Japan

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart I-1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart I-2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart I-1Markets Expect No Fed Hikes Beyond Next Year October 2018 October 2018 Chart I-2Fiscal Policy Is More Expansionary In ##br##The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart I-3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart I-4). Chart I-3U.S. Private-Sector Nonfinancial Debt Is ##br##Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart I-4U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart I-5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart I-6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart I-5The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth Chart I-6The Personal Savings Rate Has Room To Fall October 2018 October 2018 A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart I-7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart I-8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart I-9). Chart I-7Low Housing Inventories Will Support ##br##Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Chart I-8Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Chart I-9Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart I-10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart I-11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. Chart I-10U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards Chart I-11Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart I-12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart I-13). Chart I-12Banks Have Been Reducing Their ##br##Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Chart I-13Historically, The Dollar Has Moved ##br##In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart I-14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart I-15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart I-14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart I-15Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart I-16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart I-17). Chart I-16China: Debt And Capital ##br##Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand Chart I-17China: Rate Of Return On Assets ##br##Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. Chart I-18China Saves A Lot China Saves A Lot China Saves A Lot The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart I-18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart I-19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart I-20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart I-19The RMB Is Still Quite Strong The RMB Is Still Quite Strong The RMB Is Still Quite Strong Chart I-20USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart I-21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart I-22). Chart I-21Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Chart I-22Spain Most Exposed To Vulnerable EMs October 2018 October 2018 Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart I-23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart I-24). Chart I-23Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Chart I-24Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart I-25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart I-25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart I-26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart I-27). Chart I-26EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels Chart I-27EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart I-28), and a temporary countertrend decline in yields becomes quite probable. Chart I-28Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart I-29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart I-30). In contrast, China represents less than 15% of global oil demand. Chart I-29When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart I-30China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart I-31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart I-32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart I-31Canadian Dollar Still Somewhat ##br##Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart I-32Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin Chief Global Strategist Global Investment Strategy September 28, 2018 Next Report: October 25, 2018 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. APPENDIX A APPENDIX A CHART IMarket Outlook: Equities October 2018 October 2018 APPENDIX A CHART IIMarket Outlook: Bonds October 2018 October 2018 APPENDIX A CHART IIIMarket Outlook: Currencies October 2018 October 2018 APPENDIX A CHART IVMarket Outlook: Commodities October 2018 October 2018 APPENDIX B Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 II. Is It Time To Buy Value Stocks? Per the most commonly referenced growth and value indexes, growth has been outperforming value for over 11 years, the longest stretch in the history of the series. Growth's extended winning streak has split investors into two camps: those who believe that value is finished because of overexposure and shortened investor timeframes, and those who are trying to identify the point at which reversion to the mean will ensue. In this Special Report, we argue that the traditional off-the-shelf indexes are poor proxies for true value. Their methodology strays quite far from the principles enumerated by Benjamin Graham, the father of value investing, and Fama and French, the researchers who demonstrated that lower-priced stocks have outperformed over time. The headline S&P 500 indexes currently differentiate between growth and value stocks using simplistic metrics that introduce considerable sector bias, reducing the difference between growth and value to a binary choice between Tech and Financials. Using tools developed by BCA's Equity Trading Strategy service, we create sector-neutral U.S. value and growth indexes that correct for the off-the-shelf indexes' flaws, and broaden the range of metrics Fama and French employed to make style distinctions. The ETS-derived indexes appear to better distinguish between value and growth stocks. The ETS value-versus-growth portfolio beat its Fama and French counterpart by four percentage points annually over its 22-year life. We join our custom value and growth indexes to Fama and French's to study the impact of macro variables on relative style performance over time for the purpose of gaining insight into the most opportune points to shift between styles. Relative style performance has not corresponded consistently or robustly enough with the business cycle, inflation, interest rates, or broad market direction to support reliable style-decision rules. We find that monetary policy settings, as defined by our stylized fed funds rate cycle, are a consistently reliable predictor of relative style performance. Per the fed funds rate cycle, tight policy is most conducive to value outperformance. From this perspective, value's decade-long slump is not a surprise, given that the ultra-accommodative tide has been lifting all boats. There is no rush to increase value exposure while policy remains easy, but investors should look to load up on value once policy becomes tight, using the metrics in our ETS model to identify true value stocks. We expect that the policy inflection will occur sometime in the second half of 2019, or the first half of 2020. Growth stocks have been on a tear for the longest stretch in the history of the series, based on the most commonly referenced growth and value indexes, even if their gains haven't yet matched the magnitude of the 1990s (Chart II-1). It is no surprise, then, that growth stocks are as expensive as they have ever been, outside of the tech-bubble era in the late 1990s. Many investors are thus wondering if the next "big trade" is to bet on an extended reversion to the mean during which value regains the ground it has given up. Chart II-1A Lost Decade For Value Stocks A Lost Decade For Value Stocks A Lost Decade For Value Stocks In this Special Report, we argue that the traditional off-the-shelf indexes are not very good at differentiating growth from value stocks. Trends in relative performance have much more to do with sector performance than intrinsic value, making the indexes a poor proxy for investors who are truly interested in selecting stocks based on their value and growth profiles. We create U.S. value and growth indexes that are unaffected by sector performance, using stock selection software provided by BCA's Equity Trading Strategy service. The results will surprise readers who are used to dealing with canned measures of value and growth. What Is Value Investing? Value investing principles have been around at least since the days when Benjamin Graham was a money manager himself. Style investing has been a part of the asset-management lexicon for four decades. Yet there is no universally agreed-upon definition of a value stock versus a growth stock. Based on our reading of Graham's Intelligent Investor, we submit that an essential element of value investing is the identification of stocks that are temporarily trading below their intrinsic value. The temporary drag may persist for a while - stock markets can remain oblivious to fundamentals for extended stretches - but it is ultimately expected to dissipate. Value investing is a play on negative overreaction or neglect, and dedicated value investors have to be contrarians, not to mention contrarians with strong stomachs. The temporary nature of undervaluation is a recurring theme in Graham's book. The stock market's ever-present proclivity toward overreaction ensures a steady supply of value opportunities: "The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.1" "[W]hen an individual company ... begins to lose ground in the economy, Wall Street is quick to assume that its future is entirely hopeless and it should be avoided at any price.2" "[T]he outstanding characteristic of the stock market is its tendency to react excessively to favorable and unfavorable influences.3" Graham viewed security analysis as the comparison of an issue's market price to its intrinsic value. He advised buying stocks only when they trade at a discount to intrinsic value, offering an investor a "margin of safety" that should guard against significant declines. His favorite measure for assessing intrinsic value was a sober, objective estimate of average future earnings, grossed-up by an appropriate multiple. A low price-to-average-earnings ratio was the linchpin of his margin-of-safety mantra. Decades after Graham's heyday, University of Chicago professors Eugene Fama and Kenneth French bestowed the academy's seal of approval on value investing. Their landmark 1992 paper found that low price-to-book ("P/B") stocks consistently and convincingly outperformed high P/B stocks.4 Several "growth" and "value" indexes have been developed over the years, but they bear no more than a passing resemblance to Graham's, and Fama and French's, work. It is important to realize that the off-the-shelf indexes are far from an ideal proxy for the value factor that Fama & French tried to isolate. Traditional Growth And Value Indexes Are Wanting The off-the-shelf growth and value indexes shown in Chart II-1 all share similar cyclical profiles, with only small differences in long-term returns. Given the similarity of the indexes, we will focus on Standard & Poor's/Citigroup methodology for the purposes of this report.5 The headline S&P 500 indexes currently differentiate between growth and value stocks using the following metrics: 3-year growth rates in EPS, 3-year growth rates in sales-per-share, and 12-month price momentum; along with valuation yardsticks including price-to-book, price-to-earnings, and price-to-sales. Companies with higher growth rates in earnings and sales, and better price momentum, are classified as growth stocks, while those with lower valuation multiples are considered value stocks. Several stocks are cross-listed in both indexes, which is baffling and counterproductive for an investor seeking to implement a rigorous style tilt.6 Table II-1 contains a summary of the current sector breakdowns for the S&P 500 Growth and Value indexes. Table II-2 sheds light on each index's aggregate geographical and U.S. business cycle exposure, the former of which is based on our U.S. Equity Strategy service's judgment. Table II-1Current S&P 500 Style Index Exposures October 2018 October 2018 Table II-2The Value Index Has Less Global ##br##And Late Cyclical Exposure October 2018 October 2018 Growth is currently heavily weighted in Health Care, Technology and Consumer Discretionary sectors, while value has a high concentration of Financials, Energy and Consumer Staples (Table II-1). Table II-2 shows that the growth index has a clear current bias toward sectors with global economic exposure that typically outperform the broad equity market late in the business cycle. The value benchmark flips growth's global/domestic exposure, and has slightly more exposure to defensive sectors, while splitting its cyclical exposure evenly between early and late cyclicals. Sector Dominance Unfortunately, the reigning methodology creates a major problem - shifts in the relative performance of growth and value indexes are dominated by sector performance. Financials' higher debt loads, and banks' low-margin operations, depress their multiples relative to nonfinancial firms. Thus, Financials hold permanent residency in the off-the-shelf value indexes. Conversely, Tech stocks perennially account for an outsized proportion of most growth indexes' market cap. Value-versus-growth boils down to a binary choice between Financials and Tech.7 The growth/value price ratio has closely tracked the Technology/Financials price ratio since the late 1990s (Chart II-2, top panel). The correlation was much less evident before 1995, when Tech stocks accounted for a much smaller share of market capitalization. Chart II-3 demonstrates that the positive correlation between growth/value and Tech has steadily climbed over the decades to almost 1, while the correlation with Financials has become increasingly negative (currently at -0.75). Chart II-2The S&P 500 Style Indexes Merely Mimic Relative Sector Performance The S&P 500 Style Indexes Merely Mimic Relative Sector Performance The S&P 500 Style Indexes Merely Mimic Relative Sector Performance Chart II-3Style Capture Style Capture Style Capture In contrast, the Fama/French approach, which focuses exclusively on price-to-book while ensuring equal representation for large- and small-market-cap stocks, appears much less affected by sector skews; the growth/value index created from their data has not tracked the Tech/Financials ratio, even after 1995 (Chart II-2, second panel). Moreover, note that the extended downward trend in the Fama/French growth/value ratio is consistent with other academic research that shows that value stocks outperform growth over the long-term. The off-the-shelf indexes show the opposite, but that is because they are merely tracking the long-term outperformance of Tech relative to Financials. The bottom line is that the standard indexes incorporate flawed measures of growth and value that limit their usefulness for true style investing. Conventional Wisdom With respect to style investing and the economic cycle, the prevailing conventional wisdom holds that: Inflation - Growth stocks perform best during times of disinflation and persistently low inflation, whereas value stocks perform best during periods of accelerating inflation; Interest Rates - Periods of high and rising interest rates favor value stocks at the expense of growth; and Business Cycle - It is believed that growth stocks outperform value during recessions, because the latter tend to be more highly leveraged to the economic cycle than their growth counterparts. According to the conventional view, value stocks shine in the early and middle phases of a business cycle expansion. Growth stocks return to favor again in the late states of an expansion, when investors begin to worry about the pending end to the business cycle and are looking for reliable and consistent earnings growth. Do the traditional measures of growth and value corroborate this conventional wisdom? Chart II-4 shows that the S&P value/growth index and headline CPI inflation have both trended lower since the early 1980s, but there has been no tendency for value to outperform when inflation rises. Value has shown some tendency to outperform during rising-rate phases since the mid-1980s, but the relationship with the level of the fed funds rate is stronger than its direction, as we discuss below. The growth-over-value relationship with the business cycle is complicated by the tech bubble in the late 1990s, which heavily distorted relative sector performance. The Citigroup measure of growth began to outperform very late in the cycle and through the subsequent recession in some business cycles (1979-1981, 1989-1991, and 2007-2009; Chart II-5). The early and middle parts of the cycles, however, were a mixed bag. Chart II-4Spiting The Conventional Wisdom Spiting The Conventional Wisdom Spiting The Conventional Wisdom Chart II-5No Consistent Relationship With The Business Cycle No Consistent Relationship With The Business Cycle No Consistent Relationship With The Business Cycle The bottom line is that there appears to be some rough correspondence between the Citigroup index and the interest rate and growth cycles, but it is too variable to point to reliable rules for shifting between styles. Ultimately, determining the direction of the growth and value indexes is more about forecasting relative Tech and Financials performance than it is about identifying cheap stocks. A Better Value Approach We identify four broad shortcomings of off-the-shelf value indexes: They exclusively use trailing multiples, a rear-view mirror metric. They rely on simple price-to-book multiples, which flatter serial acquirers. They rely entirely on reported earnings, which are an imperfect proxy for cash flow. A share of stock ultimately represents a claim on its issuer's future cash flows. They make no attempt to place relative metrics into historical context. Without a mechanism to compare a particular segment's valuation relative to its history, structurally low-multiple stocks will be over-represented and structurally high-multiple stocks will be under-represented. BCA's Equity Trading Strategy (ETS) platform provides a way of differentiating value from growth stocks that avoids these problems. The web-based platform uses 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top decile of stocks ranked using the "BCA Score" methodology has outperformed stocks in the bottom decile by over 25% a year. The overall BCA Score includes all 24 factors when ranking stocks, but to develop our custom value index, we use only the five valuation measures in the ETS database: trailing P/E, forward P/E, price-to-tangible-book, price-to-sales and price-to-cash flow. Every quarter we rank the stocks within each of the 11 sectors based on an equally-weighted composite of the five valuation measures. Note that we are using the data to rank stocks only against other stocks in the same sector. We calculate the total return from owning the top 30% of stocks by value in each sector. We do the same with the bottom 30% and refer to this as our "growth" index.8 We then compute an equally-weighted average of the total returns for the growth indexes across the 11 sectors. We do the same for the value indexes. By comparing stock valuation only to other stocks in the same sector, this approach avoids the sector composition problem suffered by the off-the-shelf measures. Chart II-6 compares the ETS value/growth total return index to the Fama/French value/growth index. Data limitations preclude comparing the two measures before 1996, but the ETS index confirms the Fama/French result that value trumps growth over the long term. The ETS index follows a similar cyclical profile to the Fama/French index from 1997 to 2009, rising and falling in tandem. The two series subsequently diverge: per the criteria ETS uses to identify value and construct an index, lower-priced stocks have outperformed higher-priced ones for most of this expansion, while the Fama/French methodology suggests the reverse. Chart II-6The ETS Model Builds On Fama And French's Work The ETS Model Builds On Fama And French's Work The ETS Model Builds On Fama And French's Work By avoiding sector composition problems and using a wider variety of value measures, the ETS approach appears to be a superior measure of value. An investor that consistently over-weighted value stocks according to the ETS approach would have outperformed someone who did the same using the Fama methodology by an annual average of four percentage points from 1996 to 2018. The history of our ETS index only covers two recessions, limiting our ability to gauge its performance vis-Ã -vis a variety of macro factors, so we extend the ETS index back to 1926 using the Fama/French index. While joining two indexes with different methodologies is less than ideal, we feel the drawbacks are outweighed by the benefit of observing growth and value relative performance across more business cycles. The top panel of Chart II-7 shows U.S. real GDP growth, shaded for recessions. The bottom panel presents our extended ETS value/growth index, shaded for declines of more than 10%. The shaded periods overlap in many, but not all, cycles (indicated by circles in the chart). That is, growth stocks have tended to outperform during economic downturns, although this is not a hard-and-fast rule. Chart II-7No Hard-And-Fast Relationship With The Business Cycle... No Hard-And-Fast Relationship With The Business Cycle... No Hard-And-Fast Relationship With The Business Cycle... Value-over-growth relative returns exhibit some directionality with the overall equity market when looking at corrections (peak-to-trough declines of at least 10%, as shaded in the top panel of Chart II-8), though it should be noted that it is nearly impossible to flag a correction in advance. The relationship weakens when considering bear markets, i.e. peak-to-trough declines of at least 20%, which can be forecast with at least some reliability.9 The bottom panel is the same as in Chart II-7; the extended ETS index, shaded for periods of significant value stock underperformance. The correspondence between the shaded periods is hardly perfect, and there does not appear to be a practical style exposure message, even if an investor could call corrections in advance. Chart II-8...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years ...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years ...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years Valuation Relative valuation also provides some useful information on positioning, though it is not always timely. Chart II-9 presents an aggregate valuation measure for the stocks in our value index relative to that of the stocks in our growth index. Value stocks are expensive relative to growth when the valuation indicator is above +1 standard deviation, and value is cheap when the indicator is less than -1 standard deviation. Historically, investors would have profited if they had over-weighted value stocks when the valuation indicator reached the threshold of undervaluation, although subsequent outperformance was delayed by as much as a year in two episodes. In contrast, the valuation indicator is not useful as a 'sell' signal for value stocks because they can remain overvalued for long periods. Value was overvalued relative to growth for much of the time between 2009 and 2016. Value stocks have cheapened since then, although they have yet to reach the undervaluation threshold. The Fed Funds Rate Cycle While relative style performance may generally lean in one direction or another in conjunction with the business cycle, inflation, interest rates, or broad equity-market performance, there are no hard-and-fast rules. It is difficult to formulate any sort of rotation view between styles, and history does not inspire confidence that any such rule would generate material outperformance. The monetary policy backdrop offers a path forward. We have found the fed funds rate cycle offers a consistent guide to equity and bond returns in other contexts, and our Global ETF Strategy service has found a robust link between the policy cycle and equity factor performance.10 We segment the fed funds rate cycle into four phases, based on whether or not the Fed is hiking or cutting rates, and whether policy is accommodative or restrictive (Chart II-10). Our judgment of the state of policy is derived from comparing the fed funds rate to our estimate of the equilibrium fed funds rate, the policy rate that neither encourages nor discourages economic activity. Chart II-9Sizeable Undervaluation Flags Turning ##br##Points, But You May Have To Wait A While Sizeable Undervaluation Flags Turning Points, But You May Have To Wait A While Sizeable Undervaluation Flags Turning Points, But You May Have To Wait A While Chart II-10The Fed Funds Rate Cycle October 2018 October 2018 As defined by Fama and French, value stocks outperform growth stocks by a considerable margin when monetary policy is restrictive (Table II-3 and Chart II-11, top panel). Considering value and growth stocks separately, both perform extremely well when policy is easy (Chart II-11, second panel), but growth stocks barely advance when policy is tight, falling far behind their value counterparts. A strategy for generalist investors may be to seek out value exposure when policy is tight, while investing without regard to styles when it is easy. Table II-3The State Of Monetary Policy Is The ##br##Best Guide To Style Performance October 2018 October 2018 Chart II-11The State Of Monetary Policy Drives Style Performance The State Of Monetary Policy Drives Style Performance The State Of Monetary Policy Drives Style Performance Investment Conclusions: U.S. equity sectors that have traditionally been considered "growth" have outperformed value sectors for an extended period. The long slump has led some investors to argue that value investing is finished, killed by a combination of overexposure and short-term performance imperatives. Other investors see value's long drought as an anomaly, and are looking for the opportune time to bet on a reversal. We are in the latter camp. The difficulty lies in finding an indicator that reliably leads value stocks' outperformance. Most macro measures are unhelpful, though broad market direction offers some insight, as stocks with low price-to-book multiples have outperformed their high-priced peers by a wide margin during bear markets. Bear markets aren't the most useful timing guide, however, because one only knows in retrospect when they begin and end. The monetary policy backdrop holds the most promise as a practical guide. Although our determination of easy or tight policy turns on the modeled estimate of a concept and should not be looked to for absolute precision, it has provided a timely, reliable guide to value outperformance. We expect the relationship will persist because of the cushion provided by less demanding multiples. Earnings and multiples surge when policy is easy, lifting all boats. It is only when policy is tight, and the tide is going out, that the margin of safety offered by lower-priced stocks yields the greatest benefit. Per our estimate of the equilibrium fed funds rate, we are still firmly ensconced within Phase I of the policy rate cycle, and expect that we will remain there until sometime in the second half of 2019. We therefore expect that value, in Fama and French terms, will continue to underperform growth for another year. The clock is ticking for growth, though, as the expansion is in its latter stages and building inflation pressures will likely force the Fed to take a fairly hard line in this rate-hiking cycle. Once monetary policy turns restrictive, investors should hunt for value candidates using a range of valuation metrics, and combine them in a sector-neutral way, as we have via our Equity Trading Strategy service's model. Mark McClellan Senior Vice President The Bank Credit Analyst Doug Peta Senior Vice President U.S. Investment Strategy 1 Graham, Benjamin, The Intelligent Investor, Harper Collins: New York, 2005, p. 97. 2 Ibid, p. 15. 3 Ibid, p. 189. 4 Fama, Eugene F. and French, Kenneth R., "The Cross-Section of Expected Stock Market Returns," The Journal of Finance, Volume 47, Issue 2 (June 1992), pp. 427-465. 5 S&P currently brands its Growth and Value Indexes as S&P 500 Dow Jones Indexes, but Citigroup has the longest history of compiling S&P 500 Growth and Value Indexes, beginning in 1975, so we join the Citigroup S&P 500 style indexes to the Standard & Poor's series to obtain the maximum style-index history. We use the terms Citigroup and S&P interchangeably. 6 The Pure Value and Pure Growth indexes include only the top quartile of value and growth stocks, respectively, with no overlap between indexes, and are therefore better gauges of true style investing. 7 The Tech-versus-Financials cast of the indexes endures because all of the other sectors, ex-regulated Telecoms and Utilities, which account for too little market cap to make a difference, regularly move between the indexes as their fundamental fortunes, and investor appetites, wax and wane. The current Early Cyclical/Late Cyclical/Defensive profiles are not etched in stone and should be expected to shift, perhaps considerably, over time. 8 We created a second growth index by taking the top 30% of stocks ranked by earnings momentum. However, it made little difference to the results, so we will use the bottom 30% of stocks by value as our measure of "growth" for the purposes of this report, consistent with Fama/French methodology. 9 Please see The Bank Credit Analyst. September 2017, available on bca.bcaresearch.com 10 Please see the May 17, 2017 Global ETF Strategy Special Report, "Equity Factors And The Fed Funds Rate Cycle," available at getf.bcaresearch.com. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits remain potent enough to drown out scattered negative messages. Our Monetary Indicator remains at the low end of a multi-year range, suggesting that liquidity conditions have tightened. Our Composite Technical Indicator is in no-man's land, not far above the zero line that marks a sell signal, but coming close to issuing a buy signal by crossing above its 9-month moving average. Our Composite Sentiment Indicator is in a healthy position that suggests that the current level of investor optimism is sustainable. On the other hand, not one of our Willingness-to-Pay (WTP) Indicators is moving in the right direction. The U.S. version is still weak and slowly getting weaker; the European one has flat-lined; and our Japanese WTP extended its decline, albeit from a high level. Our Revealed Preference Indicator (RPI) for stocks continues to issue a sell signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, underlining the idea that caution is warranted. On balance, our indicators continue to suggest that the underlying supports of the U.S. equity bull market are eroding. Surging U.S. profits are papering over the cracks, and may still have some legs. Earnings surprises are at an all-time high, and the net revisions ratio remains elevated. The 10-year Treasury yield's march higher is due to run out of steam. Valuation (slightly cheap) and technicals (oversold by almost 2 standard deviations) imply that a countertrend pullback is not too far around the corner. Beyond a near-term correction, though, complacency about inflation and the Fed's ability to hike rates to at least the level of the FOMC voters' median projection points to looming capital losses. The dollar is quite expensive on a purchasing power parity basis, and its long-term outlook is not constructive, but policy and growth divergences with other major economies will likely keep the wind at its back in the near term. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Doug Peta Senior Vice President U.S. Investment Strategy

