swedish inflation expectations have substantially decreased this week which might give the Riksbank cover to remain dovish. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Chart 5Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Chart 11Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly The GOP's proposed legislation would have reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the corporate tax cuts may simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 17From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 17). As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. Chart 19Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Chart 32The Contribution To Growth From Rising Human Capital Is Falling Chart 33Math Skills Around The World Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. Global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 36 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. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Animal spirits have soared, according to soft data from surveys. But 6-month credit impulses have slumped in the euro area, U.S. and China, according to hard data from the ECB, Federal Reserve and PBOC. The negative 6-month credit impulse - rather than soaring animal spirits - is more important for the cyclical direction of the global economy. A growth-pause would blindside financial markets. Lean against any rise in high-quality bond yields and equity prices until the conflict between soaring animal spirits and slumping credit impulses is resolved. Feature Animal spirits have soared since the surprise election of President Trump on November 8. For many investors, the heightened animal spirits - shown in surging sentiment and survey data (Chart I-2) - are a strong signal that the global economy is about to accelerate. Unfortunately, these investors could end up very disappointed. Chart of the Week6-Month Credit Impulses Have Slumped Chart I-2Animal Spirits Have Soared... The problem is that the hard data on bank credit are giving the exact opposite signal. Over the past few months, global credit flows have slumped (Chart of the Week, Chart I-3 and Chart I-4). Chart I-3...But Credit Impulses Have Slumped Chart I-4The Global 6-Month Credit Impulse Has Turned Negative Despite Heightened Animal Spirits The ECB's latest Monetary Developments in the Euro Area shows that the euro area 6-month credit flow has shrunk by €26 billion. The most recent 6-month credit flow fell to €321 billion from €347 billion in the previous period. The U.S. Federal Reserve's latest weekly H8 release paints an even starker picture. The U.S. 6-month credit flow has shrunk by $271 billion, equivalent to 3% of U.S. GDP (at an annualised rate). The most recent 6-month credit flow plunged to just $152 billion from $423 billion in the previous period. For completeness, look at the world's other major economy, China. Given the lower credibility of official bank credit data in China we prefer to focus on the broad money supply numbers. The People's Bank of China does not seasonally adjust this data, but it is straightforward to do ourselves using standard seasonal adjustment functions. The seasonally-adjusted data shows that the most recent 6-month flow, at 8.1 trillion yuan, was slightly higher than the preceding 7.7 trillion yuan. Nevertheless, the resulting marginally positive China 6-month impulse is sharply down from previous months. Why Optimism Is Up, But Borrowing Is Down Let's explain why sentiment data and credit flows have headed in polar opposite directions since the shock electoral success of Donald Trump. Imagine that firms (or households) are willing to borrow $1 billion for investment projects at a long-term borrowing cost of 1.5%. Then, an unexpected event causes animal spirits to surge. Suddenly, firms will become more optimistic about the expected profits from the investment projects. At this higher net1 profitability, firms might be willing to borrow and invest more than $1 billion, let's say $1.5 billion. In which case, the sentiment data will be higher and so will the credit flow, resulting in a credit impulse of +$0.5 billion. Chart I-5A Sharp Rise In Borrowing Costs Has##br## Countered Heightened Animal Spirits Now imagine that in response to this improved economic outlook, the financial markets expect the central bank to hike interest rates quicker and further. So the markets push up the bond yield to 2.0%. For firms, this higher cost of long-term borrowing might now exactly neutralise the expected profit boost from the investment projects. At this unchanged net profitability, firms will continue to borrow and invest $1 billion. In which case, the sentiment data will be higher but the credit flow will be unchanged, resulting in a credit impulse of zero. Finally imagine that in response to the improved economic outlook, the financial markets get carried away. They push up the bond yield to 2.5%. Now, the much higher cost of long-term borrowing will more than neutralise the expected profit boost from the investment projects. At a sharply lower net profitability, firms will borrow and invest less than $1 billion, let's say $0.5 billion. In which case, the sentiment data will be higher but the credit flow will fall, resulting in a credit impulse of -$0.5 billion. Note that in all three cases, animal spirits are up sharply. For credit flows, these heightened animal spirits in isolation are a tailwind. But any associated rise in the cost of long-term borrowing is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from higher long-term borrowing costs. Today, we would suggest that for global credit flows, the tailwind from heightened animal spirits is weaker than the headwind from the sharpest rise in bond yields in a decade (Chart I-5). The result is a negative 6-month global credit impulse. And it is this negative 6-month credit impulse - rather than heightened animal spirits per se - that is more important for the cyclical direction of the global economy. The History Of "Animal Spirits" In the early nineteenth century, the 'British Currency School', led by David Ricardo, postulated that expansions and contractions of bank credit and the broad money supply are the main cause of the economic cycle. We are very strong advocates of Ricardo's Currency School thesis. In opposition to the Currency School, the 'British Banking School' believed that expansions and contractions of bank credit are merely the passive effects of the economic cycle. The true cause of the economic cycle is fluctuations in business speculation and expectations of profit, which ultimately come from psychological mood swings. A century later in 1936, John Maynard Keynes wrote The General Theory of Employment, Interest and Money. In it, Keynes reiterated the Banking School's psychological mood swing explanation of the cycle. To describe these mood swings, he came up with the now very familiar phrase "animal spirits". Keynes blamed the Great Depression on the collapse of these animal spirits, and a consequent collapse in investment and consumption. But Keynes was only partly right. Animal spirits in isolation do not cause the cycle. As discussed in the previous section, borrowing costs lean against mood swings in both directions. Optimism results in higher borrowing costs, countering the desire to borrow. Pessimism results in lower borrowing costs, countering the