Highlights The Global Golden Rule (GGR): The gap between market expectations of global central bank policy rates and realized interest rate outcomes is a reliable predictor of government bond returns. Thus, "getting the policymaker call right" is the key to outperformance for bond investors. Implied Government Bond Yields: Given the strong correlation between policy rate surprises and government bond yield changes, we can use the GGR to forecast yields one year from now based on our own assumptions of how many rate hikes (cuts) will be delivered versus what is discounted in money market yield curves. Total Return Forecasts: We can use implied government bond yield changes from the GGR to generate expected 12-month total returns for government bond indexes of different maturities, taking into account different rate hike assumptions for various central banks. Feature Chart 1Global Monetary Divergences? Global Monetary Divergences? Global Monetary Divergences? This month marked the ten-year anniversary of the 2008 Lehman Brothers default, which set off a worldwide financial crisis and a massive easing of global monetary policy. Extraordinary measures - zero (or negative) interest rates, large-scale asset purchases and dovish forward guidance from policymakers - were all successful in suppressing both global bond yields and volatility over time, helping the global economy slowly heal from the crisis. Now, a decade later, such hyper-easy monetary policies are no longer required given low unemployment rates and rising inflation in the major developed economies. That can be seen today with the Federal Reserve shifting to "quantitative tightening" (letting bonds run off its swollen balance sheet) alongside steady rate hikes, the European Central Bank (ECB) set to stop net new buying of euro area bonds at year-end, and the Bank of Japan (BoJ) dramatically slowing its pace of asset purchases. BCA's Central Bank Monitors, which assess the cyclical pressure on policymakers to tighten or ease monetary policy, have collectively been calling for interest rate increases since the start of 2017. Yet our Central Bank Monetary Barometer, which measures the percentage of central banks that have tightened policy over the previous three months, shows that only 1 in 5 banks have actually delivered rate hikes of late (Chart 1). Thus, the risks are tilted towards more countries moving away from highly accommodative monetary conditions given tightening labor markets and rising inflation pressures. This now-global shift towards policy normalization has major implications for global bond investing. The focus is now returning back to more traditional drivers of government bond returns, like changes in central bank policy rates. We recently shared a Special Report published by our colleagues at our sister BCA service, U.S. Bond Strategy, describing a methodology they dubbed "The Golden Rule of Bond Investing".1 That report introduced a numerical framework that translates actual changes in the U.S. fed funds rate relative to market expectations into return forecasts for U.S. Treasuries. The historical results convincingly showed that investors who "get the Fed right" by making correct bets on changes in the funds rate versus expectations were very likely to make the right call on the direction of Treasury yields. In this Special Report, we extend that Golden Rule analysis to government bonds in the other major developed markets (DM). Our conclusion is that utilizing a "Global Golden Rule" (GGR) framework that links bond returns to unexpected changes in policy rates can help bond investors correctly forecast changes in non-U.S. bond yields. The report is set up in two sections. First, we illustrate how the GGR works and how it empirically tends to generally succeed over time for different DM bond markets. In the second section, we make use of the GGR to generate expected return forecasts for non-U.S. government bonds for a variety of interest rate "surprise" scenarios. ECB Policy Rate Surprises Dovish surprises from the ECB do reliably coincide with positive German government bond excess returns versus cash (Chart 2A). Chart 2AECB Policy Rate Surprise & Yields I ECB Policy Rate Surprise & Yields I ECB Policy Rate Surprise & Yields I Chart 2BECB Policy Rate Surprise & Yields II ECB Policy Rate Surprise & Yields II ECB Policy Rate Surprise & Yields II The 12-month ECB policy rate surprise and the 12-month change in the Bloomberg Barclays German Treasury index yield displays a strong positive correlation (Chart 2B). The excess returns during periods of dovish surprises is 14.4% on average and are positive 85% of the time. Hawkish surprises on the other hand, coincide with negative average excess returns of -1.5% (Chart 2C). In terms of total return, the picture is roughly the same except that under hawkish surprises, the average total return you would expect is now positive, given that it factors in coupon income (Chart 2D). Chart 2CGermany: Government Bond Index Excess Return & ECB Policy Rate Surprises (2004 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 2DGermany: Government Bond Index Total Return & ECB Policy Rate Surprises (2004 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Table 1Germany: 12-Month Government Bond Index Returns And Rate Surprises (2004 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Looking ahead, the ECB should not deviate from its current dovish forward guidance of no interest rate hikes until at least the third quarter of 2019. That is somewhat consistent with the reading of the ECB monitor being almost equal to zero. Bank Of England (BoE) Policy Rate Surprises The GGR works well for the U.K. as can be seen in Chart 3A. Chart 3ABoE Policy Rate Surprise & Yields I BoE Policy Rate Surprise & Yields I BoE Policy Rate Surprise & Yields I Chart 3BBoE Policy Rate Surprise & Yields II BoE Policy Rate Surprise & Yields II BoE Policy Rate Surprise & Yields II The 12-month BoE policy rate surprise and the 12-month change in the Bloomberg Barclays U.K. Treasury index yield displays a strong positive correlation except for a major divergence in 1997-1998 (Chart 3B). Dovish surprises coincide with positive excess returns over cash 78% of the time and are on average equal to 6.2% over the full sample (Chart 3C and Chart 3D). As you would expect if the GGR applies, hawkish surprises coincide with negative excess returns. Chart 3CU.K.: Government Bond Index Excess Return & BoE Policy Rate Surprises (1993 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 3DU.K.: Government Bond Index Total Return & BoE Policy Rate Surprises (1993 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Table 2U.K.: 12-Month Government Bond Index Returns And Rate Surprises (1993 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Looking ahead, outcomes will be biased toward dovish surprises over the next six months given the uncertain outcome of the U.K.-E.U. Brexit negotiations. Against that backdrop, the BoE will remain accommodative despite inflationary pressures building up. Bank Of Japan (BoJ) Policy Rate Surprises The GGR does not seem to work when it comes to the Japanese bond market. This reflects the fact that both the markets and the Bank of Japan (BoJ) have understood that chronic low inflation has required no changes in BoJ policy rates (Chart 4A, second panel). Chart 4ABoJ Policy Rate Surprise & Yields I BoJ Policy Rate Surprise & Yields I BoJ Policy Rate Surprise & Yields I Chart 4BBoJ Policy Rate Surprise & Yields II BoJ Policy Rate Surprise & Yields II BoJ Policy Rate Surprise & Yields II While the 12-month BoJ policy rate surprise and the 12-month change in the Bloomberg Barclays Japan Treasury index yield displayed a strong positive correlation pre-1998, the correlation has broken down since then (Chart 4B). Negative excess returns over cash both coincide with dovish and hawkish surprises, on average over time. Further, dovish surprises coincide with positive excess returns only 45% of the time (Chart 4C and Chart 4D). Chart 4CJapan: Government Bond Index Excess Return & BoJ Policy Rate Surprises (1994 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 4DJapan: Government Bond Index Total Return & BoJ Policy Rate Surprises (1994 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Table 3Japan: 12-Month Government Bond Index Returns And Rate Surprises (1994 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Looking ahead, given that the BoJ will in all likelihood maintain its ultra-accommodative monetary policy stance in the near future, we do not expect the GGR to become more effective when applied to the Japanese bond market. Bank Of Canada (BoC) Policy Rate Surprises The GGR works relatively well for the Canadian bond market (Chart 5A). Chart 5ABoC Policy Rate Surprise & Yields I BoC Policy Rate Surprise & Yields I BoC Policy Rate Surprise & Yields I Chart 5BBoC Policy Rate Surprise & Yields II BoC Policy Rate Surprise & Yields II BoC Policy Rate Surprise & Yields II We observe a tight correlation between 12-month BoC policy rate surprises and the 12-month change in the Bloomberg Barclays Canada Treasury index yield, especially post-2010 (Chart 5B). Dovish surprises coincide with positive excess returns 81% of the time and 94% of the time if we look at total returns (Chart 5C and Chart 5D). Chart 5CCanada: Government Bond Index Excess Return & BoC Policy Rate Surprises (1993 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 5DCanada: Government Bond Index Total Return & BoC Policy Rate Surprises (1993 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Table 4Canada: 12-Month Government Bond Index Returns And Rate Surprises (1993 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Looking ahead, the BoC will most likely continue to follow the tightening path of the Federal Reserve, admittedly with a lag. However, accelerating inflation at a time when there is no spare capacity in the Canadian economy suggests that the BoC could deliver more rate hikes than are already priced for the next 12 months. As shown in Table 4, hawkish surprises from the BoC do coincide with negative monthly excess returns of -2.8%. Reserve Bank Of Australia (RBA) Policy Rate Surprises The GGR applies extremely well to the Australian bond market (Chart 6A). Chart 6ARBA Policy Rate Surprise & Yields I RBA Policy Rate Surprise & Yields I RBA Policy Rate Surprise & Yields I Chart 6BRBA Policy Rate Surprise & Yields II RBA Policy Rate Surprise & Yields II RBA Policy Rate Surprise & Yields II The 12-month RBA policy rate surprise and the 12-month change in the Bloomberg Barclays Australia Treasury index yield displays the tightest correlation out of all the countries covered (Chart 6B). Dovish surprises coincide with positive excess returns 83% of the time and 96% of the time if we look at total returns (Chart 6C and Chart 6D). Turning to hawkish surprises, they reliably coincide with negative excess returns. Chart 6CAustralia: Government Bond Index Excess Return & RBA Policy Rate Surprises (1994 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 6DAustralia: Government Bond Index Total Return & RBA Policy Rate Surprises (1994 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Table 5Australia: 12-Month Government Bond Index Returns And Rate Surprises (1994 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing As can be seen on the bottom panel of Chart 6A, the RBA Monitor has been rapidly falling since 2016 and now stands in the "easier monetary policy" required. However, the RBA will likely have to see a rise in unemployment or a decline in realized inflation before it considers cutting rates, which raises a risk of "hawkish" surprises if the market begins to price in rate cuts. Reserve Bank Of New Zealand (RBNZ) Policy Rate Surprises The GGR works fairly well for Nez Zealand (NZ) government bonds (Chart 7A). Chart 7ARBNZ Policy Rate Surprise & Yields I RBNZ Policy Rate Surprise & Yields I RBNZ Policy Rate Surprise & Yields I Chart 7BRBNZ Policy Rate Surprise & Yields II RBNZ Policy Rate Surprise & Yields II RBNZ Policy Rate Surprise & Yields II 12-month RBNZ policy rate surprises and the 12-month change in the Bloomberg Barclays NZ Treasury yield exhibit a decent correlation (Chart 7B). Unusually, NZ is the only bond market covered in this report where both dovish and hawkish surprises coincide with positive excess returns on average, although positive episodes are much less frequent for hawkish surprises than for dovish surprises; respectively 55% and 86% (Chart 7C and Chart 7D). Chart 7CNZ: Government Bond Index Excess Return & RBNZ Policy Rate Surprises (2000 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 7DNZ: Government Bond Index Total Return & RBNZ Policy Rate Surprises (2000 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Table 6New Zealand: 12-Month Government Bond Index Returns And Rate Surprises (2000 - Present) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Looking ahead, the RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will most likely stay flat until 2020 - an assessment that we agree with, so the odds are against any policy surprises over at least the next 6-12 months. Using The Global Golden Rule To Forecast Government Bond Returns The practical application of the GGR is that it can be used as a framework for generating expected changes in yields and calculating total return forecasts for global government bond indices. The strong correlation demonstrated in the previous section between the 12-month policy rate surprises and the 12-month change in the average yield from the government bond indexes allows us to translate our "assumed" policy rate surprise over the next 12 months into expected changes in yields along the curve. With these expected yield changes, we can simply generate expected total returns using the following formula: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(DY2) E(DY2) = 1-year trailing estimate of yield volatility It is important to note that we would not give too much importance to what this analysis yields for longer-dated bonds. As shown in the Appendices, once we move into longer government bond maturities, the correlation between the policy rate surprise and the change in yields declines or even becomes non-existent for some countries. This result should not be surprising, as longer-term yields are driven by other factors besides simply changes in interest rate expectations. Inflation expectations, government debt levels and demand from longer-term investors like pension funds all can have a more outsized influence on the path of longer-term bond yields relative to the shorter-end. That results in much more uncertainty when it comes to the total return forecasts for long-dated maturities calculated with this framework. Practically speaking, we are not encouraging our readers to blindly follow that yield and return expectations generated by the GGR, even for bond markets where it clearly seems to be working over time. Rather, the GGR can be integrated in a larger asset-allocation framework for a global fixed-income portfolio by providing one possible set of bond market outcomes. On a total return basis, the results presented below, interpreted alongside the readings on the BCA Central Bank monitors, suggest that investors should be underweight core Euro Area (Germany, France and Italy), Australia and New Zealand while remaining overweight the U.K. and Canada over the next twelve months. As for Japan, given the likelihood that BoJ will leave its policy rate flat, the results hint at a neutral allocation. Jeremie Peloso, Research Analyst jeremie@bcaresearch.com Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com. 2 Please see Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: Divergences Opening Up," dated September 19, 2018, available at gfis.bcaresearch.com. Global Golden Rule: Germany In light of the forward guidance ECB President Mario Draghi has been providing to the markets, it appears that the most likely scenario over the next 12 months is for the ECB to keep interest rates on hold. Based on the strong relationships between 12-month ECB policy rate surprises and 12-month changes in yields along the curve (Appendix A), a flat interest rate scenario would be bond bearish for German government bonds especially at the short end of the curve with the 1-year German yield expected to rise by 16bps (Table 7A). Table 7AGermany: Expected Changes In Bund Yields Over The Next 12 Months (BPs) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Using the expected change in yields thus inferred by the policy rate surprise, the German government bond aggregate index is forecasted to return 0.45% over the next 12 months (Table 7B). Table 7BGermany: Government Bond Index Total Return Forecasts Over The Next 12 Months The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Global Golden Rule: U.K. Markets are currently discounting only 21bps of rate hikes in the U.K. over the next year. Thus, even a scenario where the BoE delivers only a single 25bp rate hike would be bearish for U.K. Gilts, especially at the short-end of the curve. Applying the GGR, 1- and 3-year Gilt yields would be expected to rise by 20bps and 10bps respectively (Table 8A). Table 8AU.K.: Expected Changes In Gilt Yields Over The Next 12 Months (BPs) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Interpolating these expected yield changes, the 1-3 year government bond index total return forecast would be 0.46%. On the other hand, if the BoE prefers to keep rates on hold given the uncertainty of the Brexit outcome, that same 1-3 year government bond index is forecasted to deliver 0.97% of total return over the next 12 months (Table 9B). This is our current base case scenario for Gilts. Table 8BU.K.: Government Bond Index Total Return Forecasts Over The Next 12 Months The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Global Golden Rule: Japan Despite many rumors to the contrary earlier this year, the base case view remains that the BoJ will not change its stance on monetary policy anytime soon. As such, the expected changes in JGB yields under a flat interest rate scenario over the next 12 months are close to zero at the short end of the curve and rather bond bullish at the longer end of the curve; for instance, the 30-year JGB yield would be expected to rally by 9bps (Table 9A). Table 9AJapan: Expected Changes In JGB Yields Over The Next 12 Months (BPs) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing In that most likely scenario, the Japanese government bond index is forecasted to deliver 0.83% of total return over the next 12 months. In the event that the BoJ surprises the markets by delivering one rate hike of 25bps, it would be bond bearish for JGBs and the total return forecasts for the government bond indices would be negative, regardless of the maturity (Table 9B). Table 9BJapan: Government Bond Index Total Return Forecasts Over The Next 12 Months The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Global Golden Rule: Canada Will the Bank of Canada follow the footsteps of the Fed? The markets certainly seem to think so, with more than three 25bps rate hikes priced in for next 12 months in the OIS curve. Table 10ACanada: Expected Changes In Government Bond Yields Over The Next 12 Months (BPs) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing That scenario would be outright bearish for Canadian government bonds, with 1- and 2-year yields rising by 16bps and 21bps, respectively (Table 10A). In terms of total returns, the GGR framework forecasts that with 75bps of rate hikes, the Canadian government bond aggregate index would deliver a positive return of 2.35% (Table 10B). This is because 75bps of hikes are currently discounted in the Canadian OIS curve, thus it would neither be a hawkish nor dovish surprise. Table 10BCanada: Government Bond Index Total Return Forecasts Over The Next 12 Months The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Global Golden Rule: Australia The RBA Monitor just dipped below the zero line, implying that easier monetary policy is required based on financial and economic data. Table 11A shows that a rate cut delivered by the RBA in the next 12 months would be bond bullish for Aussie yields, especially at the long end of the curve, where the 30-year Aussie bond yield would fall by 34bps. Table 11AAustralia: Expected Changes In Aussie Yields Over The Next 12 Months (BPs) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Of all the interest rate scenarios presented in Table 11B, the two rate cut scenarios would return the highest total returns. For instance, the Australian government bond aggregate index would return 2.80% and 3.90% in the event of one and two 25bps rate hikes, respectively. Table 11BAustralia: Government Bond Index Total Return Forecasts Over The Next 12 Months The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Global Golden Rule: New Zealand Our view is that the Reserve Bank of New Zealand will stay on hold for a while longer, which is broadly the same message conveyed by the RBNZ Monitor being positive, but very close to 0. With that in mind, a flat interest rate scenario appears to be bond bearish for the NZ bond yields, except for the longer end of the curve (Table 12A). Table 12ANew Zealand: Expected Changes In NZ Yields Over The Next 12 Months (BPs) The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Table 12BNew Zealand: Government Bond Index Total The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing For New Zealand, the government bond aggregate bond index is the only index provided by Bloomberg Barclays, as opposed to the other countries in our analysis where different maturities are given. In the flat interest rate scenario, the total return forecast for the overall index would be of 2.53% over the next 12 months. Appendix A: Germany Chart 1Change In 1-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 2Change In 2-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 3Change In 3-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 4Change In 5-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 5Change In 7-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 6Change In 10-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 7Change In 30-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Appendix B: France Chart 8Change In 1-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 9Change In 2-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 10Change In 3-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 11Change In 5-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 12Change In 7-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 13Change In 10-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 14Change In 30-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Appendix C: Italy Chart 15Change In 1-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 16Change In 2-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 17Change In 3-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 18Change In 5-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 19Change In 7-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 20Change In 10-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 21Change In 30-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Appendix D: U.K. Chart 22Change In 1-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 23Change In 2-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 24Change In 3-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 25Change In 5-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 26Change In 7-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 27Change In 10-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 28Change In 30-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Appendix E: Japan Chart 29Change In 1-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 30Change In 2-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 31Change In 3-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 32Change In 5-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 33Change In 7-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 34Change In 10-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 35Change In 30-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Appendix F: Canada Chart 36Change In 1-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 37Change In 2-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 38Change In 3-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 39Change In 5-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 40Change In 7-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 41Change In 10-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 42Change In 30-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Appendix G: Australia Chart 43Change In 1-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 44Change In 2-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 45Change In 3-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 46Change In 5-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 47Change In 7-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 48Change In 10-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Appendix H: New Zealand Chart 49Change In 1-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 50Change In 2-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 51Change In 3-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 52Change In 5-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 53Change In 7-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing Chart 54Change In 10-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise The Global Golden Rule Of Bond Investing The Global Golden Rule Of Bond Investing

Highlights The U.S. dollar is likely to correct further over the coming weeks. The CAD should benefit as it is cheap and oversold, and the inflationary back-drop warrants tighter monetary conditions. This will be a bear market rally, not the ultimate trough for the loonie. EUR/SEK should correct as the Riksbank will start tightening policy in December; a pause in the global growth slowdown should also give the cheap SEK a welcome boost. Cheap long-term valuations will not help the yen in the coming weeks; instead, falling Japanese inflation expectations and growing investor expectations of Chinese stimulus will weigh on the JPY. A better opportunity to buy the yen on its crosses will emerge later this year. EUR/CHF has upside over the coming months; the swissie needs additional global growth weakness to rally further. This is unlikely to happen for a few months. Feature Chart I-1DXY Correction Has Further To Run DXY Correction Has Further To Run DXY Correction Has Further To Run By the middle of the summer, the dollar had hit massively overbought levels, which left it vulnerable to any signs of stabilization in global growth, especially if some key U.S. activity gauges began to soften (Chart I-1). This is exactly what is transpiring. As we highlighted last week, BCA's Global LEI Diffusion Index is rebounding, EM and Japanese exports are stabilizing and U.S. core inflation and building permits have disappointed. This bifurcation in the data suggests the dollar has more room to correct, as neither our Capitulation Index nor our Intermediate-Term Technical Indicator have hit technically oversold levels. Last week we also argued that this correction in the dollar is likely to prove a temporary reprieve, but that in the interim the euro and the Australian dollar were well placed to experience significant rebounds.1 This week, we explore if the same case can be built for the Canadian dollar, the Swedish krona, the yen and the Swiss Franc. CAD: The Bank of Canada Will Proceed Cautiously The first half of 2018 has not been kind to the Canadian dollar. A rout in EM assets, signs of softening global growth and tough rhetoric from the White House on trade generally and NAFTA and Canada in particular have conspired to create fertile grounds for loonie-selling. Since the end of June, the CAD has managed to regain some composure, rallying by 3.3% against the USD. Essentially, much bad news has been embedded in this currency, which now trades at a significant discount to BCA's estimate of its short-term fair value (Chart I-2). Moreover, speculators, who had been aggressively buying the CAD at the end of 2017, now hold large short positions in the currency (Chart I-2, bottom panel). This combination is now resulting in a situation where any pause in the USD's strength is being mirrored in CAD strength. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Chart I-2No One Is Going Crazy For The Loonie No One Is Going Crazy For The Loonie No One Is Going Crazy For The Loonie Chart I-3Canada: Growth Picture Is Mixed Canada: Growth Picture Is Mixed Canada: Growth Picture Is Mixed The weakness in Canadian consumption partly reflects the underperformance of Canadian employment relative to the U.S. However, the slowdown in house prices has played a bigger role (Chart I-4). Canadian households are burdened by a debt load of 170% of disposable income. Now that mortgage rates are rising, Canadians are spending more than 14% of their disposable income servicing their debt, a burden last experienced in 2008 when mortgage rates were 220 basis points higher. Without the benefit of rapidly rising real estate assets, it is much more difficult for Canadian retail sales to grow at an 8.7% annual rate as they did three quarters ago. Despite these weaknesses, it is hard to justify that Canadian monetary conditions - as approximated by the slope of the yield curve, the level of real rates, and the trade-weighted CAD - should be as easy as they are today (Chart I-5). This is even truer when we take into account Canadian inflationary conditions. Chart I-4Canadian Consumers Have A Problem Canadian Consumers Have A Problem Canadian Consumers Have A Problem Chart I-5Canadian Monetary Conditons Are Very Easy Canadian Monetary Conditons Are Very Easy Canadian Monetary Conditons Are Very Easy The three inflation gauges targeted by the Bank of Canada stand between 1% and 3%, or at its objective. This means that the BoC's 1.5% policy rate is negative in real terms. Moreover, this inflationary pressure is unlikely to abate. The BoC estimates that the output gap has closed, and companies are running into growing capacity constraints (Chart I-6, top panel). Despite a correction last month, wages are in an uptrend, powered by growing and severe labor shortages (Chart I-6, bottom panel). Thanks to these conditions, we anticipate that the BoC will track the pace of rate increases by the Federal Reserve over the next 12 months. This is not very different from what is currently priced into Canadian money markets. Chart I-6Canadian Capacity Pressures Point To A Hawkish ##br##BoC Inflation Will Force The BoC's Hand Canadian Capacity Pressures Point To A Hawkish BoC Inflation Will Force The BoC's Hand Canadian Capacity Pressures Point To A Hawkish BoC Inflation Will Force The BoC's Hand If the BoC does not disappoint, the combination of a cheap and oversold CAD should help the loonie rally against the USD, so long as the current stabilization in global growth continues. A move toward USD/CAD 1.26 is likely. The biggest risk to this view is that trade negotiations between the U.S. and Canada deteriorate further. While we do not anticipate an imminent breakthrough in these negotiations, we do not see much scope for significant deterioration in the relationship either. The energy market could prove to be another positive for the loonie. Bob Ryan, who leads BCA's Commodity and Energy Strategy service, argues that the oil market is currently very tight and vulnerable to supply disruptions.2 Under these circumstances, the removal of Iranian exports, tensions in Iraq, declining Nigerian production and Venezuela's cascading implosion all risk causing a melt-up in oil prices by the first half of 2019. This could help the CAD as well, even if the Canadian oil benchmark remains at a large discount to Brent. Longer-term, the upside in the CAD is likely to be capped. There is only one rate hike priced into the U.S. OIS curve from June 2019 to December 2020. We expect the Fed to hike rates by more than that. Meanwhile, the emerging softness in the Canadian household sector suggests it will be much more difficult for the BoC to keep following the Fed higher over that period. The CAD is not cheap enough to compensate for these long-term headwinds (Chart I-7). Bottom Line: On a short-term basis, the Canadian dollar is cheap and oversold. While the Canadian consumer has begun to disappoint, the inflationary pressures present in Canada should keep the BoC on track to follow the Fed and push rates higher over the coming 12 months. The CAD should therefore benefit from any USD weakness, with USD/CAD moving toward 1.26. Once the short-term undervaluation and oversold conditions are corrected, USD/CAD should rebound toward 1.40. Chart I-7We Like The CAD For Now, But The Rally Has A Limited Shelf Life We Like The CAD For Now, But The Rally Has A Limited Shelf Life We Like The CAD For Now, But The Rally Has A Limited Shelf Life EUR/SEK Will Trade Heavy Any which way we cut it, the SEK is cheap. The trade-weighted krona is trading at its cheapest levels relative to BCA's long-term fair value since the Great Financial Crisis (Chart I-8). The SEK is not only trading at a 32% discount to its purchasing-power parity against the greenback, it is also trading at a 10% discount against its PPP relative to the euro. Chart I-8The SEK Is An Attractive Long-Term Buy... The SEK Is An Attractive Long-Term Buy... The SEK Is An Attractive Long-Term Buy... The SEK is not only cheap on a long-term basis, it is also cheap on a short-term basis. This is most evident against the euro. Currently the SEK trades at a 7% discount to the euro according to our short term fair value model based on real rate differentials, commodity prices and global risk aversion. Historically, this kind of discount in the SEK has been followed by a prompt rebound (Chart I-9). Are there any catalysts to convert this good value into good returns? We see many. First, as was the case in Canada, Sweden's Monetary Gauge has not been at such easy levels since the Great Financial Crisis (Chart I-10). Meanwhile, the economy is also experiencing rising capacity pressures. The OECD's estimate of the output gap stands at 0.7% of GDP, and inflationary pressures are building, as evidenced by the Riksbank's Capacity Utilization measure (Chart I-11). Chart I-9...And A Short-Term One As Well ...And A Short-Term One As Well ...And A Short-Term One As Well Chart I-10The Riksbank Is Too Easy The Riksbank Is Too Easy The Riksbank Is Too Easy Chart I-11Swedish Inflation Has Upside Swedish Inflation Has Upside Swedish Inflation Has Upside This set of circumstances suggests the Riksbank could start hiking rates as early as this coming December, well ahead of the European Central Bank. As a result, we project that Swedish real interest rates could rise further relative to the euro area. Historically, falling euro area / Swedish real interest rate spreads precede depreciations in EUR/SEK (Chart I-12). Chart I-12Real Rate Differentials Point To A Lower EUR/SEK EUR/SEK AND REAL INTEREST RATE SPREAD*: EMU-SWEDEN FX.EURSEKTHEME Real Rate Differentials Point To A Lower EUR/SEK EUR/SEK AND REAL INTEREST RATE SPREAD*: EMU-SWEDEN FX.EURSEKTHEME Real Rate Differentials Point To A Lower EUR/SEK Chart I-13Chinese Liquidity Injections Point To A Lower EUR/SEK Chinese Liquidity Injections Point To A Lower EUR/SEK Chinese Liquidity Injections Point To A Lower EUR/SEK The global context also points toward an imminent correction in EUR/SEK. The krona is much more pro-cyclical than the euro. This reflects the more volatile nature of the Swedish economy and the extraordinarily large role of trade in its GDP. EUR/SEK greatly benefited from the tightening in Chinese liquidity conditions, as evidenced by the widening between the 1-month and 1-week Chinese interbank rate (Chart I-13). EUR/SEK essentially sniffed out a slowdown in Chinese capex, a key source of ultimate demand for Swedish goods. However, now that the PBoC is injecting liquidity in the Chinese interbank system, EUR/SEK is likely to suffer. Moreover, the outperformance of Chinese infrastructure and real estate stocks in recent weeks also suggests the SEK could appreciate further against the EUR. The rally of risk assets on the day that U.S. President Donald Trump announced an additional 10% tariff on US$200 billion worth of Chinese exports further confirms that investors may be in the process of discounting additional stimulus out of China, which would further hurt EUR/SEK. To be clear, we have already noted that we do not anticipate the Chinese authorities to attempt to boost growth - we only expect them to limit the damage created by an intensifying trade war with the U.S. As a result, the positive impact of China on the krona should prove transitory. But for the time being, it could be enough to help correct the SEK's 7% discount to the euro. Since we anticipate the USD to continue to correct in the coming weeks, this also implies that USD/SEK possesses ample tactical downside. This negative EUR/SEK view is not without risks. The first comes from the fact that the Swedish current account surplus is now smaller than the euro area's, something not seen since the early 1990s. This is mitigated by the fact that Sweden's net international investment position is now 10% of GDP, while it used to be negative as recently as 2015. The euro area NIIP is still in negative territory. The second risk is that Swedish house prices have begun to contract in response to macroprudential measures. However, we believe that Sweden's inflationary backdrop is likely to dominate the Riksbank's reaction function. Bottom Line: The SEK is cheap against the dollar and the euro on both long-term and short-term metrics. As the Riksbank is set to lift rates in December, we expect EUR/SEK to decline significantly. Recent injections of liquidity by the PBoC and growing expectations among investors of Chinese stimulus could create additional downward impetus under both EUR/SEK and USD/SEK. This is a tactical view. We anticipate the reprieve in the global growth slowdown to be temporary. Once it resumes, the SEK will find it difficult to rally further. JPY: Down Now, Up Later Investors are well aware that the yen is one of the cheapest G10 currencies on a long-term basis. BCA's long-term fair value model shows that the real trade-weighted yen is trading at a 17% discount, close to its cheapest levels in 36 years. However, despite its prodigious long-term cheapness, the yen is not nearly as attractive when compared to its short-term determinants, which show a small premium in the price of the yen versus the dollar (Chart I-14). This means the direction of Japanese monetary policy and global growth will remain more important for the yen's price action over the coming months than its long-term cheapness. When it comes to growth, Japan is doing okay. We witnessed a decline in industrial production driven by foreign demand this summer, but domestic machinery orders are improving and export growth is finding a floor. Actually, BCA's real GDP model for Japan is suggesting that growth could re-accelerate significantly next quarter (Chart I-15). In our view, this improvement reflects the fact that business credit is once again growing after decades of hibernation. Chart I-14Is The JPY A Bargain? Long Term, Yes; Short Term, No! Is The JPY A Bargain? Long Term, Yes; Short Term, No! Is The JPY A Bargain? Long Term, Yes; Short Term, No! Chart I-15Japanese Growth Doing Just Fine Japanese Growth Doing Just Fine Japanese Growth Doing Just Fine However, we doubt this is enough to prompt any tightening in the Bank of Japan's policy. The most immediate problem facing the BoJ is that Japanese inflation expectations are in free fall (Chart I-16). Since the BoJ assigns the blame of low realized inflation on depressed inflation expectations, this aforementioned weakness, despite the yen's softness, guarantees that the BoJ will stay on the sidelines for much longer. After all, if any little shock can spur such a sharp impact on Japanese inflation expectations, despite an unemployment rate at 2.5% and an output gap at 0.8% of GDP, the BoJ has not anchored inflation expectations higher. Further reinforcing our bias that the BoJ is not set to tighten policy for many more quarters, the VAT is set to be increased to 10% in October 2019. The LDP leadership race is currently underway, and no one is mentioning postponing that hike. This suggests that significant fiscal tightening could emerge next year. The fact that the BoJ will continue to lag behind other global central banks forces us to be negative on the yen. However, could an external event push the yen higher, despite this absence of domestic support? A big downgrade in EM asset prices and global growth would do the trick. While we do think this is likely to happen over the next six to nine months, now does not appear to be the moment to implement such a bet. As we highlighted above, the deceleration in global growth seems to be pausing, and Chinese liquidity conditions have eased. Seven weeks ago, we introduced our China Play Index to track whether or not investors were discounting additional easing on the part of China.3 This indicator looks as if it is forming a base right now (Chart I-17), indicating that pro-growth plays could perform well over the coming weeks while countercyclical plays, like the yen, could perform poorly. Until this indicator begins a new down leg - something we anticipate for the backend of the year - the yen will remain under downward pressure against the dollar, the euro or the aussie. Chart I-16The BoJ's Problem The BoJ's Problem The BoJ's Problem Chart I-17Chinese Plays Are Stabilizing Chinese Plays Are Stabilizing Chinese Plays Are Stabilizing As a result, while we continue to expect more upside in the yen in the latter part of the year, for the time being we will remain on the sidelines as neither short-term valuations, monetary policy dynamics or the global growth environment point to an imminent rally in the yen. Bottom Line: The yen is an attractive long-term play as it displays prodigiously cheap long-term valuations. However, the short-term outlook is less favorable. The yen is not cheap enough based on our augmented interest rate differentials models, the BoJ will remain dovish for the foreseeable future, and an uptick in our China Play Index bodes poorly for countercyclical currencies like the yen. However, since we do expect that global growth will stabilize only on a temporary basis, we will look to open some long yen bets later this fall. Close Short EUR/CHF Trade Last March, we argued that EUR/CHF had more cyclical upside, but that bouts of volatility in global markets would cause periods of weaknesses in the cross.4 Based on this insight, we proceeded to sell EUR/CHF on April 6 as we worried that markets were set to price in a period of weakness in global growth.5 We closed this trade in August, but EUR/CHF kept falling. Now, is EUR/CHF more likely to rally or selloff in the coming quarter? We think a rebound is in the cards. First, the franc is once again highly valued, based on the Swiss National Bank's assessment. It is true that the SNB has not intervened to limit the franc's upside recently, but the CHF's strength is likely to short-circuit the increase in inflation that could have justified betting on the Swissie moving higher (Chart I-18). Ultimately, there is limited domestic inflationary pressures in Switzerland. Moreover, since the import penetration of goods and services in Switzerland is the highest of all the G10, imported deflation will soon be felt. Further, as Swiss labor costs remain very high internationally, the large improvement in full-time jobs witnessed this year is likely to peter off as Swiss businesses work to maintain their competitiveness. Second, the franc received an additional fillip this year as the breakup risk premium in Europe surged (Chart I-19). Every time investors perceive that the probability of a disintegration of the euro rises, they end up pouring money into stable Switzerland. Marko Papic, BCA's Geopolitical Strategy expert, believes that the euro break-up risk will continue to be a red herring in the coming few years. Investors will therefore price out this risk, pulling money out of Switzerland where interest rates remain 30 basis points below the euro area, and boosting EUR/CHF in the process. Chart I-18The Swissie's Strength Will Be Deflationary The Swissie's Strength Will Be Deflationary The Swissie's Strength Will Be Deflationary Chart I-19If A Euro Break-Up Is A Red Herring... If A Euro Break-Up Is A Red Herring... If A Euro Break-Up Is A Red Herring... Finally, if a temporary stabilization in global growth will hurt the yen, it will also hurt the Swiss franc. As a result, the stabilization in the China Play Index should support EUR/CHF. While we expect EUR/CHF to rally over the coming months, we worry that any such rebound will prove temporary. The current expansion in Chinese stimulus is only a passing phenomenon, and not one powerful enough to put a durable bottom under global growth and EM assets. Hence, while EUR/CHF could easily rally to 1.15, any such rebound should be faded. This move, if followed by a deterioration in our China Play Index, should be used to re-open EUR/CHF shorts. Bottom Line: The Swiss franc remains in a cyclical bear market, punctuated by occasional rallies against the euro when global growth sentiment sours. We just experienced such a rally in the Swissie, but it is ending as the deflationary impact of the CHF's rally will soon be felt. Moreover, the breakup risk premium in the euro is currently too large, and the pricing-in of slowing global growth is likely to take a breather. As a result, EUR/CHF is likely rally over the coming months. We will look to bet again on a CHF rally once the reprieve in global growth ends. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergence Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: Retail sales and retail sales ex autos yearly growth underperformed expectations, coming in at 0.1% and 0.3% respectively. Capacity utilization and building permits also surprised to the downside, coming in at 78.1% and 1.229 million respectively. However, Housing starts and the Michigan Consumer Sentiment Index surprised positively, coming in at 9.2% and 100.8 respectively. DXY has fallen by nearly 1% this week. Overall, we continue to be bullish on the dollar on a cyclical basis, as inflationary pressures inside the U.S. will force the Fed to hike more than the market expects. That being said, the slowdown in the dollar's momentum, the growing Chinese stimulus, and accumulating signs of stabilizing global economic activity are likely to further weigh on the dollar on a more immediate basis. We will monitor these factors closely in order to gauge whether or not this pullback will remain a garden-variety correction or something more serious. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area has been positive: Labor costs growth outperformed expectations, coming in at 2.2%. Moreover, construction output yearly growth also surprised positively, coming in at 2.6%. Finally, both core and headline inflation came in line with expectations, at 1% and 2% respectively. EUR/USD has rallied by 1.1% this week We are bearish on the cyclical outlook for the euro, given that core inflation measures are continue to be too weak for the ECB to meaningfully change their dovish monetary policy stance. However, the current tactical rebound is likely to continue, as the weakness in the euro this year has eased financial conditions, which could lead to a temporary boon for the economy. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Industrial production yearly growth surprised negatively, coming in at 2.2%. Moreover, capacity utilization also underperformed expectations, coming in at -0.6%. Finally, both export and import yearly growth outperformed expectations, coming in at 6.6% and 15.4% respectively. USD/JPY has been relatively flat this week. We are bearish on the yen on a structural basis, given that the economy continues to suffer from strong deflationary forces, which will force the Bank of Japan to keep their ultra-easy monetary policy. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been positive: The retail price index yearly growth surprised to the upside, coming in at 3.5%. Moreover, both core and headline inflation outperformed expectations, coming in at 2.1% and 2.7% respectively. Finally, the DCLG House Price Index also surprised positively, coming in at 3.1%. GBP/USD has rallied by roughly 1.5% this week. The GBP's vol is likely to increase further going foirward, as very little political risks is priced into it. A practical strategy will be to lean against large weekly moves, both on the upside and downside. This strategy should be particularly profitable versus the euro. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been positive: The participation rate surprised to the upside, coming in at 65.7%. Moreover, the total change in employment also outperformed expectations, coming in at 44 thousand. Finally, the house price index yearly growth also surprised positively, coming in at -0.6%. AUD/USD has risen by roughly 1.8% this week. We continue to be cyclically bearish on the Australian dollar, as the deleveraging campaign in China will weigh on demand for industrial metals, Australia's main export. Moreover, the AUD will also have downside against the CAD, as oil should continue to hold up relative to other commodities thanks to supply cuts from OPEC. That being said, the AUD's recent rebound is likely to continue on a short-term basis. Hence, investors already shorting the Aussie should consider buying hedges. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 NZD/USD has rallied nearly 1.9% this week. We are negative on the New Zealand dollar on a structural basis due to the measures taken by the Ardern government, which include reducing immigration, and adopting_a dual mandate for the RBNZ. Both of these measures will weigh on the real neutral rate, which means that the RBNZ will have to hold rates lower than otherwise. However, on a more tactical basis, this cross could rally, thanks to the temporary stimulus by the Chinese authorities which will help risk assets. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been mixed: Manufacturing shipments monthly growth outperformed expectations, coming in at 0.9%. However, capacity utilization surprised to the downside, coming in at 85.5%. Finally, the new house price index yearly growth was in line with expectations, coming in at 0.5% USD/CAD has depreciated by 1% this week. We remain bullish on the CAD among the dollar bloc currencies, given that inflationary pressures continue to be strong in Canada. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has rallied by 0.5% this week. We continue to be bullish on this cross on a cyclical basis, as the Swiss economy is still too fragile for the SNB to remove its ultra-dovish monetary stance. Moreover, the recent appreciation in the franc that has taken place over the last four months should be very negative for inflation, as Switzerland is the country with the most imports as a percentage of demand in the G10, and thus the country with the most sensitive inflation to currency movements. Finally, on a tactical basis we are also bullish on this cross, as the recent easing of monetary policy by Chinese authorities should be weigh on safe heaven assets like the franc. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Yesterday, Norges Bank increased rates for the first time since 2011, yet the NOK was flat against a weak USD, and fell against the euro and the Swedish krona, suggesting that the hike was well anticipated by market participants. Despite this price action, USD/NOK has depreciated by 1.2% this week. We are positive on the NOK against other non-oil commodity currencies, as oil should outperform base metals in the current environment. After all, OPEC supply cuts and geopolitical risk in the Middle East should provide a boon for oil prices. On the other hand, while temporary easing is likely, the Chinese deleveraging campaign will continue once the Chinese economy has stabilized. Finally, the positive NIIP, and positive current account of the NOK should give it an additional advantage against the rest of the commodity currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been negative: Headline inflation underperformed expectations, coming in at 2%. Moreover, the unemployment rate increased from 6% in July to 6.1% on the August reading. USD/SEK has depreciated by almost 2.8% this week. We expect the Riksbank to begin tightening policy in December, as Swedish inflationary pressures remain strong. Moreover, the recent stimulus from the PBoC should put additional downward pressure on EUR/SEK, given the krona's more pro-cyclical profile than the euro. Finally, valuations also support the SEK, as the krona is cheap according to multiple measures. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. The message now conveyed by the Monitors is that divergences between the cyclical pressures faced by the individual central banks are growing larger. This is occurring within some countries, where the growth and inflation indicators are trending in opposite directions. This is also visible across countries, with not every Monitor calling for rate hikes - a significant shift from the coordinated backdrop seen in 2017 (Chart of the Week). Chart of the WeekFrom Convergence To Divergence In The BCA Central Bank Monitors From Convergence To Divergence In the BCA Central Bank Monitors From Convergence To Divergence In the BCA Central Bank Monitors The combined message from the Monitors is that the slower pace of global growth seen in 2018 has not been enough put a serious dent in inflation pressures stemming from a dearth of spare capacity in most major countries. Perhaps that changes if a full-blown U.S.-China trade war develops, or if the tensions in emerging markets spill over more broadly into global financial conditions, but that remains to be seen. Add it all up, and a below-benchmark stance on overall global duration exposure remains appropriate. Feature An Overview Of The BCA Central Bank Monitors Chart 2CB Monitor Divergence = Bond Yield Divergence CB Monitor Divergence = Bond Yield Divergence CB Monitor Divergence = Bond Yield Divergence The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Our current recommended country allocation for global government bonds reflects the trends seen in the Central Bank Monitors - underweighting countries were the Monitors are most elevated (the U.S., Canada) in favor of regions where the Monitors are lower (Australia, Japan, euro area, New Zealand). In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the Monitors plotted against the relative returns for each country versus the overall Bloomberg Barclays Global Treasury index (shown inversely in the charts so that a rising line means underperformance versus the benchmark index). Fed Monitor: Still On A Gradual Rate Hike Path Our Fed Monitor remains in the "tight money required" zone, signalling that the cyclical backdrop justifies additional Fed rate hikes (Chart 3A). Resilient U.S. growth, a dearth of spare capacity and an acceleration of both wage growth and core inflation are all consistent with a U.S. economy starting to overheat and requiring tighter monetary policy (Chart 3B). Chart 3AU.S.: Fed Monitor U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BU.S. Inflation On The Rise U.S. Inflation On The Rise U.S. Inflation On The Rise The growth and inflation components of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published back in April. Most notably, the inflation component has blasted through the zero line to the highest level since 2008 (Chart 3C). The financial conditions component has retreated from very elevated (i.e. growth-supportive) levels, mostly due to the stronger U.S. dollar but also because of wider corporate credit spreads seen since the start of 2018. Importantly, the financial conditions component has not tightened enough to offset the impact on the Monitor from faster growth and inflation. Chart 3CAll Fed Monitor Components Now Above Zero All Fed Monitor Components Now Above Zero All Fed Monitor Components Now Above Zero Recent comments from senior Fed officials (Chair Jay Powell and Governor Lael Brainard) have indicated that the Fed is less confident in its own estimates of the full-employment NAIRU or the appropriate neutral level of the funds rate. Our read on this is that the Fed will instead continue to raise the funds rate at a gradual 25bp per quarter pace until there are signs that U.S. monetary policy has become tight (i.e. an inverted yield curve, wider credit spreads, softer U.S. economic data). Until then, the message sent by the Fed Monitor is to remain underweight U.S. Treasuries with below-benchmark duration, as market pricing of expectations for both the funds rate and inflation remain too low (Chart 3D). Chart 3DU.S. Treasury Underperformance Will Continue - Stay Underweight U.S. Treasury Underperformance Will Continue - Stay Underweight U.S. Treasury Underperformance Will Continue - Stay Underweight BoE Monitor: Brexit Uncertainty Trumps Inflation Pressures The BoE Monitor remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has kept monetary policy at highly accommodative levels, only raising the base rate 50bps over the past year. The BoE Monetary Policy Committee remains torn between signs that inflation risks are tilted to the upside and the downside risks to U.K. growth from an uncertain Brexit outcome. The U.K. unemployment rate is well below NAIRU with an output gap that is now estimated to be closed (Chart 4B). Yet realized inflation has peaked, with core inflation drifting back below 2%. Wages are finally starting to grow in real terms, which the BoE cites as an important factor underpinning consumer spending, but the pace remains modest. Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BNo Spare Capacity, Yet Has Inflation Peaked? No Spare Capacity, Yet Has Inflation Peaked? No Spare Capacity, Yet Has Inflation Peaked? Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator have recently reaccelerated (Chart 4C). Yet U.K. leading economic indicators continue to decline and dampened business confidence measures reflect the heightened uncertainty over the future relationship between the U.K. and the European Union. Chart 4CBoth Growth & Inflation Components Are Boosting The BoE Monitor Both Growth & Inflation Components Are Boosting The BoE Monitor Both Growth & Inflation Components Are Boosting The BoE Monitor The performance of U.K. Gilts has diverged from the Monitor since the 2016 Brexit vote (Chart 4D), as the BoE has been more worried about Brexit than inflation and has stayed accommodative. Stay overweight U.K. Gilts within global government bond portfolios, even with the more bearish signal implied by our BoE Monitor, given the weakening trend in leading economic indicators and persistent Brexit uncertainty. Chart 4DBrexit Uncertainty Preventing More BoE Hikes - Stay Overweight Gilts Brexit Uncertainty Preventing More BoE Hikes - Stay Overweight Gilts Brexit Uncertainty Preventing More BoE Hikes - Stay Overweight Gilts ECB Monitor: No Pressure To Hike Rates Quickly Post-QE Our European Central Bank (ECB) Monitor has fallen sharply since we last published this Chartbook back in April, and it now sits below the zero line (Chart 5A). The growth deceleration in the first half of the year from the rapid pace seen in 2017 is the main reason for this move, as inflation pressures have not subsided (Chart 5B). Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BEuro Area At Full Capacity Euro Area At Full Capacity Euro Area At Full Capacity ECB President Mario Draghi noted last week that the plan remains in place to end the net new buying phase of the ECB's Asset Purchase Program at the end of 2018. Policymakers' have grown more confident that their inflation forecasts will be met as most measures of euro area wage growth (and headline inflation) have accelerated to 2% over the past year. It remains to be seen if those expectations are too optimistic, as the growth component of our ECB Monitor remains well below the zero line, while the inflation component is no longer rising (Chart 5C). Chart 5CGrowth Component Dragging Down The ECB Monitor Growth Component Dragging Down The ECB Monitor Growth Component Dragging Down The ECB Monitor For now, we recommend a neutral stance on core euro area government bonds with an underweight posture on Peripheral sovereign debt as a way to manage these conflicting trends. The overall performance of euro area bonds versus global benchmarks has followed the pace of the ECB's bond-buying since 2015, and not the pressures suggested by our ECB Monitor (Chart 5D), suggesting a bearish stance as the bond buying ends. Yet from a more bullish perspective, the mixed message on growth and lack of immediate pressures on core inflation (still at 1%) imply that the ECB will not deviate from its current dovish forward guidance of no interest rate hikes until at least September 2019. Chart 5DECB Will Not Hike Rates Quickly After QE Ends - Stay Neutral Core European Bonds ECB Will Not Hike Rates Quickly After QE Ends - Stay Neutral Core European Bonds ECB Will Not Hike Rates Quickly After QE Ends - Stay Neutral Core European Bonds BoJ Monitor: Too Soon To Consider Policy Changes Our Bank of Japan (BoJ) Monitor has stayed just barely in the "tighter money required" zone since last October, due mostly to growing inflation pressures (Chart 6A). Yet with the Japanese labor market now as tight as it has been in decades, headline and core CPI inflation are only at 0.9% and 0.3% respectively, well below the BoJ's 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BInflation Pressures Slowly Building In Japan Inflation Pressures Slowly Building In Japan Inflation Pressures Slowly Building In Japan Japanese firms appear to finally be reacting to the tightness of the labor market, however, as wage growth has accelerated in recent months. The pick-up in wages has helped boost inflation expectations, both of which are part of the inflation component of the BoJ Monitor that is now at the highest level since 2008 (Chart 6C). However, the growth component just rolled over and now sits at the zero line, as the Japanese economy has lost some momentum. Chart 6CInflation Boosting BoJ Monitor Inflation Boosting BoJ Monitor Inflation Boosting BoJ Monitor We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings - especially compared to the rest of the developed markets - until there is much higher realized inflation in Japan. JGBs have indeed been outperforming over the past year, even with the less dovish signal sent by the BoJ Monitor (Chart 6D). Yet the absolute level of the Monitor remains around zero, suggesting that no policy changes should be expected. That means no upward adjustment of the BoJ's 0% yield target on 10-year JGBs or major further reductions in the annual pace of BoJ JGB buying (even though the central bank is hitting capacity constraints as it now owns close to ½ of all outstanding JGBs). Chart 6DBoJ In No Hurry To Turn Hawkish - Stay Overweight JGBs BoJ In No Hurry To Turn Hawkish - Stay Overweight JGBs BoJ In No Hurry To Turn Hawkish - Stay Overweight JGBs BoC Monitor: Rate Hikes - More To Come The Bank of Canada (BoC) Monitor has stayed in "tighter money required" since the beginning of 2017 and is now well above the zero line (Chart 7A). The BoC has been following our BoC Monitor, hiking rates by a cumulative 100bps since July 2017. Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BAn Overheating Canadian Economy? An Overheating Canadian Economy? An Overheating Canadian Economy? The BoC has been responding to the growing inflation pressure in Canada. There is no evidence that spare economic capacity exists, while realized inflation is near the upper bound of BoC's target range of 1-3% (Chart 7B). There is a growing divergence between the growth and inflation subcomponents of the BoC Monitor, with the latter decelerating over the past several months. That was due to a combination of slowing Chinese import demand and the imposition of trade tariffs on Canada by the Trump administration (Chart 7C). Yet the domestic economy remains in good shape, with the overall indicator from the BoC's Business Outlook Survey at the highest level since 2010. Chart 7CInflation Component Boosting BoC Monitor Inflation Component Boosting BoC Monitor Inflation Component Boosting BoC Monitor We continue to recommend an underweight stance on Canadian government bonds, as the relative performance has broadly followed the path of the BoC Monitor over the past three years (Chart 7D). The BoC tends to follow the policy actions of the Fed with a short lag, thus our bearishness on Canadian government bonds is related to our more hawkish views on the Fed. Yet the surge in Canadian inflation, at a time when the economy has no spare capacity, suggests that there are good domestic reasons to expect more rate hikes from the BoC over the next year than what is currently discounted by markets. Chart 7DBoC Not Done Yet - Stay Underweight Canadian Bonds BoC Not Done Yet - Stay Underweight Canadian Bonds BoC Not Done Yet - Stay Underweight Canadian Bonds RBA Monitor: Easier Policy Needed The Reserve Bank of Australia (RBA) monitor has rapidly fallen below the zero line for the first time since 2016, and now indicates that easier monetary policy is required (Chart 8A). This stands out from the more stable trajectory of the rest of the BCA Central Bank Monitors. Unlike most other developed countries, there is still excess capacity in the Australian economy. Australia's output gap has not closed while the current unemployment rate is just at the OECD's NAIRU estimate of 5.3%. Headline and core inflation are at the low end of the RBA's 2-3% target and struggling to gain much upward momentum (Chart 8B). Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BMinimal Inflation Pressure In Australia Minimal Inflation Pressure In Australia Minimal Inflation Pressure In Australia While both the growth and inflation components of the RBA Monitor have fallen, the biggest decline has come from the inflation side (Chart 8C). The sluggishness of Australia's economy is due to the slow growth of consumer spending and a big deceleration in exports related to softer Chinese demand. On inflation, excess labor market slack, with an underemployment rate close to 8.5%, is the main factor explaining soft wage growth and overall sluggish inflation. Chart 8CInflation Component Weighing On RBA Monitor Inflation Component Weighing On RBA Monitor Inflation Component Weighing On RBA Monitor Our highest conviction country allocation call this year has been to overweight Australian Government bonds, and we see no need to change that given the bullish signal from our RBA Monitor (Chart 8D). It would likely take a rise in unemployment, a renewed decline in realized inflation or a big external shock for the RBA to actually cut rates as our Monitor suggests, but the signal is still bullish for Australian debt on a relative basis. Chart 8DRBA A Long Way From A Hike - Stay Overweight Australian Government Bonds RBA A Long Way From A Hike - Stay Overweight Australian Government Bonds RBA A Long Way From A Hike - Stay Overweight Australian Government Bonds RBNZ Monitor: Policy On Hold For A While Longer The Reserve Bank of New Zealand (RBNZ) Monitor is currently just above the zero line, indicating that tighter monetary policy is required (although just barely) (Chart 9A). This is consistent with the mixed messages in the New Zealand economic data. For example, there is no spare capacity in the economy according to estimates of the output and employment gaps, yet both headline and core inflation have decelerated to the lower end of the RBNZ's 1-3% target band (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNo Spare Capacity In NZ, But No Inflation Either No Spare Capacity In NZ, But No Inflation Either No Spare Capacity In NZ, But No Inflation Either Looking at the components of the RBNZ Monitor, the growth factors have continued to plunge whereas the inflation factors have been increasing (from below zero) since the start of 2018 (Chart 9C). New Zealand's economic growth has slowed because of softer consumer spending and weaker housing activity, the latter of which is related to lower net immigration. Yet business confidence is falling, both the manufacturing and services PMIs have also declined, and export growth has cooled thanks to weaker growth from China and Australia. Meanwhile, the uptick in the inflation components has not yet translated into any broader improvement in realized inflation that would cause the RBNZ to take a more hawkish turn. Chart 9CConflicting Trends Within The RBNZ Monitor Conflicting Trends Within The RBNZ Monitor Conflicting Trends Within The RBNZ Monitor We continue to recommend an overweight stance on New Zealand Government Bonds, in line with the bullish signal sent by our RBNZ Monitor (Chart 9D). The RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will stay unchanged until 2020, and it will take some time before there is evidence that the recent hook down in inflation is nothing more than a temporary blip. Chart 9DRBNZ To Remain On Hold - Stay Long New Zealand Bonds RBNZ To Remain On Hold - Stay Long New Zealand Bonds RBNZ To Remain On Hold - Stay Long New Zealand Bonds Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Central Bank Monitor Chartbook: Divergences Opening Up BCA Central Bank Monitor Chartbook: Divergences Opening Up Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Two key issues will remain important drivers of global financial markets in the coming quarters: the direction of the dollar and Chinese policy stimulus. Policy and growth divergences will remain tailwinds for the dollar and there is little the Trump Administration can do to reverse the upward trend. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon. Expect more EM fireworks. EM market turmoil could pause the Fed's tightening campaign, but this would require evidence that the U.S. economy and/or financial markets are being negatively affected. Chinese stimulus is a risk to our base-case outlook. A growth impulse might keep the RMB from weakening further, boost commodity prices and support EM exports. However, we believe that Chinese stimulus will not be a 'game changer', and might even cause more problems if the authorities push the RMB lower. The U.S. economy and financial system are less exposed to emerging markets than in the Eurozone. An excellent profit backdrop also provides U.S. risk assets with a strong tailwind. Nonetheless, the U.S. is not immune to EM woes. Poor valuation implies a meaningful correction in U.S. risk assets on any flight-to-quality event. Stay cautious on asset allocation. Fed Chair Powell is willing to wait for the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Evidence of labor market overheating is accumulating. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. We believe that investors are underestimating the upside in U.S. inflation risks over the medium term. We recommend below-benchmark duration, although government bonds would temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Japanese corporate profits have been stellar, but that will soon change. EPS growth is likely to soften in the Eurozone too. Favor the U.S. market in unhedged terms. Feature There are numerous key issues on the investment landscape, but two stand out at the moment because they both have wide-ranging global implications: (1) Will the U.S. dollar continue to appreciate; and (2) Will Chinese policymakers place structural reform on the back burner and 'go for growth' in the near term? The latest U.S. economic and profit data provide a strong tailwind for American risk assets. Nonetheless, the mighty U.S. dollar is casting a dark shadow over the heavily-indebted emerging market economies, sparking comparisons with the late 1990s. Could Turkey be the start of a 'domino' effect, similar to Thailand's plunge into financial crisis in 1997 that eventually spread to Brazil and Russia, and finally contributed to the demise of Long-Term Capital Management in the fall of 1998? On the global growth front, the story has not changed much from our assessment last month. Growth is solid, but slowing, in part due to a deceleration in developed-economy capital spending. The global expansion has become less synchronized and relative growth dynamics are pointing to more upside for the greenback (Chart I-1). Chart I-1Cyclical Divergence Is Still Dollar Bullish Cyclical Divergence Is Still Dollar Bullish Cyclical Divergence Is Still Dollar Bullish As in the late 1990s, the Fed is likely to ignore turbulence in EM financial markets and will continue on its tightening path until it begins to affect the U.S. economy or asset prices. The path of least resistance for the dollar is up until something breaks. A major policy impulse from China could alter the feedback loop between the strengthening dollar and EM asset prices. A growth pickup would lift China's imports and commodity prices, both of which would support emerging market economies and asset prices. There is plenty of uncertainty regarding the size of the recently-announced Chinese stimulus measures, but our take is that they are likely to underwhelm because a major growth push would undermine the authorities' structural initiatives. The implication is that the global backdrop will remain unfriendly to emerging market assets at a time when they are more vulnerable than the consensus believes. The risk of a financial accident is escalating. The good news is that the U.S. earnings picture remains excellent, which precludes us from being underweight on risk assets. Nonetheless, investors should have no more than a benchmark allocation to equities and corporate bonds in the major advanced economies. We are upgrading government bonds to neutral at the expense of cash on a tactical basis, to reflect the rising possibility of a global flight-to-quality. The First Domino Turkey has had all the hallmarks of a crisis for a long while. Erdogan's slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. The central bank has been forced to provide large injections of liquidity into the banking system, despite double-digit inflation readings. The country suffers from a classic "twin deficit" problem. Turkish private sector external debt stands at 40% of GDP, of which 13% of GDP is short-term, the highest among EM countries. Erdogan wants economic growth at all costs, but has done little in terms of the structural reforms necessary to lift the country's growth potential. The Lira has lost almost 26% of its value versus the dollar since August 1 and Turkish spreads have blown out. It appears that a lot of bad news has been discounted, but our EM strategists do not see this as a buying opportunity. One risk is that Erdogan imposes capital controls next. Our emerging market team's long held caution on EM is rooted in concern for failing fundamentals.1 They emphasize that Turkey was the catalyst, not the main cause, for the broader financial stress observed across EM assets in August. BCA has highlighted for some time that EM debt is a ticking time bomb. Chart I-2 shows that EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports. Chart I-3 highlights the most vulnerable EM economies in terms of the foreign currency funding requirement, and the foreign debt-servicing obligation relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart I-2Debt Makes EM Vulnerable Debt Makes EM Vulnerable Debt Makes EM Vulnerable Chart I-3EM Debt Exposure September 2018 September 2018 In all previous major EM selloffs, any decoupling between different EM regions proved to be unsustainable. And it certainly does not help that the Fed remains on its tightening path; EM equities usually fall when U.S. financial conditions tighten (Chart I-4). The combination of a strong dollar and weak RMB is a deadly combination for highly-indebted emerging market economies. Chart I-4EM Highly Sensitive To U.S. Financial Conditions... EM Highly Sensitive To U.S. Financial Conditions... EM Highly Sensitive To U.S. Financial Conditions... Investors should expect contagion to intensify. China To The Rescue? Some investors are hoping that China will 'save the day' by providing a major dose of policy stimulus, as it did in 2015, the last time that EM was close to a tipping point. We doubt China will be able to play the same stabilizing role. The Chinese authorities are committed to their long-term structural goals. They have been trying to reorient the economy toward consumption and away from investment and exports, as well as undertake other reforms to reduce financial risk, pollution, poverty and corruption. China kept policy on the tight side until recently, which resulted in a gradual growth slowdown. The Li Keqiang index (LKI) is a good coincident indicator for economic growth (Chart I-5). This index has ticked up in recent months, along with imports, but this likely reflects industrial activity designed to fill foreign orders before the new U.S. tariffs take effect. Our LKI model, based on money and credit, points to further economic weakness ahead. Chart I-5China: Watch Credit And Fiscal Impulse China: Watch Credit And Fiscal Impulse China: Watch Credit And Fiscal Impulse The escalation of the trade war with the U.S. is forcing the Chinese authorities to provide some short-term policy stimulus in order to pre-empt any resulting economic damage. A flurry of policy announcements over the past month has given investors the impression that Beijing has cranked up the policy dial, including cuts to short-term interest rates, a decrease in reserve requirements, liquidity provision to the banking system, and promises of various forms of fiscal stimulus. Chinese stimulus has historically been positive for commodity prices and EM assets. However, we are less sanguine this time. First, the authorities are not abandoning structural reforms, which means that the associated growth headwinds will not disappear. Second, our China experts believe that Chinese policy is only turning moderately reflationary; this is not the 'big bang' that followed the Great Recession in the late 2000s, or the same level of stimulus provided following the 2015-16 global manufacturing downturn. There will no doubt be some fiscal stimulus, but we do not expect a major expansion in bank credit to the private sector because of the government's crackdown on shadow banking, excessive leverage and growing non-performing loans. The change in the policy stance amounts to 'taking the foot off the brake' rather than pressing firmly on the accelerator.2 Third, and perhaps most importantly, the authorities may rely even more on the currency lever to do the heavy lifting if the economy continues to slow and/or the tariff war escalates further. This would be negative for commodity demand because a weaker RMB will make commodities dearer for Chinese producers. Metals prices are particularly at risk. China's competitors will also feel the sting of a cheaper RMB. It will be critical to watch the Chinese money and credit data in the coming months to gauge whether our view on the policy stimulus is correct. We will also be watching the combined credit and fiscal impulse which, at the moment, points to continued weakening in import growth in the near term (Chart I-5, bottom panel). Slower EM growth and/or more financial market turbulence is likely to take a larger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks (Chart I-6). Notably, Spanish banks - BBVA in particular - has sizable exposure to Turkey. Meanwhile, Italian assets have come under pressure as the rift between the European Commission and the new populist government widens and Italian banks become increasingly wary of financing their government. Chart I-6DM Bank Exposure To EM September 2018 September 2018 European growth will therefore likely continue to trail that of the U.S. Our base case does not see euro area growth falling below a trend pace in the coming quarters, but relative growth momentum and the ongoing policy divergence will favor the dollar over the euro. FOMC: No Urgency The key message from the latest FOMC Minutes and Chairman Powell's Jackson Hole speech is that policymakers are sticking with the "gradual" approach to tightening, despite the late-cycle acceleration in economic growth. The blowout second-quarter GDP report supports the view that fiscal stimulus is stoking the economy at a time when there is little slack. Evidence that the labor market is overheating is not simply anecdotal anymore. In past cycles, an acceleration in growth at a time when inflation is already at target and unemployment is below estimates of full employment would have sparked aggressive Fed action. But the Minutes and Powell's speech revealed no sense of urgency. Powell made the case that the Fed must proceed carefully in an environment where there is much uncertainty about the level of the neutral policy rate, the natural rate of unemployment and the slope of the Phillips curve. Moreover, long-term inflation expectations are still hovering below a level that is consistent with meeting the 2% target over the medium term. Some FOMC policymakers believe that this fact justifies taking chances with an inflation overshoot in the coming quarters. Another reason for the FOMC to proceed cautiously is the wage picture, which is confusing even to economic experts because the official measures paint a mixed picture (Chart I-7). The Employment Cost Index for private sector workers continues to march higher. However, growth in compensation per hour, average hourly earnings (AHE) and unit labor costs have all eased a little this year. The Atlanta Fed Wage Tracker, one of the cleanest measures of wages, reveals an even more significant pullback. The softening in wage growth has been fairly widespread across age cohorts, educational attainment and regions, according to the Atlanta Fed data (Chart I-8). Part-time workers appear to be the only segment that has bucked the trend. It is not clear why workers in the 16-24 age group, as well as those with bachelor's degrees (of any age), have seen the most pronounced softening in wage growth this year. Chart I-7Mixed U.S. Wage Data Mixed U.S. Wage Data Mixed U.S. Wage Data Chart I-8U.S. Wage Slowdown Broadly-Based U.S. Wage Slowdown Broadly-Based U.S. Wage Slowdown Broadly-Based Which measure is telling the correct story: the ECI or the Atlanta Wage Tracker? Both are a relatively clean measure of wages and it is difficult to tell based on the relative merits of each index alone. Nonetheless, there is little doubt that the labor market is now very tight by historical standards. Small business owners' compensation plans remained near record levels in July, while concerns about the "quality of labor" have never been higher (Chart I-9). Chart I-10 shows that the ratio of the level of job openings to unemployed workers has surpassed the pre-recession level in all but one sector according to the Jolts survey. Indeed, in most cases this ratio is well above the previous peak. Unemployment is now below the estimated level of full-employment in more than 80% of U.S. states. Chart I-9U.S. Labor Shortage Is Growing U.S. Labor Shortage Is Growing U.S. Labor Shortage Is Growing Chart I-10JOLTS Signals Very Tight Jobs Market JOLTS Signals Very Tight Jobs Market JOLTS Signals Very Tight Jobs Market No Evidence Of U.S. Overheating? Labor shortages first appeared for skilled workers, helping to explain why highly-skilled workers have enjoyed the fastest wage gains in recent years. But this year's Fed Beige Books have noted that many businesses are now having trouble finding low- and middle-skilled workers, as listed in Table I-1. These industries roughly line up with the ones that reveal above-average growth in average hourly earnings, and with the ones where labor market tightness is the most acute according to the Jolts survey (second and third columns in the table). The shortages appear to be broadly based, ranging from truck transportation to financial services, manufacturing and construction. This makes it all the more curious that Chairman Powell finds that there is no evidence of overheating in the labor market. The evidence seems pretty conclusive to us and it even features in the Fed's own Beige Book. Keep in mind that inflation is not always the 'cost push' type, beginning in the labor market and traveling to consumer prices. Sometimes inflation can begin in the market for goods and services, and then affect wage demands. U.S. consumer price inflation appears to be headed higher based on the New York Fed's Underlying Inflation Gauge (Chart I-11). Our CPI diffusion index shows that inflation is accelerating in a majority of categories. Other measures of underlying inflation, such as the Sticky Price Index, the Trimmed Mean, and the Median inflation rate are all in a solid uptrend. Dollar strength this year will eventually put downward pressure on core goods inflation, but that will take some time; non-energy goods inflation is more likely to rise in the near term as it catches up to the previous acceleration in imported goods prices (Chart I-11, bottom panel). Table I-1Labor 'Shortages' Identified In The Beige Book September 2018 September 2018 Chart I-11U.S. Underlying Inflation Is Rising U.S. Underlying Inflation Is Rising U.S. Underlying Inflation Is Rising U.S. Inflation To Surprise On Upside We believe that the market is underestimating the risk of a meaningful inflation overshoot over the medium term. Investors still do not believe that the Fed will be able to consistently meet the 2% target over the long-term, based on CPI swaps and TIPS breakeven rates. BCA's Chief Global Strategist, Peter Berezin, penned a two-part Special Report in August on the potential for upside inflation surprises over the coming years.3 First, increasing political pressure on the major central banks is worrying. Second, policymakers are coming around to the idea that there may be an exploitable trade-off between higher inflation and lower unemployment. This was a mistake last made in the inflationary 1970s. Finally, the pressure to keep monetary policy accommodative until the "whites of the eyes" of inflation are visible will remain strong. Bonds are in for some trouble if we are correct on the inflation outlook. We recommend that investors with a 6-12 month investor horizon remain short in duration and overweight TIPS versus conventional Treasurys. That said, we cannot rule out a flight-to-quality episode at some point, possibly reflecting trade tensions and/or EM turmoil, which would send Treasury yields temporarily lower. The Fed may be forced to place rate hikes on hold if financial conditions tighten too quickly. No Margin Peak Yet In The U.S.... The S&P 500 was unfazed by the turmoil in emerging markets and the re-widening in Italian bond spreads in August, likely because of continuing good news on the profit front. Corporate earnings remained in a sweet spot in the second quarter. Nominal GDP grew by a whopping 5.4% from a year ago, helping to boost the top line for the corporate sector. The lagged effect of previous dollar depreciation is still flattering earnings, although this only accounts for about two percentage points according to our model (Chart I-12). Meanwhile, equity buybacks have kicked into overdrive (Chart I-13). Chart I-12U.S. Dollar Impact On EPS Growth U.S. Dollar Impact On EPS Growth U.S. Dollar Impact On EPS Growth Chart I-13U.S. Equity Buyback In Overdrive U.S. Equity Buyback In Overdrive U.S. Equity Buyback In Overdrive Margins continued their impressive ascent in the second quarter to well above the pre-Lehman peak (Chart I-14). A lot of the increase is related to the tax cuts; EBITDA margins are still substantially below the 2007 peak according to the S&P data. It is disconcerting that all of the surge in S&P 500 margins is due to the Tech sector (Chart I-14, bottom panel). Excluding Tech, S&P after-tax margins have simply moved sideways since 2010. Looking ahead, the tailwind from previous dollar depreciation will shift to a headwind by mid-2019. Chart I-12 shows that the contribution from changes in the dollar to EPS growth will shift from a positive two percentage points to a drag of 1½ percentage points if the dollar is flat from today's level in broad trade-weighted terms. If the dollar rises by another 5% this year, then next year's drag on EPS growth will reach three percentage points. Moreover, the impact of the tax cuts on after-tax profits will fade next year. Wage pressures are building and this should eventually squeeze profit margins. That said, a margin peak does not appear to be imminent. Last month we introduced some macro indicators for profit margins (Chart I-15). Most appeared to be rolling over a month ago, but they have all since ticked up. Chart I-14Tech And Taxes Driving Profit Margins Tech And Taxes Driving Profit Margins Tech And Taxes Driving Profit Margins Chart I-15U.S. Margin Indicators Have Turned Up U.S. Margin Indicators Have Turned Up U.S. Margin Indicators Have Turned Up The bottom line is that we continue to expect a mean reversion in U.S. profit margins in the coming years, but this is not a risk for at least the rest of 2018. ...But Profit Outlook Darkening In Japan Second quarter earnings season was also a good one for Japanese companies. Twelve-month forward earnings estimates have been in a steep incline and margins have been rising (Chart I-16). Despite this, the Nikkei has only managed to move sideways this year in local currency terms. Concerns over trade and global growth have perhaps weighed on Japanese stock performance. Company profits have a high beta with respect to global growth. Things are looking shaky on the domestic front too. Domestic demand growth is decelerating, consistent with a weakening Economy Watcher's Survey. Some of the weakness may be related to poor weather, but the LEI suggests that this trend will continue in the coming quarters (Chart I-17, bottom panel). Chart I-16Japan: Trailing Earnings Are Solid... Japan: Trailing Earnings Are Solid... Japan: Trailing Earnings Are Solid... Chart I-17...But Profit Margins Will Narrow ...But Profit Margins Will Narrow ...But Profit Margins Will Narrow Chart I-17 presents some of the variables that have helped to explain historical trends in Japanese EPS. Industrial production growth, a good proxy for top line growth, is decelerating. Nominal GDP growth has fallen to just 1.1% year-over-year, at a time when total labor compensation has surged by more than 4%. The difference between these two, a proxy for profit margins, has therefore plunged. Previous shifts in the yen have not had a large impact on EPS growth over the past year and we do not expect that to change much in 2019. On a positive note, Japanese stocks are attractively valued now that the 12-month forward P/E ratio has fallen below 13 (Chart I-16, bottom panel). It is also constructive that the Bank of Japan is the only central bank that is not backing away from monetary stimulus. The recent widening of the trading band for the 10-year JGB yield was a technical change meant to give the central bank more flexibility, not a signal that policymakers are planning to change tack. Nonetheless, we believe that earnings growth and margins will disappoint market expectations over the next year. The story is much the same for the Eurozone. Both trailing and forward profit margins have been in a strong uptrend. Twelve-month forward EPS growth has been holding at a solid 9%. Nonetheless, the data that feed into our Eurozone profit model point to some softening ahead, including industrial production and the difference between nominal GDP and the aggregate wage bill (not shown). The Eurozone's credit impulse turned negative even before concerns about EM and Italian politics exploded onto the scene. Thus, home-grown profit generation is likely to moderate along with foreign-sourced earnings. For the moment, the BCA House View remains at benchmark on Japanese and Eurozone stocks in currency-hedged terms. In unhedged terms, we prefer the U.S. market to these other bourses because of our bullish dollar bias. Investment Conclusions: Two key issues will remain important drivers of global financial markets in the coming months and quarters: the direction of the dollar and Chinese policy stimulus. We believe that the U.S. dollar has additional upside potential due to growth and policy divergences. There is some speculation in the financial community that President Trump might resort to currency intervention. However, any intervention would be sterilized by the Fed. The only way to shift currencies on a sustained basis would be to organize a coordinated change in monetary or fiscal policies among the U.S. and its main trading partners. This is highly unlikely. Thus, the path of least resistance is up for the U.S. dollar. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon because high debt levels make these economies vulnerable to any weakness in global growth, commodity prices or global liquidity conditions. EM financial market turmoil could cause the Fed tightening campaign to go on hold, but this would require evidence that the former is negatively affecting the U.S. economy and/or financial markets. In other words, we need to see some pain before the Fed blinks. Chinese stimulus is a risk to our base-case EM outlook. Policy stimulus might keep the RMB from weakening further, boost commodity prices and support EM exports. This would not change the EM debt situation, but would at least give emerging economies a temporary reprieve. Careful analysis suggests that Chinese stimulus will not be a 'game changer', and might even cause problems if the authorities push the RMB lower. But it will be critical to monitor the next couple of money and credit reports. The U.S. economy and financial system are less exposed to further EM turmoil than in the Eurozone. But as the LTCM event demonstrated in 1998, the U.S. is not immune. Moreover, U.S. equity prices are more expensive than they were during previous EM selloffs that have occurred since the Great Recession. This could mean a larger equity re-rating on any flight-to-quality. This is not to say that we expect a bear market in DM risk assets to get underway in the near future. A U.S./global recession before 2020 is unlikely. Nonetheless, the risk of a meaningful correction is elevated enough that caution is warranted, especially at a time when all risk assets appear expensive. Chart I-18 updates our valuation measures for some major asset classes. All appear to be expensive, especially U.S. equities, raw materials and gold. EM sovereigns and equities are at the cheaper end of the spectrum, but are still not cheap in absolute terms even after the recent selloff. Chart I-18Major Asset Valuation Comparison September 2018 September 2018 Treasurys rallied briefly after Chairman Powell signaled that he is not willing to accelerate the pace of rate hikes in light of the U.S. economy's growth acceleration. He is willing to wait until he sees the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. Over the medium term, we believe that investors are underestimating the upside in U.S. inflation risks. We recommend below-benchmark duration, although bonds may temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Finally, as we go to press, the U.S. is trying to force Canada to sign on to the U.S./Mexico 'agreement in principal' by August 31. A framework deal with Canada would likely leave many tough issues unresolved. There is also a chance that Canada misses the deadline and that the existing trilateral deal will not survive. It is technically possible that Canada's refusal to join the U.S.-Mexico bilateral deal will delay its ratification well into next year. In the meantime, Trump could raise the stakes for Canada by boosting tariffs on Canadian autos and/or by suspending NAFTA altogether. As a result, we decided to go ahead and publish our Special Report on U.S. equity sector implications if NAFTA is not ratified and tariffs rise to WTO levels. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst August 30, 2018 Next Report: September 27, 2018 1 Please see BCA Emerging Market Strategy Weekly Report "What's Really Driving The EM Selloff?"dated June 28, 2018, available on ems.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report "China is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available on cis.bcaresearch.com 3 Please see BCA Global Investment Strategy Special Reports: "1970s-Style Inflation: Could It Happen Again? Parts I and II," dated August 10 and 24, 2018, available on gis.bcaresearch.com II. What If NAFTA Is Not A Done Deal? U.S. Equity Implications This Special Report examines the impact of a NAFTA cancelation on 21 level-three GICs industries. While the latest news on the NAFTA renegotiation with Mexico is positive as we go to press, there is still a non-negligible risk that the existing trilateral deal will not survive. The U.S.-Mexico bilateral deal is an "agreement in principle" and will take time to ratify. Meanwhile, a framework deal with Canada would leave many thorny issues to be resolved. President Trump can still revert to his tough tactics on Canada ahead of the U.S. mid-term elections. If the President does not gain major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base. The probability of Trump triggering Article 2205 and threatening to walk away from the suspended U.S.-Canada free trade agreement is still not trivial, despite the deal with Mexico. By itself, the cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved (especially Autos). We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and input cost exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. While the latest news on the renegotiation of the North American Free Trade Agreement (NAFTA) is positive as we go to press, there is still a non-negligible risk that President Trump could revert to his tough tactics ahead of the U.S. mid-term elections.1 Even if Canada signs on to a framework deal, a lot of thorny details will have to be worked out. A presidential proclamation triggering Article 2205 of the NAFTA agreement (as opposed to tweeting that the U.S. will withdraw) would initiate a six-month "exit" period. Trump could use this deadline, and the threat of canceling the underlying U.S.-Canada FTA, to put pressure on Canada (if not Mexico) to concede to U.S. demands, just as he could revoke his exit announcement anytime within the six-month period. While some market volatility would ensue upon any exit announcement, even a total withdrawal at the end of the six months would have a limited macro-economic impact as long as the U.S. continued to respect its WTO commitments and lifted tariffs only to Most Favored Nation (MFN) levels. Nonetheless, a modest tariff hike is not assured given the Administration's "America First" policy, its looming threat of Section 232 tariffs on auto imports, its warnings against the WTO itself, and the steep tariffs it has already imposed on Canada, including a 20% tariff on softwood lumber and the 300% tariff on Bombardier CSeries jets. Moreover, even a small rise in tariffs to MFN levels would have a significant negative impact on industries that are heavily integrated across borders. Our first report on the evolving U.S. trade situation analyzed the implications of the U.S.-China trade war for the 24 level two U.S. GICs equity sectors. This Special Report examines the impact of a NAFTA cancelation on 21 level three GICs industries (finer detail is required since NAFTA covers mostly goods industries). We find that there are no "winners" among the U.S. equity sectors because the negative impact would outweigh any positive effects. The hardest hit U.S. industries would be Autos, Metals & Mining, Food Products, Beverages, and Textiles and Apparel, but many others are heavily exposed to a failure of the free trade agreement. Out Of Time President Trump is seeking a new NAFTA deal ahead of the U.S. midterms in November. While this timing may yet prove too ambitious, the U.S. has made progress in recent bilateral negotiations with Mexico, raising the potential that Trump will be able to tout a new NAFTA framework deal by November 6. Yet, investors should be prepared for additional volatility. There are technical issues with the bilateral U.S.-Mexico deal that could delay ratification in Congress until mid-2019. The new Mexican Congress must ratify the deal by December 1 if outgoing President Enrique Peña Nieto is to sign off. Otherwise, the incoming Mexican President Andrés Manuel López Obrador may still want to revise any deal he signs, prolonging the process. Meanwhile, it would be surprising if the Canadians signed onto a U.S.-Mexico deal they had no part in negotiating without insisting on any adjustments.2 The important point is that President Trump's economic and legal constraints on withdrawing from NAFTA have fallen even further with the Mexican deal. If Trump does not get major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base, as a gray area of "continuing talks" will not inspire voters. This could mean imposing the threatened auto tariffs or threatening to cancel the existing trade agreements with Canada. Thus, the risk of Trump triggering Article 2205 is still not trivial. A bilateral Mexican trade deal is not the same as NAFTA. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act. Some provisions of NAFTA under this act may continue, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. The potential saving grace for trade with Canada was that the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989, was incorporated into NAFTA. The U.S. and Canada agreed to suspend CUSFTA's operation when NAFTA was created, but the suspension only lasts as long as NAFTA is in effect. However, Trump may walk away from both CUSFTA and NAFTA in the same proclamation. In that event, WTO rules for preferential trade would require the U.S. and Canada to raise tariffs on trade with each other to Most Favored Nation (MFN) levels. These tariff levels are shown in Charts II-1A and II-1B. The Charts also show the maximum tariff that could potentially be applied under WTO rules. The latter are much higher than the MFN levels, underscoring that the situation could get really ugly if a full trade war scenario somehow still emerged among these three trading partners. Chart II-1AU.S.: MFN Tariff Rates By GICS Industry (2017) September 2018 September 2018 Chart II-1BMexico & Canada: MFN Tariff Rates By GICS Industry (2017) September 2018 September 2018 Current tariffs are set at zero for virtually all of these GICs industries, which means that the MFN levels also indicate how much tariffs will rise at a minimum if NAFTA is cancelled. Tariffs would rise the most for Automobiles, Textiles & Apparel, and Food Products (especially agricultural products), and Beverages. U.S. tariffs under the WTO are not significantly higher than NAFTA's rates; the average MFN tariff in 2016 was 3½%, which compares to 4.1% for the average Canadian MFN tariff. Would MFN Tariffs Be Painful? An increase in tariff rates of 3-4 percentage points may seem like small potatoes. Nonetheless, even this could have an outsized impact on some industries because tariffs are levied on trade flows, not on production. A substantial amount of trade today is in intermediate goods due to well-integrated supply chains. Charts II-2A and II-2B present a measure of integration. Exports and imports are quite large relative to total production in some industries. The most integrated U.S. GICs sectors include Automobiles & Components, Materials, Capital Goods and Electrical & Optical Equipment. Higher tariffs would slam those intermediate goods that cross the border multiple times at different stages of production. For example, studies of particular automobile models have found that "parts and components may cross the NAFTA countries' borders as many as eight times before being installed in a final assembly in one of the three partner countries."3 Tariffs would apply each time these parts cross the border if NAFTA fails. Chart II-2AU.S./Canada Supply Chain Integration September 2018 September 2018 Chart II-2BU.S./Mexico Supply Chain Integration September 2018 September 2018 Appendix Tables II-1 to II-4 show bilateral trade by product between the U.S. and Canada, and the U.S. and Mexico. In 2017, the U.S. imported almost $300b in goods from Canada, and exported $282b to that country, resulting in a small U.S. bilateral trade deficit. The bilateral deficit with Mexico is larger, with $314b in U.S. imports and $243b in exports. The largest trade categories include motor vehicles, machinery, and petroleum products. Telecom equipment and food products also rank highly. As mentioned above, the impact of rising tariffs is outsized to the extent that a substantial portion of trade in North America is in intermediate goods. Box II-1 reviews the five main channels through which rising tariffs can affect U.S. industry. Box II-1 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: (1) The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of import tariffs via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines). NAFTA also eliminated many non-tariff barriers, especially in service industries. Cancelling the agreement could thus see a return of these barriers to trade; (2) Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs. There would also be a loss of economies-of-scale and comparative advantage to the extent that firms are no longer able to use an "optimal" supply network that crosses borders, further raising the cost of doing business; (3) Foreign Direct Investment: Some U.S. imports emanate from U.S. multinationals' subsidiaries outside the U.S., or by foreign OEM suppliers for U.S. firms. NAFTA eliminated many national barriers to FDI, expanded basic protections for companies' FDI in other member nations, and established a dispute-settlement procedure. The Canadian and Mexican authorities could make life more difficult for those U.S. firms that have undertaken significant FDI in retaliation for NAFTA's cancellation; (4) Macro Effect: The end of NAFTA, especially if it were to lead to a trade war that results in tariffs in excess of the MFN levels, would take a toll on North American trade and reduce GDP growth across the three countries. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. The macro effect would probably not be large to the extent that tariffs only rise to MFN levels; (5) Currency Effect: To the extent that a trade war pushes up the dollar relative to the Canadian dollar and Mexican peso, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given that tariffs would rise for all three countries. Chart II-3 is a scatter chart of GICs industries that compares the average MFN tariff on U.S. imports to the average MFN tariff on Canadian and Mexican imports from the U.S. A U.S. industry may benefit if it garners significant import protection but does not face a higher tariff on its exports to the other two countries. Unfortunately, there are no industries that fall into the north-west portion of the chart. The opposite corner, signifying low import protection but high tariffs on exports, includes Beverages, Household Durables, Household Products, Personal Products and Machinery. Chart II-3Import And Export Tariffs Faced By U.S. GICS Industries September 2018 September 2018 Model-Based Approach The C.D. Howe Institute has employed a general equilibrium model to estimate the impact of a NAFTA failure at the industrial level.4 The model is able to capture the impact on trade conducted through foreign affiliates. The study captures the direct implications of higher tariffs, but also includes a negative shock to business investment that would stem from heightened uncertainty about the future of market access for cross-border trade. It also takes into consideration non-tariff barriers affecting services. Table II-1Impact Of NAFTA Cancellation By Industry September 2018 September 2018 As with most studies of this type, the Howe report finds that the level of GDP falls by a relatively small amount relative to the baseline in all three countries - i.e. there are no winners if NAFTA goes down. Moreover, the U.S. is not even able to reduce its external deficit. While the trade barriers trim U.S. imports from NAFTA parties by $60b, exports to Canada and Mexico fall by $62b. At the industry level, the model sums the impacts of the NAFTA shock on imports, exports and domestic market share to arrive at the estimated change in total shipments (Table II-1). It is possible that an industry will enjoy a boost to total shipments if a larger domestic market share outweighs the damage to exports. However, the vast majority of U.S. industries would suffer a decline in total shipments according to this study, because the estimated gain in domestic market share is simply not large enough. Beef, Pork & Poultry and Dairy would see a 1-2% drop in total shipments relative to the baseline forecast. Next on the list are textiles & apparel, food products and automotive products. Even some service industries suffer a small decline in business, due to indirect income effects. Foreign-Sourced Revenue And Input Cost Approach Another way to approach this issue is to identify the U.S. industries that garner the largest proportion of total revenues from Mexico and Canada. Unfortunately, few companies provide much country detail on where their foreign revenues are derived. Many simply split U.S. and non-U.S. revenues, or North American and non-North American revenues. Table II-2 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the industry by market cap (in some cases the proportion that is generated outside of North America was used as a proxy for foreign- sourced revenues). While this approach is not perfect, it does provide a good indication of how exposed a U.S. industry is to Canada and Mexico. This is because any company that has "gone global" will very likely be doing substantial business in these two countries. Table II-2Foreign Revenue Exposure September 2018 September 2018 At the top of the list are the Metals & Mining, Personal Products, and Auto Component industries. Between 62% and 81% of revenues in these three industries is derived from foreign sources. Following that is Household Durables, Leisure Products, Chemicals and Tobacco. Indeed, all of the level three GICs industries we are analyzing are moderately-to-highly globally-oriented, with the sole exception of Construction Materials. Table II-3Import Tariff Exposure September 2018 September 2018 U.S. companies are also exposed to U.S. tariffs that boost the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A then sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that would be affected by a rise in tariffs to MFN levels. We then allocated the industries contained in the input/output tables to the 21 GICs level 3 industries we are considering, in order to obtain an import exposure ranking in S&P industry space (Table II-3). All 21 industries are significantly vulnerable to rising input costs, which is not surprising given that we are focusing on the manufacturing-based GICs industries and NAFTA focused on trade in goods. The vast majority of the industries could face a cost increase on 50% or more of their intermediate inputs to the production process. The Automobile industry is at the top of the list, with 72% of its intermediate inputs potentially affected by the shift up in tariffs (Automobile Components is down the list, at 56%). Containers & Packaging, Oil & Gas, Aerospace & Defense, Textiles and Food Products are also highly exposed to tariff increases. The automobile industry is a special case because of the safeguards built into NAFTA regarding rules-of-origin and the associated tracing list. The U.S. is seeking significant changes in both in order to tilt the playing field toward U.S. production, but this could severely undermine the intricate supply chain linking the three countries. Box II-2 provides more details. Box II-2 Automotive Production In NAFTA; Update Required We are focused on two key aspects to the renegotiation of the NAFTA rules that could have far reaching implications for automakers and the auto component maker supply base: the tracing list and country of origin rules. Regarding the first of these, the Trump administration has a legitimate gripe when it comes to automotive production. A tracing list was written in the early-1990's to define automotive components such that the rules of origin (ROO) could be easily met; anything not on the list is deemed originating in North America. As anyone who has driven a vehicle of early-1990's vintage and one of late-2010's vintage can attest, high tech components (largely not included on the tracing list) have grown exponentially as a percentage of the cost of the vehicle and, at least with respect to electronic and display components, are sourced mostly from overseas. Updating the tracing list would force auto makers to source a significantly greater amount of components domestically, almost certainly raising the cost of the vehicle and either hurting margins or hurting competitiveness through higher prices. The current NAFTA ROO require that 62.5% of the content of a vehicle must be sourced in North America, with no distinction between any of the member nations. The result of this legislation has been the creation of a highly integrated supply base that sees components move back and forth across borders through each stage of the manufacturing process. Early proposals from the Trump administration for a NAFTA rework included a country of origin provision for as much as 50% U.S. content. Such a provision would certainly cause a massive disruption in the automotive supply chain with components manufacturers forced to relocate or automakers electing to source overseas and pay the 2.5% MFN tariff on exports within North America. Either scenario presents a headwind to the tightly woven auto components base, underscoring BCA's U.S. Equity Strategy's underweight recommendation on the sector. The recently announced bilateral trade deal with Mexico raises the ROO content requirements to 75% from the 62.5% contemplated under NAFTA but, importantly, no country of origin provisions appear in the new deal. Still, given how quickly this is evolving, a final NAFTA deal could be significantly different. Chart II-4 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries in the north-east corner of the diagram are the most exposed to NAFTA failure. The problem is that there are so many in this region that it is difficult to choose the top two or three, although Metals & Mining stands out from the rest. It is easier to identify the industries that face less risk in relative terms: Pharmaceuticals, Construction Materials, Health Care & Supplies, Leisure Products and, perhaps, Machinery. The rest rank highly in terms of both foreign revenue exposure and import tariff exposure. Chart II-4Foreign Revenue And Import Tariff Exposure September 2018 September 2018 Conclusions: By itself, a total cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved. The negative impact on GDP growth would likely be worse for Canada (and Mexico if its bilateral somehow fell through), but U.S. exporters would see some loss of business. We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and import tariff exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. As we go to press, rapid developments are taking place in the NAFTA negotiations. The U.S. and Mexico have completed a bilateral agreement in principle and a Canadian team is looking into whether to sign onto the agreement by a U.S.-imposed August 31 deadline. This deadline would enable the current U.S. Congress to proceed to ratification before turning over its seats in January, though it is not a hard deadline. It is possible that the negotiations will conclude this week and the crisis will be averted. But the lack of constraints on President Trump's trade authority gives reason for pause. If Canada demurs, Trump could move to raise the cost through auto tariffs or announcements that he intends to withdraw from existing U.S.-Canada agreements in advance of November 6. While Mexico has now tentatively secured bilaterals with both countries through the new U.S. deal and the Trans-Pacific Partnership (which includes Canada), it still stands to suffer if a trilateral agreement is not in place. Moreover it is technically possible that Canada's refusal to join the U.S.-Mexico bilateral could delay the latter's ratification well into next year. Therefore, we treat Mexico the same as Canada in our analysis, despite the fact that Mexican assets stand to benefit in relative terms from having a floor put under them by the Trump Administration's more constructive posture and this week's framework deal. If Trump does not pursue a hard line with Canada, then it will be an important sign that he is adjusting his trade policy to contain the degree of confrontation with the developed nations and allies and instead focus squarely on China, where we expect trade risks to increase in the coming months. Mark McClellan Senior Vice President The Bank Credit Analyst Matt Gertken Associate Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy APPENDIX TABLE II-1 U.S. Imports From Canada (2017) September 2018 September 2018 APPENDIX TABLE II-2 U.S. Exports To Canada (2017) September 2018 September 2018 APPENDIX TABLE II-3 U.S. Imports From Mexico (2017) September 2018 September 2018 APPENDIX TABLE II-4 U.S. Exports To Mexico (2017) September 2018 September 2018 1 Please see BCA Geopolitical Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28, 2018, and Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com 2 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com 3 Working Together: Economic Ties Between the United States and Mexico. Christopher E. Wilson, November 2011. 4 The NAFTA Renegotiation: What if the U.S. Walks Away? The C.D. Howe Institute Working Paper. November 2017. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits have been so strong recently as to dominate any negative market forces. Our Monetary Indicator is hovering at a low level by historical standards, suggesting that liquidity conditions have tightened. It is constructive that our Composite Technical Indicator has hooked up, narrowly avoiding a technical break below the zero line. It is also positive that our Composite Sentiment Indicator is rising, but not yet to a level that would signal trouble for stocks from a contrary perspective. However, our U.S. Willingness-to-Pay (WTP) indicator continues to erode, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Moreover, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in August. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Our indicators thus suggest that the underlying health of the U.S. equity bull market is fraying at the edges. Nonetheless, robust U.S. profits figures have sparked a euphoric late-cycle blow-off phase. The net revisions ratio is still in positive territory, and the net earnings surprises index has surged to an all-time high. Not much has changed on the U.S. Treasury front. The 10-year bond is slightly on the cheap side according to our model, and oversold conditions have not yet been worked off. This month's Overview section discusses the potential for upside inflation surprises in the U.S. that will place the FOMC "behind the curve". The term premium and long-term inflation expectations are still too low. This year's dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but economic and policy divergences vis-à-vis the U.S. and the other major economies suggests that the dollar is likely to continue moving higher in the near term. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Dear client, Our publishing schedule will be shifting over the next two weeks. Next Friday, we will publish a Special Report aggregating various pieces from our colleague Matt Gertken of BCA's Geopolitical Strategy detailing the reforms taking place in China and their past and future evolution, and the economic and investment implications for China and the rest of the world. Matt argues that Chinese reforms are in place and here to stay, which should deepen the malaise in EM and support the dollar. We will not publish any report on August 31st. We will resume our regular publishing schedule on September 7. I hope you enjoy the rest of your summer. Best regards, Mathieu Savary Highlights The 1997 Asian Crisis was a deflationary event, causing commodity prices, commodity currencies and the yen to fall against the dollar, but it had a limited impact on the euro. When Russia collapsed in 1998, the LTCM crisis hit the U.S. banking system, with fears of solvency dragging Treasury yields lower, hurting the dollar against the yen and the euro. Today is not 1997, but the tightness of the U.S. economy suggests the Federal Reserve will need a large shock before abandoning its current pace of a hike per quarter; additionally, global liquidity conditions are tightening and China is slowing. The EM crisis is therefore not over, and vulnerable Brazil, Chile, Mexico, Colombia and South Africa could still experience significant pain. Unlike in 1998, the hot potato is not hiding in the U.S. but in Europe. A contagion event is therefore more likely to hurt the euro than 20 years ago; meanwhile, the yen stands to benefit. DXY could hit 100, and commodity currencies still have ample downside, the AUD in particular. Continue to monitor our China Play Index to gauge if Chinese stimulus could delay the day of reckoning for EM; this index can also be employed as a hedge for investors long the dollar or short EM plays. Feature "Misfortune tests the sincerity of friends." - Aesop This summer is oddly reminiscent of that of 1997. The Federal Reserve is tightening policy because the U.S. economy is not only at full employment but is also growing strongly and generating increasing domestic inflationary pressures. But the most familiar echoes come from outside the U.S. Specifically, emerging market trepidations are once again front page news as the Turkish lira, which had already fallen by 24% between January 2018 and July 31st, dropped by an additional 28% at its worst in a mere two weeks. Consequently, investors are now fretting about the risks of contagion across EM markets, one that could reverberate among G10 economies as well. We too worry that the echoes of 1997 are becoming increasingly louder. EM economies have built up large stocks of debt, and have financed themselves heavily by tapping foreign investors. However, these investors can be rather fickle friends, and we are set to test their sincerity. In this piece, we review how the events of 1997-'98 unfolded, what it meant for G10 currencies, and whether the same lessons can be applied today. We find that in 2018, an EM crisis could ultimately be more supportive for the dollar versus the euro, as unlike in 1998, where the hot potatoes were held by U.S. hedge funds, this time the mess sits squarely in Europe. Tom Yum Goong Goes Viral Initiated in the second half of the 1980s, the peg of the Thai baht seemed like a very successful experiment. The stability created by this institutional setup not only contributed to keeping Thai inflation at manageable levels, but by incentivizing capital inflows in the country it also helped Thailand build up its capital stock. At the time, this yielded a large growth dividend, with real GDP growth averaging 9% from 1985 to 1996. However, the economic boost generated by this cheap financing had a dark side. The Thai current account balance ballooned to a deficit of 8% of GDP in 1995-'96. As Herb Stein famously expressed, if something cannot go on forever, it will stop. Like in Aesop's fable where one of two travelers climbed up a tree to avoid a bear, leaving his friend to fend off the bear on his own, foreign investors abandoned Thailand, which was left on its own to finance its large current account deficit. While the Bank of Thailand was able to fend off the attacks for a few weeks, on July 2nd, 1997, it abandoned its efforts. The THB was left to float freely and dropped 56% against the USD over the subsequent six months. Other EM countries including Malaysia, Brazil and Korea, to name a few, had implemented similar U.S. dollar pegs. They too enjoyed stable inflation, growing money inflows and improved growth, but also experienced growing current account deficits and foreign currency debt loads. It did not take long for investors to extrapolate Thailand's woes to other countries. The Malaysian ringgit and the Indonesian rupiah began falling soon after the THB, while the Korean won began its own steep descent four months later (Chart 1). The economic pain was felt globally. The collapse in EM Asian exchange rates and the deep recessions experienced in these countries caused their export prices to collapse, which created a global deflationary shock (Chart 2). This shock was compounded by a fall in commodity prices that materialized as market participants realized that demand for commodities from the crisis-stricken countries was set to evaporate (Chart 2, bottom panel). Chart 1How The Thai Crisis Morphed Into An Asian Crisis How The Thai Crisis Morphed Into An Asian Crisis How The Thai Crisis Morphed Into An Asian Crisis Chart 2The Asian Crisis Was A Deflationary Shock The Asian Crisis Was A Deflationary Shock The Asian Crisis Was A Deflationary Shock Not only did this deflationary shock lift the USD against EM currencies and commodity currencies, it also caused inflation breakevens in the U.S. to fall significantly (Chart 3). However, because the U.S. economy remained robust through the second half of 1997 and in the early days of 1998, real rates did not respond much (Chart 3, bottom panel). Markets where not very concerned that this shock would force the Fed to cut rates, as it did not seem to affect the outlook for U.S. growth and employment. However, this combination of stable real rates in the face of weaker growth in EM, as well as the collapse in commodity prices ended up having large second-round effects. Russia defaulted in August 1998, prompting a collapse in the ruble. To patch up its finances, Russia began pumping ever more oil out of the ground, causing oil prices to fall below US$10/bbl in December 1998, deepening the malaise in commodity prices. This caused the Brazilian real to collapse in 1999, and the Argentinian peso to follow in 2002 (Chart 4). Chart 31997: Falling Breakevens, Stable Real Yields 1997: Falling Breakevens, Stable Real Yields 1997: Falling Breakevens, Stable Real Yields Chart 4Asian Crisis Goes Global Asian Crisis Goes Global Asian Crisis Goes Global Among these contagions, the Russian default was the event with the greatest systemic impact. This was because it was a direct hit to the U.S. banking system. Long Term Capital Management, a large Connecticut-based hedge fund, had accumulated massive bets on Russia. The country's default plunged the fund into the abyss. However, LTCM had liabilities to banks to the tune of US$125 billion. The exposure was perceived as an existential threat to the banking sector, and the market began to anticipate a repeat of the 1907 panic.1 Junk bond spreads jumped, the S&P 500 fell by 18%, and U.S. government bond yields collapsed by 120 basis points (Chart 5). The Fed was forced to respond, coming out of hibernation and cutting rates by 75 basis points between September and November of 1998. As the Fed forcefully responded to this shock and 10-year Treasury yields fell, the dollar, which had managed to stay somewhat stable against the synthetic euro from July 1997 to August 1998, fell 11%. Within the same one-year window starting in July 1997, the yen dropped 23%, dragged lower by the competitive pressures created by weaker Asian currencies. However, as soon as U.S. bond yields collapsed, the yen began to surge, rising by 36% from August 1998 to January 1999 (Chart 6). Only once the Fed started increasing rates anew did the euro and the yen level off. Chart 5The Russian Default Was The Real Shock For The U.S. The Russian Default Was The Real Shock For The U.S. The Russian Default Was The Real Shock For The U.S. Chart 6The Dollar Buckled After LTCM The Dollar Buckled After LTCM The Dollar Buckled After LTCM In aggregate, the dollar's performance through the 1997-1998 period was very mixed. The trade-weighted dollar managed to rise from July 1997 to August 1998. Nevertheless, this was a complex picture. During this timeframe the dollar rose against EM currencies - against the CAD, the AUD, the NZD and the JPY - but was flat against the euro. The USD then fell against everything from August 1998 to the first half of 1999. Only once the Fed started hiking again in the summer 1999, was the greenback able to resuming its broad ascent, one that lasted all the way until late 2001. Bottom Line: In 1997, the first domino to fall was Thailand. Since many East Asian economies suffered the same ills - current account deficits, foreign currency debt loads and falling foreign exchange reserves - Asian currencies followed, dragging the yen lower in the process. This generated a deflationary shock that hurt commodity prices and commodity currencies, leading to the infamous Russian default of 1998. The associated LTCM bankruptcy threatened the survival of the U.S. banking system, forcing bond yields much lower as the Fed cut rates three times. The dollar suffered because of this policy move, especially against the yen. However, once the Fed resumed its hiking campaign, the dollar recovered across the board, making new highs all the way to late 2001 and early 2002. Is 2018: 1997, 1998, Or 2018? In one key regard, today is not the late 1990s: Dollar pegs are few and far between. However, in many respects, similarities abound. First and most obviously, EM foreign currency debt loads, as measured against exports, GDP or reserves, are at similar levels to those prevailing in the late 1990s (Chart 7). This means that EM economies suffer when the dollar rises, as it represents an increase in their cost of capital, and thus a tightening in financial conditions. Second, the Fed has been increasing interest rates. Most importantly, the Fed is growingly concerned that domestic inflationary pressures in the U.S. are intensifying, courtesy of strong growth - at least relative to potential; a high degree of capacity utilization, especially in the labor market (Chart 8); and, unique to today, the U.S. has received a large degree of unneeded fiscal stimulus. Chart 7EM Dollar Debt Is High EM Have More ##br##Foreign-Currency Debt Than In The 1990s EM Dollar Debt Is High EM Have More Foreign-Currency Debt Than In The 1990s EM Dollar Debt Is High EM Have More Foreign-Currency Debt Than In The 1990s Chart 8The Foreign Pain Threshold For The Fed Is Much Higher ##br##Now Than In 2015 or 2016 The Foreign Pain Threshold For The Fed Is Much Higher Now Than In 2015 or 2016 The Foreign Pain Threshold For The Fed Is Much Higher Now Than In 2015 or 2016 This means it will take a lot of pain to derail the Fed from its desire to hike rates once a quarter. This also makes the current environment very different from 2015, the most recent episode of EM tumult. In 2015-2016, the Fed easily abandoned its hiking campaign. When it hiked rates in December 2015, the Fed anticipated increasing rates four times over the following 12 months. It delivered only one hike in December 2016. The reason was straightforward: Unlike today, the U.S. economy was still replete with slack (Chart 8) and was not on the receiving end of a large fiscal stimulus program, suggesting the Fed could not tolerate the deflationary impact of tightening financial conditions. Third, global liquidity is tightening, which is hurting the global growth outlook. Today, global excess money, as defined by the growth of broad money supply above that of loan growth in the U.S., the euro area and Japan, is contracting. Today, as in 1997, this indicator forebodes important weaknesses in global industrial production (Chart 9). U.S. liquidity is particularly important. Not only is dollar-based liquidity crucial to financing the large stock of dollar-denominated foreign debt, but the U.S. is also driving the fall in global excess money. The pick-up in U.S. economic activity is sucking liquidity from both the rest world and from the financial system to finance U.S. loan growth (Chart 10). This phenomenon was also at play in 1997. Chart 9Excess Money Is Contracting Global Excess ##br##Money Contracting, Just Like In Early 1997 Excess Money Is Contracting Global Excess Money Contracting, Just Like In Early 1997 Excess Money Is Contracting Global Excess Money Contracting, Just Like In Early 1997 Chart 10The U.S. Economy Is ##br##Sucking In Liquidity The U.S. Economy Is Sucking In Liquidity The U.S. Economy Is Sucking In Liquidity Why does this matter? Simply put, U.S. financial liquidity; built as a composite of 3-month T-bills, total bank deposits minus bank loans, bank investments, and M2 money supply; is a wonderful leading indicator. The current collapse in financial liquidity suggests that the global economy is about to hit a rough patch. As Chart 11 illustrates, the weakness of this indicator points to declines in our Global Leading Economic Indicators and in global commodity prices. This suggests the indicator is foretelling that a deflationary scare could materialize, an event normally also associated with a stronger dollar and downside in EM export prices (Chart 12). In a logically consistent fashion, the liquidity indicator is also warning that the AUD, CAD and NZD have substantial downside, while EM equity prices could also suffer more (Chart 13). Finally, it also highlights that even the U.S. stock market may not be immune to upcoming troubles (Chart 14). Chart 11U.S. Financial Liquidity Points To Weaker Growth... U.S. Financial Liquidity Points To Weaker Growth... U.S. Financial Liquidity Points To Weaker Growth... Chart 12...And A Stronger Dollar But Weaker EM Export Prices... ...And A Stronger Dollar But Weaker EM Export Prices... ...And A Stronger Dollar But Weaker EM Export Prices... Chart 13...Falling EM Stocks And Commodity Currencies... ...Falling EM Stocks And Commodity Currencies... ...Falling EM Stocks And Commodity Currencies... Chart 14...And Maybe Even A Correction In U.S. Stock Prices ...And Maybe Even A Correction In U.S. Stock Prices ...And Maybe Even A Correction In U.S. Stock Prices Fourth, gold is sending a similar signal as in the late 1990. As we have argued in the past, gold is a very good gauge of global liquidity conditions. During the Asian Crisis and the Russia/LTCM fiasco, industrial commodity prices only experienced a serious decline after the Thai baht had dragged down Asia into a tailspin. However, gold had been falling since 1996, a move predating the fall in Asian currencies (Chart 15). The precious metal was confirming that global liquidity was tightening and being sucked back into the booming U.S. economy. Today, gold prices are sending an ominous signal. After forming a large tapering wedge from 2011 to 2018, gold prices have broken down below the major upward-sloping trend line that had defined the bull market that began in 2001 (Chart 16). This indicates that gold may be starting another leg of a major bear market. Moreover, as the bottom panel of Chart 16 illustrates, it is true that net speculative positions in the yellow metal have plunged, but they remain far above the large net short positions that prevailed in the late 1990s. If gold is indeed entering another major down leg, this would confirm that tightening liquidity will further hurt EM asset prices, commodity prices and non-U.S. economic activity. Chart 15As Early As 1996, Gold Warned Of Upcoming Problems In Asia As Early As 1996, Gold Warned Of Upcoming Problems In Asia As Early As 1996, Gold Warned Of Upcoming Problems In Asia Chart 16Is A Secular Bear Market In Gold Beginning? Is A Secular Bear Market In Gold Beginning? Is A Secular Bear Market In Gold Beginning? Finally, adding insult to injury is China. The current communist party leadership is hell-bent on reforming the Chinese economy, moving it away from its dependence on capex and leverage. Consequently, China is in the midst of a major deleveraging campaign concentrated in the shadow banking sector, which has already caused money growth and total social financing to plumb to new lows (Chart 17). This is deflationary for the global economy as weaker Chinese credit weighs on capex, which in turns weighs on Chinese imports, as 69% of China's intake from the rest of the world are commodities and intermediate as well as industrial goods. Chart 17Chinese Monetary And Credit Conditions Remain ##br##Tight China Deleveraging Is Biting Chinese Monetary And Credit Conditions Remain Tight China Deleveraging Is Biting Chinese Monetary And Credit Conditions Remain Tight China Deleveraging Is Biting Chart 18No Capitulation ##br##Yet No Capitulation Yet No Capitulation Yet Moreover, the recent wave of renminbi weakness is exacerbating these deflationary pressures. The 9% fall in the yuan versus the dollar since April 11th represents a competitive devaluation that will hurt many EM countries. It also implies downside in China's import volumes, as it increases the prices paid by Chinese economic agents for foreign-sourced industrial goods and commodities.2 All these forces suggest that the pain that started in Argentina and Turkey could continue to spread across other vulnerable EM economies. It is doubtful that economies with large debt loads, large upcoming debt rollovers and other underlying economic problems will find it easy to receive financing in an environment of declining global liquidity, a strong dollar, budding deflationary pressures and a slowing China. Making this worry even more real, EM investors have not capitulated, as bottom-fishing has prompted massive inflows into Turkey in recent days (Chart 18). 2018 may not be 1997 or 1998, but it is likely to be a year to remember. Bottom Line: EM currency pegs to the dollar may not be as prevalent as they were back in the 1990s, but enough risks are present that contagion from Argentina and Turkey to other EM economies is a very real risk. Specifically, the domestic economic situation in the U.S. warrants higher interest rates, which suggests the Fed is unlikely to be fazed by EM market routs unless they become deep enough to present a threat to U.S. growth itself. Moreover, global liquidity conditions are tightening as the U.S.'s economic strength is sucking in capital from around the world. This combination means that EM countries with large dollar debt loads are likely to find debt refinancing a very onerous exercise. Finally, China is slowing and letting the RMB fall, which is exerting a deflationary impact on the world. Investment implications An environment of slower global economic activity, tightening global liquidity conditions and a potential deflationary scare is positive for the dollar. But 1998 shows that if the hot potato hides in the U.S. and the Fed is forced to ease aggressively, the dollar could nonetheless suffer. In order to get a sense as to whether the dollar can continue to strengthen or not, it is important to get a sense of where the exposure to an EM accident may lie. To begin this exercise, we need to first assess which EM countries are most vulnerable to catching the "Turkish Flu." To do so, we collaborated with our colleague Peter Berezin and his team at BCA's Global Investment Strategy to build a heat map of vulnerable EM economies. This heat map is based on the following factors: current account balance, net international investment position, external debt, external debt service obligation, external funding requirements, private sector savings/investment balance, private sector debt, government budget balance, government debt, foreign ownership of local currency bonds, and inflation. This method shows that after Turkey and Argentina, the next six most vulnerable countries are Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia in this order (Chart 19). Chart 19Vulnerability Heat Map For Key EM Markets The Bear And The Two Travelers The Bear And The Two Travelers While our long-term valuation models show that the Colombian peso is already trading at a significant discount to its fair value, the BRL, the CLP, the ZAR, and the MXN are not (Chart 20). This highlights that these markets could provide serious fireworks in the coming months. Moreover, they all have their own idiosyncrasies that accentuate these risks. Brazil will soon undergo elections that will likely not result in a market-friendly outcome.3 Chile has an extremely large dollar-debt load, copper prices are tanking and the CLP is very pricey. Finally, South Africa is contemplating the kind of land expropriations reminiscent of those that plunged Zimbabwe into chaos - not a good optic for a still-expensive currency. So, who is most exposed to this potential mess? The answer is the euro area, most specifically, Spain. As Chart 21 shows, the exposure of Spanish banks to the most vulnerable EM markets totals nearly 170% of the banking system's capital and reserves. This means that 30% of the capital and reserves of the banking systems in the euro area's five largest economies is exposed to these markets. Making the risk even more acute, French banks have large exposure to Spain, and German banks to France. This combined exposure dwarfs the exposure of the U.K., Japan or the U.S. to the most vulnerable EM economies. To be fair to Spain, Spanish banks often have set up their foreign affiliates as separate legal entities. This means that the impact on the balance sheets of the Spanish banking system of defaults in vulnerable EM countries may be more limited than seems at face value. Yet, this is far from certain. Chart 20BRL, CLP, ZAR, And MXN Are Too Expensive##br## In Light Of Their Vulnerabilities BRL, CLP, ZAR, And MXN Are Too Expensive In Light Of Their Vulnerabilities BRL, CLP, ZAR, And MXN Are Too Expensive In Light Of Their Vulnerabilities Chart 21Who Has More Exposure To EM? The Bear And The Two Travelers The Bear And The Two Travelers As a result, we would not be surprised if the European Central Bank is forced by an EM accident to back away from its desire to abandon its extraordinary accommodative stance. The ECB would first use forward guidance to message that a hike will be delayed ever further in the future. The ECB may even be forced to resume government and corporate bonds purchases past 2018. This is a potential nightmare scenario for the euro. In fact, as Chart 22 illustrates, a euro at parity may not be a far stretch. Historically, the euro bottoms when it trades 10% below our fair value model, based on real short rate differentials, relative yield curve slopes and the ratio of copper to lumber prices. Such a discount would correspond to EUR/USD at parity. Because under such circumstances the Fed could be forced to pause its own hiking cycle for a quarter or two, a move to EUR/USD between 1.10 and 1.05 seems more likely than a collapse to parity right now. This also means that in conjunction with BCA's Geopolitical Strategy team, we recommend our clients close overweight positions in Spanish assets. Chart 22The Euro Still Has Downside If EM Go Bust The Euro Still Has Downside If EM Go Bust The Euro Still Has Downside If EM Go Bust What about the yen? In the late 1990s, the yen fell against the U.S. dollar as Asian currencies were collapsing, but surged once the Fed backtracked and bond yields tanked in 1998. This time could follow a different road map. Japan does not compete against Brazil, Colombia, Mexico, Chile and South Africa in the same way as it was competing against industrial companies in countries like Taiwan, Singapore or South Korea. This means that Japan is unlikely to need to competitively devalue to remain afloat if the BRL, COP, MXN, CLP and ZAR collapse further. However, since an EM shock is likely to prove to be a deflationary event, this means that bond yields could experience downside, especially as positioning in the U.S. bond market is massively crowded to the short side (Chart 23). A countertrend bull market in bonds would greatly flatter the yen. As a result, we are maintaining our short EUR/JPY bias over the coming months. The G10 commodity currency complex is also at risk. Not only does tightening dollar liquidity imply further weakness in this group of currencies, so does slowing EM activity and a deflationary scare. Additionally, the CAD and the NZD are not trading at much of a discount to their fair value, and the AUD trades at a premium (Chart 24). This means we would anticipate these currencies to suffer more in the coming quarters, led by the AUD, which is not only the most expensive of the group, but also the most geared to EM economic activity. Being short AUD/CAD still makes sense. Chart 23A Bond Rally Would ##br##Support The Yen A Bond Rally Would Support The Yen A Bond Rally Would Support The Yen Chart 24TDollar-Bloc Currencies Offer Limited Cushion##br## In The Event of An EM Selloff TDollar-Bloc Currencies Offer Limited Cushion In The Event of An EM Selloff TDollar-Bloc Currencies Offer Limited Cushion In The Event of An EM Selloff Finally, the pound is its own animal. GBP/USD is now quite cheap, but the U.K.'s large current account deficit of 3.9% of GDP, which is not funded through FDIs anymore, means that Great Britain remains vulnerable to tightening global liquidity conditions. Moreover, Brexit negotiations will heat up in the fall, as the March 2019 deadline for reaching a deal with the EU looms large. This means that political tumult in the U.K. will remain a large source of risk for the pound. We will explore the outlook for the pound in an upcoming report this September. Currently, our long DXY trade is posting an 8.5% profit, with a target at 98. The above picture suggests that the dollar could move well past 98, especially as the momentum factor that is so important to the greenback still plays in favor of the USD.4 As a result, we are upgrading our target on the dollar to 100. However, we are also tightening our stop loss to 94.88. We will update our stop loss to 97 if the DXY hits 98 in the coming weeks, in order to protect gains while still being exposed to the dollar's potential upside. Bottom Line: Beyond Turkey and Argentina, the EMs most vulnerable to tightening global liquidity conditions are Brazil, Colombia, Mexico, Chile and South Africa. Spanish banks have outsized exposure to these markets, which means the euro area is at risk if the "Turkish Flu" becomes contagious. As such, the ECB could be forced to remain easier than it wants to. The euro is still at risk. The yen could strengthen if global bond yields suffer. Hence, it still makes sense to be short EUR/JPY. While the CAD, AUD and NZD are also all vulnerable to a deflationary scare, the Aussie is the worst positioned of the three. Shorting AUD/CAD still makes sense. The DXY is likely to experience significant upside from here, with a move to 100 becoming an increasingly probable scenario. Risks To Our View Chart 25A Gauge And A Hedge Against Chinese Stimulus A Gauge And A Hedge Against Chinese Stimulus A Gauge And A Hedge Against Chinese Stimulus The biggest risk to our view is China. In 2016, a vicious EM selloff was staunched by a large wave of stimulus that put a floor under Chinese economic activity, and caused China to re-lever. The impact was felt around the world, lifting commodity prices and EM assets while plunging the dollar into a vicious selloff in 2017. It is conceivable that such an outcome materializes anew, especially as China is, in fact, injecting stimulus into its economy. However, as we wrote two weeks ago, the current stimulus still pales in comparison to what took place in 2015. Moreover, reforms and deleveraging have much greater primacy now than they did back then.5 BCA believes that the current wave of stimulus is not designed to cause growth to surge again, as was the case in 2015, but is instead aimed at limiting the negative impact of the ongoing trade war with the U.S. Yet, we cannot be dogmatic. Not only is it hard to gauge the actual degree of stimulus currently applied to the Chinese economy, there is a heightened risk that the flow of policy announcements causes a shift in the dominant narrative among market participants. Such a shift in attitudes could easily cause a mass buying of EM assets and commodities, delaying the day of reckoning for vulnerable EM. As a result, we continue to promulgate that investors track the behavior of our China Play Index, introduced two weeks ago (Chart 25).6 Not only does this index provide a live read on how traders are pricing in Chinese developments, but it also provides a great hedge for investors long the dollar, short EM, or short the commodity complex. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 In the panic of 1907, the Knickerbocker Trust Company went bankrupt, threatening the health of the U.S. banking system. The stock market crashed, money markets went into paralysis, and a consortium of bankers led by J.P. Morgan himself ended up acting as a lender of last resort, staunching the crisis. As a consequence of this panic, the Federal Reserve System was born in 1913. 