reluctance to borrow. And it is the net impact on credit flows that drives the cycle. The specific problem in the Depression was a slump in asset prices. This depressed the value of households' and firms' balance sheet assets to below the value of the liabilities - an extreme event which economist Richard Koo calls a 'balance sheet recession'. Crucially, in a balance sheet recession, no amount of borrowing cost reduction can counter the reluctance to borrow, because households' and firms' single-minded objective is to regain solvency. Hence for us, the Ricardian bank credit cycle - rather than Keynesian animal spirits - is the better explanation for the Great Depression, as well as for Japan's post-1990 bust and for the 2008-09 Great Recession. The Ricardian bank credit cycle also explains the more common and garden variety of economic fluctuations (Box I-1). Readers should review our February 2 report Slowdown: How And When? for the compelling theoretical and empirical evidence. Right now, the important message is that the global bank credit cycle is weakening. Box I-1The Mathematics Of Mini-Cycles Credit Slumps While Animal Spirits Soar: What Should Investors Do? Many commentators and investors look at sentiment and survey data and note that animal spirits have soared. On this basis, they expect global growth to accelerate. But to reiterate, animal spirits in isolation do not cause the economic cycle. Heightened animal spirits do generate a tailwind for credit creation, but any associated rise in the cost of long-term borrowing generates a headwind (Chart I-6). And it is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy (Chart I-7). Chart I-6Higher Borrowing Costs Weaken Credit Flows... Chart I-7...And Weaker Credit Flows Slow The Economy Today, the hard data on bank credit in the euro area, the U.S. and China show that 6-month impulses have slumped. The risk is that this could generate an unwelcome surprise. Rather than accelerate in the coming months, global growth may level off or even decelerate. Even if it were a short-lived pause, major financial markets - including all of those in Europe - would be blindsided. The risk-on mode so far in 2017 would turn out to be incongruous. At the very least, until the conflict between soaring animal spirits and weakening credit impulses is resolved, we will lean against any rise in high-quality bond yields and equity prices. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Profitability net of borrowing cost. Fractal Trading Model* Excessive optimism in global equity prices reinforces our near-term caution towards stocks. We are expressing this through a short position in the AEX. 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-8 * 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

Highlights Renewed deflationary pressures indicate that the Hong Kong dollar may have once again become expensive. The currency peg will stay and domestic prices will adjust as a release valve. Developing deflationary pressures and slowing rent growth may reinforce one other. Rising risk free interest rate calls for higher rental yield, which can only be achieved via lower home prices. Remain short HK government bonds relative to US Treasurys; Remain short HK property investors relative to benchmark. More evidence that China's profit cycle is in an upturn. Feature The election of Hong Kong's Chief Executive this past weekend garnered little coverage among the global mainstream media. Carrie Lam easily beat her competitors, purportedly with blessings from Beijing. However, she will face an uphill battle to reunite the citizens of Hong Kong, who have become increasingly divided in recent years. As a regional financial hub heavily exposed to global forces, local politics barely matter for Hong Kong's economy and financial markets. Nonetheless, the significance of politics has clearly been on an upward trajectory in recent years, which could impact investors' long-term risk perceptions for a market that has historically been largely viewed as an "apolitical" Laissez Faire system. On the economic front, also largely ignored has been Hong Kong's inflation statistics released early last week, which showed that headline consumer price inflation dropped by 0.1% in February, the first negative reading since August 2009. While one single data point certainly does not denote a trend, odds are high that deflationary forces are re-emerging in Hong Kong, with important implications for asset prices, particularly for the currency and local real estate market. Budding Deflation... Chart 1Deflation Is Coming Back The negative February CPI reading was largely attributed to some poverty relief factors, declining vegetable prices and the base effect due to the Chinese New Year holiday. However, headline CPI has been decelerating since the peak of 2011 (Chart 1). Indeed, after briefly dipping below zero at the height of the global financial crisis and then roaring back in the aftermath on improving growth, consumer prices in Hong Kong have been in a prolonged period of disinflation. In fact, February's negative CPI figure is just a continuation of a well-established trend rather than an anomaly caused by one-off factors. Moreover, falling inflation and developing deflation is rather broad-based. It is true that the nosedive in fresh food prices has clearly played a role in dragging down headline CPI. However, price inflation has been trending lower in almost all major components of the consumption basket such as housing, eating out and other miscellaneous services (Chart 1, bottom panel). Meanwhile, consumer durable goods inflation has been stuck in negative territory for more than 10 years. Interestingly, amid strengthening global growth momentum, most major economies have been experiencing bouts of reflation, particularly in sectors associated with commodities prices - intensifying disinflationary/deflationary pressures in Hong Kong are a notable exception. It means that inflation dynamics in Hong Kong are likely rooted in unique domestic factors. ...Indicates An Expensive Hong Kong Dollar In our view, a key factor behind Hong Kong's budding deflationary pressure is the exchange rate. As the Hong Kong dollar is pegged to the U.S. dollar, the relative shift in price levels between Hong Kong and the rest of the world cannot be adjusted through a change in the nominal exchange rate. Therefore, the adjustment must be achieved in real terms through price changes. Chart 2 shows that prior to 1983 when the currency board system was established, Hong Kong inflation largely followed that in the U.S., while the exchange rate fluctuated against the dollar. Since the 1983 currency peg, Hong Kong inflation has been swinging around the U.S. level, with the economy alternating between inflationary booms and deflationary busts. A new factor that has also become increasingly important in Hong Kong's inflation dynamics is China's price levels, which also relates to the exchange rate. Chart 3 shows Hong Kong headline inflation has outpaced Chinese inflation since 2013, and the RMB's depreciation against the Hong Kong dollar in recent years has put further downward pressure on local Hong Kong price levels. Chart 2Exchange Rate And Inflation Tango Chart 3Hong Kong Inflation: The China Factor In short, renewed deflationary pressures indicate that the Hong Kong dollar may have once again become expensive, and therefore domestic price levels have begun to adjust as the release valve. It remains to be seen how long the adjustment process will last. From investors' point of view, a few observations are in order: There is little risk that the Hong Kong dollar peg will break, unless it is a voluntary policy choice by the authorities. Hong Kong's solid banking sector is not prone to financial crises, and its massive fiscal and foreign exchange reserves give the government plenty of fire powder to defend the exchange rate in the event of a speculative attack, let alone the mighty official reserves held in mainland China (Chart 4). We remain convinced that Hong Kong's ultra-low interest rates compared with the U.S. are unjustified and unsustainable (Chart 5). Hong Kong 10-year government bond yields are still 84 basis points lower than their U.S. counterparts, which probably reflects upward pressure on the Hong Kong dollar to appreciate against the U.S. dollar, partially driven by Chinese capital outflows. In this vein, budding deflationary pressures in Hong Kong further diminish the odds of an upward move of the HKD against the U.S. dollar. Remain short Hong Kong government bonds against U.S. Treasurys with comparable durations. Historically Hong Kong's flexible and largely Laissez Faire system has been able to stomach drastic swings in domestic price levels induced by the currency peg. The rising grassroots anti-establishment movement in recent years suggests the side effects of the Hong Kong system may have become increasingly unpopular. It will be interesting to see if any deflationary growth downturn in Hong Kong triggers a populist backlash that leads to a change in Hong Kong's exchange rate scheme. Chart 4Ample Resources To Defend HKD Peg Chart 5HK Rates Should Move Higher Real Estate: Sky's The Limit? Another key reason behind Hong Kong's falling CPI inflation is rent, which has also turned sharply lower in recent months (Chart 1, bottom panel). This is in stark contrast to home prices, which have continued to rally strongly. After a temporary pullback last year, Hong Kong real estate prices have roared back to new record highs. Looking forward, the outlook for Hong Kong's real estate sector looks decisively bearish. First, Hong Kong's real estate market has become increasingly detached from economic fundamentals. Home prices have dramatically outpaced household income, in greater proportion than the previous housing bubble peak in the late 1990s (Chart 6). Therefore, it is not surprising that both transactions and construction activity have declined substantially to near-record lows. Thinning transaction activity suggests that ordinary local households may have been priced out, underscoring frothy market conditions. The saving grace is that the dramatic increase in prices has not led to euphoria in housing demand and transactions, which should limit financial sector risk should home prices decline. Second, developing deflationary pressures and slowing rent growth may reinforce one other, potentially creating a downward spiral. Meanwhile, risk-free interest rates, driven by Federal Reserve policy, will likely edge higher. This is an especially poor combination for Hong Kong real estate investors. Historically, higher risk-free yields should lead to higher rental yields (Chart 7). With falling rents, the only way for rental yields to go up is via lower prices. Chart 6Housing Market: Soaring Prices, Falling Volume Chart 7Rental Yield Will Be Pushed Higher From a big-picture vantage point, Hong Kong deflation and Fed tightening will lead to much higher real interest rates in Hong Kong, which amounts to significant tightening in monetary conditions. This will create further headwinds for both the Hong Kong domestic economy and property prices. The bottom line is that the risk in Hong Kong home prices is tilted to the downside. The market may have been boosted by an influx of capital from the mainland, which may sustain the bubble for a while longer. However, investors should not chase the market. Chart 8The Widening Valuation Gap Budding deflationary pressures also bode poorly for profits and equity prices. However, Hong Kong stocks are more heavily exposed to China and the global cycle than local business conditions, and therefore should not be impacted materially. Moreover, Hong Kong stock multiples historically have tracked their U.S. counterparts closely - the valuation gap has widened sharply since 2013 (Chart 8). This should further limit the downside in Hong Kong stocks. Meanwhile, we expect property owners such as REITs to underperform the broader market. A Word On Chinese Profits The latest numbers show Chinese industrial profits jumped by over 30% in the first two months of the year compared with a year ago, a sharp acceleration from recent months, as predicted by our model (Chart 9). The strong profit recovery has important implications. For equity earnings, the upturn in the profit cycle is also confirmed by bottom-up analysts. Net earnings revisions have been lifted, which has historically led to acceleration in forward earnings growth (Chart 10). Remain positive on Chinese H shares. From a macro perspective, rising earnings should lead to stronger investment, especially in the manufacturing and mining sectors. This should further boost domestic demand and prolong the ongoing mini cycle upturn. The profit recovery also helps alleviate financial stress in the banking system, as it will reduce the pace of accumulation of non-performing loans (NPL). Importantly, profits are rising particularly strongly in some of the hardest hit sectors in previous years, such as steelmakers and coal miners, which were precisely where the increase in NPLs were the most rampant. We will follow up on this issue in upcoming reports. Chart 9China's Profit Cycle Upturn Chart 10Chinese Equity Earnings Will Accelerate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The end game for the Kingdom of Saudi Arabia (KSA), Russia and their respective allies is fairly obvious: Remove enough production from the market to draw down storage and make the oil-supply curve, once again, more inelastic. This would allow these states to use forward guidance and small adjustments in production to influence prices, the sine qua non of petro-states desperate to maintain revenues and diversify away from near-complete dependence on hydrocarbon exports. We think the effort will succeed over the short run. Just how durable this pact will be remains to be seen, given oil is, once again, super-abundant. If production discipline breaks down, all bets are off. Energy: Overweight. We are now solidly positioned for backwardation in oil - long Dec/17 vs. short Dec/18 WTI and Brent; these positions are up 141.6% and 68.4%, respectively. We also are positioned for a rally on drawdowns in inventories as refiners come back from turnarounds over the next few weeks: We are long $50/bbl WTI calls vs. short $55/bbl calls in Jul-Aug-Sep 2017; these positions are up 7.66% on average. Base Metals: Neutral. Workers at Chile's Escondida mine are back on the job, after a 44-day strike. The strike is estimated to have cost BHP Billiton some $1 billion, according to Reuters.1 Precious Metals: Neutral. Gold has rallied by 4.3% since the FOMC raised overnight rates. Our long volatility position - long a Jun/17 put and call spread for $21/oz - is down 30%. Ags/Softs: Underweight. The long-awaited and much-anticipated USDA planting intentions report is due out tomorrow. We remain bearish, expecting an early indication stocks-to-use ratios for grains and beans will remain elevated. Feature Chart of the WeekStorage Was Well On Its Way to Drawing##br## Before the Year-End Production Surge KSA and Russia have to make oil supply more inelastic in order to regain some control over where prices go and, consequently, where their revenues go. Their end game is obvious - i.e., remove the excess oil production that pushed inventories to historically high levels - but their execution has been, at best, halting. Prior to KSA and Russia delivering an historic production-management Agreement at the end of last year, oil markets were well on the way to removing the storage overhang by year-end 2017, as any Econ 101 text would have suggested. Low prices following OPEC's market-share war declaration destroyed supply and lifted demand, which was drawing down stocks. This is easily seen in the Chart of the Week showing inventories beginning to head south in mid-2016. Then came the KSA - Russia Agreement between OPEC and non-OPEC producers to cut output by some 1.8mm b/d. The goal of the deal was to accelerate the drawdown in record high storage levels. Even while the deal was being negotiated, it was apparent some producers in the know were getting a jump on shipping those last barrels out the door before they were obliged to cut. This produced the end-of-year production surge, which swelled global inventories. The year-end surge by OPEC and non-OPEC producers could be expected (Chart 2), but it came at a really bad time for the market, since 1Q17 also was when refiners took units down for maintenance. This is fairly routine, but in some key markets like the U.S. Gulf, the current maintenance season was busier than average, according to the EIA (Chart 3). This left a lot of crude in storage, as product inventories were being drawn. Chart 2Year-End Production Surge ##br##Powered The Storage Build Chart 3Maintenance Season In 1Q17 ##br##Exacerbated The Storage Build Where are we today? Most of the pre-Agreement production and export surge has been absorbed, and inventories in the U.S. are drawing a bit. Floating storage has been drained. But, in an interesting economic twist, OECD storage levels are likely to reach the targeted drawdown of 10% (300mm bbl) by year-end 2017, which is exactly what would have happened absent any action by KSA and Russia at the end of last year. It is difficult to resist reiterating that had nothing been done at the end of last year by KSA and Russia, and the market was left to do its necessary work of removing high-cost production and encouraging increased demand via lower prices, the market would have ended up in the exact same place it now finds itself. Trust But Verify Be that as it may, the really hard work of the KSA - Russia deal now begins. We expect OECD inventories to hit the 10% drawdown target by year end. However, if parties to the deal do not maintain production discipline markets will almost surely take prices lower. This could easily happen if prices start to percolate as we expect in 2Q17, and cash-strapped non-OPEC producers decide to see how far they can push KSA and its Gulf-state allies on their deal. Russia has been slow to deliver on its production commitment, while KSA has over-delivered (Chart 4). The same can be said for their respective allies (Chart 5). We believe markets will remain skittish, until evidence Russia and Iraq also are abiding by the end-2016 Agreement becomes incontrovertible. It is true Russian President Vladimir Putin personally involved himself in this deal, and helped close it on the non-OPEC side, but markets will want proof production actually is falling. Like former U.S. President Ronald Reagan, markets may be willing to trust, but they certainly will want to verify compliance. Chart 4KSA Over-Delivers On Its Cuts, ##br##Russia Is Slow To Deliver Chart 5KSA's Allies Are Delivering, ##br##Russia's Not So Much While not our base case, it is possible Russia and its fellow travelers could decide to risk keeping their production above agreed volumes under the Agreement, in the belief KSA is more in need of keeping prices above $50/bbl or so over the next 18 months, given the Kingdom wants a successful IPO of state-owned Saudi Aramco. Should this occur, markets would correct violently. At the end of the day, such a gamble likely would be ruinous for both, if it provoked KSA to abandon its commitment to keep production below 10mm b/d. Short-term goals - getting OECD storage levels down to five-year averages - would be sacrificed. Importantly, long-term goals we believe are driving KSA and Russia to cooperate in the first place, namely developing a modus operandi for containing U.S. shale-oil output, will become moot, possibly returning the market to the production free-for-all that motivated the KSA - Russia dialogue. The Quest For Relevance Chart 6Odds Favor Backwardated Markets ##br##As the Production Cuts Lead To Physical Deficits Our base case envisions a successful KSA - Russia Agreement in which production discipline is maintained, and the deal produces its desired result - drawing storage down by ~ 300mm bbls. Forward curves then backwardate (Chart 6). This sets the stage for deeper discussions among KSA, Russia and their respective allies re how they can work together going forward to contain U.S. shale-oil production. In effect, the parties to this deal have a choice to make: Either they figure out a way to make room for shale, which has catapulted the U.S. to major-producer status once again, or they leave this to the market. We are fairly confident these discussions already are ongoing, and will be well advanced by year-end. Next week, we will be publishing a theoretical piece on how the KSA - Russia pact could provide a platform that allows these petro-states - which we are taking the liberty of dubbing OPEC 2.0 - to re-gain a modicum of control over the rate at which U.S. shale-oil resources are developed. In earlier research, we advanced a theory that shale rig counts are highly sensitive not only to the level of prices at the front of the curve, but to the curve shape itself. We were able to demonstrate that contango markets - i.e., prices for promptly delivered crude are less than prices for deferred delivery material - favor shale producers, and, all else equal, incentivize them to hedge forward so as to lock in future revenues that maximize the number of rigs they deploy.2 In backwardated markets, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. This limits the rate at which the resource can be developed. Based on these theoretical results, we believe it is in the interest of the OPEC 2.0 states to keep the WTI forward curve in backwardation, so that, at the margin, the number of rigs deployed to the shales is contained. Our research suggests that the deeper the backwardation, the slower rig counts grow. So, if the ideal price level for KSA is, as has been reported in the media, $60/bbl for Brent, then, in the best of all worlds, the Kingdom, Russia and their respective allies target spot prices at this level and use production, storage and forward guidance to backwardate the WTI curve, which is used by shale producers to hedge.3 Such a strategy has numerous risks, particularly if OPEC 2.0 cannot react quickly enough to keep prices from rising above a level that keeps shale-oil producers restricted to their core production areas. This would allow higher-cost shale reserves to be brought on line, which would raise the likelihood of lower prices, and cost OPEC 2.0 market share.4 Such a strategy also would tempt OPEC 2.0 producers to free ride, raising production at the margin to increase their revenues. This also risks lower prices. Nonetheless, we believe such a strategy could benefit both KSA and Russia and their allies, which is why it likely will at least be considered and attempted.5 KSA would be able to IPO Aramco into a relatively stable higher-price market, which would allow it to invest in additional refinery capacity in Asia and elsewhere, and in alternative-energy resources like solar, to free up oil for export. Russia also is better off keeping prices at a level at which its economy can continue to work on diversifying its exposure away from its heavy dependence on oil and gas exports.6 We will present more of our thinking on this next week. In the meantime, we highly recommend BCA clients read Matt Conlan's article in this week's Energy Sector Strategy entitled "Shale Dynamics: Sensitivities Within Modeling A Shale Recovery."7 This is an excellent analysis of shale-oil economics. Bottom Line: We continue to expect crude and products storage to draw as production cuts become apparent and refiners bring units back up off maintenance. This will backwardate WTI and Brent forward curves. Based on our high level of conviction in this outcome, we added a long Brent Dec/17 vs. short Dec/18 Brent position to our recommended trades, along with a similar WTI position. We also are positioned for a rally on drawdowns in inventories as refiners come back from turnarounds over the next few weeks, by being long $50/bbl WTI calls vs. short $55/bbl calls in Jul-Aug-Sep 2017. We continue to expect the U.S. benchmark WTI crude prices to average $55/bbl to 2020 and for WTI prices to trade most of the time between $45/bbl and $65/bbl. For 2018 and beyond, our conviction is lower: The massive capex cuts seen in the industry will place an enormous burden on shale producers and conventional oil producers - chiefly Gulf Arab producers and Russia - to offset natural decline-curve losses and meet increasing demand. For the international benchmark, Brent crude oil, we expect the spread between Brent and WTI prices to average $1.50/bbl (Brent over). Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Escondida outcome seen as disaster for BHP as workers return," published by Reuters.com on March 24, 2017. 2 We introduced this line of research in our February 16, 2017, issue of Commodity & Energy Strategy, in an article entitled "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," it is available at ces.bcaresearch.com. We continue to delve into this topic, and will be presenting out latest thinking next week. 3 Please see "Exclusive: Saudi Arabia wants oil prices to rise to around $60 in 2017 - sources," published by Reuters February 28, 2017. Russia's budgeting assumption for 2017 to 2019 is $40/bbl, according to a Bloomberg report from March 24, 2017, entitled "OPEC Be Warned: Russia Prepares for Oil at $40." 4 It is not in KSA's, Russia's or their allies' interests to kill off shale production. The more-than-$1 trillion of capex for projects that would have been developed between 2015 and 2020, and would have translated into some 7mm b/d of oil-equivalent production will not be available to the market beginning later this decade. As we have noted, an enormous burden will be placed on shale production, Gulf OPEC producers and Russia to meet growing demand later this decade. 5 We also would note this would be a boon to long-only commodity index investors, whose returns are driven by roll yields that only exist in backwardated markets. More on that in subsequent research as well. 6 Russia's exports are dominated by oil and gas, while KSA's are dominated by crude oil and, increasingly, refined products. In 2015, the Carnegie Endowment for International Peace calculated close to 70% of Russia's economy is dependent on revenue from hydrocarbons - production, trade, investments in non-oil industries funded by oil revenues, and consumption made possible via oil and gas production and sales. We discuss this at length in the September 8, 2016, issue of Commodity & Energy Strategy, in an article entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." 7 Please see Energy Sector Strategy Weekly Report entitled "Shale Dynamics: Sensitivities Within Modeling A Shale Recovery," This article was published March 29, 2017, available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights The financial market landscape has shifted over the past month with asset correlations changing and the so-called 'Trump trades' going into reverse. Equity valuation is stretched and plenty of risks remain. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. The economic data remain constructive for profits in the major countries. The risks posed by upcoming European elections have eased for 2017, now that the Italian election appears unlikely until 2018. The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. If a tax reform package proves too difficult to pass, then the GOP will settle for straight tax cuts and a modest amount of infrastructure spending. Market reaction to the FOMC's 'dovish hike' was overdone. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Not before September will the ECB be in a position to announce a further tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. In Japan, the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. Our views on U.S. fiscal policy and the major central banks paint a bullish picture for the dollar, and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Another key market development has been the continuing drop in risk asset correlations. This reflects falling perceptions of downside "tail risk", which is reflected in a declining equity risk premium (ERP). Absent further negative shocks, perceptions of downside risk should continue to wane, allowing risk premia and asset correlations to ease further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can focus more on long-term revenue generation rather than on guaranteeing their existence. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. The only adjustment to asset allocation we are making this month is an upgrade for U.S. high-yield based on improved valuation. Feature The financial market landscape has shifted over the past month with asset correlations changing and a number of popular trades going into reverse. First, the failure to replace Obamacare triggered a pull-back of the so-called 'Trump trades.' Stock indexes are holding up well, but the U.S. dollar has given back most of the gains made in March and the 10-year Treasury yield has dropped back to the bottom of the post-U.S. election trading range. Moreover, the negative correlation between the U.S. dollar and risk assets has flipped (Chart I-1). Even oil prices have diverged from their usual negative trading relationship with the dollar. Second, investors are questioning the FOMC's appetite for rate hikes in the coming months. They are also wondering how much longer the European Central Bank (ECB) and the Bank of Japan (BoJ) can maintain current hyper-stimulative policy settings. The whole narrative regarding equity strength, a dollar overshoot and bond price weakness may be over if there is not going to be any fiscal stimulus in the U.S., the Fed is not going to hike more aggressively than the market currently expects, and monetary policy is near a turning point in Japan and the Eurozone. Is it time for investors to become defensive, scale back on risk assets, upgrade bonds and short the dollar? We believe the answer is 'not yet', although 2017 was always destined to be a rough ride given the ups-and-downs in the U.S. legislative process and the lineup of European elections. President Trump's first 100 days are turning out to be even more tumultuous than many expected. Allegations of wiretaps and the FBI investigation into the alleged interference of Russia in the U.S. election are costing the President political capital, as well as raising question marks over the Republican Party's wish list. Simply removing the possibility of corporate tax cuts would justify a healthy haircut on the S&P 500. The political situation has admittedly become more complicated, but our geopolitical team makes the following observations: The GOP base supports Trump: Until the mid-term elections, Trump's popularity with Republican voters remains strong, which means that the President still has political capital (Chart I-2). Chart I-1Changing Correlations Chart I-2Trump Not Dead To Republicans Yet Republicans want tax reform: Even if reform gets bogged down, there is broad support for cutting taxes at a minimum. Many deficit hawks appear willing to use the magic of "dynamic scoring" to justify tax cuts as revenue-neutral. Even the chairman of the Freedom Caucus has signaled that he is open to tax reform that is not revenue neutral. Tax reform not conditional on Obamacare: The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. The Republicans will need to show success on at least one of their signature platforms before heading into the mid-term elections. The prospective savings from Obamacare's repeal are not needed to "fund" tax cuts. Infrastructure: We still expect that President Trump will get his way on additional spending on defense, veterans, infrastructure and the wall. The tax reform process will undoubtedly be full of drama and may be stretched out, adding volatility to the equity market. Our base case is that some sort of tax reform and infrastructure package will be passed by year end. However, if a reform package proves too difficult to pass, then we believe that the GOP will settle for straight-forward tax cuts and a modest amount of infrastructure spending (please see Table I-1 in the March 2017 monthly Bank Credit Analyst for the probabilities we have attached to the various GOP proposals). Tax cuts and increased spending will be positive for risk assets. The caveat is that we see little change in Trump's commitment to mercantilism. This means he will lean toward backing the border tax or tariff increases, which will offset some of the benefits for risk assets from reduced tax rates. Excess Reaction To FOMC Chart I-3FOMC & Market Disagree Beyond This Year Given the uncertainty on the fiscal side, one can't blame the FOMC for taking a "wait and see" approach. The range for the funds rate was raised to 0.75-1.00% at the March meeting, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50 bps of tightening is expected by the Committee this year, with 75 bps expected in both 2018 and 2019 (Chart I-3). The FOMC signaled in March that it was not yet prepared to adjust the 'dot plot,' sparking a rally in bond prices and a pullback in the dollar. This market reaction seemed excessive in our view. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target, as highlighted by the decision to strip the reference to the "current shortfall of inflation" from the statement. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Is The Dollar Bull Over? Still, recent market action suggests that the dollar may not get a lift from future Fed rate hikes because the outlook for global growth outside of the U.S. is brightening. Moreover, it could be that monetary policy in the Eurozone and Japan is at a turning point. There is increasing speculation that the ECB will have to taper the quantitative easing program sooner than planned. Some are even speculating the ECB will lift rates this year. The recent economic data for the euro area have indeed been stellar. The composite PMI surged to 56.7 in March, with the forward-looking new orders components hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart I-4). In addition, private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. Our real GDP model for the Eurozone, based on our consumer and business spending indicators, remains quite upbeat for the first half of the year. With unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to establish a consensus view on the ECB policy committee. The Bundesbank has been quite vocal on this issue, especially given that Eurozone headline HICP inflation reached 2% in February. The core rate of inflation remains close to 1%, but the rising diffusion index suggests that budding inflation pressure is becoming more broadly based (Chart I-5). Chart I-4Solid Eurozone Economic Data Chart I-5Eurozone Inflation Broadening Out BCA's Global Fixed Income Strategy service recently compared the current economic situation to that of the U.S. around the time of the Fed's 2013 "Taper Tantrum."1 In Chart I-6, we show "cycle-on-cycle" comparisons for the Euro Area and U.S. In the Euro Area, the number of months to the first rate hike discounted in money markets peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, this indicator has converged with the U.S. path. There is less spare capacity in European labor markets today than was the case in the U.S. when the Fed first hinted at tapering its asset purchases. Nonetheless, the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Not before September will the ECB be in a position to announce another tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. We do not believe that the ECB will raise short-term interest rates before it starts the tapering process. A rate hike would result in a stronger euro, downward pressure on inflation, and an unwanted tightening in financial conditions that would threaten the current economic impulse. This means that, between now and September, the window is still open for U.S./Eurozone interest rate spreads to move further in favor of the dollar. The European election calendar remains a risk to our view on currencies and risk assets. Widening OAT/Bund yield spreads highlight that investors remain concerned that the French election will follow last year's populist script in the U.K. and the U.S. However, our geopolitical team believes that Le Pen is unlikely to win since she trails in the polls by a 25-30% margin relative to Macron, her most likely opponent. Even if she were to pull off a win, she will not hold the balance of power in the National Assembly. Over in Germany, where the election is heating up, the fact that the Europhile SPD party is gaining in the polls means that the September vote is unlikely to be a speed bump for financial markets. The real political risk lies in Italy. While the election has been pushed off to February 2018, it appears that there will be genuine fireworks at that time because Euroskeptic parties have seized the lead in the polls (Chart I-7). In the meantime, European elections will be a source of volatility, but investors should ride it out until we get closer to the Italian election. Chart I-6Less Spare Capacity In Europe ##br##Now Vs. Pre-Taper Tantrum U.S. Chart I-7Italian Elections: The Big Risk Japanese Yield Cap To Hold Chart I-8Japanese Wages Still Disappointing Similar to our view on the ECB, we do not believe that the Bank of Japan (BoJ) will be in a position to begin removing monetary accommodation anytime soon. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. True, deflationary forces appear to have eased somewhat. Japan is also benefiting from the faster global growth on the industrial side. Nonetheless, the domestic demand story is less positive, with consumer confidence and real retail sales growth languishing. Wages continue to struggle as well (Chart I-8). This year's round of Japanese wage negotiations was particularly disappointing, with many manufacturing companies offering pay raises only half as large as those of last year. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. Our views on U.S. fiscal policy and the outlook for the major central banks paint a bullish picture for the dollar and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Admittedly, however, the next major move in global yields may not occur until the autumn when the ECB takes a less dovish tone. In the meantime, our fixed-income strategists remain underweight Treasurys within global currency-hedged portfolios. The team recently upgraded (low beta) JGBs to overweight at the expense of core European government bonds, which move to benchmark. Correlation, ERP And Hurdle Rates Chart I-9Market Correlations Are Shifting Another key market development has been the continuing drop in risk asset correlations, a trend that began before the U.S. election (Chart I-9). Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification. Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart I-10). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.2 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart I-11). But why was the ERP so elevated after 2007? Chart I-10Market Correlation And The ERP Chart I-11Modeling The Stock ##br##Correlation Within The S&P 500 The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.3 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending Chart I-12Capex Hurdle Rates Never Came Down An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.4 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart I-12). J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.5 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list, as highlighted in this month's Special Report on Brexit's implication for Scotland independence, beginning on page 19. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart I-13). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. We continue to favor higher beta developed markets where value is less stretched, such as the euro area and Japan, over the U.S. on a currency-hedged basis. Europe is about one standard deviation cheap relative to the U.S. index, although the extra value in the Japanese market has dissipated recently (Chart I-14). Moreover, both Eurozone and Japanese stocks in local currency terms will benefit from weaker currencies in the coming months, as rising inflation expectations and stable nominal interest rates result in declining in real rates, at least relative to the U.S. Chart I-13Forward Multiple Scenarios Chart I-14Eurozone Stocks Are Cheap Conclusion We have reassessed our asset allocation given that several market calls have gone against us over the past month. However, three key views argue to stay the course for now: Recent economic data support our view that a synchronized global acceleration is underway. This is highlighted by an update of the real GDP growth models we introduced last month (Chart I-15). The implication is that earnings growth will be constructive for stocks; Tax reform is still likely to be passed this year in the U.S. Moreover, were a broad tax reform package to elude the Administration, the fallback position will involve (stimulative) tax cuts, some infrastructure spending and de-regulation; and The FOMC will shift to a more hawkish tone in the coming months, while the ECB, Bank of England and Bank of Japan will maintain extremely accommodative monetary policy at least into the fall. The result is that stocks will outperform cash and bonds, while the dollar still has another 10% upside potential. The only adjustment we are making this month is in the U.S. high-yield corporate bond allocation. According to our fixed-income strategists, value has improved enough that it is worth upgrading the sector to overweight at the expense of Treasurys. Some of the indicators that comprise our default rate model have become more constructive for credit risk, including lending standards, the PMIs and profits. The combination of wider junk spreads and an improving default rate outlook have resulted in a widening in our estimate of the default-adjusted high-yield spread to 219 basis points (Chart I-16). Historically, high-yield earns a positive 12-month excess return 81% of the time when the default-adjusted spread is between 200 and 250 basis points. Chart I-15GDP Models Are Bullish Chart I-16Upgrade U.S. High Yield Turning to oil markets, we expect recent price weakness to reverse despite dollar strength. Building inventories have weighed on crude, but this is a head fake according to our commodity experts. We expect to see a sustained draw in OECD storage volumes this year, now that the year-end surge on crude product from OPEC's Gulf producers has been fully absorbed. With global supply/demand fundamentals now dominating price movements, the recent breakdown in the inverse correlation between oil prices and the dollar should persist. Oil prices will rise back toward the US$55 range that we believe will be the central tendency over 2016 and 2017. Risks are to the upside. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Shift to benchmark in Eurozone government bonds and upgrade JGBs to overweight within currency-hedged portfolios. The U.S. remains at underweight. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks over bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues in the U.S.; upgrade U.S. high-yield to overweight, but downgrade European investment-grade to underweight due to fading support from the ECB. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. Favor oil to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst March 30, 2017 Next Report: April 27, 2017 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?" dated March 7, 2017, available at gfis.bcaresearch.com. 2 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 3 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 4 Are Firms Underinvesting - and if so why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 5 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016. II. Will Scotland Scotch Brexit? This month's Special Report, on Scotland's role in Brexit negotiations, was penned by our colleagues Matt Gertken, Marko Papic, and Jesse Kurri of BCA's Geopolitical Strategy service. Scottish secessionist sentiment has increased in response to First Minister Nicola Sturgeon's decision to push for a second popular referendum on Scottish independence, tentatively set for late 2018 or early 2019, though likely to be denied for some time by Westminster. The outcome of a referendum on leaving the U.K., which eventually will occur, is too close to call at this point. The possibility will influence the U.K.'s negotiations with the EU, and vice versa. The risk of a U.K. break-up adds an important constraint to Prime Minister Theresa May's government in the Brexit talks. Since the EU also has an interest in avoiding a devastating outcome for the U.K., our geopolitical team believes that the worst version of a "hard Brexit" will be avoided. That said, independence for Scotland cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s divorce proceedings. I trust that you will find the report as insightful as I did. Mark McClellan Senior Vice President A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland's First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.'s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the "Great Repeal Bill" that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the "Phoney War" has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart II-1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart II-2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart II-3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart II-1A Second Independence Referendum... Chart II-2...Is Looking More Likely Chart II-3Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, the outcome will be "too close to call," at least judging by the data available at present. In what follows we discuss why, and how Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "the End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland resented the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. If that had happened in 2014, it was estimated that the country's fiscal deficit would have been 5.9% of GDP and that its national debt would have been 109% of GDP. (Today those numbers are 8% and 84% of GDP respectively) (Table II-1). A newborn Scotland would have to adopt austerity quickly. Table II-1Scotland Would Be A High-Debt Economy Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart II-4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Chart II-4Highly Financialized Societies Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart II-5). Brexit does indeed mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. Chart II-5Three Cheers For Brexit And The Tories It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that a new independence vote would be justified in case of "a significant and material change in the circumstances that prevailed in 2014, such as Scotland being taken out of the EU against our will." Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart II-6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart II-7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart II-6Immigration Curbs ##br##Threaten Scots Growth Chart II-7Scottish Patriots ##br##Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart II-8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart II-9). Decommissioning costs are also expected to be high as the sector is wound down. England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart II-10). Chart II-8No Golden Goose In The North Sea Chart II-9Limited Domestic Energy Supplies Chart II-10The U.K. Pays For Scotland's Allegiance Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart II-11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart II-12). Chart II-11Scotland's Deficits Getting Worse Chart II-12Scottish Financial Assets Need Currency Stability Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts II-13 and II-14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart II-15). Chart II-13Irish Independence: ##br##Poverty Not An Obstacle Chart II-14Scotland: If The Irish ##br##Can Do It So Can We Chart II-15EU Market No ##br##Substitute For British Market Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart II-16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart II-17). Youngsters are willing to take risks for the thrill of freedom, while their elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart II-16No Relationship Between IndyRef And Brexit Chart II-17Old Folks Loyal To The Union Jack The most striking indicator of Scottish secessionism is unemployment (Chart II-18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart II-19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart II-18Joblessness Boosts Independence Vote Chart II-19The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, though of course Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart II-5, page 24). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism and migration, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the common market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the common market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. Our Geopolitical Strategy service has been short EUR/GBP since mid-January and the trade is down 2%. This suggests that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer this currency trade as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken Associate Editor Geopolitical Strategy Marko Papic Senior Vice President Geopolitical Strategy Jesse Anak Kuri Research Analyst Geopolitical Strategy 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also may work against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. III. Indicators And Reference Charts The S&P 500 index has pulled back from its recent highs, but it has not corrected enough to 'move the dial' in terms of the valuation or technical indicators. Stocks remain expensive based on our valuation index made up of 11 different measures. The technical indicator is still bullish. Our equity monetary indicator has dropped back to the zero line, meaning that it is not particularly bullish or bearish at the moment. The speculation index is elevated, however, pointing to froth in the market. The high level of our composite sentiment index and the low level of the VIX speaks to the level of investor complacency. Net earnings revisions remain close to the zero mark, although it is somewhat worrying that the earnings surprises index is slowly deteriorating. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500. 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. However, the widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking ahead, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. The composite technical indicator for the 10-year Treasury shows that oversold conditions are unwinding, although the indicator is not yet back to zero. This suggests that the consolidation period for bonds is not yet complete. Oversold conditions are almost completely gone in terms of the U.S. dollar. The dollar is very expensive on a PPP basis, although it is less so by other measures. We believe the dollar has more upside. Technical conditions are also benign in the commodity complex. However, we are only bullish on oil at the moment. 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 ##br##And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And 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 Chart III-27U.S. And Global Macro Backdrop ECONOMY: 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