2 For a more detailed discussion of the deflationary risk created by the RMB, please see Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report, "Brazil: Faceoff Time", dated July 27, 2018, available at ems.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com 6 Ibid. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Real Rate "Targeting": Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. U.K.: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Japan: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Feature Chart Of The WeekA 'New, New Normal' Of Higher Real Rates? A 'New, New Normal' Of Higher Real Rates? A 'New, New Normal' Of Higher Real Rates? Three major central banks met last week and, surprisingly, the most important message did not come from the Federal Reserve. The Bank of England (BoE) and Bank of Japan (BoJ) both delivered policy decisions that appeared more hawkish on the surface, even though the underlying message was far more mixed. The BoE hiked rates by 25bps, while the BoJ tweaked its yield curve control policy by raising the allowable ceiling for the 10-year Japanese Government Bond (JGB) to 0.2%. Yet both central banks signaled - through published research, commentary and outright forward guidance - that the timing of the next policy move is uncertain. This contrasts with the Fed, who continues to signal a slow-but-steady path of U.S. rate hikes over at least the next year. The BoE and BoJ are dealing with the same issues that all the major developed market central banks are facing now - how to reconcile low unemployment and an apparent dearth of spare economic capacity with only modest upward inflation momentum and real interest rates that appear too low (Chart of the Week). Against that backdrop, the communication of central banker strategies to the public, and to the financial markets, is critical to their success, defined by keeping inflation stable around target levels. The Fed has been a leader in introducing nuance into the execution, and communication, of post-crisis policymaking. First, by focusing more on underutilized capacity in the U.S. labor market to justify keeping the funds rate low despite the headline unemployment rate falling below its estimate of "full" employment. Later, by focusing attention on real interest rates and the possibility that the neutral level of that rate (a.k.a. "r-star") can vary cyclically from levels that would previously have been considered consistent with full employment and stable inflation. In both cases, the Fed has provided a framework that allows some wiggle room as it continues to normalize away from crisis-era policy settings. Passionate advocates of the concept like current New York Fed President John Williams have led the Fed's growing focus on r-star. Yet in its latest Inflation Report published last week, the BoE dedicated five full pages to the topic of estimating r-star in the U.K.1 Other central banks have discussed their own estimates of r-star over the past year, as well.2 This is an important point for global bond markets. If other central banks begin to follow the lead of the Fed and elevate the importance of "real rate targeting" into their inflation targeting frameworks, then real bond yields could have significant upside with policy rates still not above realized inflation in the major developed economies. This will especially be true if factors that have kept r-star cyclically depressed in many countries in the post-crisis era - weak productivity growth, fiscal consolidation, excess capacity in labor markets, household deleveraging, among others - continue to slowly dissipate. At the moment, the most important themes for global financial markets relate to the ongoing Fed tightening cycle, the potential for policy stimulus in China in response to slowing domestic growth, and the slowing growth of central bank balance sheets (Chart 2). All three are bond bearish. We could add a fourth item to that list - U.S. protectionism, which can lead to slowing global through diminished trade activity. While there is evidence from many countries that a more uncertain outlook for global trade has negatively affected business confidence, there is also some tentative evidence that the deceleration in global trade activity may be in the process of stabilizing (Chart 3). Yet even if the U.S. - China trade tensions worsen and industrial activity slows further, tariffs and trade barriers represent a supply shock that could result in higher global inflation and prevent a meaningful decline in bond yields. Summing it all up for our government bond investment strategy, we continue to recommend: a below-benchmark overall portfolio duration stance country allocation (Chart 4) with underweight exposure to countries where central banks can credibly raise interest rates (U.S., Canada) and overweight exposure where rate hikes will be more difficult to deliver (U.K., Japan, Australia) Bottom Line: Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. Chart 2The Biggest Market Risks Are Bond Bearish The Biggest Market Risks Are Bond Bearish The Biggest Market Risks Are Bond Bearish Chart 3Tentative Signs Of Global Trade Stabilization? Tentative Signs Of Global Trade Stabilization? Tentative Signs Of Global Trade Stabilization? Chart 4Underweight Countries That Can Credibly ##br##Raise Rates (And Vice Versa) Underweight Countries That Can Credibly Raise Rates (and vice versa) Underweight Countries That Can Credibly Raise Rates (and vice versa) Stay Overweight U.K. Gilts, Even After The BoE Rate Hike The BoE delivered a 25bp rate hike last week, bringing its Bank Rate to 0.75%. The growth and inflation forecasts for the next three years were essentially unchanged, however. The hike was described by BoE Governor Mark Carney as a sign of growing confidence by the Monetary Policy Committee (MPC) in its forecast. Thus, another step towards normalizing the Bank Rate from accommodative levels was appropriate. In the press conference following the MPC meeting, Carney noted that the recent pickup in U.K. wage growth was an important development. Carney said that with the economy at full employment,3 the BoE's job is to "manage demand" to control inflation while nominal wage growth expands. Real wage growth has crept back into positive territory in recent months (Chart 5). Numerous indicators were presented in the August 2018 Inflation Report to suggest that U.K. labor markets are growing increasingly tight - including faster wage growth for those switching jobs than those staying in jobs (bottom panel) and survey data showing greater pay increases in sectors facing recruitment and retention difficulties. The BoE did downplay the recent cooling of realized U.K. inflation, which has been more a product of the stability of the pound than an easing of domestic inflation pressures. While this is true, market-based measures of inflation expectation like CPI swaps have also been following the path of the pound, rather than typical forces like oil prices, since the collapse in the pound after the 2016 Brexit vote (Chart 6). On the margin, however, the more stable pound means that U.K. inflation will be more influenced by domestic factors, like tight labor markets and wage pressures. Chart 5Mixed Signals From The U.K. Labor Market Mixed Signals From The U.K. Labor Market Mixed Signals From The U.K. Labor Market Chart 6U.K. Inflation Following The Pound, Not The Labor Market U.K. Inflation Following The Pound, Not The Labor Market U.K. Inflation Following The Pound, Not The Labor Market As discussed earlier, the BoE did devote a significant section of the latest Inflation Report to the topic of the neutral real rate or r-star. The BoE noted that there was a longer-term and shorter-term r-star, and that the latter had to be deeply negative in recent years given the shocks from the 2008 Financial Crisis and recession to the 2016 Brexit vote to the fiscal austerity of recent Conservative governments. As the impacts of those shocks fades, the shorter-term r-star increases, requiring faster BoE rate hikes. Or as it was described in the Inflation Report: "The expected rise in r* over coming years, combined with the absorption of spare capacity over the forecast period, means that - even as inflation is projected to fall back toward 2% - the Bank Rate is likely to need to rise gradually to keep inflation at the target. But the persistence of the fall in the trend real rate means that any rises in the Bank Rate are expected to be limited, and interest rates are likely to need to remain low by historical standards for some time to come." That sounds like the BoE wanting to have its cake and eat it too, talking up rate hikes while making the case for rates to stay low for longer. The longer-run r-star estimates shown in the Inflation Report (between 0.5% and 1.5%) when added to the 2% BoE inflation target, suggests that the neutral nominal Bank Rate is between 2.5% and 3.5%. That does imply that there is a lot of scope for additional BoE rate hikes without even reaching a level that could be considered "'neutral' from a longer-term perspective" (Chart 7). It will be difficult for the BoE to deliver on any additional rate hikes, however, while both the economy and inflation are decelerating. The current pricing in the U.K. Overnight Index Swap (OIS) curve shows that there are only 42bps of hikes discounted by the end of 2020. That represents a very low hurdle to overcome, even if the U.K. economy remains sluggish and the Brexit outcome turns ugly. From a strategy perspective, we think that Gilt yields can rise above the current shallow path of the forward curve over the next 6-12 months, suggesting that a below-benchmark duration stance in the U.K. is appropriate. Yet with U.K. growth slowing and leading indicators suggesting more of that is to come, and with still no resolution to the Brexit negotiations with the March 29, 2019 "Brexit Day" looming in the distance, Gilt yields are likely to stay relatively subdued versus global peers. We continue to recommend an overweight stance on Gilts in hedged global bond portfolios (Chart 8). Chart 7U.K. Real Rates Are WAY Below Longer-Run R-Star U.K. Real Rates Are WAY Below Longer-Run R-Star U.K. Real Rates Are WAY Below Longer-Run R-Star Chart 8Stay Overweight U.K. Gilts Stay Overweight U.K. Gilts Stay Overweight U.K. Gilts Bottom Line: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Bank of Japan: Zero Pressure On The 0% Target Global bond yields got a bit of a jolt recently from the most unlikely of sources - Japan, the place where bond volatility goes to die. Amid media speculation that the Bank of Japan (BoJ) was considering an upward adjustment to its JGB yield target, the 10-year JGB took several runs at breaching the BoJ's implied pain threshold of 0.10%, resulting in the BoJ intervening with offers of "unlimited" purchases to quell the selloff. Yet at the monetary policy meeting last week, the BoJ only delivered modest changes: The allowable range for the 10-year JGB yield was widened to -0.20% to +0.20% New forward guidance was introduced indicating no rate hikes until at least 2020 A shift in the BoJ's equity ETF purchases to favor ETF's that target a broader index We were not surprised by the outcome, given that there was absolutely no reason why the BoJ should have even considered a change in policy settings. Back in February, we outlined the three things that we believed must ALL occur before the BoJ could plausibly raise its yield target for the 10-year Japanese government bond (JGB).4 Five months later, none of those conditions has been met (Chart 9): 1) The USD/JPY exchange rate must at least get back to the 115-120 range. USD/JPY has struggled to reach even the bottom end of our target range, only getting to an intraday high of 113.17 on July 19th. The starting point for the yen must be weaker than that before the BoJ can deliver any sort of more hawkish policy that would likely send the yen roaring higher. 2) Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5%. The extremely tight Japanese labor market (Chart 10) has finally begun to put upward pressure on wage growth, which now sits at 2.2% on a year-over-year basis. There has been no follow through into core inflation, however, which only got as high at 0.5% in March before sliding back to 0.2% in June. Chart 9None Of Our Conditions For A BoJ Hike Have Been Met None Of Our Conditions For A BoJ Hike Have Been Met None Of Our Conditions For A BoJ Hike Have Been Met Chart 10How Does This Job Market Not Produce Inflation? How Does This Job Market Not Produce Inflation? How Does This Job Market Not Produce Inflation? 3) The 10-year JGB yield must reach an overvalued extreme versus U.S. Treasuries. We judge this by looking at the residual from a fundamental model of the 10-year JGB yield published by the BoJ. The model includes both the 10-year U.S. Treasury yield as the proxy for global yields, and the share of outstanding JGBs owned by the central bank to measure the impact of BoJ buying (Table 1). That model suggests that current JGB yields are only at fair value, and that U.S. Treasury yields have to rise by a lot more (to at least 3.5%) to make the current level of JGB yields look "expensive", thus justifying a higher BoJ yield target (USD/JPY would likely be in the 115-120 range if that happened, as well). Yet despite all these factors arguing against any change in the BoJ's policy settings, the topic was seriously discussed at last week's policy meeting, according to Reuters.5 The renewed weakness of Japanese inflation scuttled any chance that a serious policy change could be delivered. The decision to widen the allowable yield range for the 10-year JGB yield not associated with any signaled change to the 0% yield target. Investors got the hint, and yields have calmed down after the late July turbulence. The BoJ is increasingly backed into a corner with its hyper-easy monetary policy. There is no spare capacity in the economy, with the unemployment rate at a 25-year low of 2.4% and the BoJ estimating that the output gap is closed. Our own Japan Central Bank Monitor is no longer in negative territory, indicating that the next policy move should be a tightening (Chart 11). The BoJ has indeed been "tightening", but only by reducing the pace of its bond buying. BoJ purchases now only matches the pace of new JGB - a far cry from when the BoJ was buying more than all new JGBs issued between 2013 and 2017 (bottom two panels). Table 1JGB Yield Model An R-Star Is Born An R-Star Is Born Chart 11BoJ Has Been Quantitatively Tightening BoJ Has Been Quantitatively Tightening BoJ Has Been Quantitatively Tightening There is a reported disagreement within the BoJ over the impact of the negative interest rate and yield curve control policies on Japanese bank profitability and lending capacity. Yet any sort of rate hike, at either end of the yield curve, would result in a sharp increase in the yen. To have that happen now would harm Japanese exporters' competitiveness at the worst possible time. Economic growth is decelerating in two of Japan's major trading partners, China and South Korea. At the same time, U.S. protectionism risks trade wars that would slow global trade at a time when Japanese export growth, and business confidence, may already be peaking (Chart 12). We continue to recommend an overweight position in Japanese government debt within hedged global government bond portfolios. Admittedly, the idea of overweighting a market where nearly half of all bonds still have a negative yield does not sound like a path to riches. Yet the BoJ stands out as the one major central bank that has virtually no chance at credibly talking about, much less delivering, any sort of monetary tightening with core inflation close to 0%. If non-Japanese yields continue to rise over the next 6-12 months, as we expect, then JGBs will once again be a relative outperformer in a global bond bear market (Chart 13). Chart 12Japan Is Vulnerable To A Global Trade War Japan Is Vulnerable To A Global Trade War Japan Is Vulnerable To A Global Trade War Chart 13Stay Overweight JGBs In Hedged Global Bond Portfolios Stay Overweight JGBs In Hedged Global Bond Portfolios Stay Overweight JGBs In Hedged Global Bond Portfolios Bottom Line: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The r-star discussion can be found on pages 39-43 of the August 2018 BoE Inflation Report, which can be found here https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2018/august/inflation-report-august-2018.pdf 2 For example, the BoJ's estimates of Japan's r-star can be found here, https://www.boj.or.jp/en/research/wps_rev/wps_2018/data/wp18e06.pdf, while the Bank of Canada's estimates for Canadian r-star can be found here https://www.bankofcanada.ca/wp-content/uploads/2017/11/boc-review-autumn2017-dorich.pdf 3 The BoE estimates full employment to be around the current unemployment rate of 4.25%, which is well below the OECD's estimate of 5.5% shown in the top panel of Chart 5. 4 Please see BCA Global Fixed Income Strategy Special Report "What Would It Take For The Bank Of Japan To Raise Its Yield Target?" dated February 13, 2018, available at gfis.bcaresearch.com 5 https://www.reuters.com/article/us-japan-economy-boj-policy-insight/bojs-architect-of-shock-and-awe-plots-retreat-from-stimulus-idUSKBN1KR0TA Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Paradox 1: U.S. growth will slow, and this will force the Fed to raise rates MORE quickly. Paradox 2: China will try to stimulate its economy, and this will HURT commodities and other risk assets. Paradox 3: Global rebalancing will require the euro area and Japan to have LARGER current account surpluses. Feature Faulty Assumptions Investors assume that slower U.S. growth will cause the Fed to turn more dovish; efforts by China to stimulate its economy will boost market sentiment towards risk assets; and global rebalancing requires the euro area and Japan to reduce their bloated current account surpluses. In this week's report, we consider the possibility that all three assumptions are wrong. Let's start with the U.S. growth picture. U.S. Growth About To Slow? The U.S. economy grew by 4.1% in the second quarter, the fastest pace since 2014. The composition of growth was reasonably solid. Net exports boosted real GDP by 1.1 percentage points, but this was largely offset by a 1.0 point drag from a slower pace of inventory accumulation. As a result, domestic final demand increased at a robust rate of 3.9%, led by personal consumption (up 4.0%) and business fixed investment (up 7.3%). Unfortunately, the second quarter is probably as good as it gets for growth. We say this not because we expect aggregate demand growth to falter to any great degree. Quite the contrary. Consumer confidence is high and the labor market is strong, with initial unemployment claims near 49-year lows. The Bureau of Economic Analysis' latest revisions revealed a much higher personal savings rate than had been previously estimated (Chart 1). The savings rate is now well above levels that one would expect based on the ratio of household net worth-to-disposable income (Chart 2). This raises the odds that consumer spending will accelerate. Chart 1Households Are Saving More ##br##Than Previously Thought Households Are Saving More Than Previously Thought Households Are Saving More Than Previously Thought Chart 2Consumption Could Accelerate ##br##As The Savings Rate Drops Three Macro Paradoxes Are About To Come True Three Macro Paradoxes Are About To Come True Rising consumer demand will prompt businesses to expand capacity (Chart 3). Core capital goods orders surprised on the upside in June, with positive revisions made to past months. Capex intention surveys remain at elevated levels. So far, fears of a trade war have not had a major impact on business investment. Fiscal spending is also set to rise. Federal government expenditures increased by only 3.5% in Q2, far short of the 10%-plus growth rate that some forecasters were projecting. The effect of the tax cuts have also yet to make their way fully through the economy. Supply Matters Considering all these positive drivers of demand, why do we worry that growth could slow meaningfully later this year or in early 2019? The answer is that for the first time in over a decade, demand is no longer the binding constraint to growth - supply is. Today, there are fewer unemployed workers than job vacancies (Chart 4). The number of people outside the labor force who want a job is near all-time lows. Businesses are reporting increasing difficulty in finding qualified labor. Chart 3U.S. Companies Plan To Boost Capex U.S. Companies Plan To Boost Capex U.S. Companies Plan To Boost Capex Chart 4Companies Are Struggling To Fill Job Openings Companies Are Struggling To Fill Job Openings Companies Are Struggling To Fill Job Openings New business investment will add to the economy's productive capacity over time, but in the near term, the boost to aggregate demand from new investment spending will easily exceed the contribution to aggregate supply.1 The Congressional Budget Office estimates that potential real GDP growth is running at around 2%. What happens when the output gap is fully eliminated, and aggregate demand growth begins to eclipse supply growth? The answer is that inflation will rise. Instead of more output, we will see higher prices (Chart 5). Chart 5Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Three Macro Paradoxes Are About To Come True Three Macro Paradoxes Are About To Come True Rising inflation will force the Fed to engineer an increase in real interest rates, even in the face of slower GDP growth. Such a stagflationary outcome is not good for equities, which is one reason why we downgraded our cyclical recommendation on risk assets from overweight to neutral in June. Higher-than-expected real interest rates will put upward pressure on the U.S. dollar. A stronger dollar will hurt U.S. companies with significant foreign exposure more than it hurts their domestically-oriented peers. If history is any guide, a resurgent greenback will also cause credit spreads to widen (Chart 6). Chinese Stimulus: Be Careful What You Wish For Chinese stimulus helped reignite global growth after the Global Financial Crisis and again during the 2015-2016 manufacturing downturn. With global growth slowing anew, will China once again come to the rescue? Not quite. China does not want to let its economy falter, but high debt levels, and an overvalued property market plagued by excess capacity, limit what the authorities can do (Chart 7). Chart 6A Stronger Dollar Usually Corresponds ##br##To Wider Corporate Borrowing Spreads A Stronger Dollar Usually Corresponds To Wider Corporate Borrowing Spreads A Stronger Dollar Usually Corresponds To Wider Corporate Borrowing Spreads Chart 7China: High Debt Levels Make ##br##Credit-Fueled Stimulus A Risky Proposition Three Macro Paradoxes Are About To Come True Three Macro Paradoxes Are About To Come True Granted, the government has loosened monetary policy at the margin and plans to increase fiscal spending. However, our China strategists feel these actions are more consistent with easing off the brake than pressing down on the accelerator.2 They note that the authorities continue to squeeze the shadow banking system, as evidenced by the continued deceleration in money and credit growth, as well as rising onshore spreads for the riskiest corporate bonds (Chart 8). The Specter Of Currency Wars If Chinese growth continues to decelerate, what options do the authorities have? One possibility is to double down on what they are already doing: letting the RMB slide. Chart 9 shows that the Chinese currency has weakened substantially more over the past six weeks than its prior relationship with the dollar would have suggested. Chart 8Chinese Credit Growth Has Been Slowing Chinese Credit Growth Has Been Slowing Chinese Credit Growth Has Been Slowing Chart 9The Yuan Has Weakened More Than Expected ##br##Based On the Broad Dollar Trend The Yuan Has Weakened More Than Expected Based On the Broad Dollar Trend The Yuan Has Weakened More Than Expected Based On the Broad Dollar Trend Letting the currency weaken is a risky strategy. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led some commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by enough to flush out expectations of a further decline. Perhaps China was simply too timid? Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a trade war with the United States. The U.S. exported only $188 billion of goods and services to China in 2017, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, China is better positioned to wage a currency war with the United States. The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Efforts by China to devalue its currency would invite retaliation from the United States. However, since the Trump Administration seems keen on pursuing a protectionist trade agenda no matter what happens, the Chinese may see their decision to weaken the yuan as the least bad of all possible outcomes. Unlike traditional stimulus in the form of additional infrastructure spending and faster credit growth, a currency devaluation would roil financial markets, causing risk asset prices to plunge. Metal prices would take it on the chin, since a weaker RMB would make it more expensive for Chinese businesses to import commodities. China now consumes close to half of the world's supply of copper, zinc, nickel, aluminum, and iron ore (Chart 10). Investors should remain underweight emerging market equities relative to developed markets and shun the currencies of commodity-exporting economies. We are currently short AUD/CAD on the grounds that a China shock would hurt metal prices more than energy prices. The Canadian dollar is highly levered to the latter, while the Aussie dollar is more levered to the former. Global Rebalancing: It's Not About Getting To Zero We have argued before that China's high savings rate explains why the country has maintained a structural current account surplus, despite the economy's rapid GDP growth rate.3 Both the euro area and Japan also have an excessive savings problem, minus the mitigating effect of rapid trend growth. The euro area's excessive savings problem was masked during the nine years following the introduction of the euro by a massive credit boom across much of the region (Chart 11). Germany did not partake in that boom, but it was still able to export its excess savings to the rest of the euro area via a rising current account balance. Chart 10China Is A More Dominant Consumer ##br##Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil Chart 11Germany Did Not Take Part ##br##In The Credit Boom Germany Did Not Take Part In The Credit Boom Germany Did Not Take Part In The Credit Boom Germany Needs A Spender Of Last Resort Chart 12 shows that Germany's current account surplus with other euro area members mirrored the country's increasing competitiveness vis-à-vis the rest of the region. In essence, the spending boom in southern Europe sucked in German exports, with German savings financing the periphery's swelling current account deficits. This is the main reason why German banks were hit so hard during the Global Financial Crisis: They were the ones who underwrote the periphery's spendthrift ways. That party ended in 2008. With the periphery no longer the spender of last resort in Europe, Germany had to find a way to export its savings to the rest of the world. But that required a cheaper currency, which Mario Draghi ultimately delivered in 2014 when he set in motion the ECB's own quantitative easing program. So where do we go from here? Germany's excess savings problem is not about to go away anytime soon. The working-age population is set to decline over the next few decades, which means that most domestically oriented businesses will have little incentive to expand capacity (Chart 13). The peripheral countries remain in belt-tightening mode. This will limit demand for German imports. Meanwhile, countries such as Spain have made significant progress in reducing unit labor costs in an effort to improve competitiveness and shift their current account balances back into surplus. Chart 12Competitiveness Gains In The 2000s Allowed ##br##Germany To Increase Its Current Account Surplus Competitiveness Gains In The 2000s Allowed Germany To Increase Its Current Account Surplus Competitiveness Gains In The 2000s Allowed Germany To Increase Its Current Account Surplus Chart 13Germans Need To Have More Children Three Macro Paradoxes Are About To Come True Three Macro Paradoxes Are About To Come True The ECB And The BOJ Can't Afford To Raise Rates The private sector financial balance in the euro area - effectively, the difference between what the private sector earns and spends - now stands near a record high (Chart 14). Fiscal policy also remains fairly tight. The IMF estimates that the euro area's cyclically-adjusted primary budget balance will be in a surplus of 0.9% of GDP in 2018-19, compared to a deficit of 3.8% of GDP in the United States (Chart 15). Chart 14Euro Area: Private Sector ##br##Balance Remains Elevated Euro Area: Private Sector Balance Remains Elevated Euro Area: Private Sector Balance Remains Elevated Chart 15The Euro Area's Fiscal Policy Is Tight The Euro Area's Fiscal Policy Is Tight The Euro Area's Fiscal Policy Is Tight If the public sector is unwilling to absorb the private sector's excess savings by running large fiscal deficits, those savings need to be exported abroad in the form of a current account surplus. Failure to do so will result in higher unemployment, and ultimately, further political upheaval. This means that the ECB has no choice other than to keep rates near rock-bottom levels in order to ensure that the euro remains cheap. Japan has been more willing than Europe to maintain large budget deficits, but the problem is that this has resulted in a huge debt-to-GDP ratio. The Japanese would like to tighten fiscal policy, starting with the consumption tax hike scheduled for October 2019. However, this may require the economy to have an even larger current account surplus, which can only be achieved if the yen weakens further. This, in turn, suggests that the Bank of Japan will not abandon its yield curve control policy anytime soon. We were not in the least bit surprised this week when Governor Kuroda poured cold water on the idea that the BoJ was contemplating raising either its short or long-term interest rate targets. The bottom line is that thinking about global imbalances solely in terms of current account positions is not enough. One should also think about the distribution of aggregate demand across the world. Countries with demand to spare such as the United States can afford to run current account deficits, while economies with insufficient demand such as the euro area and Japan should run current account surpluses. The key market implication is that interest rates will remain structurally higher in the United States, which will keep the dollar well bid. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This is partly because it can take a while for additional capital spending to raise aggregate supply. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights President Trump has expressed dissatisfaction with the Fed's policy tightening. However, we do not think he will be able to influence policy in a dovish fashion this cycle. Trump has suggested that many nations are manipulating their exchange rates to the detriment of the U.S. We do not see the U.S. as having the same capacity to force large exchange rate appreciation for its trading partners as it previously did. We expect instead this rhetoric to result in more favorable trade deals for the U.S. As a result, while we believe Trump's rhetoric was the catalyst for a much-needed correction in the dollar, his utterances do not mark the end of the dollar rally for 2018. We have been hedging the dollar's short-term downside by selling USD/CAD. We do not anticipate the BoJ to tweak its YCC policy next week. As a result, we fade the yen's recent strength against the dollar. However, we do believe the global economic outlook warrants staying long the yen against the euro and the Aussie for the remainder of the year. Feature U.S. President Donald Trump has begun to fight back against the impact of his stimulative fiscal policy. Obviously, it is not that he is displeased with the decent growth and job performance of the U.S. Instead, he is not happy that this increase in economic activity and build-up in inflationary pressures is causing the Federal Reserve to hike interest rates faster than he would like, and the dollar to be stronger as well. Despite President Trump's intentions, it is unlikely that he actually has enough levers to push the Fed to conduct easier monetary policy, and it is even more doubtful that he can push the dollar lower by pressuring the euro area, China, and other trading partners to revalue their currencies. The Fed Is No Pushover While BCA has argued that President Trump is unconstrained when it comes to his international agenda, there are certainly large constraints on his domestic agenda. When it comes to the Fed, this constraint is binding, as the Federal Reserve Act of 1913 clearly states that the U.S. central bank is a creature of Congress. Moreover, historically, the Fed has been a staunch defender of its independence. As Chart I-1 illustrates, through the post-war period, even when we include the 1970s when former U.S. President Richard Nixon's interferences temporarily eroded the Fed's independence, the U.S. central bank has been among the most fiercely independent monetary guardians in the G-10. Chart I-1The Fed Values Its Independence Rhetoric Is Not Always Policy Rhetoric Is Not Always Policy The 1970s offer a counter-argument to the view that the President has little influence on the Fed. However, Nixon chose Arthur Burns as Fed Chair in 1970 with the goal of maintaining very easy policy. Moreover, Burns continued to target full employment as his priority, which meant inflationary pressures only grew larger in response to the 1973 oil shock. This is in sharp contrast with today's Fed. In opposition to the period prior to the 1977 amendment of the Federal Reserve Act, which required the Fed to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," the Fed is now much more focused on controlling inflation - even if this means more frequent large overshoots in unemployment (Chart I-2). Chart I-2Trump's Fed Is Not Nixon's Fed Trump's Fed Is Not Nixon's Fed Trump's Fed Is Not Nixon's Fed This means that in today's context, the Fed will continue to push rates higher in order to combat inflationary pressures in the U.S. (Chart I-3). Moreover, as Chart I-4 illustrates, our composite capacity utilization measure shows that the U.S. economy is experiencing its tightest conditions since the late 1980s. Historically, such a dearth of economic slack is accompanied by higher interest rates. Chart I-3Upside Risks To U.S. Inflation Budding Price Pressures Upside Risks To U.S. Inflation Budding Price Pressures Upside Risks To U.S. Inflation Budding Price Pressures Chart I-4Maximum Pressure... Capacity Pressures That Is Maximum Pressure... Capacity Pressures That Is Maximum Pressure... Capacity Pressures That Is This also means that it is highly unlikely the Fed will sit idly by in front of the large amount of fiscal stimulus implemented in the U.S. while the economy is at full employment (Chart I-5). Not since the late 1960s has the U.S. experienced this kind of a policy mix. While in the late 1960s it took some time for inflationary pressures to emerge, they ultimately did with much vigor by 1968. However, for inflation to become as pernicious a force as it was in the 1970s, the Fed had to maintain too-easy monetary policy. With its dual mandate that includes keeping inflation at bay, we doubt the Fed will allow the 1970s experience to repeat itself.1 Chart I-5Trump Will Push Rates Higher Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Trump Will Push Rates Higher Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Trump Will Push Rates Higher While this means that President Trump is unlikely to be able to affect policy this cycle, it does not mean that he has zero levers. He can ultimately change the Fed leadership to find a great dove; however, this will require that he waits until Fed Chairman Jerome Powell's term ends - something not in sight until 2020. And really, who can he find today that is that dovish; we doubt that Paul Krugman will make any Trump shortlist for Fed leadership anytime soon. In the meantime, we would anticipate President Trump to continue to voice his displeasure with the Fed's policy, as at the very least it will give him a culprit to blame in 2020 if the economy does not perform as he has promised. As a result, we remain confident that the Fed is likely to try to follow the path of rate hikes it currently envisions in its latest set of forecasts. As Chart I-6 illustrates, this path for policy remains above the path currently anticipated in the market. Moreover, we do not believe the Fed will tighten more than it currently anticipates only to assert its own independence. For the Fed to deviate from its current interest rate forecast, economic growth and inflationary pressures will also have to significantly deviate from current expectations, not for Trump to grow louder. Chart I-6U.S. Rate Pricing Has Upside Market Expectations Have Converged With The Fed Dots U.S. Rate Pricing Has Upside Market Expectations Have Converged With The Fed Dots U.S. Rate Pricing Has Upside Bottom Line: President Trump may express his unhappiness with the Fed's hiking campaign, but he can do little more than complain. For now, he cannot affect monetary policy directly, as the Fed is very independent and is very set on limiting the long-term upside to inflation. Since the White House's policies are inflationary, we expect the Fed to continue to tighten as per its current intended path. Trump will only be able to affect policy in a dovish fashion once he gets to change the Fed's leadership. In the meantime, blaming the Fed is an insurance policy for 2020: if the economy is not as strong as he promised, someone else will be responsible for it. Currency Manipulators? Another issue raised by President Trump has contributed to the recent decline in the dollar: His assertions that various currencies, including the euro, are being manipulated downward. Is there much to this assertion, and can the White House do anything to generate downward pressure on the dollar? Let's begin with China. We have argued that at the very least, the Chinese authorities are facilitating the recent slide in the RMB. As Chart I-7 illustrates, CNY/USD is much softer than implied by the level of the dollar itself. If we want to stretch the argument that one country is pushing down its currency today, it is China. Can President Trump do much about it? For the time being, we doubt it. The White House has announced a flurry of implemented and proposed tariffs on China (Chart I-8), and in the interim, the CNY has not strengthened; it has only weakened. Instead of letting the U.S. bully them on their exchange rate policy, it seems the Chinese authorities are finding other means to alleviate the pain created by U.S. tariffs. Chart I-7China Is Manipulating Its Currency... China Is Manipulating Its Currency... China Is Manipulating Its Currency... Chart I-8... And Is Already Facing An Onslaught Of Tariffs... Rhetoric Is Not Always Policy Rhetoric Is Not Always Policy To begin with, the People's Bank of China has injected RMB502 billion into the banking system in recent weeks in order to put downward pressure on overnight rates. Most importantly, earlier this week, it was revealed that the State Council in Beijing would accelerate the issuance of CNY1.4 trillion in local government bonds to support infrastructure. This significant amount of fiscal stimulus may not be enough to prevent China from slowing in response to its own deleveraging effort, it is nonetheless likely to soften the blow to the Chinese economy created by the Trump tariffs. Essentially, we believe that China wants to avoid the shock Japan suffered in the wake of the 1985 Plaza accord. In the 1980s, U.S. President Ronald Reagan and the American public were fed up with the growing Japanese trade surplus with the U.S. The White House started proposing tariffs on Japanese exports and ultimately got Japan to revalue the yen violently. However, this huge yen rally had massively deflationary consequences for Japan. At first, the Bank of Japan responded by cutting rates, inflating the Japanese bubble in the process. Once the bubble popped and the Japanese private sector debt burden was laid bare, the true deflationary impact of the sudden yen revaluation became evident (Chart I-9). To this day, Japan is still dealing with the consequences of these series of policy mistakes. Chart I-9... But It First And Foremost ##br##Wants To Avoid Japan's Fate ... But It First And Foremost Wants To Avoid Japan's Fate ... But It First And Foremost Wants To Avoid Japan's Fate Today, Chinese policymakers not only benefit from the insight of Japan's disastrous experience, but also they already face an enormous debt problem. China's corporate debt stands at 160% of GDP, versus Japan's corporate debt, which stood at 110% of GDP in 1985 when the yen began appreciating and 135% of GDP in 1989 just before the bubble burst. The deflationary consequences of a large FX revaluation are thus at least as dangerous in China today as they were in Japan in the 1980s. In fact, if China is serious about deleveraging and reforming its economy, it will need a cheap currency to ease the deflationary impact of these domestic economic adjustments. On the political front, the U.S. does not have the same levers on China today as it did on Japan in the 1980s. The U.S. is not a military ally; it does not defend the Middle Kingdom against foreign attacks. However, the U.S. was - and still is - Japan's most important military ally, its protector against the Soviet Union in the 1980s and China today. As a result, while Reagan was able to threaten Tokyo with the removal of the U.S. military umbrella, Trump does not have the same tool when it comes to China. Hence, we continue to expect that the outcome of the China-U.S. trade conflict to more likely result in a renegotiation of bilateral investments, tariffs and quotas than a sharply higher RMB. What about Trump's stance on the euro? After all, the U.S. does remain the EU's most important military ally, and the key financial contributor to NATO. This should count as leverage, no? Politically Europe is not as beholden to the U.S today as it was in the 1980s. As Marko Papic argues in BCA's Geopolitical Strategy service, the international political order has entered a multipolar state, with various regional powers vying for local dominance. In the 1980s, the world had two poles of power: the U.S. and the Soviet Union. Back then, Moscow constituted a real threat to Western Europe, as Warsaw Pact nations had tanks parked at the EUs border. Today, this is no longer the case. Russia has weakened, its army is technologically beleaguered, and, in fact, Russia is more dependent on the EU than a threat. As a result, the support of the U.S. is not as crucial to Europe as it once was. Moreover, as Marko also argues, global trade is not expanding as fast as it once was. This means that the U.S. allies are not as likely to tolerate a higher exchange rate as they once were. Essentially, in the 1970s and 1980s, Europe was willing to pushup its exchange rates and absorb an immediate negative shock in order to reap the benefits of growing trade later. This is not feasible anymore as future export growth will not be large enough to compensate for the immediate cost of a euro revaluation. This will limit the tolerance of Europeans to pushup the euro just because the U.S. asked them to do so.2 Nonetheless, President Trump is correct to insist that the euro is cheap, and that this is contributing to the huge trade surplus that Europe runs with the U.S. (Chart I-10). However, the euro area does not target a lower exchange rate, and the European Central Bank does not actively sell euros in the open market. Instead, the undervaluation of EUR/USD simply reflects the fact that the ECB continues to conduct very stimulative monetary policy, which is dragging European real rates lower versus the U.S. It is because of this domestic imperative that EUR/USD remains cheap (Chart I-11). Chart I-10European Exports Are ##br##Benefiting From A Cheap Euro.. ...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance European Exports Are Benefiting From A Cheap Euro.. ...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance European Exports Are Benefiting From A Cheap Euro.. Chart I-11... But This Cheapness Is A Consequence##br## Of Diverging Monetary Policies Relative Monetary Policy Has Driven The Euro's Undervaluation... ... But This Cheapness Is A Consequence Of Diverging Monetary Policies Relative Monetary Policy Has Driven The Euro's Undervaluation... ... But This Cheapness Is A Consequence Of Diverging Monetary Policies However, we think Europe does still need much easier monetary policy than the U.S. because: European growth is lagging that of the U.S. (Chart I-12); The European output gap remains negative, while the U.S.'s is now positive; The U.S. will receive a much larger dose of fiscal stimulus than Europe in 2018 and 2019 (Chart I-13). Chart I-12U.S. Growth Still##br## Outperforms Europe's... U.S. Growth Still Outperforms Europe's... U.S. Growth Still Outperforms Europe's... Chart I-13... And The Relative Fiscal Policy Points##br## To Continued Monetary Divergences Rhetoric Is Not Always Policy Rhetoric Is Not Always Policy This means that we do not expect the euro's long-term undervaluation to get anywhere near corrected this year. In fact, while we have argued that the dollar is likely to experience a correction in the very near term,3 we continue to anticipate that EUR/USD will make deeper lows later in 2018. As we have highlighted, the euro may be cheap on a long-term basis, but it continues to trade at a premium to its short-term drivers (Chart I-14). Moreover, relative inflation between the U.S. and the euro area has been a powerful driver of anticipated monetary policy shifts between these two economies. As a result, relative core inflation has been a good prognosticator of EUR/USD, and currently points to a lower euro (Chart I-15). Therefore, we are not closing our long DXY trade in the face of the dollar's anticipated correction. Instead, we prefer to hedge our risk through this countertrend move by selling USD/CAD. Chart I-14The Euro Is Not A Buy Yet... The Euro Is Not A Buy Yet... The Euro Is Not A Buy Yet... Chart I-15... And Will Not Become So Until Later This Year ... And Will Not Become So Until Later This Year ... And Will Not Become So Until Later This Year Bottom Line: President Trump can call China and Europe currency manipulators if he wants to, but this does not mean he has much leverage over these two economies. China already has a large debt load and is vulnerable to the kind of deflationary shock that Japan endured in the wake of the yen's appreciation following the 1985 Plaza Accord. This limits Beijing's willingness to let the CNY appreciate. Meanwhile, the euro is not manipulated per se; its undervaluation only reflects the fact that Europe needs much easier monetary policy than the U.S. This state of affairs is not changing this year. Thus, only once Europe is ready to withstand higher interest rates will the euro's undervaluation disappear. Japan: The End of YCC? Rumors have been circulating this week that the Bank of Japan may tweak its Yield Curve Control Strategy as soon as next week's Monetary Policy meeting. We are skeptical. First, it is true that Japanese wages have been accelerating in response to the tightest labor market conditions in 30 years (Chart I-16). However, Japanese inflation excluding food and energy has again weakened to 0.3%, pointing to the difficulty the country has in achieving its 2% inflation target. Second, economic numbers have been quite mixed. Japanese Manufacturing PMIs have weakened to 51.6 from as high as 54.8, five months ago. Moreover, industrial production has softened, heeding the message from the sagging shipments-to-inventories ratio (Chart I-17). As a result, capacity utilization will remain too low to be consistent with upward risk to core CPI. Chart I-16Strengthening Japanese ##br##Wages Are Inflationary... Strengthening Japanese Wages Are Inflationary... Strengthening Japanese Wages Are Inflationary... Chart I-17... But Capacity Utilization Concerns ##br##Cap The Upside To Inflation ... But Capacity Utilization Concerns Cap The Upside To Inflation ... But Capacity Utilization Concerns Cap The Upside To Inflation Third, money growth has also slowed significantly in Japan, and is now at the low end of the post-Abenomics experience (Chart I-18). This weighs on the outlook for both growth and inflation. Fourth, if there were a valid reason to removed YCC it would be if banks were in danger. After all, low rates and a flat yield curve hurt banks' profitability, potentially creating risks to the financial system. However, as Chart I-19 shows, Japanese regional banks have not experienced any meaningful downward pressure on their profits since YCC has been implemented, and are far from generating aggregate losses. Chart I-18Japanese Money Trends Do Not Justify Tweaking YCC Japanese Money Trends Do Not Justify Tweaking YCC Japanese Money Trends Do Not Justify Tweaking YCC Chart I-19YCC Does Not Yet Threaten Japanese Banks Health YCC Does Not Yet Threaten Japanese Banks Health YCC Does Not Yet Threaten Japanese Banks Health Fifth, it is customary in Japan policy circles to float trial balloons to test policy ideas. It is very likely that the recent rumors of a tweak to YCC were such a balloon. However, the market impact of this trial was clear: a rallying yen, rising yields and falling equity prices. All these market moves suggest that if YCC was indeed tweaked next week, Japan would experience a violent tightening in monetary conditions - exactly what the BoJ wants to avoid if it ever wishes to hit its 2% inflation target. Moreover, we do not read much into the decline of JGB purchases by the Japanese central bank. The BoJ does not need to buy many JGBs in order to cap Japanese bond yields. Instead, speculators can force JGB yields towards the BoJ's target, on the expectation that if JGB yields deviate too much from this target, the BoJ will force bond prices back to its objective. We think these dynamics are currently at play, explaining why the BoJ has not been buying JPY80 trillion of JGBs per annum. Instead, we think that the BoJ will stay the course with YCC. While Japanese wages are stronger than they have been for 20 years, they are still not consistent with 2% inflation. As such, the BoJ needs to engineer further labor market tightening for inflation to move to target. Even in the U.S., where the economy is not in the thralls of deep-seated deflationary pressures, the job-hoppers are the ones pocketing the lion's share of accelerating wages - not people staying in their current positions (Chart I-20). Since Japanese workers do not tend to switch jobs, the Japanese labor market needs to become a genuine pressure cooker before inflation can rise meaningfully. The BoJ will thus need to maintain very easy monetary policy. Chart I-20You Need To Leave Your Job To Get A Raise You Need To Leave Your Job To Get A Raise You Need To Leave Your Job To Get A Raise As a result, we are not buying into the current rally in the yen versus the dollar. We do believe the yen can continue to perform well this year versus the euro and the AUD, but this is because we expect the U.S. monetary policy to tighten along with China's efforts to de-lever to continue to weigh on EM asset prices, EM economic activity, and thus global trade. In the short term, the yen could correct against these currencies as we continue to foresee a temporary correction in "growth slowdown" trades. But ultimately we expect the yen to continue to rally against the more pro-cyclical euro and Australian dollar. Bottom Line: The BoJ will not adjust YCC next week. Japanese wages may have picked up, but inflation itself is not only still well below target, it has weakened of late. Additionally, economic growth is not strong enough to justify a removal of monetary accommodation, especially as YCC has not negatively affected the health of regional banks. As a result, we recommend investors fade the recent strength in the yen versus the dollar. The yen still has room to rally further against the EUR and AUD over the course of the next six to nine months, but this is a reflection of our stance on global growth and EM asset prices, not a consequence of any anticipated shift in YCC. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "The Dollar May Be Our Currency, But It Is Your Problem", dated July 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Reports, "Time To Pause And Breathe" dated July 6, 2018 and "That Sinking Feeling", dated July 13, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Markit Manufacturing PMI came in at 55.5, outperforming expectations. It also increased from last month's reading. However, both services and composite PMI underperformed expectations, coming in at 56.2 and 55.9 respectively. Finally, existing home sales surprised to the downside, coming in at 5.38 million. This measure also decreased compared to last month's reading. The DXY has declined by roughly 1.3% this week. We are bearish on the dollar on a tactical basis. Stretched positioning in the USD as well as a respite in the global growth slowdown due to Chinese easing will combine to temporarily weigh on the greenback. However, we believe the DXY will resume its uptrend before year-end, as a combination of fed tightening, slower global growth, and positive momentum will help the dollar on a cyclical basis. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The Euro Recent data in the Euro area has been mixed: Manufacturing PMI outperformed expectations, coming in at 55.1, and increasing from last month's reading. Moreover the German IFO, also outperformed expectations, coming in at 101.7. However, both Markit Composite PMI and Markit Services PMI underperformed expectations, coming in at 54.3 and 54.4 respectively, while also decreasing from last month's numbers. Finally, Belgian Business confidence showed a deceleration in the month of July. EUR/USD is flat this week, as the surge at the beginning of the week was counteracted by a relatively dovish announcement by the ECB yesterday. On a 6-month basis we are bearish on the euro, given that the cumulative tightening by both the People's Bank of China and the Fed will still combined in a toxic cocktail for global growth, and hence, drag the euro lower in the process. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The Yen Recent data in Japan has been mixed: The Nikkei Manufacturing PMI underperformed expectations, coming in at 51.6. It also decreased from last month's reading of 53. However, the All Industry Activity Index month-on-month growth outperformed expectations, coming in at 0.1%. USD/JPY has declined by roughly 1.5%, partly due to the fall in the U.S. dollar, but also because of the newly perceived hawkish tone by the BoJ. On a short-term basis, we continue to be bullish on the yen against the euro and the Aussie, as we expect Chinese deleveraging to add volatility to the markets. On a longer-term basis, however, we are bearish on the yen, as the BoJ will have to remains very accommodative in order to meet its inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 British Pound Recent data in the U.K. has been positive: Public sector net borrowing outperformed expectations, coming in at 4.530 billion pounds. This measure also increased relatively to last month's number. Moreover, mortgage approvals also surprised to the upside, coming in at 40.541 thousand. This measure also increased relatively to last month's number. Finally, the CBI Distributed Trades Survey also surprised positively, coming in at 20%. GBP/USD has risen by nearly 1.5% this week. Overall, we are cyclically bearish on the pound, as the uncertainty of the Brexit negotiations continue to weigh on capital flows into the U.S. Moreover, the rise in the dollar will add further downward pressure to cable. That being said, the pound could have some upside against the euro, given that the U.K. is less exposed to global trade and industrial activity than its continental counterpart. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Headline inflation came in at 2.1%, underperforming expectations. However, this measure increased from 1.9% the month before. Meanwhile, the RBA trimmed mean CPI yearly growth came in at 1.9%, in line with expectations and with the previous' month number. AUD/USD has rallied by roughly 1.7%, in part due to the fall in the dollar, as well as in response to positive news in China concerning the issuance of infrastructure bonds. Despite these temporary positives, we continue to be cyclically bearish on the Aussie, as a slowdown in the Chinese industrial cycle will weigh heavily on this currency, given its high exposure to base metals, and given the continued presence of slack in the Australian labor market. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 New Zealand Dollar NZD/USD has risen by roughly 1.7% this week, as trade tensions have eased following the announcement by President Trump that the EU and the United States would collaborate to eliminate tariffs between the two economies. Moreover, Chinese authorities have implemented some easing at the margin, which should provide a temporary boost to high beta economies like New Zealand. However, on a cyclical basis, we remain bearish on the kiwi, as the tightening campaign in China is likely to continue. Moreover, a tightening fed will continue to put pressure on EM dollar borrowers, affecting New Zealand in the process, given its high exposure to global growth. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Headline inflation came in at 2.5%, surprising to the upside. It also increased from last month's reading. Moreover, retail sales and retail sales ex-autos month-on-month growth both outperformed expectations, coming in at 2% and 1.4% respectively. However, core inflation underperformed expectations, coming in at 1.3%. This measure stayed stable compared to last month's reading. USD/CAD has declined by roughly 1.4% this week. In our view, the best cross to play what we believe will be a temporary correction in the greenback is to short USD/CAD, as the Canadian dollar trades at a deep discount to fair value, while short positions are likely overextended. Moreover, the BoC is the only nation among the G10 commodity producers raising rates, adding another boon for the Lonnie. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Swiss Franc EUR/CHF is down roughly 0.5% this week, especially after the perceived dovish tone to the ECB's press conference on Thursday. On a short-term basis, we are bearish on this cross, given that tightening by the fed and a sluggish Chinese economy should cause a risk-off period in markets, creating a supportive environment for the franc. On the other hand, we are bullish on this cross on a longer-term basis, given that the SNB will likely continue with its ultra-dovish monetary policy, as well as currency intervention to make sure that an appreciating franc does not derail its campaign to reach its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Norwegian Krone USD/NOK is down roughly 0.7% this week. Overall we continue to be bullish on this cross, given that the tightening of the fed should increase the interest rate differential between Norway and the U.S., counteracting any further appreciation in oil prices due to OPEC output cuts. That being said, we are positive on the NOK within the commodity complex, as Norway will likely be less affected than New Zealand or Australia by the tightening campaign in China, given that oil has a lower beta to Chinese growth than other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Swedish Krona EUR/SEK is down by slightly more than 1% this week, falling substantially after the interest rate decision by the ECB. We are bullish on the krona on a long-term basis, as inflationary pressures continue to be strong in Sweden, and the Riksbank has become progressively more hawkish. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades