Japan

Highlights Easier financial conditions will lift U.S. growth in the second half of this year. However, given the Fed's dovish predisposition, aggressive tightening measures are unlikely until next year, when inflation will begin to accelerate. We see little downside for the dollar over the coming months, but think the next major leg of the structural dollar bull market will only come in 2018, as the Fed begrudgingly comes to terms with the fact that it has been behind the curve in raising rates. Even then, the Fed's efforts to tighten monetary policy will not be enough to prevent a secular rebound in inflation from taking root. Structural factors, ranging from population aging to chronically weak productivity growth, will further fuel inflation in the U.S. and around the world. Political populism - historically, an inflationary force - will come roaring back, while globalization, a deflationary force, will remain in retreat. Remain overweight global equities for now, but look to raise cash next summer. A structurally underweight position in government bonds is appropriate. Feature The Fed Stands Pat As expected, the Fed kept rates on hold this week and signaled its intention to start shrinking its balance sheet later this year. The FOMC upgraded its assessment of the state of the labor market to "solid," but sounded a note of caution on the recent weak inflation readings. It was the latter point that caught investors' attention. The dollar promptly sold off. We went long the DXY index in October 2014. We maintained our bullish dollar view going into the U.S. presidential elections, controversially arguing in September 2016 that "Trump will win and the dollar will rally."1 While our long dollar trade is still comfortably in the black, the dollar's recent swoon does imply that we stayed at the party longer than was warranted. Chart 1Investors Dismiss Future Inflation Risk Investors Dismiss Future Inflation Risk Investors Dismiss Future Inflation Risk What went wrong this year? The failure of the Trump administration to make progress on tax reform in recent months has hurt the dollar. So has the decline in core inflation. Core PCE inflation registered 1.4% in May, down from a high of 1.8% in January. As a result, the market is now pricing in only 26 basis points of rate hikes over the next 12 months and just a 45% chance that the Fed will raise rates by December. Hawkish comments from the ECB, the Bank of Canada, and several other central banks have added fuel to the dollar selloff. Shifts in speculative positioning haven't helped either. Investors were extremely bullish the dollar going into 2017 while bearish the euro. Today, euro longs are at record highs, while sentiment towards the dollar is in the pits. Looking out, sentiment towards the dollar should normalize, while U.S. growth should surprise to the upside over the next few quarters. U.S. financial conditions have eased sharply this year thanks to the decline in bond yields, narrower credit spreads, higher equity prices, and of course, a weaker dollar. Historically, easier financial conditions have boosted growth with a lag of 6-to-9 months. In contrast, euro area growth may be close to plateauing, as already foreshadowed this week by the decline in the PMI for July. All this should be enough to put a floor under the dollar over the remainder of the year. However, at this point, it looks increasingly likely that the next (and last) leg of the dollar bull market will have to wait until inflation begins to accelerate. This may not happen until 2018, suggesting that the dollar could trade in a range until then. We are maintaining our view that EUR/USD will eventually reach parity, but now see this as most likely to happen in the second half of next year. Many investors are skeptical that inflation will rise even if the unemployment rate continues to trend downwards. They argue that the relationship between economic slack and inflation - epitomized by the so-called Phillips curve - has completely broken down. We disagree with this assessment. As we argue below, not only is inflation likely to accelerate next year, but a number of powerful structural factors will propel inflation higher over a longer-term horizon. In fact, the 2020s could turn out to look a lot like the 1970s. Current market-based inflation expectations do not reflect this risk at all (Chart 1). Cyclical Forces Will Boost Inflation Spare capacity has declined significantly in most economies since 2009 (Chart 2). By many measures, the U.S. is now close to full employment (Table 1). Historically, diminished slack has corresponded with higher inflation (Chart 3). Chart 2Output Gaps Have Narrowed Output Gaps Have Narrowed Output Gaps Have Narrowed Table 1Comparing Current Labor Market Slack With Past Cycles A Secular Bottom In Inflation A Secular Bottom In Inflation Chart 3Diminished Slack Has Corresponded With Higher Inflation A Secular Bottom In Inflation A Secular Bottom In Inflation The fact that decreased spare capacity has not yet translated into higher inflation is not especially surprising. Inflation is a severely lagging indicator. As we noted last week, inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 4).2 Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Chart 4Inflation Is A Lagging Indicator A Secular Bottom In Inflation A Secular Bottom In Inflation Moreover, the relationship between slack and inflation tends to be highly non-linear. When there is a lot of spare capacity, reducing it modestly tends not to have much of an effect on inflation. However, when there is little or no slack, even a small reduction in spare capacity can lead to a big jump in inflation. The 1960s provide an extreme example of what can happen (Chart 5). The unemployment rate steadily declined between 1960 and 1966. Yet, core inflation remained remarkably stable during this period, consistently hovering between 1.5% and 2%. In early 1966, the unemployment rate finally broke below 4%. Within the span of 12 months, core inflation jumped from 1.5% to 3.7%. Such a rapid burst in inflation is unlikely in the near term. Inflation expectations are better anchored and unions have less power today than in the 1960s. Moreover, unlike then, some of the excess in aggregate demand can be absorbed through a larger trade deficit rather than through higher prices for goods and services. Nevertheless, as slack elsewhere in the world comes down, global inflation will rise. Our "pipeline inflation" indices, comprised of such variables as core PPI inflation and unit labor costs, are already pointing in that direction (Chart 6). The cyclical pressure on inflation will only intensify if crude prices grind higher, as our energy strategists expect they will. Chart 5Inflation In The 1960s Took Off Once ##br##The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Chart 6Pickup In Global Pipeline Measures Of Inflation Pickup In Global Pipeline Measures Of Inflation Pickup In Global Pipeline Measures Of Inflation Structural Trends Are Becoming More Inflationary Meanwhile, several structural forces will slowly lift inflation over a longer-term horizon of five-to-fifteen years. Weaker productivity growth is one of them (Chart 7). We have argued in the past that much of the decline in global productivity growth reflects structural factors.3 As a matter of arithmetic, gross domestic output (GDP) must equal gross domestic income (GDI). If productivity growth stays weak, slow income growth could end up depressing savings by more than it depresses investment. This could push up equilibrium real interest rates. Unless central banks respond by raising policy rates, inflation will rise. The retirement of millions of highly paid baby boomers could also lead to labor shortages and lower aggregate savings. Chart 8 shows the estimated consumption and income profile for a typical U.S. individual over a lifetime. Notice that consumption tends to peak very late in life due to rising health care expenditures. Chart 7Productivity Growth Has Fallen, ##br##Particularly In Developed Economies Productivity Growth Has Fallen, Particularly In Developed Economies Productivity Growth Has Fallen, Particularly In Developed Economies Chart 8Spending And Saving Over The Lifecycle Spending And Saving Over The Lifecycle Spending And Saving Over The Lifecycle Using existing demographic projections, we can compute the impact that population aging is likely to have on savings. The effect is substantial. In the U.S., aging will reduce the household saving rate by about four percentage points between now and 2030. In Germany, the saving rate will sink by six points, while in China it will decline by five points. This will reduce the massive current account surpluses in these two countries, which have been major contributors to the global savings glut and the corresponding low level of real interest rates. The Japan Experience Japan's household saving rate will also continue to fall, having already declined from 14% in the late 1980s to 2% today. Amazingly, the decline in Japan's saving rate over the past few decades has occurred even though a larger share of the population is employed today than in 1980 (Chart 9). Rising female participation accounts for this. However, now that Japan's female employment rate has surpassed America's and Europe's, this demographic tailwind will dissipate (Chart 10). As a result, Japan's labor force will begin to shrink in earnest, while spending on health care and pensions will keep rising. What will be left is a large government debt burden. Chart 9Japan: Saving Rate Has Fallen Despite Rising Employment/Population Japan: Saving Rate Has Fallen Despite Rising Employment/Population Japan: Saving Rate Has Fallen Despite Rising Employment/Population Chart 10Japan: Female Employment-To-Population ##br##Has Surpassed The U.S. And Euro Area Japan: Female Employment-To-Population Has Surpassed The U.S. And Euro Area Japan: Female Employment-To-Population Has Surpassed The U.S. And Euro Area Whether debt is inflationary or deflationary depends both on economic and political considerations. On the one hand, a high degree of indebtedness may restrain spending throughout the economy. That is deflationary. On the other hand, high debt levels may provide an incentive for governments to crank up inflation in order to reduce the real value of outstanding debt obligations. Historically at least, the latter factor has often won out. One can debate whether Japan would have welcomed higher inflation even if it had the means to generate it. There are good arguments for both sides of the issue. But, in practice, the Bank of Japan's ability to create inflation was cut off very early into its first lost decade. This is because falling property prices and pervasive corporate deleveraging pushed the neutral nominal interest rate deep into negative territory. This meant that even an interest rate of zero was not enough to boost inflation. Now that property prices appear to be bottoming, corporate balance sheets are in reasonably good shape, and the prospect of significant labor shortages looms on the horizon, Japan may finally be able to gain some traction over monetary policy. Such an outcome would come as a complete surprise to most investors. The Benefits Of Higher Inflation Japan's struggles illustrate the pitfalls of excessively low inflation. Had Japanese inflation been higher in the early 1990s, the Bank of Japan might have been able to bring real rates far enough into negative territory without ever encountering the zero-bound constraint on nominal rates. This may have prevented a vicious circle where falling inflation put upward pressure on real rates, leading to weaker growth and even lower inflation. Fast forward to the present and what was once regarded as a uniquely Japanese problem is now seen as a concern in many countries. It is not surprising, therefore, that a growing chorus of economists is advocating that central banks aim for a higher inflation target than the standard 2%. The logic is straightforward: If inflation is 4% and a deep economic downturn requires that central bankers temporarily bring real rates down to -3%, this can be achieved by cutting nominal rates to 1%. In contrast, if inflation is 2%, it may be difficult to cut nominal rates to -1% since people could choose to hold cash over a negative-yielding asset. Another lesson that central bankers have learned from both the Great Recession and the recession that followed the dotcom boom is that burst asset bubbles can cause significant harm to economies. Here again, a bit more inflation can provide a safety valve of sorts. If the trend rate of inflation had been higher going into the housing bust, nominal home prices would have fallen less for any given change in real prices. This implies that fewer mortgages would have gone underwater. A higher underlying inflation rate would have also made it more difficult for lenders to offer zero-interest mortgages since their funding costs in real terms would have been greater. This would have imposed more discipline on lenders and borrowers alike. Then there is the labor market. The reluctance of workers to accept nominal wage cuts makes it difficult for real wages to adjust downwards in the face of adverse economic shocks when underlying inflation is very low. If inflation is higher, that problem diminishes. This point is especially relevant for the euro area, where labor markets are quite inflexible to begin with and many countries do not have the ability to respond to adverse shocks with either countercyclical fiscal policy or currency depreciation. Inflation As A Political Choice It is sometimes said that low inflation or even outright deflation is the natural state of affairs in capitalist economies. This is arguably true under monetary regimes such as the gold standard, but it is not true in a world of fiat money. Inflation took off in the late sixties because policymakers who grew up during the 1930s were more concerned about propping up aggregate demand than keeping a lid on prices. In contrast, the generation that reached adulthood in the 1970s was more worried about runaway inflation. It is this latter group that has run the world's central banks for the better part of the past few decades. As they step aside, they will be replaced by a younger cohort whose formative years were shaped by the financial crisis and the deflation shock that followed. Things have come full circle again. A recent NBER paper documented that age plays a major role in determining whether central bankers turn out to be dovish or hawkish.4 Those who witnessed stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in diapers back then. The implication is the future generation of central bankers is likely to see the world through a more dovish lens than its predecessors. Globalization In Retreat, Populism Ascendant Globalization has been a strong deflationary force through history. That force is now waning, as evidenced by the stagnation in global trade (Chart 11). In contrast, political populism - historically, a highly inflationary force - is on the rise. Much of the slowdown in globalization can be attributed to structural factors. Tariff rates fell steadily in the second half of the 20th century, helping to boost global trade in the process (Chart 12). Now that most goods cross borders duty free, further efforts at trade liberalization will be subject to diminishing returns. The same goes for outsourcing. In fact, growing evidence suggests that many firms have outsourced too much, leaving them with an unwieldy maze of suppliers around the world. Chart 11Globalization Has Stalled Globalization Has Stalled Globalization Has Stalled Chart 12Global Trade Was Boosted By Falling Tariffs ##br## In The Second Half Of The 20th Century Global Trade Was Boosted By Falling Tariffs In The Second Half Of The 20th Century Global Trade Was Boosted By Falling Tariffs In The Second Half Of The 20th Century Likewise, the integration of Eastern Europe and China into the capitalist economy brought a billion additional workers into the global labor force, giving globalization a huge boost (Chart 13). Nothing similar awaits over the horizon. Chart 13The Transition To Capitalism Enlarged The Global Labor Force The Transition To Capitalism Enlarged The Global Labor Force The Transition To Capitalism Enlarged The Global Labor Force Politics represents another headwind to globalization. Trade among rich countries tends to have smaller distributional consequences than trade between rich and poor countries. As emerging markets have become larger players in the global trading system, the impact on less-skilled workers in developed countries has grown. People in Michigan, Ohio, and Pennsylvania voted for Trumpism, not Trump. The problem is that Trump does not understand this, as his cyberbullying of Attorney General Jeff Sessions this week demonstrates. If Trump deserts his base, his base will find someone more to their liking. Either way, populism will prevail. For their part, the Democrats are also honing their populist message. Their "Better Deal" agenda harkens back to the populist roots of FDR's New Deal. It promises to "raise the wages and incomes of American workers," "crack down on unfair foreign trade and fight back against corporations that outsource American jobs," and root out "monopolies and the concentration of economic power," while also making sure that "Wall Street never endangers Main Street again."5 Bernie Sanders may have lost the Democratic nomination, but he won the soul of the Democratic party. European populists have been on the back foot over the past year, having suffered defeats in the Dutch, Austrian, and French elections. Yet, it would be a mistake to count them out. Populists do best when times are tough. European growth is strong these days and unemployment is falling. When the next recession rolls around, populist parties will gain favor. This will especially be the case if the migrant crisis re-escalates, as seems likely. Investment Conclusions Getting inflation up to 2% - let alone something higher - has seemed like "mission impossible" for most of the past eight years because of elevated levels of economic slack. However, as this slack is absorbed, boosting inflation will become easier. Central banks only need to raise rates by less than standard Taylor rules imply. As we discussed last week, the Fed, the Bank of Canada, the Swedish Riksbank, and the central banks of Australia and New Zealand are all somewhat behind the curve in raising rates.6 As inflation in these economies picks up next year, they will be forced to raise rates more aggressively than what the markets are currently discounting, causing bond yields to rise and their currencies to strengthen. This could sow the seeds of a slowdown or even a recession in 2019. The recession is unlikely to be especially severe since financial and economic imbalances are not as pronounced today as they were a decade ago. Yet, the policy reaction will be disproportionately large: Interest rates will be cut and talk of additional asset purchases will begin to swirl. Inflation will come down, but not all the way back to current levels. Likewise, bond yields will fall, but nowhere close to the secular lows recorded in mid-2016. As in previous inflationary episodes, the path for nominal bond yields over the next 15 years will be marked by higher highs and higher lows. Fixed-income investors should pare back duration and increase exposure to inflation-indexed securities. Gold will become a valuable hedge once the dollar peaks next year. Equities will suffer in a stagflationary environment. We remain cyclically overweight global stocks for now, as reflected in our asset allocation recommendations (Appendix 1). However, we will be looking to reduce exposure significantly next summer. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Are Central Banks Behind The Curve Or Ahead Of It?" dated July 21, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017, available at gis.bcaresearch.com. 4 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 5 Chuck Schumer, "A Better Deal for American Workers," The New York Times, July 24, 2017, and "A Better Deal," available at http://www.democraticleader.gov. 6 Please see footnote 2. Appendix 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models generally favor global equities over bonds over a three-month horizon (Appendix Table 1). Our business cycle equity indicators remain firmly in bullish territory, as reflected in strong global growth and rising corporate earnings. The monetary and financial indicators are also flashing green. In contrast, our sentiment readings are sending mixed signals. Low implied equity volatility points to a heightened risk of complacency, while continued investor skepticism towards the rally (especially among retail investors) suggests that stocks have further to run. As has been the case for some time, our valuation measures are saying stocks are expensive, but these are typically useful only for horizons beyond one or two years. Calendar effects are also negative at the moment due to the tendency of stocks to underperform during the summer months. Regionally, we see more upside in more cyclically-exposed, higher-beta equity markets such as those in Europe and Japan. Canada also looks attractive based on our cyclically positive outlook for crude prices. Emerging market equities are fairly valued, although China still appears cheap based on our measures. Within the fixed-income arena, U.S. Treasurys remain overvalued based on the cyclical outlook, as do, to a lesser extent, most European bonds. Japanese bonds are the default winners simply because JGB yields are likely to remain flat on account of the BoJ's interventions. Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* A Secular Bottom In Inflation A Secular Bottom In Inflation Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Major central banks outside the U.S. have fired a warning shot across the bow of global bond markets by signaling that "emergency" levels of monetary accommodation are no longer required. Pipeline inflation pressures have yet to show up at the consumer price level outside of the U.K. Most central bankers argue that temporary factors are to blame, but longer-lasting forces could be at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. However, this is not confirmed in the productivity data. Productivity is dismally low and we do not believe it is due to mismeasurement. The Phillips curve is not dead. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus. The real fed funds rate is not far from the neutral short-term rate, but it is still well below the Fed's estimate of the long-run neutral rate. Market expectations for the Fed are far too complacent; keep duration short. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts. Expansionary fiscal policy would make life more difficult for the FOMC, given that unemployment is on course to reach the lowest level since 2000. This would force the Fed to act more aggressively, possibly triggering a recession in 2019. The peak Fed/ECB policy divergence is not behind us, implying that recent dollar weakness will reverse. However, the next dollar upleg has been delayed. Fading market hopes for U.S. fiscal stimulus this year have not weighed on equities, in part because of a solid earnings backdrop. Global EPS growth continues to accelerate in line with the recovery in industrial production. In the U.S., results so far suggest that Q2 will see another quarter of margin expansion. Overall earnings growth should peak above our 20% target later this year. It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. Expect to downgrade stocks in the first half of 2018. Corporate bonds are also benefiting from the robust profit backdrop. Balance sheet health continues to deteriorate, but the spark is missing for a sustained corporate bond spread widening. Feature Chart I-1Sell-Off In Global Bond Markets ##br##Triggered By Central Bank Talk Sell-Off In Global Bond Markets Triggered By Central Bank Talk Sell-Off In Global Bond Markets Triggered By Central Bank Talk Major central banks outside the U.S. fired a warning shot across the bow of global bond markets by signaling a recalibration of monetary policy at the ECB's Forum on Central Banking in late June (Chart I-1). The heads of the Bank of England (BoE), Bank of Canada (BoC) and Swedish Riksbank all took a less dovish tone, warning that the diminished threat of deflation has reduced the need for ultra-stimulative policies. The BoC quickly followed up in July with a rate hike and a warning of more to come. The central bank now expects the economy to reach full employment and hit the inflation target by mid-2018, much earlier than previously expected. The Riksbank also backed away from its easing bias at its most recent policy meeting. The ECB's shift in stance was evident even before its Forum meeting, when President Draghi gave a glowing description of the underlying strength of the Euro Area economy. The labor market is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum.1 European core inflation is admittedly below target today, but so was the U.S. rate leading up to the 2013 Tantrum. We have not forgotten about Europe's structural problems or the inherent contradictions of the single currency. Banks are still laden with bad debt (although the recapitalization of Italian banks has gone well so far). Nonetheless, from a cyclical economic standpoint, solid momentum this year will allow Draghi to scale back the ECB's ultra-accommodative monetary stance by tapering its asset purchase program early in 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank (CB) Monitors, which measure pressure on central bankers to raise or lower interest rates (Chart I-2). The Monitors became less useful when rates hit the zero bound and quantitative easing was the only game in town, but they are becoming relevant again as more policymakers consider their exit strategy. All of our CB Monitors are currently in "tighter policy required" territory except for Japan and the Eurozone (although even those are close to the zero line). The Monitors have been rising due to both their growth and underlying inflation components. Another tick higher in PMI's for the advanced economies in July underscored that the rebound in industrial production is continuing (Chart I-3). Our short-term forecasting models, which include both hard and soft data, point to stronger growth in the major countries in the second half of 2017 (Chart I-4). Chart I-2Most In The "Tighter Policy Required" Zone Most In The "Tighter Policy Required" Zone Most In The "Tighter Policy Required" Zone Chart I-3Industrial Production Recovery Is Intact Industrial Production Recovery Is Intact Industrial Production Recovery Is Intact On the inflation side, our pipeline indicators have all signaled a modest building of underlying inflation pressure over the past year (although they have softened recently in the U.S. and Eurozone; Chart I-5). In terms of the components of these indicators, rising core producer price inflation has been partly offset by slower gains in unit labor costs in some economies. Chart I-4Our Short-Term Growth Models Are Bullish Our Short-Term Growth Models Are Bullish Our Short-Term Growth Models Are Bullish Chart I-5Some Rise In Pipeline Inflation Pressure Some Rise In Pipeline Inflation Pressure Some Rise In Pipeline Inflation Pressure These pipeline pressures have yet to show up at the consumer level. Most central bankers argue that temporary special factors are to blame, but many investors are wondering if longer-lasting forces are at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. Amazon, Uber, robotics and shale oil production are just a few examples. If this is the main story, then the inability for central banks to reach their inflation targets is a "good thing" because it reflects the adaptation of game-changing new technology. There is no doubt that important strides are being made in certain areas where new technologies are clearly driving prices down. The problem is that, at the macro level, it is not showing up in the productivity data. Productivity is dismally low across the major countries and we do not believe it is simply due to mismeasurement. A Special Report from BCA's Global Investment Strategy2 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, it appears that productivity is over-estimated in some industries. It is also important to keep in mind that technological change is nothing new. There is a vigorous debate in academic circles on whether today's new technologies are anywhere near as positive as previous ones like indoor plumbing, electricity, the internal combustion engine and the internet. We are wowed by today's new gizmos, but they are not as transformative as previous innovations. While productivity is surging in some high-profile firms, studies show that there is a long tail of low-productivity companies that drag down the average. A full discussion is beyond the scope of this report and more research needs to be done, but we are not of the view that technology and productivity preclude rising inflation. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus in the coming months and quarters. Did Yellen Turn Dovish? As with other central banks, the consensus among Fed policymakers is willing to "look through" low inflation for now. Yellen's Congressional testimony did not deviate from that view, although investors interpreted her remarks as dovish. The financial press focused on her statement that "...the policy rate is not far from neutral." However, this was followed up by the statement that "...because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal." Chart I-6Bond Market Does Not Believe The Fed Bond Market Does Not Believe The Fed Bond Market Does Not Believe The Fed The Fed believes there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is currently close to the short-term neutral level, which is depressed by economic headwinds. However, Yellen and others have made the case that the short-term neutral rate is trending up as headwinds diminish, and will converge with the long-term neutral rate over time. The Fed's Summary of Economic Projections reveals what the FOMC thinks is the neutral long-term real fed funds rate; the median forecast calls for a nominal fed funds rate of 2.9% at the end of 2019 and 3% in the longer run. Incorporating a 2% inflation target, we can infer that the Fed anticipates a real neutral rate of 1% in the longer run. The Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart I-6 shows this estimate of the neutral rate, called R-star, alongside the real federal funds rate that is calculated using 12-month trailing core PCE. The resulting real fed funds rate has risen sharply during the past seven months due to both three Fed rate hikes and a decline in inflation. If the Fed lifts rates once more this year and core inflation stays put, then the real fed funds rate would end 2017 close to zero, only 42 bps below neutral. However, it's more likely that the Fed will need to see inflation rebound before it delivers another rate hike. In a scenario where core inflation rises to 1.9% and the Fed lifts rates once more, then the real fed funds rate would actually decline between now and the end of the year. The implication is that the real fed funds rate is not far from R-star, but the nominal rate will have to rise a long way before the real rate reaches the Fed's estimate of the long-term neutral rate. Investors simply don't believe Fed policymakers. According to the bond market, the real fed funds rate will not shift into positive territory until 2021 (see real forward OIS line in Chart I-6). We think this is far too complacent. U.S. Health Care Reform: RIP The speed at which short-term rates converge with the long-run neutral rate will depend importantly on the path of fiscal policy. The Republicans' failure to pass their health care legislation is leading the investors to doubt the prospect for (stimulative) tax cuts. This may be premature. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for President Trump and the Republican Party. According to the Congressional Budget Office, the proposed legislation would have caused 22 million fewer Americans to have health insurance in 2026 compared with the status quo. The Senate bill would have also led to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Many of these voters came out in support of Trump last year. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts anyway. The chances for broad tax reform have certainly diminished, since that will be just as difficult to get passed as healthcare reform. The GOP also wanted to use the roughly $200 billion in savings from healthcare reform to fund reduced tax rates. However, tax cuts are something that all Republicans can easily agree too, and they will need to show a legislative victory ahead of next year's mid-term elections. The difficulty will be how to pay for these cuts. We expect them to be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This would generate a modest amount of fiscal stimulus over the next few years. Sub-4% U.S. Unemployment Rate Followed By Recession? Chart I-7Inside The Fed's Forecasts Inside The Fed's Forecasts Inside The Fed's Forecasts Expansionary fiscal policy would make life more difficult for the FOMC, which may have already fallen behind the curve. The unemployment rate is below the Fed's estimate of the full employment level, and it will continue to erode unless productivity picks up soon. We backed out the productivity growth rate implied by the Fed's latest Summary of Economic Projections, given its assumption that real GDP growth will be roughly 2% over the next couple of years and that the unemployment rate will stabilize near the current level. This combination implies that productivity growth will accelerate from the average rate observed so far in this expansion (0.7%) to about 1%, which is consistent with monthly payrolls of 135,000 assuming real GDP growth of 2% (Chart I-7). If we instead assume that productivity does not accelerate (and real GDP growth is 2%), then payrolls must jump to 160,000 and the unemployment rate would fall below 4% next year. The implication is that the unemployment rate is likely to soon reach levels not seen since 2000, which would force the FOMC to tighten more aggressively. The Fed would hope for a soft landing as it tries to nudge the unemployment rate higher, but the more likely result is a recession in 2019. For this year, we expect the Fed to begin balance sheet runoff in the autumn, followed by a rate hike in December. The latter hinges importantly on at least a modest rise in core PCE inflation in the coming months. A rebound in oil prices would help the Fed reach its inflation goal, even though energy prices affect the headline by more than the core rate. Saudi Energy Minister Khalid al-Falih indicated at a recent press conference in St. Petersburg that no changes are presently needed to the production deal under which OPEC and non-OPEC producers pledged to remove 1.8mn b/d from the market. The Saudi energy minister's remarks leave open the possibility of deeper cuts later this year if global inventories do not draw fast enough, or for the cuts to be extended beyond March 2018 if officials are not satisfied with progress on the storage front. We still believe they are capable of meeting this goal, despite rising shale production. Chart I-8Forecast Of Oil Inventories Forecast Of Oil Inventories Forecast Of Oil Inventories Our commodity strategists expect OECD oil inventories to reach their five-year average level by year-end or early 2018 Q1 (Chart I-8). In the absence of additional cuts, the five-year average level of OECD inventories will be higher than we estimated earlier this year, indicating that our expectation for the overall inventory drawdown later this year has been trimmed. Still, our oil strategists believe the inventory drawdowns will be sufficient to push WTI above the mid-$50s by year-end. If this forecast pans out, rising oil prices will push up headline inflation and inflation expectations in the major advanced economies. The bottom line is that the backdrop has turned bond-bearish now that central bankers in the advanced economies are in the process of scaling back the easier monetary policy that followed the deflationary 2014/15 oil shock. Duration should be kept short within global fixed income portfolios. In terms of country allocation, our global fixed income strategists have downgraded the Eurozone government bond market to underweight, joining the Treasury allocation, in light of the pending ECB tapering announcement that could place more upward pressure on yields. This was offset by upgrading Japan to maximum overweight. Max Policy Divergence Has Not Been Reached Chart I-9Europe Has A Lower Neutral Rate Europe Has A Lower Neutral Rate Europe Has A Lower Neutral Rate The change in tone by central bankers outside the U.S. has weighted heavily on the U.S. dollar. The Canadian dollar and the Euro have been particularly strong. Investors have apparently decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but rate hikes are a long way off because there remains a substantial amount of economic slack in the Eurozone. Laubach and Williams estimate R-star in the Eurozone to be close to zero, which is 50 basis points below the U.S. neutral rate (Chart I-9). The difference is related to slower potential growth and greater unemployment. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008, and 6.7 points higher outside of Germany. The current real short-term rate is about -1%. We expect U.S. R-star to rise in absolute terms and relative to the neutral rate in the Eurozone because the U.S. is further advanced in the economic expansion. As Fed rate hike expectations ratchet up in the coming months, interest rate differentials versus Europe will widen in favor of the dollar. It is the same story for the dollar/yen rate because the Bank of Japan is a long way from raising or abandoning its 10-year bond yield peg. Japanese core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year. The annual shunto wage negotiations this summer produced little in the way of salary hikes. The major exception to our "strong dollar" call is the Canadian loonie, which we expect to appreciate versus the greenback. We also like the Aussie dollar, provided that the Chinese economy continues to hold up as we expect. Stocks Get A Free Pass For Now Chart I-10Global EPS And Industrial Production Global EPS And Industrial Production Global EPS And Industrial Production Fading market hopes for U.S. fiscal stimulus have weighed on both U.S. Treasury yields and the dollar, but the equity market has taken the news in stride. Are equity investors simply in denial? We do not think so. The equity market appears to have been given a "free pass" for now because earnings have been supportive. The combination of robust earnings growth, steady real GDP growth of around 2%, and low bond yields has been bullish for stocks so far in this expansion. At the global level, EPS growth continues to accelerate in line with the recovery in industrial production, which is a good proxy for top line growth (Chart I-10). Orders and production for capital goods in the major advanced economies have been particularly strong in recent months. The global operating margin flattened off last month according to IBES data, although margins continued to firm in the U.S. and Europe (Chart I-11). The profit acceleration is widespread across these three economies in the Basic Materials and Consumer Discretionary sectors. Industrials, Energy, Health Care and Consumer Staples are also performing well in most cases. Telecom is the weak spot. Our sector profit diffusion indexes paint an upbeat picture for the near term (Chart I-12). Chart I-11Operating Margins On The Rise Operating Margins On The Rise Operating Margins On The Rise Chart I-12Earnings Diffusion Indexes Are Bullish Earnings Diffusion Indexes Are Bullish Earnings Diffusion Indexes Are Bullish In the U.S., the second quarter earnings season is off to a good start. Results so far suggest that Q2 will see another quarter of margin expansion. We believe that U.S. margins are in a secular decline, but they are in the midst of a counter-trend rally that will last for the rest of this year. Using blended results for the second quarter, trailing S&P 500 EPS growth hit 18½% on a 4-quarter moving total basis (Chart I-13). The acceleration in earnings is impressive even after excluding the Energy sector. We projected early this year that EPS growth would peak at around 20%4 by year end, but it appears that earnings will overshoot that level. Chart I-13Robust EPS Growth Even Without Energy Robust EPS Growth Even Without Energy Robust EPS Growth Even Without Energy It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. We are expecting to scale back our overweight equity recommendation sometime in the first half of 2018, although the global rally could be extended by constructive earnings data in Europe and Japan. The earnings recovery in both economies is behind the U.S., such that peak growth will come later in 2018. There is also more room for margins to expand in Europe than in the U.S. The relative earnings cycle is one of the reasons why we continue to favor Eurozone and Japanese stocks to the U.S. in local currency terms. Japanese stocks are also cheap to the U.S. based on our top-down valuation indicator (Chart I-14). European stocks are not far from fair value relative to the U.S., after adjusting for the fact that Europe trades structurally on the cheap side. The message from our top-down valuation indicator for European stocks is confirmed when using the bottom-up information contained in the new BCA Equity Trading Strategy platform. The Special Report beginning on page 20 describes a bottom-up valuation measure that we will use in conjunction with our top-down (index-based) measures. Corporate Bonds: Kindling And Sparks Healthy EPS growth momentum is also constructive for corporate bonds, although overall balance sheet health continues to erode in the U.S. The release of the U.S. Flow of Funds data allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart I-15). The level of the CHM moved slightly deeper into "deteriorating health territory." Chart I-14Top-Down Relative Equity Valuation Top-Down Relative Equity Valuation Top-Down Relative Equity Valuation Chart I-15Deteriorating Since 2015, But... Deteriorating Since 2015, But... Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years, calling almost all major turning points in advance. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. It also requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to ramp up, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist normally occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. It will be some time before U.S. short-term interest rates reach restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart I-16 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, eased in the fourth quarter 2016 and the first quarter of 2017 (Chart I-17). Ratings migration has also improved (i.e. moderating net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The diminished appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart I-16Still Some Value In ##br##High-Yield Corporates Still Some Value In High-Yield Corporates Still Some Value In High-Yield Corporates Chart I-17Net Transfers To Shareholders ##br##Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle. Value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Investment Conclusions A key change in the global financial landscape over the past month is a signal from central banks that they see the need for policy recalibration. Policymakers view sub-target inflation as temporary, and some are concerned that low interest rates could contribute to the formation of financial market bubbles. The bond market remains skeptical, given persistent inflation undershoots and growing anecdotal evidence that new technologies are very deflationary. It would be extremely bullish for stocks if these new technologies were indeed boosting the supply side of the economy at a faster pace than the official data suggest. Robust advances in output-per-worker would allow profits to grow quickly, and would provide the economy more breathing space before hitting inflationary capacity limits (keeping the bond vigilantes at bay). We acknowledge that there are important technological breakthroughs being made, but we do not see any evidence that this is occurring on a widespread basis sufficient to "move the dial" in terms of overall productivity growth. Indeed, the stagnation of middle class personal income is consistent with a poor productivity backdrop. Chart I-18 highlights that "creative destruction" is in a long-term bear market. Chart I-18Less Creative Destruction Less Creative Destruction Less Creative Destruction That said, the equity market is benefiting from the mini-cycle in corporate profits, which are still recovering from the earnings recession in 2015/early 2016. We expect the recovery to be complete by early 2018, which will set the stage for a substantial slowdown in EPS growth next year. It won't be a disaster, absent a recession, but demanding valuations suggest that the market could struggle to make headway through next year. We expect to trim exposure sometime in the first half of 2018. To time the exit, we will watch for a roll-over in the growth rate of S&P 500 EPS on a 4-quarter moving total basis. Investors should look for a peak in industrial production growth as a warnings sign for profits. We are also watching for a contraction in excess money, which we define as M2 divided by nominal GDP. Finally, a rise in core PCE inflation to 2% would be a signal that the Fed is about to ramp up interest rates. For now, remain overweight equities relative to bonds and cash. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. We are comfortable with our pro-risk recommendations and our below-benchmark duration stance. Unfortunately, that can't be said of our bullish U.S. dollar and oil price house views. Both are controversial calls among our strategists. As for oil, supply and demand are finely balanced and our positive view hinges importantly on OPEC agreeing to more production cuts. The obvious risk is that these cuts do not materialize. The dollar call has gone against us as the latest signs of improving global growth momentum have admittedly been outside the U.S. Meanwhile, the U.S. is stuck in a political morass, which delays the prospect of fiscal stimulus. This is not to say that U.S. growth will slow. Rather, the growth acceleration may fall short of the high expectations following last November's election. We continue to believe that the market is too complacent on the pace of Fed rate hikes in the coming quarters. An upward adjustment in rate expectations should push the dollar higher on a trade-weighted basis, as outlined above. Nonetheless, this shift will require higher U.S. inflation, the timing of which is highly uncertain. We remain dollar bulls on a 12-month horizon, but we are stepping aside and calling for a trading range in the next three months. Mark McClellan Senior Vice President The Bank Credit Analyst July 27, 2017 Next Report: August 31, 2017 1 Please see Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up," dated July 4, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 3 Kathryn Holston, Thomas Laubach, and John C. Williams "Measuring The Natural Rates Of Interest: International Trends And Determinants," Federal Reserve Bank of San Francisco, Working Paper 2016-11 (December 2016). 4 Calculated as a year-over-year growth rate of a 4-quarter moving total of S&P data. II. The BCA ETS Trading Platform Approach To Valuing Eurozone Stocks The performance of European stocks relative to the U.S. has been dismal in the post-Lehman period. However, the Eurozone economy is performing impressively, profit growth is accelerating and margins are rising. This points to a period of outperformance for Eurozone stocks, at least in local currency terms. Standard valuation measures based on index data suggest that Eurozone stocks are cheap to the U.S. Nonetheless, the European market almost always trades at a discount, due to persistent lackluster profit performance. In Part II of our series on valuation, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction. Investors can be confident that they will make money on a 12-month horizon by taking a position when the new bottom-up indicator reaches +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. Valuation alone does not justify overweight Eurozone positions at the moment, although we like the market for other reasons. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. Total returns in the European equity market have bounced relative to the U.S. since 2016 in both local-currency and common currency terms (Chart II-1). However, this has offset only a tiny fraction of the dismal underperformance since 2007. In local currencies, the relative EMU/U.S. total return index is still close to its lowest level since the late 1970s. Compared with the pre-Lehman peak, the U.S. total return index is more than 96% higher according to Datastream data, while the Eurozone total return index is only now getting back to the previous high-water mark when expressed in U.S. dollars (Chart II-2). Chart II-1EMU Stocks Lag Massively... EMU Stocks Lag Massively... EMU Stocks Lag Massively... Chart II-2...Due To Depressed Earnings ...Due To Depressed Earnings ...Due To Depressed Earnings The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share (EPS) generated by U.S. companies now exceed the pre-Lehman peak by about 19%. In contrast, earnings produced by their Eurozone peers are a whopping 48% below their peak (common currency). This reflects both a slower recovery in sales-per-share growth and lower profit margins. Operating margins in Europe have been on the upswing for a year, but are still depressed by pre-Lehman standards. Margin outperformance in the U.S. is not a sector weighting story; in only 2 of 10 sectors do European operating margins exceed the U.S. The return-on-equity data tell a similar story. Nonetheless, a turning point may be at hand. Chart II-3Europe Trades At A Discount Europe Trades At A Discount Europe Trades At A Discount The Eurozone economy has been performing well, especially on a per-capita basis, and forward-looking indicators suggest that growth will remain above-trend for at least the next few quarters. U.S. profit margins have also been (temporarily) rising, but the Eurozone economy has more room to grow because there is still slack in the labor market. There is also more room for margins to rise in the Eurozone corporate sector than is the case in the U.S., where the profit cycle is further advanced. Traditional measures of value based on the MSCI indexes suggest that European stocks are on the cheap side. But are they really that cheap? Based on index data, Eurozone stocks trade at a hefty discount across most of the main valuation measures (Chart II-3). This is the case even for normalized measures such as price-to-book (P/B). However, Eurozone stocks have almost always traded at a discount. There are many possible explanations as to why there is a persistent valuation gap between these two markets, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American stock valuations relative to Europe. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole were significantly more profitable even before the Great Financial Crisis (Chart II-3). U.S. companies also tend to have lower leverage and higher interest coverage. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. RoE and operating margins are lower in Europe even applying U.S. sector weights to the European market.1 Why corporate Europe has been a perennial profit under-achiever is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European companies were less successful in squeezing down labor costs. Measuring Value In the first part of our two-part Special Report on valuation, published in July 2016, we took a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for different sector weights and persistent differences in the underlying profit fundamentals. A regression approach that factored in various profitability measures performed reasonably well, but the top-down "mechanical" approach that relied on a 5-year moving average provided the most profitable buy/sell signals historically. We approach the issue from a bottom-up perspective in Part II of our series, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. 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 have outperformed stocks in the bottom decile by over 25% a year.2 The BCA Score includes all 24 factors when ranking stocks, but we are interested in developing a valuation metric that provides valued added on its own and is at least as good as the top-down index-based measure developed in Part I. The five valuation measures in the ETS database are trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combine all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranks the stocks from best to worst on a daily basis (i.e. cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. Chart II-4 presents the resulting bottom-up indicator, along with our previously-published top-down valuation measure. A high reading indicates that European stocks are cheap to the U.S., while it is the opposite for low readings. Chart II-4Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's causes major shifts in relative valuation among sectors and between the U.S. and Eurozone that skew the indicator when constructed using the entire data set. We obtain a cleaner indicator when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local currency) excess returns over 3, 6, 12 and 24-month horizon generated by (1) overweighting European stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European market was one and two standard deviations expensive (Table II-1). Table II-1Value Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 The trading rule returns were best when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation were not as good, but still more than 3% on 12- and 24-month horizons. Table II-1 also presents the trading rule's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. The batting average ranged from 50% on a 3-month horizon to 68% over 24 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The charts and tables in the Appendix present the results of the same analysis at the sector level. The results are equally as good as the aggregate valuation indicator, with a couple of exceptions. European stocks are cheap to the U.S. in the Energy, Financials, and Utilities sectors, while U.S. stocks offer better value in Consumer Discretionary, Consumer Staples, Health Care, Industrials and Technology. Materials, Real Estate, and Telecommunications are close to equally valued. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reach undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals, muddying the message provided by valuation alone. In contrast, adding some information from the technical factors in the ETS model does add value, at least when using +/-1 standard deviations as the trigger point for trades (Chart II-5). Excess returns to the trading rule rise significantly when the medium-term momentum and long-term mean reversion factors are included in the valuation indicator (Table II-2). The batting average also improves. Chart II-5Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 Adding technical information does not improve the trading rule performance when +/-2 sigma is used as the trigger point. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Historical analysis using a trading rule demonstrates that the new bottom-up valuation indicator provides real value to investors. We would normally evaluate its track record using stretching analysis, where we use only the historical information available at each point in time when determining relative value. However, the relatively short history of the available data precludes this test because we need at least a few cycles to best gauge the underlying volatility in the data. Still, investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up indicator reaches +/-1 sigma over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of the fundamental or technical factors. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. At the moment, the top-down version proposes that European stocks are somewhat cheap to the U.S., while the bottom-up indicator points to slight overvaluation. Considering the two together suggests that valuation is close enough to fair value that investors cannot make the decision on value alone. Valuation indicators need to be near extremes to be informative. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. at the moment, although not because of valuation. Rather, the Eurozone economy and corporate earnings have more room to grow because of lingering labor market slack. This also means that the ECB can keep rates glued to the zero bound for at least the next 18 months while the Fed hikes, which will place upward pressure on the dollar and downward pressure on the euro. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix: Trading Rule Returns By Sector Chart II-6, Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12, Chart II-13, Chart II-14, Chart II-15, Chart II-16. Chart II-6Consumer Discretionary Consumer Discretionary Consumer Discretionary Chart II-7Consumer Staples Consumer Staples Consumer Staples Chart II-8Energy Energy Energy Chart II-9Financials Financials Financials Chart II-10Health Care Health Care Health Care Chart II-11Industrials Industrials Industrials Chart II-12Materials Materials Materials Chart II-13Real Estate Real Estate Real Estate Chart II-14Utilities Utilities Utilities Chart II-15Technology Technology Technology Chart II-16Telecommunication Telecommunication Telecommunication 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" July 2016, available at bca.bcaresearch.com. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach to Bottom-Up Stock Picking," December 2, 2015, available at ets.bcaresearch.com. III. Indicators And Reference Charts Stocks continue to outperform bonds against a constructive backdrop of improving global economic prospects and accelerating EPS growth, while low inflation is expected to keep central banks from tightening quickly. Our main equity and asset allocation indicators remain bullish for risk, with a few exceptions. Our new Revealed Preference Indicator (RPI) jumped back to a 100% equity weighting in July. We introduced the RPI in last month's Special Report. Quite simply, it 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. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The U.S. WTP remains bullish, but has topped out, suggesting that flows into the U.S. market are beginning to moderate. In contrast, the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway, although it has not yet shown up in terms of equity market outperformance versus the U.S. On the negative side, our Monetary Indicator last month fell a little further below the zero line and our composite Technical Indicator appears to be rolling over; the latter generates a 'sell' signal when it drops below its 9-month moving average. Value is stretched, but our Valuation Indicator has not yet reached the +1 standard deviation level that indicates clear over-valuation. As highlighted in the Overview section, the U.S. and global earnings backdrop continues to support equity markets. Forward earnings estimates are in a steep uptrend, and the recent surge in the net revisions ratio and the earnings surprise index suggests that EPS growth will remain impressive for the remainder of the year. Bond valuation is largely unchanged from last month, sitting very close to fair value. We still believe that fair value is rising as economic headwinds fade. However, much depends on our forecast that core inflation in the major countries will grind higher in the coming months. Central banks stand ready to "remove the punchbowl" if they get the green light from inflation. The dollar's downdraft in July reduced some of its overvaluation based on purchasing power parity measures. The dollar appears less overvalued based on other measures. Our composite Technical Indicator has fallen hard, but has not reached oversold levels. This suggests that the dollar has more downside before it finds a bottom. 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-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators 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-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro 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

Highlights The "Trump Put" rumbles on, spurring equities, driving U.S. Treasury yields down, and hurting the dollar; White House incompetence, which underpins the "Trump Put," is about quantitative and qualitative staffing decisions, not the Russia collusion investigation; Tax reform will happen, but Congress is now in charge; Watch for the next Fed Chair nomination, more dollar downside could be ahead; China has preempted the next financial crisis with new regulatory oversight; The death of Abenomics is overstated. Feature We introduced the "Trump Put" in a recent report as a risk to our view that President Trump would get his populist economic agenda through Congress.1 The Trump Put posits that White House disarray and congressional incompetence will combine with decent earnings growth and steady global growth to produce Goldilocks conditions for U.S. equities, while simultaneously weakening the USD and supporting Treasuries. Thus far, the Trump Put continues to be in effect (Chart 1). Our House Views of further yield-curve steepening and a stronger USD have suffered from the ongoing "gong show" that is the Trump administration. The saving grace has been our high-conviction bullish equity view (Chart 2).2 Chart 1The Trump Put: Good For Equities,##br## Bad For Everything Else The Trump Put: Good For Equities, Bad For Everything Else The Trump Put: Good For Equities, Bad For Everything Else Chart 2S&P 500 Does Not##br## Care About Russia S&P 500 Does Not Care About Russia S&P 500 Does Not Care About Russia That said, we maintain our high-conviction view that the GOP will pass tax legislation in Q1 2018. Why? First, the failure to repeal Obamacare means that congressional Republicans will enter the midterm election season with no legislative wins. That is extraordinary given Republican control of both chambers of Congress and the executive. The House GOP members will not want to face an angry electorate in primary elections a year from now, or the general election, without a single major accomplishment. Second, Trump's low popularity will be an albatross around the neck of GOP candidates in the November 2018 elections, with potentially ominous results (Chart 3). Trump needs to pass a major piece of legislation; GOP congressmen have an interest in lifting Trump's popularity. Third, the House has passed the FY2017 budget resolution, which includes reconciliation instructions for tax reform. Given that only one budget resolution can be effective at any one time, the Obamacare replacement effort will end with the current fiscal year, on October 1.3 Chart 3GOP Is Running Out Of Time The Wrath Of Cohn The Wrath Of Cohn While we remain confident that some form of tax legislation will ultimately pass - either watered down tax reform or mere tax cuts - we are far less confident that it will be stimulative. In other words, it will be done according to the congressional, not the White House, blueprint. House Speaker Paul Ryan has long demanded revenue-neutral reform. The just-passed budget resolution calls for $203 billion in spending cuts in order to make tax cuts revenue-neutral. This is a reversion to form after the period earlier this year in which several fiscal conservatives, like Representatives Kevin Brady and Mark Meadows, intoned that they would be comfortable with tax reform that was not revenue-neutral. At the beginning of the year, it looked like Trump would be able to use his bully pulpit to cajole the Congressional Republicans into stimulative tax reform or tax cuts. Previous Presidents, including Obama with the Affordable Care Act, have been able to punish overly ideological legislators for the sake of pragmatism and/or expediency. Certainly Trump remains popular with GOP voters (Chart 4), suggesting that he might be able to do so as well. Chart 4Trump Retains Political ##br##Capital With GOP Voters The Wrath Of Cohn The Wrath Of Cohn Six months into his presidency, however, Trump remains a no-show in terms of leadership. This is not merely the result of distraction with the "Russian collusion" charges against his campaign team and inner circle. The White House is simply not playing its traditional coordinating role to shepherd key bills through Congress. Political insiders, even the ones close to Trump, are signaling privately and via the media that the White House is in disarray and understaffed both quantitatively and qualitatively. It is in no shape, in other words, to coordinate the legislative process and play the role of peacemaker between the different congressional factions. At the heart of the disarray is an elite dispute within the White House itself between what we call the "Goldman" and "Breitbart" factions of the administration. The Goldman Clique: Donald Trump has staffed his administration with several financial sector luminaries whom he met while building his business empire. At the head of this faction is Gary Cohn, Director of the National Economic Council and leading candidate for the next Chair of the Board of Governors of the Federal Reserve System (more on that later). Other members are Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross, and the most recent addition to the administration, the new White House Communications Director Anthony "the Mooch" Scaramucci. This faction is pragmatic, un-ideological (Cohn and "the Mooch" are essentially Democrats), and focused on passing tax reform and pro-business regulation. They prefer tax reform to mere tax cuts, and want middle class tax cuts to be balanced with pro-business corporate tax reform. The Breitbart Clique: Most commentators see the Goldman clique as the more powerful of the two White House factions, but Trump owes his electoral victory to a campaign molded along the ideological bent in line with the Breitbart faction. This group is led by Chief Strategist Steven Bannon and policy advisor Steven Miller.4 Behind the scenes, Bannon and Miller have managed to staff the White House with several Breitbart alumni, such as presidential advisors Sebastian Gorka and Julia Hahn, and (until her departure this month) Security Council Deputy Chief of Staff Tera Dahl. Factional fighting is not new to the White House. For example, the Obama administration was divided between foreign policy hawks - Secretary of State Hillary Clinton and Secretary of Defense Robert Gates - and doves - National Security Advisor Susan Rice and Ambassador to the UN Samantha Power. White House policy is often a product of compromise between different factions, producing sub-optimal outcomes. The problem with the Trump administration, however, is that the Breitbart faction is severely outmatched and unqualified for the job of coordinating legislative policy. Putting aside its ideological zealotry, this faction consists mainly of journalists without policy experience. This inexperience came to light with Trump's original executive order banning entry into the U.S. of nationals of several countries, penned by Bannon and Miller, which would have barred green card holders from entry. While that order may or may not have been constitutional, it was clearly impractical and aggressive. Another clear problem for the Trump administration is that its current Chief of Staff, former RNC Chairman Reince Priebus, is weak and ineffective. Priebus was a compromise candidate between the two factions and someone seen as acceptable to Republicans in Congress. Since his appointment, however, he has been a no-show. It was his idea to focus on replacing Obamacare ahead of tax reform (despite the absence of a GOP blueprint for the former and the existence of a blueprint for the latter), and it was his idea to give the overmatched Sean Spicer the role of managing the press. The chief of staff should be a force of nature, capable of instilling fear into the president's congressional allies in order to get legislation moving and reduce cliquish in-fighting. A successful chief of staff is usually a controversial and abrasive figure, such as Rahm Emanuel at the beginning of President Obama's first term. He bullied and cajoled Democrats into passing Obamacare with legendary brutality. BCA's Geopolitical Strategy rarely delves into personality-driven analysis. It is too idiosyncratic, not systematic. However, as a country's political leadership becomes more "charismatic"5 - driven by personality rather than institutions - individuals, factions, and court intrigue matter more. What does all of this mean for investors? First, the White House is failing in its coordinating role. As such, Republicans in the House will take the lead on tax reform. Revenue neutrality will be emphasized. For this to change, the White House would have to reshuffle its personnel more extensively, including replacing Priebus. Second, if fiscal policy fails to take off, Trump will put greater stock in monetary policy. Our colleagues - who are economists, not political analysts - believe that the U.S. is likely to enter into recession in 2019, as the 2020 electoral campaign heats up. However, folks like Gary Cohn and Steve Mnuchin can see the same writing on the wall, and will probably try to avoid such a badly timed recession. Chart 5 shows that household debt has continued to decline as a share of disposable income; the share of national income going to labor has increased; and wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All of this should give consumers the wherewithal to spend more, warranting higher interest rates. Meanwhile, financial conditions have significantly eased due to USD weakness and declining bond-yields, which should boost growth in the second half of this year (Chart 6). Chart 5Households Have The ##br##Wherewithal To Spend More Households Have The Wherewithal To Spend More Households Have The Wherewithal To Spend More Chart 6Financial Conditions##br## Have Eased Financial Conditions Have Eased Financial Conditions Have Eased With Congress increasingly in charge of fiscal policy and a recession possible in 2019, we would expect Trump to do everything he can to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. While there is some speculation regarding Cohn's policy preference, we are yet to find an insider (either of the FOMC or the White House) who denies that he is a dove. The intrigue should not last long. Both Yellen and Bernanke were nominated with considerable lead time: 114 days before the end of her predecessor's term for Yellen, and 91 days for Bernanke (Chart 7). We would therefore expect the next Fed Chair to be known by Thanksgiving. Is Cohn a controversial pick? Not really. As our colleague John Canally of BCA's U.S. Investment Strategy has pointed out, lack of Fed experience does not make Cohn particularly unique as a candidate. Since the late 1970s, presidents have tended to select the Fed Chair based on their relationship with a candidate, not previous central banking experience (Table 1).6 Cohn would only break the orthodoxy by being the first candidate to be appointed from across the ideological aisle, given that he is a Democrat. (Although several chairs have been reappointed by presidents from opposing political parties.) Chart 7How Long Does It Take To Confirm The Fed Chair? The Wrath Of Cohn The Wrath Of Cohn Table 1Characteristics Of Fed Chairs Since 1970 The Wrath Of Cohn The Wrath Of Cohn A number of previous Fed chairs were selected for loyalty over academic merit or central banking experience. President Nixon's pick for the chair, Arthur Burns (Chair from 1970-1978), was the head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to Nixon before being appointed. William Miller (Chair from 1978-1979), although having served as an outside director for the Boston Fed, was appointed largely because of his work on the political campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987-2006) served as Chair of President Reagan's Social Security Commission in the early 1980s, Chair of President Ford's CEA, and advised Nixon's campaign in 1968. Only Volcker, Bernanke, and Yellen had previously held posts in the Federal Reserve System. The market cares about the appointment of the Fed chair. In 2013, for example, Larry Summers and Janet Yellen were in the running for the position, with Summers viewed as the more hawkish of the two. When he withdrew from the race on September 15, the market's expected pace of rate hikes plunged and long-dated TIPS breakevens surged on the expectations of a more dovish Fed (Chart 8). Given that the market is currently discounting just 27.4 bps of rate hikes during the next 12 months, down from the recent peak of 36 bps (Chart 9), there may not be much room to get more dovish.7 Chart 8Yellen Vs. Summers Drove Markets In 2013 Yellen Vs. Summers Drove Markets In 2013 Yellen Vs. Summers Drove Markets In 2013 Chart 9Market May Be Right? Market May Be Right? Market May Be Right? Nonetheless, President Trump may not want to gamble with his Fed appointments. If we are right to assume that he is an economic populist, and that his fiscally stimulative agenda is slipping away, then we would expect the White House to err on the side of Fed appointments that would be behind the proverbial curve. In addition to Yellen, Trump will have the opportunity to appoint a new Vice Chairman of the Fed in place of Stanley Fischer on June 12, 2018 (Diagram 1), as well as another candidate for the Board of Governors (after already having nominated Marvin Goodfriend and Randal Quarels). By mid-2018, the Fed will start to take on a new composition altogether. Diagram 1Federal Reserve Board Of Governors Calendar The Wrath Of Cohn The Wrath Of Cohn Staffing the Fed with doves fits at least two of President Trump's campaign promises. First, if the Fed were to fall behind the curve, nominal GDP would likely surprise to the upside. Second, the USD would continue its downward trajectory, helping rebalance America's trade deficit. As such, we take the potential nomination of Gary Cohn seriously. And we expect the market will as well. That said, a Cohn-led Fed would not be a fundamental break with the past. In fact, Yellen has herself intoned that the Fed may want to let inflation run above 2% in past speeches. In addition, Trump's first two nominees to the Fed do not fit a dovish mold. Conservative economist Marvin Goodfriend is a hawk and favors rule-based policymaking. Randal Quarels will focus on regulating the financial sector, or rather deregulating it, although his policy orientation is largely unknown. Furthermore, other potential Fed Chair nominees, such as Kevin Warsh and Richard Fisher, would be more hawkish than Yellen. And if they are not selected to replace Yellen, they could replace the current Vice-Chairman Fischer. As such, investors should not overreact to a Cohn appointment. However, currency markets might, given that the Trump White House has been highly unorthodox. Bottom Line: There is likely more downside to the USD over the rest of the year. China: A Preemptive Dodd-Frank Last week we argued that China is likely to escalate financial regulation considerably over the next 6-12 months.8 Essentially, the "financial crackdown" or "deleveraging campaign" seen in H1 of this year was just a dress rehearsal for what is to come. The larger policy shift will exert downward pressure on economic growth in H2 2017 and throughout 2018, essentially putting a cap of about 7% on China's growth rate. True, the Chinese government will strive to avoid letting the new regulatory push lead to a sharp slowdown, i.e., shattering its preexisting commitment to an average GDP growth rate of 6.5% per year through 2020. However, the risks lie to the downside over the next 18 months due to the combination of unaddressed structural imbalances, cyclically fading economic tailwinds, and further policy tightening. We have outlined the structural flaws before. In brief, they include: Demographics: The working-age population is declining, yet the social systems to improve productivity are not yet adequate. Economic model: The investment-led model has become inefficient, requiring China to add more and more debt in order to generate the same amount of growth, in a manner reminiscent of South Korea prior to the Asian Financial Crisis (Chart 10). The transition to consumer-led growth is incomplete, with households still reluctant to take over from corporates in driving spending. Financial transmission: China's banking sector has expanded quickly, leading to a rise in bad loans and "special mention" assets, as losses from large companies remain elevated (Chart 11). The shadow banking sector is highly leveraged, poorly regulated, and extremely risky, and has mushroomed since 2008. Fiscal system: Local governments lack stable sources of funding and therefore rely on SOE debt and manipulation of the land market in order to fund their 85% share of China's fiscal spending. The government's recent fiscal reforms (the VAT extension) have actually further deprived local governments of revenues. Inequality and social ills: Wealth inequality, social immobility, regressive taxation (Chart 12), and an inadequate social safety net have hindered the development of the consumer society as well as innovation and entrepreneurship. Centralized authoritarianism: The political system perpetuates the above ills by disallowing free speech, free association, free movement, and other freedoms that would encourage innovation and total factor productivity. Chart 10More And More Reliant On Debt For Growth More And More Reliant On Debt For Growth More And More Reliant On Debt For Growth Chart 11Bad Loans Rising Bad Loans Rising Bad Loans Rising Chart 12Communism Fails To Redistribute Income The Wrath Of Cohn The Wrath Of Cohn Meanwhile, we have several reasons for anticipating a larger, less accommodative policy shift over the next six-to-twelve months: Policy drift: China's economic policy has been adrift over the past year and a half, as reflected by elevated economic policy uncertainty. While President Xi Jinping's anti-corruption campaign is no longer relevant in a macroeconomic sense - and this theoretically opens the way for him to pursue his ambitious economic reform agenda - he has so far chosen stimulus over restructuring due to the instability of 2015-16. Now, as the latest stimulus measures fade (Chart 13), the question of how to go forward is pressing, since to re-apply the same policy mix in 2018 would be to forgo his reform agenda until 2019 ... and probably once and for all. Warning signs: The central government's launch of a deleveraging campaign this year was risky and surprising. It was risky because central financial authorities in any country threaten a liquidity squeeze when they tighten financial conditions into large and rapidly growing leverage. It was surprising because the authorities chose to do so when a mistake could have upset political stability in advance of the midterm party congress. The implication is: (1) authorities intended a limited campaign from the beginning; (2) the newly appointed leaders of financial regulatory bodies are no-nonsense people.9 They take very seriously, as we do, China's systemic financial risks. They believe risky measures are necessary to prevent the dangerous credit excesses. The National Financial Work Conference: The conference concluded with Xi putting his imprimatur on a renewed policy focus on the financial sector: Reducing systemic risk, reducing speculation (lending to the real economy), and eventually putting the sector back on the path of liberalization. The specific outcomes amount to something like a preemptive Dodd Frank: The People's Bank of China will take on a larger role in identifying and monitoring systemically important institutions; it will also host a new inter-agency body - the Financial Stability and Development Committee (FSDC) - that will ostensibly ensure better cooperation and coordination between the regulators of banks, stock markets, insurance, etc. Finally, the meeting signaled that this year's deleveraging campaign would expand (beyond shadow banking, insurance companies, and private companies roving overseas) to affect over-leveraged SOEs and local government financing vehicles. Significantly, local government officials will be made accountable for excessive debt. This last point should not be underrated. At the height of the anti-corruption campaign, in late 2014, fiscal spending numbers remained depressed and government agency cash deposits continued rising even after the central government tried to encourage faster growth (Chart 14), suggesting that local officials were refraining from spending due to fears that they would be punished for it.10 We consider these announcements to be substantive - i.e., not the usual propaganda - even if they take some time to get off the ground. The financial conference was frowned upon by much of the mainstream media because some interpret the FSDC as failing to live up to the rumor that China would create a new "financial super-ministry." But the rise of super-ministries under the Hu Jintao administration resulted in very little substantive change to Chinese policy. By contrast, Xi Jinping signaled that the PBoC would be the chief instrument of the new financial regulatory push, and he has already shown he can operate exceedingly effectively through existing institutions - namely the Central Discipline and Inspection Commission (CDIC), which went from being an ineffective intra-party corruption watchdog to a nationwide vehicle for the party's most aggressive corruption investigations and personnel purges in recent memory. We are willing to bet that the PBoC's new powers, including the new financial stability committee, will be more aggressive than the merely status quo multiplication of administrative functions that the financial media and markets apparently expect. The changing of the PBoC's Guard: It is not a coincidence that greater regulatory powers are being planned for the PBoC in the final months of Governor Zhou Xiaochuan's term. Zhou has been in office since late 2002. He has been a cornerstone figure in China's financial stability and reform throughout this period, including during the global crisis and the various financial panics from 2010-16. He has allegedly desired a more muscular central bank to tackle the country's ballooning credit risks. By handing off the baton, he clears the way for a new, ambitious governor to succeed him, one who will maintain policy continuity while also taking the opportunity of the transition to implement a new and tougher regulatory framework. Consider that after Xi put the ambitious Guo Shuqing in charge of the China Banking Regulatory Committee in February, Guo immediately launched a notable crackdown on shadow banking.11 Guo is a possible contender for the central banker position; the other likely contenders have strong credentials in regulatory oversight as well as banking. The 19th National Party Congress: The midterm leadership reshuffle will mark Xi's consolidation of power, which will enable him to pursue his policy preferences more effectively in 2018-22. He could still be prevented by exogenous events, but domestic politics should be less of an obstacle for him going forward. Chart 13China's Economic##br## Tailwinds Fading China's Economic Tailwinds Fading China's Economic Tailwinds Fading Chart 14Anti-Corruption Campaign Hindered##br## Local Government Spending Anti-Corruption Campaign Hindered Local Government Spending Anti-Corruption Campaign Hindered Local Government Spending What about Xi's political capital within the top Communist Party bodies? We are in the thick of major decisions as we go to press. The highest level of leadership - the Politburo Standing Committee (PSC) - is expected to have its members chosen, in secret, in August when the current PSC and other party heavyweights will likely convene at Beidaihe to settle the list. The fall of Chongqing Party Secretary Sun Zhengcai in mid-July gives a few hints as to what might occur. Sun was ostensibly sympathetic with Xi, and until now the likeliest candidate for Premier Li Keqiang's replacement in 2022. His ouster means that four of the top five candidates on the PSC come from the rival camp to President Xi, i.e., the "Hu Jintao faction," which is rooted in the Chinese Communist Youth League (CCYL) (Diagram 2). Diagram 2Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced? The Wrath Of Cohn The Wrath Of Cohn There are two likely pathways from here: either Sun's fall is part of a bargaining process and other CCYL members will soon be removed from the running for the PSC; or they will not be removed, which would mean that Xi gets along much better with the top CCYL members than is generally believed. The latter is unlikely, but possible, given that Xi and former President Hu Jintao did cooperate on critical power arrangements in the 2012 leadership transition. However, the most recent reports suggest that several CCYL members who were seen as rising stars (for 2022 leadership and beyond) have not received invitations to the party congress, including the current party secretary of the CCYL.12 If this proves to be the case, then it strongly suggests that Xi is continuing to undercut the CCYL. That, in turn, suggests that Xi will not tolerate the current scenario in which he stands to be outnumbered four-to-one on a five-member PSC. Instead, we should expect at least one major CCYL contender for the PSC to be removed in the coming months. This would enable Xi to gain the balance on a seven-member PSC. If the PSC is to be reduced to five members, then he would have to oust two major CCYL members - a more dramatic power play, but presumably within his reach given what he has achieved so far. Ultimately it is impossible to predict the PSC (and broader Politburo) membership precisely. All we can point out is that a failure by Xi to consolidate control on the top bodies - which is no longer our baseline view - would have bullish short-term but bearish long-term implications for growth. It would suggest, first, that Xi is weaker than he appears; second, that the aggressive financial regulatory drive outlined above, as well as other painful but necessary reforms, will be watered down as a result of resistance at top levels; third, that China is increasingly resisting the "creative destruction" that Xi threatens to bring about in the pursuit of making China more efficient. Bottom Line: A number of signs suggest that Chinese politics will become a headwind, rather than tailwind, to growth after the party congress. Xi's move to undercut the opposing CCYL faction ahead of the party congress confirms this view. His new policy will focus on deleveraging and financial sector restrictions. The commitment to stability will remain in place, however. Japan: Abe Is Not Yet Dead, Long Live Abenomics Shinzo Abe's approval rating has plummeted since June (Chart 15). His Liberal Democratic Party (LDP) has also seen its popularity fall. This has been notable in relation to the flat polling of the LDP's main coalition partner, New Komeito (Chart 16). Chart 15Abe's Luck Runs Out? The Wrath Of Cohn The Wrath Of Cohn Chart 16Ruling LDP Also In Trouble Ruling LDP Also In Trouble Ruling LDP Also In Trouble Abe has been buffeted by a combination of spiraling corruption scandals and the loss of the Tokyo Metropolitan legislature in the local election of July 2. As if this were not bad enough, the Japanese economy is set to slow down (Chart 17).13 Chart 17A Slowdown In Japan A Slowdown In Japan A Slowdown In Japan Our readers will recall that we think there is a deeper cause for Abe's sudden loss of popularity: his proposed constitutional revisions, which he laid out in detail in May. Ever since he secured a virtual two-thirds supermajority in the House of Councillors (the Upper House) in July 2016, we have maintained that he would push ahead with controversial constitutional revisions that aim to enshrine the Japanese military. We expected that these changes would sap Abe's support - as did the debate over the new national security law in 2015 (Chart 18), only bigger this time because the matter is constitutional.14 However, the Tokyo election loss does not portend the death of Abe, and regardless, Abenomics itself will survive. Why? Because it is Abe's constitutional and security agenda that is unpopular, not Abenomics. Understood as economic reflation with elements of restructuring, like wage growth, Abenomics will actually intensify over the next year and a half as a result of the new threats to Abe's and the LDP's popularity and agenda, to which they will respond. Abe is more deeply committed to this constitutional mission than to Abenomics. It is his most ambitious plan and his economic policy supports it. Revising the constitution is about Japan seizing its own destiny again as a sovereign nation and also locking in the American alliance by offering greater military assistance to the U.S. Hence, at this point, economic reflation is not only an end in itself but also a means to a constitutional end. First, note that Abe's coalition in the upper house is not as "super" of a super-majority as is widely believed. He needs the support of smaller right-wing parties that are sympathetic toward his constitutional revisions to cross the 162-seat threshold for a two-thirds vote in the upper House of Councillors to approve constitutional reforms. But the LDP's three partner parties that are in favor of revision, as well as at least one independent, could raise objections and that would sink the revisions (Diagram 3). There are others with misgivings. Economic slowdown is not a recipe for Diet members to make big political sacrifices on Abe's account, so we expect monetary and fiscal policy to remain easy. Chart 18Abe Loses Support When He Talks ##br##Security Instead Of Economy The Wrath Of Cohn The Wrath Of Cohn Diagram 3Super-Majority ##br##Barely Within Reach The Wrath Of Cohn The Wrath Of Cohn Second, if the constitutional changes pass the upper and lower houses of the Diet by two-thirds votes, they must pass a nationwide referendum. While there is majority support for revisions of some sort, there is a roughly 50-50 division on the question of altering Article 9 (Chart 19), the article that forbids Japan to maintain military forces. This is the bullseye of Abe's proposal. The need for 50% of the nation to vote "yes" is an even bigger reason for Abe to pull policy levers to keep the economy humming before a potential referendum date in December 2018. Finally, even in the unlikely scenario that Abe's approval rating drops into the mid-20s or below and the LDP ousts him, we do not expect the next LDP leader to alter Abenomics in any significant way. The frontrunners for Abe's replacement in the September 2018 LDP party leadership poll, such as Foreign Minister Fumio Kishida, would likely soften their predecessor's policy on remilitarization and constitutional revision, but would also launch a substantively similar economic policy that the media would promptly dub "Kishidanomics," "Ishibanomics," or "Asonomics." Thus, on fiscal policy, the focus will remain on fiscal support and lifting wages and social spending. Rules calling for fiscal restraint will be relaxed. On monetary policy, BoJ Governor Haruhiko Kuroda is eligible for reappointment on April 8, 2018. So are his two deputies. Furthermore, the monetary policy committee members appointed since Kuroda have also been ultra-dovish like him.15 In short, the BoJ underwent a regime change in 2012 and will not revert back to the norms that prevailed before the global financial crisis, before the LDP lost power to a serious opposition party (2009), and before the shock to the national psyche that occurred during the 2011 earthquake, tsunami, and nuclear crisis. Further, Japanese households are only hardly net savers anymore (Chart 20), and have for five years voted for a more reflationary policy. And aside from the current path of stealth debt monetization, there is no other way of managing the nation's debt other than fiscal austerity, which is not an option for an increasingly elderly population dependent on government social spending. The era of BoJ unorthodoxy is here to stay, at least as long as the LDP is in power (December 2018), if not longer. Chart 19Revise The Constitution? Yes.##br## End Pacifism? Maybe. The Wrath Of Cohn The Wrath Of Cohn Chart 20Japanese No Longer ##br##Savers Who Fear Inflation Japanese No Longer Savers Who Fear Inflation Japanese No Longer Savers Who Fear Inflation Bottom Line: Abe's downfall is not assured, and would portend the end of Abenomics in name only. The next LDP government would maintain Abenomics, as it is driven by structurally limited options. Fade any selloff in Japanese equities. However, in the long run, Abenomics may prove a failure in terms of defeating deflation. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 4 As a reminder to the uninitiated readers, Breitbart is a conservative magazine that has been a platform for a slew of unorthodox right-wing views more in line with modern nationalist European political movements than the American conservative movement. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 6 Please see BCA U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration," dated July 17, 2017, available at usis.bcaresearch.com. 7 Please see BCA U.S. Bond Strategy Weekly Report, "Every Which Way But Loose," dated July 18, 2017, available at usbs.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 10 Please see BCA China Investment Strategy Weekly Reports, "Questions From The Road," dated July 1, 2015, and "Policy Mistakes And A Silver Lining," dated October 7, 2015, available at cis.bcaresearch.com. 11 Please see Gabriel Wildau, "China bank overseer launches 'regulatory windstorm,'" Financial Times, April 18, 2017, available at www.ft.com. 12 Please see Jun Mai, "Guess who's not invited to China's key Communist Party congress," South China Morning Post, July 23, 2017, available at www.scmp.com. 13 Please see BCA Foreign Exchange Strategy Weekly Report, "A Soft-Spoken Yellen," dated July 14, 2017, available at fes.bcaresearch.com. 14 Please see footnote 11 above. 15 The last two dissenters, Takehiro Sato and Takehide Kiuchi, stepped down when their terms expired on July 23, 2017. They were replaced by Goshi Kataoka and Hitoshi Suzuki, who are expected to support Governor Haruhiko Kuroda's dovish approach. Now all nine policy board members have been appointed by the Abe administration. Please see "Two new Bank of Japan policymakers join board," Japan Times, July 24, 2017, available at www.japantimes.co.jp.

Highlights The Fed is behind the curve in raising rates, as is the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand, and the Swedish Riksbank. In contrast, the Bank of Japan, the ECB, and the Swiss National Bank have little need to tighten monetary policy. Accordingly, investors should favor USD, CAD, SEK, NZD, and to a lesser extent, AUD. EUR, CHF, and JPY will weaken. GBP will trade sideways. Short-term momentum could push EUR/USD to 1.18, but the euro will ultimately reach parity against the dollar next year, as the Fed is forced to accelerate the pace of rate hikes. Stay structurally long DXY. Go long SEK/CHF. We are closing our longstanding overweight positions in Australian and New Zealand government bonds for a handsome profit. Remain overweight global equities for now, but be prepared to turn bearish in the second half of 2018. Feature The Fed: It's Time To Get A Bit More Hawkish In our December 2015 report "The Fed Makes An Unforced Error," we made the case that the Federal Reserve would regret its decision to tighten monetary policy.1 Subsequent events validated this view: U.S. growth sagged in the first half of 2016, leading to a sharp flattening in the yield curve. It would be another 12 months before the Fed raised rates again. As bond prices and the economic data evolved over the course of 2016, our recommendations changed accordingly. On July 5th, we published a note entitled "The End Of The 35-Year Bond Bull Market" arguing that it was time to take profits on long duration positions.2 As luck would have it, this was the exact same date that the 10-year Treasury yield hit a record closing low of 1.37%. Fast forward to the present and investors are once again debating the next steps that central banks are likely to take. However, unlike in 2015, a strong case can be made that the Fed is now behind the curve in raising rates, rather than ahead of it. There are three reasons for this: There is less slack now than in 2015. The unemployment rate stands at 4.4%, down from 5% in December 2015. The broader U-6 unemployment rate has fallen even more, from 9.9% to 8.6%. Other measures of labor market slack are also closing in on their past business-cycle lows (Table 1). Table 1Comparing Current Labor Market Slack With Past Cycles Are Central Banks Behind The Curve Or Ahead Of It? Are Central Banks Behind The Curve Or Ahead Of It? The neutral interest rate has likely risen somewhat over the past 18 months (Chart 1). Household debt has continued to decline as a share of disposable income. The share of national income going to labor has increased. Wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All this should give consumers the wherewithal to spend more, warranting higher interest rates. Bank balance sheets have also continued to improve, as evidenced by the recent stress test results. In addition, fiscal policy has eased modestly and could ease even more if Congress is able to pass legislation cutting taxes later this year or in early 2018. Financial conditions have eased significantly since the start of the year, which should boost growth in the second half of this year (Chart 2). This is in sharp contrast to 2015, a year when financial conditions tightened sharply. Easier financial conditions are boosting credit growth. The annualized 3-month change in bank credit has accelerated from 1.1% in April to 4.2% at present. (Chart 3). Chart 1Households Have The Wherewithal To Spend More Households Have The Wherewithal To Spend More Households Have The Wherewithal To Spend More Chart 2Financial Conditions Have Eased Financial Conditions Have Eased Financial Conditions Have Eased Chart 3Credit Growth Has Picked Up Credit Growth Has Picked Up Credit Growth Has Picked Up The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%. If that were to happen, the unemployment rate would end up being nearly a full percentage point below the Fed's estimate of NAIRU. It is possible, of course, that the true value of NAIRU is lower than official estimates suggest. Older workers change jobs less frequently, and so an aging workforce tends to produce less frictional unemployment. The internet has also improved the ability of companies to fill vacancies with suitable workers. On the flipside, declining geographical mobility and falling demand for low-skilled labor may have raised structural unemployment. On balance, we are skeptical that the current estimate of NAIRU of 4.7% - already one percentage point below its post-1960 average (Chart 4) - is significantly overstated. A tighter U.S. labor market will put upward pressure on wages. While recent wage data has been on the soft side, our wage tracker is still growing twice as fast as in 2010 (Chart 5). Indeed, for all the talk about how wage growth is "inexplicably" slow, real wages have been rising more quickly than productivity for three straight years now - the longest stretch since the late 1990s (Chart 6). Chart 4NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards Chart 5A Stronger Labor Market Will Lead To Faster Wage Growth A Stronger Labor Market Will Lead To Faster Wage Growth A Stronger Labor Market Will Lead To Faster Wage Growth Chart 6Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Inflation: A Lagging Indicator When will accelerating wage growth translate into sharply higher price inflation? Probably not this year. Historically, inflation has been the mother-of-all lagging indicators. Core inflation peaked at 2.5% in August 2008, eight months after the start of the recession. In fact, core inflation has topped out in every single business cycle over the past 40 years only after the expansion has ended and the recession begun (Chart 7). Likewise, core inflation typically bottoms several years after the economic recovery is underway. This suggests that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. Chart 7Inflation Is A Lagging Indicator Are Central Banks Behind The Curve Or Ahead Of It? Are Central Banks Behind The Curve Or Ahead Of It? If the Fed drags its feet in raising interest rates, it will be difficult to achieve a soft landing. Stabilizing the economy is akin to landing a plane: You don't just need to know the speed at which you have to hit the runway, you also have to time your descent in order to touch the ground at precisely the right speed. Even if the Fed knew where the neutral interest rate stood (which it doesn't), tightening monetary policy too late could end up pushing the unemployment rate to such a low level that it has nowhere to go but up. And as we have shown before, once the unemployment rate starts rising, it generally keeps rising, owing to the presence of numerous negative feedback loops.3 The Fed has arguably already fallen into the trap of waiting too long. If so, gradual rate hikes this year will give way to more aggressive hikes late next year, setting the stage for a recession in 2019. The Bank Of Canada Turns Hawkish On the other side of the 45th parallel, the Bank of Canada raised rates last week and signaled that further hikes lie in store. The BoC revised up its GDP growth forecasts for 2017 and 2018. It also indicated that the output gap would close later this year, rather than next year as it had earlier projected. The Bank of Canada's newfound optimism was bolstered by the most recent Business Outlook Survey, which pointed to accelerating growth, dwindling spare industrial capacity, and an increasingly tight labor market (Chart 8). The moose in the living room is the Canadian housing market (Chart 9). Central bankers are generally reluctant to use the blunt tool of tighter monetary policy to target excessive property prices. However, when stricter macroprudential regulations fail to do the job, the standard prescription is to tighten monetary policy slowly but early. The Bank of Canada has done the former but not the latter. Consequently, as my colleague Jonathan LaBerge argued in last week's Special Report, the coming housing bust is likely to be a nasty affair.4 This will be the price the Bank of Canada pays for being behind the curve. Chart 8Canadian Growth Picture Is Upbeat Are Central Banks Behind The Curve Or Ahead Of It? Are Central Banks Behind The Curve Or Ahead Of It? Chart 9Housing Bubbles Abound Housing Bubbles Abound Housing Bubbles Abound For now, we remain long the Canadian dollar in our currency recommendations. We are expressing this view by being long CAD/EUR, a trade that has gained 3.5% in the nine weeks since we initiated it. We also recommend being underweight Canadian government bonds within a global fixed-income portfolio. It is important to stress, however, that these are 12-month views. Most Canadian mortgages are floating rate. Higher borrowing costs will likely trigger a housing bust late next year or in 2019, forcing the Bank of Canada to slow or even reverse the pace of rate hikes. The RBA And RBNZ ... Behind The Curve Too Australia and New Zealand have also been grappling with dangerously overvalued housing markets, and just as in Canada, the RBA and RBNZ have been behind the curve in responding to the brewing excesses. That is starting to change. The Reserve Bank of Australia struck a hawkish tone in the July 4 meeting minutes released this week, sending the Aussie dollar to a 26-month high against the greenback. The RBA highlighted the improvement in business conditions and a tightening labor market. It also indicated that the "neutral cash rate" was 3.5%, two points higher than the rate of 1.5%. Australia's terms of trade have been recovering of late and this should support the economy as well as the Aussie dollar (Chart 10). The RBNZ is even further behind the curve than the RBA (Chart 11). Nominal GDP is growing at over 6% and retail sales are expanding at nearly 8%. Population growth has risen sharply in recent years due to increased immigration, leading to greater demand for housing. The government has increased infrastructure spending and cut taxes. The unemployment rate has fallen back to an 8-year low of 4.9%, while the terms of trade is approaching record-high levels. Chart 10RBA Behind The Curve... RBA Behind The Curve... RBA Behind The Curve... Chart 11... And RBNZ Too? ... And RBNZ Too? ... And RBNZ Too? With all this in mind, we are closing our longstanding overweight positions in Australian and New Zealand government bonds for gains of 59.5% and 74.2%, respectively.5 Riksbank: End Of NIRP? The Swedish repo rate stands at -0.5%, despite the fact that the output gap has moved into positive territory (Chart 12). Inflation is still slightly below target, but is moving higher. The Riksbank is taking notice of the changing economic environment. The central bank backed away from its easing bias at its most recent policy meeting. The facts on the ground support this decision. Sweden's GDP is now 0.7% above potential and the economy continues to strengthen. The Riksbank's resource utilization indicator points to a sharp acceleration in Swedish inflation in the coming quarters. Nonfinancial private credit has reached 237% of GDP, up from 106% in 2000. If the Riksbank falls too far behind the curve, it will be forced to jack up rates very aggressively down the road, reviving the specter of the debt crisis of the early 1990s. The ECB, SNB, And BoJ: Take It Easy Whereas a strong case can be made that the central banks discussed above are behind the curve in normalizing monetary policy, the same cannot be said for the ECB, Swiss National Bank, or Bank of Japan. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008 and 6.7 points higher outside of Germany (Chart 13). Moreover, as we discussed two weeks ago, the neutral rate in the euro area remains very depressed.6 Thus, even if the euro area economy were close to full employment, the ECB would still not have much scope to raise rates. Chart 12NIRP In Sweden: R.I.P. NIRP In Sweden: R.I.P. NIRP In Sweden: R.I.P. Chart 13Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany In this light, investors have gotten too optimistic about the ability of the ECB to tighten monetary policy. While the ECB will further taper asset purchases as early as this autumn, sustained rate hikes are still a few years away. Mario Draghi explicitly said during his press conference yesterday that "the last thing that the governing council may want is actually an unwanted tightening of the financing conditions." This is in sharp contrast to the Fed, which is trying to tighten financial conditions by raising rates. Swiss monetary conditions are far from accommodative, despite a policy rate that remains buried in negative territory (Chart 14). Core inflation is close to zero and wage growth is anemic. An overvalued currency has offset the benefits from lower interest rates. Given the SNB's policy of intervening in the currency markets to keep EUR/CHF within a reasonably tight range, the recent appreciation of the euro will further add to the deflationary pressures weighing on the Swiss economy. Investors should position for a weaker franc (and euro) in the months ahead. Go long SEK/CHF (Chart 15). Chart 14The Swiss Economy Still Needs Low Rates The Swiss Economy Still Needs Low Rates The Swiss Economy Still Needs Low Rates Chart 15Long SEK/CHF Long SEK/CHF Long SEK/CHF Similar to the ECB and the SNB, the Bank of Japan is in no position to tighten monetary policy. Core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year (Chart 16). The annual shunto wage negotiations this summer produced little in the way of salary hikes. And even if inflation were to rise, the government would likely want to tighten fiscal policy before contemplating removing the monetary punch bowl. The Bank Of England: A Tough Call If one didn't know what transpired last June, the case for tighter monetary policy in the U.K. would be fairly straightforward. The unemployment rate is at a 9-year low and inflation is well above target. The trade-weighted pound has weakened by 21% since November 2015, which in most cases, would translate into stronger growth in the years ahead. Reflecting these points, our Central Bank Monitors show that the U.K. is more in need of tighter money than any other major developed economy (Chart 17). Chart 16BoJ: In No Position To Tighten BoJ: In No Position To Tighten BoJ: In No Position To Tighten Chart 17The Message From Our Central Bank Monitors The Message From Our Central Bank Monitors The Message From Our Central Bank Monitors Brexit negotiations are likely to cast a pall over the economy, however. The EU will be forced to take a tough line with the U.K., for fear that the Brexit vote could prompt other countries to follow's Britain's lead. BCA's geopolitical strategists ultimately expect a "hard Brexit" to be averted, but things may need to be brought to the precipice before that happens. The pound is cheap and so we do not expect it to weaken significantly from current levels. Nevertheless, the upside for both sterling and gilt yields will remain constrained until political uncertainty abates. Investment Conclusions As a rule of thumb, investors should favor currencies in economies whose central banks are behind the curve. Such central banks are likely to find themselves in a position where they have to scramble to tighten monetary policy. We noted on July 7th that short-term momentum favors the euro and that we would not be surprised if EUR/USD reaches 1.18 over the coming weeks. Looking further ahead, the appreciation of the euro in the first half of this year will weigh on growth in the remainder of 2017 and into early 2018. This will force the ECB to cool its heels. In contrast, U.S. growth should accelerate. Against the backdrop of diminished spare capacity, this will prompt the Fed to turn more hawkish. We expect EUR/USD to fall to 1.05 by year-end, and reach parity next year as the Fed ramps up the pace of rate hikes. The market is betting that the Fed will deliver fewer rate hikes than implied by the 'dots'. Our hunch is that the Fed will deliver more hikes than what its forecast suggests, especially starting early next year when inflation is liable to accelerate. Bullish sentiment towards the dollar has collapsed. Investors should turn contrarian and position for a stronger greenback over the next 12 months. In addition to the dollar, we like the Swedish krona, Canadian dollar, and New Zealand dollar. The Aussie dollar should also perform reasonably well, provided that the Chinese economy continues to hold up, as we expect it will. The Japanese yen remains our least favorite currency. Despite the dollar selloff, USD/JPY has managed to gain 3% since mid-April. As the Fed and a number of other central banks raise rates, the spread in yields between foreign government bonds and JGBs will widen. This will push down the yen, helping Japanese stocks in the process. As far as overall risk sentiment is concerned, another rule of thumb says that stocks rarely fall on a sustained basis outside of recessions (Chart 18). We do not expect a recession in the U.S. or elsewhere until 2019. This implies that investors should maintain an overweight position in global equities for now, favoring cyclical sectors over defensive ones. Chart 18Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Fed Makes An Unforced Error," dated December 18, 2015, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Special Report, "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com. 5 Calculated as the total excess return on the 10-year bond index relative to global government benchmark since inception in 2009, foreign-currency hedged since 2014. The 10-year yield for New Zealand government bonds has dropped from 4.28% at the time of inception to 2.94% today. The 10-year yield for Australian government bonds has fallen from 4.10% to 2.74% over this period. 6 Please see Global Investment Strategy Weekly Report, "Draghi's Dilemma," dated July 7, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights DM Rates Strategy: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. U.S. Corporate Bond Liquidity: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Feature Chart of the Week2013 Revisited 2013 Revisited 2013 Revisited Developed Market (DM) policymakers continue to push towards a less accommodative monetary stance. Last week, the Bank of Canada (BoC) became the second central bank to hike rates this year, following the Fed's earlier tightenings. The European Central Bank (ECB) continues to signal a move to reduce the pace of its asset purchases, likely to be announced at the September policy meeting. A very public debate has opened up among the members of the Bank of England (BoE) policy committee against the stagflationary backdrop of high inflation and cooling growth. This current backdrop is reminiscent of the 2013 synchronized global economic upturn that also put pressure on policymakers to become less accommodative according to our Central Bank Monitors (Chart of the Week). That year was terrible for government bonds, but spread product held in well given the solid growth backdrop. A big difference now is that there is greater evidence of diminished economic slack (lower unemployment rates, higher capacity utilization) than in 2013, so the underlying inflation pressures should be greater. Realized inflation rates remain subdued in most countries (excluding the U.K.), but central bankers are attributing that to temporary factors that should soon fade. That forecast may prove to be wrong, which risks a potential policy mistake if interest rates move up too much or too fast. For now, however, central banks are in charge and bond investors should position accordingly by limiting duration exposure and overweighting growth-sensitive assets like corporate bonds versus sovereign debt. A Country-By-Country Summary Of Our Interest Rate Views With central banks now in the process of adjusting policy settings to varying degrees, financial markets are starting to show a greater level of diversification than in previous years. This can be seen in the moves in bond yields, equity markets and currencies since the speech by ECB President Mario Draghi on June 27 that ignited the latest bond sell-off (Chart 2). The largest yield moves have occurred in the Euro Area, U.K., Canada and Australia, which have also coincided with currency strength and equity market underperformance in those countries. As the markets now try to sort out the growing divergences between monetary policies, this has opened up opportunities for diversification of duration exposures, country allocation and yield curve strategies. This week, we present a brief summary of our individual country recommendations for the remainder of the year. United States: underweight duration, underweight country allocation, steeper yield curve, long inflation protection The Fed remains on track for a move to begin reducing its balance sheet at the September FOMC meeting, with another rate hike expected in December. The inflation data of late has started to raise concern among some FOMC members about how many more interest rate increases will be necessary for this tightening cycle. We expect U.S. growth to show solid improvement over the latter half of 2017, and for this current downdraft in realized inflation to soon bottom out led by tightening labor markets and the lagged impact of this year's decline in the U.S. dollar. Treasury yields will continue to grind higher in the months ahead, led more by rising inflation expectations that will bear-steepen the yield curve. (Chart 3) Chart 2Market Moves Since Draghi's Portugal Speech Global Interest Rate Strategy For The Remainder Of 2017 Global Interest Rate Strategy For The Remainder Of 2017 Chart 3U.S. Rates Strategy Summary U.S. Rates Strategy Summary U.S. Rates Strategy Summary Germany: underweight duration, underweight country allocation, steeper yield curve, long inflation protection France: underweight duration, underweight country allocation, steeper yield curve, long inflation protection Italy: underweight duration, underweight country allocation (versus Spain), steeper yield curve The ECB is clearly signaling that a taper of its asset purchase program will begin in 2018. The Wall Street Journal reported last week that Mario Draghi will speak at the upcoming Fed Jackson Hole conference in late August.1 Similar to his speech at the ECB Forum in late June, this will likely be another opportunity for Draghi to prepare financial markets and other central bankers for the ECB's policy shift. We expect an announcement of a "Fed-like" tapering of bond purchases that will begin in January and end sometime in the fourth quarter of 2018. A rate hike is still some time away, most likely in the first half of 2019 at the earliest. The ECB will want to see more signs of lower unemployment and sustainable higher core Euro Area inflation before contemplating higher short-term interest rates - especially given the likely positive impact on the euro from such a move that would risk an unwanted tightening of financial conditions. There is far more risk in longer-dated bond yields to reprice via higher term premia and/or inflation expectations, thus we are recommending a bearish stance not only on European duration and country allocation, but also a bias toward steeper yield curves (Chart 4 & Chart 5). Tapering will also put upward pressure on Peripheral European yields and spreads, particularly in Italy, as risk premiums normalize away from the tight levels seen during the ECB asset purchase program. We do not anticipate a rout in Italian debt given the current improvements in the domestic economy and the positive moves seen in consolidating and recapitalizing the troubled Italian banking sector. However, we do see continued underperformance of Italian debt versus Spanish sovereigns, thus we are maintaining an overweight stance on Spain versus Italy in our model bond portfolio (Chart 6). Chart 4Germany Rates Strategy Summary Germany Rates Strategy Summary Germany Rates Strategy Summary Chart 5France Rates Strategy Summary France Rates Strategy Summary France Rates Strategy Summary Chart 6Italy & Spain Strategy Summary Italy & Spain Strategy Summary Italy & Spain Strategy Summary U.K.: underweight duration, neutral country allocation, neutral yield curve We have been maintaining a neutral allocation to U.K. Gilts, but with an underweight duration exposure and a curve steepening bias (Chart 7). The growing rift among the members of the BoE Monetary Policy Committee does suggest that there could be more two-way risk in U.K. interest rates than at any time seen since last year's Brexit vote. The BoE responded to that political surprise with rate cuts and a new round of asset purchases, even though the U.K. economy was operating at full employment at the time and inflation pressures were rising. Now, the chickens have come home to roost for the BoE, with inflation remaining stubbornly high despite signs of slowing growth (Chart 8). With real wage growth slowing substantially and household saving rates at very low levels, the risk of a consumer spending slowdown - that the BoE was flagging earlier in the year - is increasing. Chart 7U.K. Rates Strategy Summary U.K. Rates Strategy Summary U.K. Rates Strategy Summary Chart 8Stagflation In The U.K. Stagflation In The U.K. Stagflation In The U.K. Given the ongoing uncertainties from the upcoming Brexit negotiations that will likely continue to weight on business confidence and investment spending, and with consumption likely to continue losing steam, we see little case for the BoE to seriously consider a rate hike before year-end. We are only recommending a neutral stance on Gilts, though, as realized inflation continues to run well above the BoE's target, supported by the stubbornly soft British pound. We continue to recommend a steepening bias on the Gilt curve until there is more decisive evidence that U.K. inflation is rolling over. Japan: overweight duration, maximum overweight country allocation, neutral yield curve and neutral inflation protection We continue to recommend a maximum overweight on Japanese government bonds (JGBs). JGBs are a low-beta market with the BoJ still targeting a 0% level on the benchmark 10-year yield, even as other global bond markets sell off. The BoJ has been particularly aggressive in capping any rise in JGB yields of late, offering to buy 10-year bonds in unlimited size and also increasing its purchases at shorter maturities (Chart 9). With Japanese inflation still struggling to stay in positive territory, even with the economy estimated to be operating at full employment, the BoJ will do the only thing it can do to put a floor under inflation - keep JGB yields at low levels to trigger a new wave of yen weakness and, hopefully, some imported inflation pressures via the currency. Against this backdrop, JGBs will continue to outperform other DM bond markets during this move towards strong growth and less accommodative monetary policies outside of Japan. Stay overweight Japan against global hedged bond benchmarks. Canada: underweight duration, underweight country allocation, flatter yield curve, long inflation protection We moved our Canadian country allocation to underweight last week in advance of the BoC's expected rate hike, but we had been recommending bearish Canadian trades (curve flatteners and spread wideners versus U.S. Treasuries) in our Tactical Overlay Trade Portfolio for much of the year so far.2 The BoC's 180-degree policy shift over the past month has taken many investors by surprise, but the very strong upturn in the Canadian economy is forcing the BoC into action. With the BoC now projecting the Canadian output gap to be closed this year, expect another one, even two, rate hikes by the end of 2017. This will put additional upward pressure on Canadian bond yields and bear-flatten the Canadian government bond yield curve (Chart 10). Australia: neutral duration, neutral country allocation, neutral curve Australia has been one of the trickier markets on which to have a strong opinion, given the combination of a tight labor market, low inflation, mixed readings on domestic demand and heavy exposure to China's economy. This has led us to be neutral across the board on Australian bonds (Chart 11). We will be covering the outlook for Australia in a Special Report to be published next week, in which we will re-examine our current Australia recommendations. Chart 9Japan Rates Strategy Summary Japan Rates Strategy Summary Japan Rates Strategy Summary Chart 10Canada Rates Strategy Summary Canada Rates Strategy Summary Canada Rates Strategy Summary Chart 11Australia Rates Strategy Summary Australia Rates Strategy Summary Australia Rates Strategy Summary Bottom Line: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. An Update On The State Of U.S. Corporate Bond Market Liquidity In the Fed's latest Monetary Policy Report, presented by Janet Yellen to the U.S. Congress last week, an entire section was devoted to the state of U.S. corporate bond market liquidity.3 The Fed's conclusion was that, according to many commonly used metrics like average bid/ask spreads, corporate debt has not become more difficult to trade in recent years. This goes against the intuition of many bond investors who have perceived a deterioration of liquidity in corporate credit markets since the 2008 Financial Crisis. The Fed likely felt compelled to dedicate three pages of its Monetary Policy Report to a topic as mundane as bond market functionality as a defense of its current regulatory framework for U.S. banks. The Fed has taken a lot of flak from major U.S. financial institutions, conservative free-market politicians and, since last November, the Trump White House over the "heavy-handed" rules shackling the banks. Chart 12U.S. Dealers Don't Matter U.S. Dealers Don't Matter U.S. Dealers Don't Matter Regulations such as the Volcker Rule and the Supplementary Leverage Ratio have almost certainly reduced the odds of another financial crisis caused by undercapitalized banks speculating in risky assets. Yet the critics continue to point out that banks which are more worried about meeting regulatory targets are less able to make loans or, in the case of investment banks, make markets in risky assets like corporate debt. This is important for bond investors given the sharply reduced footprint of investment banks in corporate debt markets. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 of $280bn to only $20bn this year (Chart 12). Over the same period, the size of the U.S. corporate bond market has more than tripled to $6.5 trillion (using the market capitalization of the Barclays Investment Grade and High-Yield indices as a proxy). On the surface, that indicates that dealers held 10% of "the market" at the peak. Now, dealer inventories barely represent only 0.3% of corporate debt outstanding. While that is low, it is not much lower than the share of corporates held by dealers in the early 2000s. When looking at the full span of the available data, the huge dealer footprint in the U.S. corporate bond market in the years prior to the Financial Crisis was the exception and not the norm. Like most other market participants in those years, the investment banks were seduced by the extended period of low macro and market volatility and ended up taking too much risk on their balance sheets. Now, dealers are much more cautious when trading with clients, acting more as an "agent" that matches buyers and sellers for individual trades and less as a "principal" that holds the bonds themselves. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if dealers in their usual role as market-makers cannot be there to absorb the selling pressure from investors during market sell-offs. Yet corporate bond markets have functioned well since the dark days of the Lehman crisis. According to data from SIFMA, average daily trading volumes in the U.S. corporate bond market rose from a low in 2008 of $14bn to $30bn in 2016 (Chart 13). Corporate bond issuance has surged as well, but corporate bond turnover - total annualized trading volumes relative to total bonds outstanding - has improved by nearly 35% since the 2008 low. In addition, the reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads (bottom panel). The Fed noted this in its Monetary Policy Report as a sign that market liquidity was not impaired since there were not many "unrealized arbitrage opportunities". It is evident that other market participants have picked up the slack from the dealers in U.S. corporate bond trading. Exchange Traded Funds (ETFs) are the obvious candidate, led by the popular iShares HYG and the SPDR JNK funds that have a combined $30bn in assets under management. According to the Fed's database on the Financial Accounts of the United States (formerly known as the Flow of Funds), the share of corporate bonds held by all retail funds, including ETFs, soared from 6.5% in 2008 to nearly 19% in Q1 of this year (Chart 14). This nearly offset the decline in the share of corporates held directly by households, as individual investors shifted their preferences toward the ease of trading corporate debt ETFs over individual bonds. Chart 13U.S. Corporate Bond Market Turnover Has Improved U.S. Corporate Bond Market Turnover Has Improved U.S. Corporate Bond Market Turnover Has Improved Chart 14Shifting Ownership Patterns For U.S. Corporates Shifting Ownership Patterns For U.S. Corporates Shifting Ownership Patterns For U.S. Corporates Importantly, institutional investors like insurance companies and pension funds have seen their influence in corporate bond markets increase, as they now hold a combined 35% of corporate debt, up from 26% in 2008 (bottom two panels). These groups will likely control an even greater share of the corporate bond market in the years to come with the growing usage of so-called "all-to-all" electronic trading platforms like MarketAxess or Bloomberg that allow users to trade directly with each other. All-to-all has already established a major market footprint, as activity on MarketAxess now represents 16% of all trading volume in U.S. Investment Grade corporates and 34% for High-Yield, according to The Economist.4 This is a hugely important development. If more professional bond investors can now transact directly with one another, this helps to alleviate any reduction in market liquidity caused by a smaller dealer presence in the market. Even with so much evidence pointing to no serious liquidity problems in U.S. corporate debt, some worrisome issues remain. Chart 15Market Performance Leads Fund Inflows,##BR##Not Vice Versa Market Performance Leads Fund Inflows, Not Vice Versa Market Performance Leads Fund Inflows, Not Vice Versa Average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed.5 This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. This creates an effect where it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing, on average. Corporate bond ETFs are easier to trade than the underlying bonds held in the ETFs themselves. This has worried many investors who fear that a corporate bond market downturn could turn into a much larger rout if rapid ETF redemptions cause "fire sales" of the bonds held in the ETFs to quickly raise cash. Admittedly, the unique ETF structure - where the shares of the ETF are traded and not the underlying bonds, similar to a closed-end mutual fund - has not yet been tested in a true credit bear market. However, there have been several episodes of "risk-off" bond sell-offs over the past few years, most notably for High-Yield ETFs during the 2014/15 oil bear market, which did not result in any disorderly disruption of corporate bond markets. If anything, the historical experience of U.S. corporate bond mutual funds shows that net flows into funds tend to follow, and not lead, the performance of markets (Chart 15). This may exaggerate bond market moves at turning points but, in general, outflows are a symptom, not a cause, of corporate bond downturns. Net-net, we agree with the assessment of the Fed that corporate bond market liquidity shows little sign of impairment and does not represent a threat to market stability. Bottom Line: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.wsj.com/articles/draghi-may-address-future-of-ecb-stimulus-at-jackson-hole-1499944342 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017, available at gfis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 4 https://www.economist.com/news/finance-and-economics/21721208-greater-automation-promises-more-liquidity-investors-digitisation-shakes-up 5 http://libertystreeteconomics.newyorkfed.org/2015/10/has-us-corporate-bond-market-liquidity-deteriorated.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Interest Rate Strategy For The Remainder Of 2017 Global Interest Rate Strategy For The Remainder Of 2017

Highlights Yellen pointed out that the U.S. R-star is low but that it will rise as temporary depressing factors pass. The Fed is determined to push rates toward 3% over time. The euro area R-star is substantially lower than that of the U.S., limiting the capacity of the ECB to follow the Fed's path and pace. Traders are massively long the euro. Abe's woes do not signal the end of Abenomics, in fact they point toward more stimulus. The BoC has hiked and will keep doing so, continue to favor the CAD. Feature Janet Yellen offered both a fascinating and telling glimpse on the Federal Reserve's thinking this week. She argued that the equilibrium fed funds rate is currently very depressed, which is limiting the pace at which the FOMC can increase interest rates before plunging the economy into recession. However, she also noted that the Fed anticipates equilibrium interest rates will continue to rise over time, which means the actual fed funds rate has more upside on a multi-year horizon, despite what will be a slow pace of increases. With this additional information on the Fed's mindset, investors should be even more comfortable in their assessment that the period of maximum policy divergence between the euro area and the U.S. is behind us, which justified bullish bets on the euro. However, the broader picture is a bit more complex. Different Equilibria The idea that the neutral fed funds rate is still low but rising explains why the Fed is still pegging its terminal rate at 3%. Currently, the Laubach and Williams formulation of the neutral real fed funds rate (also known as R-star) is at 0.4%, while the current real fed funds rate stands at -0.5%, which implies 0.9% upside in real rates over the next two years or so (Chart I-1). Moreover, if as we expect core inflation moves back toward 2% over the Fed's forecast horizon, the upside to rates would be closer to 150 basis points. In the euro area, however, the same long-term R-star stands at -0.1%, depressed by lower population growth, a higher savings rate and lower structural productivity gains. Since the real policy rate is at -0.7%, this signifies that the gap between the actual real policy rate and its equilibrium is a smaller 0.6% (Chart I-2). This means that euro area rates have much less upside than U.S. ones before generating a deleterious impact on growth. Chart I-1U.S. R-Star Vs. Policy Rates U.S. R-Star Vs. Policy Rates U.S. R-Star Vs. Policy Rates Chart I-2Euro Area R-Star Vs. Policy Rates Euro Area R-Star Vs. Policy Rates Euro Area R-Star Vs. Policy Rates It is easy to argue that R-star differences are nice theoretical concepts, with little practical implications for currency investors. After all, interest rate differentials at the long end of the curve are clearly a function of the relative GDP per capita between the euro area and the U.S. (Chart I-3). These same GDP-dynamics also have an impact - albeit a less tight one - on EUR/USD. Chart I-3Yield Differentials And Relative GDP Yield Differentials And Relative GDP Yield Differentials And Relative GDP Chart I-4How R-Star And GDP Tango How R-Star And GDP Tango How R-Star And GDP Tango Yet, R-star spreads do affect growth differentials between the euro area and the U.S. As Chart I-4 illustrates, when the euro area real policy rate crosses above its equilibrium, euro area real GDP per capita growth sags soon after. The same holds true for the U.S. This suggests the capacity of European GDP per capita to outperform that of the U.S. is currently limited, or at the very least needs rates in Europe to remain quite low relative to the U.S., anchored lower by the depressed level of the R-star in Europe vis-a-vis the U.S. Moreover, the recent outperformance of European GDP per capita relative to the U.S. has a lot to do with the poor performance of U.S. GDP in 2016. However, U.S. GDP should firm in the coming quarters, particularly since household income levels are well supported. As Chart I-5 shows, based on an average of the pay-related and hiring-related components of the NFIB small businesses survey, the aggregate wages and salaries received by U.S. households are set to accelerate, both in nominal and real terms. This represents a boost to aggregate income and should support consumption, or almost 70% of the U.S. economy. Additionally, the rebound in U.S. capex should continue. Both the NFIB and the various regional Fed capex intention surveys remain healthy. This, along with labor market tightness, should be accretive to per capita GDP. As Chart I-6 shows, a composite indicator based on the NFIB survey capex and "jobs hard to fill" components is very strong, which historically has led to an acceleration of real-GDP-per capita growth. Chart I-5U.S. Household Income Will Accelerate U.S. Household Income Will Accelerate U.S. Household Income Will Accelerate Chart I-6U.S. Real GDP Per Capita Will Strengthen U.S. Real GDP Per Capita Will Strengthen U.S. Real GDP Per Capita Will Strengthen As a result, we are inclined to bet on a renewal of strength in the U.S. economy, which will support R-star there and help the Fed hike rates by more than the 43 basis points currently anticipated over the next 24 months. Bottom Line: The U.S. long-term equilibrium real fed funds rate is low, but remains substantially higher than the R-star in the euro area. This suggests that U.S. rates have more upside than European ones. Moreover, the outlook for U.S. per capita GDP is healthy, while that of Europe will continue to require low rates to remain on an upward path. Tactical Considerations Around EUR/USD EUR/USD is well bid, and our base case scenario remains that the 1.15 to 1.16 zone will be retested. However, some technical indicators have made us leery to chase this move, and might even prevent this target zone from ever being breached. To begin with, the number of long speculative bets on the euro has hit a record high, while the number of short bets has collapsed (Chart I-7). Net long speculative positions are not at a record high yet, but are in the upper echelons of the distribution of the past 17 years. Interestingly - and some would argue almost mechanically - while speculators' optimist or pessimist extremes can be used as contrarian indicators, commercial traders tend to be disproportionally short or long the euro at the appropriate time - i.e., when the euro is set to plummet or rally, respectively. Theoretically, commercial and non-commercial traders' positions should be in perfect balance as they are counterparties to one another, but in practice this is rarely the case. Because of this observation, we decided to amplify the message of both series by subtracting the net long commercial positions from net long non-commercial ones. This indicator tends to work best at highlighting tops in EUR/USD. The current reading has been indicative of an upcoming period of weakness in this pair (Chart I-8). The only exception was in 2007, a period when unlike today, the Fed was cutting rates while the ECB policy rate was being lifted all the way to July 2008. Chart I-7Record Longs In The Euro Record Longs In The Euro Record Longs In The Euro Chart I-8Aggregate Positioning Points To A Lower Euro Aggregate Positioning Points To A Lower Euro Aggregate Positioning Points To A Lower Euro Moreover, the buying pressure on EUR/USD may be exhausting itself. Wednesday, despite a seemingly dovish message from Fed Chair Yellen and despite stronger-than-anticipated industrial production numbers out of the euro area, EUR/USD weakened 0.6% instead of appreciating. In fact, our European Investment Strategy Senior Vice President Dhaval Joshi's Fractal Dimension indicator - a measure of group-think in the market - is now at 1.25, a level that also warns of an imminent trend change (Chart I-9).1 Chart I-9A Risk Of Reversal A Risk Of Reversal A Risk Of Reversal As a result, we do not yet think it is time to be betting aggressively on a fall in EUR/USD, especially as next week's ECB meeting might give an occasion for President Mario Draghi to re-affirm his optimism, giving the euro its final push toward 1.15-1.16. However, nimble traders should begin building small short positions in the euro on the optic of expanding their bets if the EUR/USD gathers downward momentum. Bottom Line: The euro may well hit the 1.15-1.16 range, but positioning in EUR/USD is currently extremely overstretched, and the euro's trading action suggests that groupthink has become prevalent, confirming the message of positioning. This means the euro is at risk. Nimble traders should begin building small short positions in EUR/USD, but it is not yet time to bet aggressively on this pair. Shinzo's Troubles Are Not The Demise Of Abenomics Japanese Prime Minister Shinzo Abe's popularity has been in freefall in recent weeks, hitting the most dismal levels of his current premiership (Chart I-10). The flogging received by the LDP in the recent Tokyo Metropolitan Assembly election is indeed being perceived as a rejection of the party's policy stance since 2012. Does this represent the coup de grace that will end Abenomics? We doubt it. The key behind the recent dip in Abe's popularity is not his economic policy but his move away from it. Instead, his focus on changing the pacifist constitution of post-war Japan is the source of the LDP's and Abe's woes, as this topic remains anathema with the Japanese public. Moreover, we are not willing to bet on the demise of the LDP. The Tokyo election was a one-off event. The new Tomin First no Kai (Tokyoites First) party that is now the largest force in the regional assembly is led by the very popular Tokyo governor Yuriko Koike, and will rely on the pacifist Komeito to control the Tokyo Metropolitan Assembly. At the national level, the DPJ remains in tatters, and no potential new party is in place to carry the torch of the opposition. Japan is still effectively a one-party democracy. So what are the market implications of these political developments? We expect a doubling down by Abe on economic stimulus. If Abe ever wants a passing chance to have, let alone win, a referendum to increase Japan's militarism, the economy needs to be stronger than it is. Thus, we think this boot of unpopularity will be key to unlocking more fiscal stimulus out of Tokyo. When more fiscal stimulus finally does materialize, if it boosts growth, it will also lift long-term inflation expectations (Chart I-11). Chart I-10Abe's Plummeting##br## Popularity A Soft-Spoken Yellen A Soft-Spoken Yellen Chart I-11If Fiscal Stimulus Is Implemented ##br##CPI Expectations Will Rise... If Fiscal Stimulus Is Implemented CPI Expectations Will Rise... If Fiscal Stimulus Is Implemented CPI Expectations Will Rise... In this context, we would expect continued pressure on the Bank of Japan to remain one of the two most dovish central banks in the G10, as to not undo the benefits of fiscal stimulus. Moreover, the BoJ cannot remove stimulus, as realized CPI excluding food and energy remains in negative territory. Tokyo's CPI report, which offers a one-month lead on the national release, shows that core inflation is still in negative territory. National summer wage negotiations point to negative wage growth next year, making a revival of domestically generated inflation a remote event without an easing of financial conditions (Chart I-12). Additionally, the recent rollover in the leading diffusion index suggests the economic upswing may already be fading (Chart I-13). Continued BoJ support and higher inflation expectations would hurt Japanese real yields and handicap the yen. Chart I-12...But That Will Also Require Easy Monetary##br## And Financial Conditions ...But That Will Also Require Easy Monetary And Financial Conditions ...But That Will Also Require Easy Monetary And Financial Conditions Chart I-13A Slowdown ##br##In Japan A Slowdown In Japan A Slowdown In Japan The recent upswing in global bond yields is thus likely to continue to weigh on the yen, leading to a higher USD/JPY. As this week illustrated, rising global yields are forcing the BoJ to increase its amount of JGB purchases to cap the upside in Japanese 10-year yields. Tactically, USD/JPY has been in an upswing, but has hit an important resistance close to 114.5. A few more days of weakness could ensue, but such weakness should be used by investors to sell the yen. Bottom Line: Abe's political problems do not represent the end of Abenomics. Instead, they illustrate the Japanese public's lack of appetite toward abandoning Japan's post-war pacifism. If Abe is serious about holding a referendum on this topic, he will have to support growth going forward - which implies higher fiscal stimulus and inflation expectations. Meanwhile, the absence of inflation in Japan continues to hamstring the BoJ in keeping policy extremely supportive, limiting the upside to nominal interest rates across the Japanese yield curve. Real rate differentials will continue to support USD/JPY. Use any weakness in this pair to buy the dollar versus the yen. Canada: Poloz Delivers The Bank of Canada on Wednesday increased interest rates by 25 basis points to 0.75%, the first central bank to follow the Fed's lead. Our analysis two weeks ago suggested that the BoC was faced with some of the most supportive conditions in the world to follow the Fed's path.2 More interesting than the decision itself was the accompanying quarterly Monetary Policy Report. In the report, the BoC moved forward its estimation of the closure of the output gap from 2018 to 2017. Additionally, despite expecting a slowdown in household consumption in 2018, the BoC upgraded its GDP forecast by 0.2% in 2017 and 0.1% in 2018, to 2.8% and 2%, respectively. Obviously, the market took note of these views, with USD/CAD falling three big figures on the news. The tone of the report was quite bullish on the Canadian economy, highlighting robust as well as broad-based growth and increasing signs of vanishing slack. In fact, the message reiterated that of the summer Business Outlook Survey, which showed strong growth, growing difficulty meeting demand, and growing and intensifying labor shortages (Chart I-14). As a result, the BoC expects the weak Canadian CPI to rebound, after the transitory effects of low food inflation, automobile rebates, and Ontario's electricity subsidies dissipate. We are inclined to agree with this assessment. At 2% per annum, Canadian employment growth is robust and the unemployment rate has fallen significantly. Now that oil prices have stabilized, employment is improving, suggesting that even the weakest regions of the economy are participating in the party. Additionally, our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth (Chart I-15). Chart I-14Canada Is Booming And Slack Is Shrinking A Soft-Spoken Yellen A Soft-Spoken Yellen Chart I-15Strong Data Across The Board Strong Data Across The Board Strong Data Across The Board USD/CAD continues to trade at a discount to real interest rate differentials, signaling further upside on the CAD. Also, while investors have begun to curtail their shorts on the loonie, there do remain enough stale shorts for the CAD advance to persevere. We continue to prefer playing the CAD's strength on its crosses such as versus the AUD and the EUR, as the risk profile seems cleaner on these pairs than versus the USD. Short EUR/CAD looks particularly attractive. Our long CAD/NOK trade is near its target, and we are closing this position. Bottom Line: The Bank of Canada has not only hiked rates, but it has also highlighted that the Canadian economy is strong and inching closer to full capacity. The market has taken note, with the loonie rallying violently. The CAD has more upside going forward, especially against the euro and the AUD. We are booking profits on our long CAD/NOK position. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Special Report titled, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 2 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, 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 The greenback has largely been flat this week, despite Yellen's statements regarding rate hikes and balance sheet normalization at her Congressional Testimony, even if, 10-year yields went down. U.S. economic data has a soft tone: NFIB Business Optimism Index came in lower than expected at 103.6, reflecting broad-based softness in the details of the survey; JOLTS job openings also came in lower than expected at 5.666 mn; Initial jobless claims underperformed expectations, coming in at 247,000; Additionally, continuing jobless claims were higher than expected at 1.945 mn. While data remains mixed, the Fed is still intent on tightening policy. The dollar will follow suit, especially if inflation moves as the Fed expects. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data out of Europe this week was reasonably strong: Both exports and imports increased at a 1.4% and 1.2% monthly pace, respectively; The current account beat expectations; Industrial production increased by 4%, more than the expected 3.6%; However, despite this upbeat data, the euro remained largely flat this week. This behavior is justified from a technical perspective: the RSI is close to overbought levels; the MACD line is rolling over and closing the gap with the signal line; the number of speculators with long positions is at its highest level ever. The considerable weakness in EUR/SEK and EUR/NOK on Thursday shows underlying weakness in the euro. This decreases the likelihood that EUR/USD breaches the 1.15-1.16 zone. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 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: Labor cash earnings yearly growth outperformed expectations and grew from last month, coming in at 0.7%. However, machinery orders yearly growth was far below expectations, coming in at 0.6%. In spite of the selloff in the dollar, USD/JPY has rallied by more than 1% since last week, stopping its ascent after hitting a key technical level at 114.5. We continue to be yen bears, even in the face of the declining popularity of Shinzo Abe: the champion for expansionary fiscal policy in Japan. Instead, we are confident that Abe will double down on fiscal spending as his decline in popularity has been precisely because he has strayed away from this key policy pillar which made him so popular. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 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 mixed: Halifax House prices grew by only 2.6% YoY, underperforming expectations of 3.1%. Industrial Production contracted by 0.2% year-on-year, also underperforming expectations. While the unemployment rate decreased, coming in at 4.5% and also beating expectations, average earning growth fell to 1.8%. After appreciating by almost 2% this week, and reaching 0.895, EUR/GBP has come down to 0.885, but the pound is likely to have short term downside against the euro. Furthermore, GBP/USD is also likely to have downside, as the pound is not as attractive as it was in the beginning of the year from a valuation standpoint. Indeed, sentiment has turned much more positive on the outcome of Brexit, which means that the significant discount in the pound has disappeared. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The AUD has seen a broad-based increase this week, except for against the CAD. This increase has largely been a factor of Chinese data, although domestic conditions also played a role: Chinese exports and imports both increased at a 11.3% and 17.2% annual pace, respectively; China's trade balance in June was USD 42.77 bn, better than expected; Chinese new loans came in at RMB 1,540 bn; NAB Business Conditions and Confidence both beat expectations; However, investment lending for homes is still contracting at 1.4%, albeit at a lesser than expected pace of 2.3%; Also, home loans are increasing at a lesser than expected pace of 1%. We retain our view of the inherent weakness in the Australian economy, which will restrict the RBA from changing its view. This will weigh on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 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 AUD/NZD has rallied by almost 1.3% since last week. This in part, was the market reaction to an approved housing infrastructure fund by Prime Minister Bill English worth NZ$1 Billion aimed at increasing the supply of housing in the country. This measure provides the RBNZ with some breathing room, as it is a policy aimed at cooling housing market, which has prices growing at a 14% rate. The increase in housing supply alleviates the pent up demand generated by the dramatic increase in population in New Zealand in recent years. The RBNZ is unlikely to join the BoC and the Fed this year, as they remain cautious, and have opted for macro prudential measures to eliminate any imbalances in the economy. Stay short the NZD against the dollar and the yen. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canada followed the footsteps of its partner in the south, joining the U.S. as the only two central banks in the G10 space raising interest rates. The Bank of Canada highlighted that "the adjustment to lower oil prices is largely complete" and that "both the goods and services sectors are expanding". Alberta's economy validates this stance as all sectors of the economy are growing at a very brisk pace. The BoC estimates that the output gap will now close at the end of 2017, instead of the previous forecast of the first half of 2018, further escalating their hawkish rhetoric. The press release noted that the recent restrain in inflationary pressures will be transitory, as "excess capacity is absorbed". Recent data corroborates this view with strong employment data and stronger than expected housing starts. USD/CAD declined 1.3% at the end of the day of the hike, and outperformed all other currencies. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Unemployment remains very low, coming in at 3.2% However, producer and import prices contracted by 0.1% year-on-year, coming below expectations and decreasing from the previous month. The low unemployment number is not the only indicator that shows a tight labor market, as employment is also growing at an astonishing 5% yearly rate. However, this tightness in the labor market is not translating to higher wages, as wages are growing at a paltry 0.6%, anchored by strong deflationary forces. Thus, the SNB will continue with their ultra-dovish monetary policy and with their interventions in the currency market. Nevertheless, we will monitor if the recent plunge in the CHF against the euro creates any kind of inflationary dynamics in the economy, and causes the SNB to rethink their stance. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Manufacturing output contracted by 0.3%, falling sharply from last month number. Additionally, although both core and headline inflation came above expectations at 1.6% and 1.9% respectively, they still fell from last month reading. The Krone has appreciated sharply the past week, with USD/NOK falling by 1.45% and EUR/NOK falling by 1.15%. This has been a result of the rebound in oil prices caused by the massive draws in inventories the past couple of weeks. Indeed, last week's number, which showed an inventory draw of 7.6 million barrels was the biggest since 2011. Overall, we expect that OPEC should be able to continue managing supply, and therefore, oil should rise until the end of the year. This will be negative for EUR/NOK. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Riksbank's change in rhetoric was perfectly timed, as Sweden's economy is increasingly showing signs of strength. Data has outperformed these past two weeks: Manufacturing PMI came in at 62.4, beating expectations of 59.8; Industrial production increased at a 8% annual pace in May; Inflation in Sweden is firming, coming in at 1.7% in June and beating expectations. The SEK appreciated 0.7% against EUR, and 0.6% against USD. Markets are pricing in stronger growth and a further escalation of hawkish rhetoric from the central bank, especially as Stefan Ingves as tabulated to leave this Riksbank in a few months. Part of the reason for Sweden's strength is also a stronger European economy. With Germany leading the pack, Sweden's largest export partner is also lifting the largest Scandinavian economy. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over South Korean Impeachment Rally Over South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Japan's 2012 Clash With China Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... ...And Cut Investments In Japan... ...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere ...While Tourists Went Elsewhere ...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade Vietnam Reboots China Trade Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports China Cools On Korean Imports China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta China Opens Doors To Thai Junta China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Does It Pay To Pivot To China? Does It Pay To Pivot To China? Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading China: Stimulus Fading China: Stimulus Fading Chart 19China's Emergence As Major Global Investor Does It Pay To Pivot To China? Does It Pay To Pivot To China? The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea China Fights Either Japan Or Korea China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade The 'One China Policy' As A Trade The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over South Korean Impeachment Rally Over South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Japan's 2012 Clash With China Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... ...And Cut Investments In Japan... ...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere ...While Tourists Went Elsewhere ...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade Vietnam Reboots China Trade Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports China Cools On Korean Imports China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta China Opens Doors To Thai Junta China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Does It Pay To Pivot To China? Does It Pay To Pivot To China? Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading China: Stimulus Fading China: Stimulus Fading Chart 19China's Emergence As Major Global Investor Does It Pay To Pivot To China? Does It Pay To Pivot To China? The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea China Fights Either Japan Or Korea China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade The 'One China Policy' As A Trade The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.

Highlights Central Banks: The sharp sell-off in global bond markets last week was triggered by more upbeat comments on growth and inflation by several major central bankers, most notably ECB President Mario Draghi. ECB Tapering: Draghi's positive views on the European economy are generally accurate, which puts the ECB on a path to taper its asset purchases next year. Bunds vs. JGBs: Bund yields have more upside in the next 3-6 months as the market reprices a smaller amount of ECB bond buying. Downgrade core European government bonds to underweight (2 out of 5) and upgrade low-beta Japan to maximum overweight (5 out of 5). Feature "The threat of deflation is gone and reflationary forces are at play." - Mario Draghi Chart of the WeekA Co-Ordinated Tightening On The Horizon? A Co-Ordinated Tightening On The Horizon? A Co-Ordinated Tightening On The Horizon? Bond market volatility awoke with a vengeance last week, as investors digested a string of hawkish comments from previously dovish central banks. A surprisingly optimistic speech from European Central Bank (ECB) President Mario Draghi set the tone, triggering the biggest single day rise in German bond yields in over two years. This was followed up by comments from Bank of England (BoE) Governor Mark Carney and Bank of Canada Governor Stephen Poloz suggesting that higher rates may be needed soon in the U.K. and Canada, triggering sell-offs in Gilts and Canadian bonds. Even U.S. Treasury yields rose alongside the global move, without any positive U.S. data or more hawkish Fed commentary. This move to a more hawkish tone - or, at least, a less dovish message - is consistent with the current strength of the global economy, as well as the robust performance of risk assets so far in 2017. Policymakers are now being forced to adjust their biases to reflect the more positive backdrop, forcing a repricing of interest rate expectations with most developed economies hovering around full employment (Chart of the Week). A "coordinated" move to tweak policy rates higher suggests bond yields have more room to rise - especially after the decline since March that has driven most government bond yields to expensive levels. The bigger risk for global bonds, however, will come from a likely shift in ECB policy towards a reduction in the size of their current bond purchase program. As we saw last week, even a mere mention of a need to shift to a less accommodative monetary stance was enough to cause Bund yields to nearly double in a matter of days. We have been positioned for a renewed rise in bond yields through our recommended below-benchmark portfolio duration stance. We are also positioned for a bear-steepening of government bond yield curves in our model bond portfolio, as our recommended duration exposures are concentrated in shorter-maturity bonds. With central banks only looking to catch up to the underlying state of the global economy, rather than aiming to more aggressively tighten policy to cool off growth, there is more potential for longer-dated bond yields to rise relative to shorter-maturity debt - especially with market-based inflation expectations now looking too low in most countries. In other words, expect more bear-steepening of global yield curves (ex-Japan) in the next few months. Dissecting Draghi's Speech The jump in global yields last week was broad based, both across countries and when broken down into valuation components. The "high-yielders" among developed markets (U.S., Canada, U.K.), saw modest increases in inflation expectations and term premia, while rate hike expectations jumped sharply in Canada and the U.K. (Chart 2). Among the "low-yielders" (Germany, Japan), the 22bps jump in Bund yields came through higher term premia, with only very modest moves higher in rate hike or inflation expectations (Chart 3). Japanese yields didn't move at all, consistent with the view that the Bank of Japan is the one central bank that does not need to become less accommodative with Japanese core inflation back down to 0%. Chart 2Global Yields Starting To Perk Up A Bit... Global Yields Starting To Perk Up A Bit... Global Yields Starting To Perk Up A Bit... Chart 3...Led By Europe ...Led By Europe ...Led By Europe Mario Draghi's speech, which set off last week's yield spike, was such a shock to markets because of the upbeat description of the underlying strength of the Euro Area economy. It is important to consider where this speech was given - in front of global policymakers at the annual ECB Forum on Central Banking in Portugal (the ECB equivalent to the Fed's annual Jackson Hole conference). The head of the central bank that has been providing the highest degree of monetary stimulus among the major economies over the past couple of years told his global peers that the need for such an extreme accommodative policy stance was now diminished. This is a message shared by the BCA Central Bank Monitors, which are pointing to a need for tighter monetary policy everywhere except Japan (Chart 4). Chart 4Tighter Monetary Policy Is Required Tighter Monetary Policy Is Required Tighter Monetary Policy Is Required Is such a high-conviction view from the ECB justified? Let's do a little "truth check" on some of Draghi's most relevant comments from his speech: "All the signs now point to a strengthening and broadening recovery in the Euro Area." TRUE. Most reliable cyclical indicators - PMIs, consumer confidence, business confidence - are all at, or beyond, pre-2008 crisis levels (Chart 5). The German IFO index hit a record high in June, while data has been strengthening across all the major Euro Area economies (even Italy). "We can be more assured about the return of inflation to our objective than we were a few years ago. [However,] inflation dynamics are not yet durable and self-sustaining. So our monetary policy needs to be persistent." TRUE. The Euro Area unemployment rate at 9.5% now sits within hailing distance of the OECD's estimate of the full employment "NAIRU" rate of 9%. Already, core inflation and wage growth are stabilizing in the Euro Area (Chart 6), suggesting that the estimated full employment rate may be an accurate measure. The ECB is forecasting that the unemployment rate will fall to 8.4% by 2019, which would be below the OECD NAIRU level, and the ECB is now forecasting that Euro Area core inflation will rise to 1.8% within two years. That would likely be close enough to the ECB's official inflation target (headline inflation at or just below 2%) for a potential rate hike by then, but not before. Chart 5European Growth Looks Very Healthy European Growth Looks Very Healthy European Growth Looks Very Healthy Chart 6Full Employment Is In Sight Full Employment Is In Sight Full Employment Is In Sight "The past period of low inflation is [...] on the whole temporary and should not cause inflation to deviate from its trend over the medium term." MOST LIKELY TRUE. The steep fall in European inflation in 2014 triggered deflation fears, and prompted the ECB to finally engage in an asset purchase program just as the Fed was ending its' own "QE". Much of that decline was related to the sharp downturn in global energy prices. Draghi also noted in his speech that, by the ECB's own estimates, around two thirds of the undershoot of Euro Area inflation in 2015/16 came from the impact of lower energy prices. He also mentioned that past fall in oil prices and other "global shocks" are likely to still be restraining core inflation to some degree via pass-through effects in parts of the economy that are more energy-intensive. Draghi did also point out that the current low oil prices are mainly supply driven (a view that BCA's commodity strategists whole-heartedly agree with) and, therefore, can be "looked through" by a central bank. That may be dangerous view to take with wage inflation still subdued in Europe, but it seems clear that core inflation has indeed bottomed out and is in the process of a slow grind higher (Chart 7). This is also helping to stabilize inflation expectations in Europe to some degree, although it is far too early for the ECB to declare victory over "low-flation." "Political winds are becoming tailwinds. There is newfound confidence in the reform process, and newfound support for European cohesion, which could help unleash pent-up demand and investment." TRUE. The 2017 political calendar appeared daunting at the start of the year, with elections scheduled in the Netherlands, France and Germany anti-euro candidates scoring better-than-expected in the polling data. The ECB even cited political uncertainty as one of the reasons for extending its asset purchase program to the end of 2017, in case there was a surprise win by a "Euro-skeptic" party. The electoral losses by Geert Wilders in the Netherlands and Marine Le Pen in France were strong signals that the anti-establishment wave that had washed over the U.K. and U.S. last year would not spill over into Europe. There is a new potential risk in Italy, where fresh parliamentary elections are expected to be called sometime in the first half of 2018. The polling numbers are tight there, with pro- and anti-euro parties showing roughly equal levels of support. Yet with the Italian economy showing some improvement alongside the rest of Europe, and with Italian banks under less immediate pressure after some successful recent rescue packages for struggling lenders (Chart 8), there is less risk of an anti-euro uprising in the polls in Italy next year. Chart 7From Deflation Fears To Reflation Cheers From Deflation Fears To Reflation Cheers From Deflation Fears To Reflation Cheers Chart 8Italy Is No Constraint To An ECB Taper Italy Is No Constraint To An ECB Taper Italy Is No Constraint To An ECB Taper At a minimum, the ECB likely would not factor politics into any decision on tapering its asset purchases starting in 2018. Chart 9Taper Tantrum 2.0? Taper Tantrum 2.0? Taper Tantrum 2.0? "As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments - not to tighten the policy stance, but to keep it broadly unchanged." TRUE. The Fed was making similar arguments when they moved away from QE bond purchases and, eventually, the timing of the first rate hike. Using words like how the U.S. economy had "healed" from the financial crisis by enough to start removing some policy accommodation. In some respects, the European economy is in much better shape than when the Fed began its own taper in 2014. In Chart 9, we present an idea that we published earlier this year, showing the comparison of Europe now versus the U.S. pre-Fed taper. This is a "cycle-on-cycle" analysis, where the European and U.S. data are lined up to the peak of our months-to-hike indicator, noting the timing of the first rate hike priced into OIS curves after the period of 0% policy rates. The chart shows that the current Euro Area economy is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum. The Fed began signaling that major policy shift with core inflation below its 2% target, at similar levels to the current European core inflation rate. A look at the subsequent moves in bond yields and term premia (bottom two panels) suggests that Europe could be on the verge of its own Taper Tantrum in the next few months. Summing it all up, we conclude that the optimism on the European growth and inflation outlook expressed by Draghi is justified. Barring a sudden collapse in the economy or inflation over the summer, the ECB looks to be on course to announce a tapering of its bond purchases, starting in 2018, at the upcoming September policy meeting. Bottom Line: The sharp sell-off in global bond markets last week was triggered by more upbeat comments on growth and inflation by several major central bankers, most notably ECB President Mario Draghi. We see Draghi's positive views on the European economy to be generally accurate, which puts the ECB on a path to taper its asset purchases next year. Downgrade Core European Government Bonds To Underweight Our expectation heading into 2017 was that core European bonds would outperform U.S. Treasuries in the first half of the year as the Fed delivered more rate hikes and the ECB maintained a highly dovish tone at least through the April/May French presidential elections.1 After that, assuming the French election went according to our expectations with a Le Pen loss, the ECB would then turn its attention to potential "taper talk" that would trigger an underperformance of core Europe versus Treasuries. The U.S. Treasury rally since March defied our forecast, even though the Fed did actually hike rates twice! While we still see more Fed tightening and higher U.S. yields as the base case in the latter half of the year, the European story is playing out as we expected. We are sticking to our plan after last week's developments, and we are downgrading core European bonds (Germany, France, Italy) to a recommended underweight ranking (2 out of 5). Importantly, we've likely seen the low in European yields even if there is no tapering in 2018. In Chart 10, we update an analysis we did earlier this year, looking at the projected size of the ECB's monetary base under various asset purchase scenarios for next year: The ECB stops "cold turkey" on December 31 and buys no additional bonds in 2018; The ECB tapers its €60bn/month of bond buying to zero by June 2018; The ECB tapers its €60bn/month of bond buying to zero by December 2018; The ECB announces no taper and keeps on buying at €60bn/month throughout 2018. In the bottom two panels of Chart 10, we show the growth rate of the ECB's monetary base versus the German Bund yield and the term premium. The projections for the growth rates are based off the four scenarios laid out above. In all cases, the growth in the expansion of the ECB monetary base (and its balance sheet) will slow next year - even if there is no tapering. Importantly, the euro is unlikely to spike versus the U.S. dollar in the event of a tapering, as relative money supplies and policy interest rates will remain USD-bullish (Chart 11). Chart 10The ECB Effect On Bunds Will Soon Fade The ECB Effect On Bunds Will Soon Fade The ECB Effect On Bunds Will Soon Fade Chart 11A Taper-Fueled Rise In The Euro Has Its Limits A Taper-Fueled Rise In The Euro Has Its Limits A Taper-Fueled Rise In The Euro Has Its Limits This is the dirty little secret about central bank asset purchase programs. They must be delivered in even bigger sizes than before to have the same impact on asset prices and, eventually, economic growth and inflation. Chart 12UST-Bund Spread Looks Too Low UST-Bund Spread Looks Too Low UST-Bund Spread Looks Too Low We now feel comfortable shifting to a reduced recommended country allocation to core Europe in our model bond portfolio. We have been maintaining a below-benchmark duration stance in core Europe for the past couple of months, by placing less recommended exposure in the longer maturity "buckets" in our portfolio and overweighting the shorter-maturity buckets. Now, we are comfortable cutting the allocation to core Europe across all buckets based on our views on the ECB. What should be upgraded if we are downgrading Europe? As mentioned, we had expected to upgrade U.S. Treasuries at this point in the year, but the disappointing run of U.S. data (especially versus Europe) drove the Treasury-Bund spread sharply lower (Chart 12). Given our view that the U.S. economy and inflation will rebound in the latter half of this year and prompt the Fed to deliver more hikes, we see the Treasury-Bund spread as too low to recommend shifting out of core Europe into the U.S. Instead, we see a better case to upgrade the most defensive country in the developed bond universe - Japan. There is a clear divergence between recent growth and inflation data in the Euro Area versus Japan, most notably with core inflation returning to 0% in Japan (Chart 13). The JGB-Bund spread looks to be at critical support levels that could trigger a quick tightening, especially if there are more upside data surprises in Europe or disappointments in Japan (Chart 14). Chart 13Europe & Japan Are Diverging Europe & Japan Are Diverging Europe & Japan Are Diverging Chart 14Reduce Core European Exposure In Favor Of JGBs Reduce Core European Exposure In Favor Of JGBs Reduce Core European Exposure In Favor Of JGBs Bottom Line: Bund yields have more upside in the next 3-6 months as the market reprices a smaller amount of ECB bond buying. Downgrade core European government bonds to underweight (2 out of 5) and upgrade low-beta Japan to maximum overweight (5 out of 5). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "How To Think About Global Bond Investing In 2017", dated December 20 2016, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Central Banks Are Now Playing Catch-Up Central Banks Are Now Playing Catch-Up

Highlights Recommended Allocation Quarterly - July 2017 Quarterly - July 2017 Risk assets have continued to outperform, despite soft inflation data and falling interest rates. Either inflation will pick up again, amid decent growth, and the Fed (and, to a degree, other central banks) will tighten, or the Fed will capitulate and stay on hold. Either scenario should be good for risk assets. No indicator signals a recession on the horizon, and so we continue to expect equities to outperform bonds over the next 12 months. Within equities, we favor DM over EM; we maintain a pro-cyclical sector tilt, but rotate out of Tech into Financials, which are cheaper and should benefit from steeper yield curves. In fixed income, we prefer credit to government bonds, but trim our overweight in investment grade credit as spreads are unlikely to contract further. We are overweight TIPS and Japanese inflation-linked bonds. Feature Overview How To Square Lower Rates And Rising Equities One of the basic principles of BCA's Global Asset Allocation service is that it is highly unusual for equities to underperform bonds for any extended period except in the run-up to, and during, recessions (Chart 1). After the recent decline in long-term interest rates and softness in inflation, we find investors worldwide becoming increasingly nervous about the outlook. We see nothing in the data, however, to indicate a recession in the coming 12 months. Of the three historically most reliable recession indicators - PMIs, credit spreads, and the yield curve (Chart 2) - only the last raises some concerns, but it is still far from inverting, which is the requirement for a recession signal. None of the formal recession models is flashing a warning signal either (Chart 3). Chart 1Stocks Outperform Except Ahead Of Recession Stocks Outperform Except Ahead Of Recession Stocks Outperform Except Ahead Of Recession Chart 2Usual Recession Signals Still Absent Usual Recession Signals Still Absent Usual Recession Signals Still Absent Chart 3Recession Risk Models Not Rising Either Recession Risk Models Not Rising Either Recession Risk Models Not Rising Either Nonetheless, market action in recent months has been unusual. Bond yields have fallen (with the 10-year U.S. Treasury yield slipping to 2.2% from 2.6%), and the dollar has weakened, but risk assets have continued to perform well, with global equities giving a total return of 13% year to date and 4% in Q2. Can this desynchronization continue? We see three possible scenarios:1 Chart 4Market Expects Fed To Be Dovish Market Expects Fed To Be Dovish Market Expects Fed To Be Dovish Reflation returns. The Fed proves to be right that the recent weak inflation data is temporary. Inflation picks up and the Fed raises rates more quickly than the market is currently pricing in (which is only 25 bps over the next 12 months, Chart 4). Initially, the rebound in inflation might be a shock for risk assets but, as long as the Fed is tightening because it is confident about growth and unconcerned about global risk, over 12 months risk assets such as equities should continue to outperform. The Fed capitulates. Inflation fails to rebound and the Fed tightens only in line with what the market is currently pricing in. This could be good for risk assets, as long as the soft inflation is not accompanied by disappointing data on growth. The U.S. dollar would probably weaken further, which should be positive for EM assets and commodities. A policy mistake. The Fed pushes stubbornly ahead with tightening even though inflation fails to rebound. Bond yields fall and the yield curve moves closer to inverting. This would be negative for risk assets, which would start to price in the risk of recession. We think the first scenario is the most likely. Leading indicators of employment suggest the recent sluggish wage growth should prove temporary (Chart 5). The softness in U.S. PCE inflation probably reflects mostly the weak economic growth last year and the recent fall in commodity prices (as well as special factors in telecoms, healthcare and autos). Even if reflation pushes the Fed to tighten more quickly - followed by central banks in the euro area, U.K, and Canada, which have also sounded more hawkish recently - this should not fundamentally undermine the case for risk assets, given how easy monetary policy remains everywhere (Chart 6). It would represent merely a step towards "normalization". Chart 5Sluggish Wage Growth Should Be Temporary Sluggish Wage Growth Should Be Temporary Sluggish Wage Growth Should Be Temporary Chart 6Real Rates Still Negative Everywhere Real Rates Still Negative Everywhere Real Rates Still Negative Everywhere While scenario (2) would also probably be generally positive for risk assets, the correct portfolio allocation would be different. Under scenario (1) - our central view - the dollar would appreciate, causing commodities and EM assets to underperform, higher beta markets (such as the euro area and Japan) and cyclical sectors would perform the best, and in bond markets investors should be underweight duration and overweight TIPS. Scenario (2) would suggest a less aggressive positioning in equities, with income-generating assets outperforming as bond yields stay low at around current levels. Scenario (3), which we see only as a tail risk, would point to an outright defensive stance. What should investors watch for over the coming months? Besides the trends in inflation and wages discussed above, we would be concerned to see any slippage in global growth expectations, which have so far continued to rise despite the softness in inflation and wages (Chart 7). The most likely cause of this would be a Chinese slowdown, though recent comments by Premier Li Keqiang ("we continue to implement a proactive fiscal policy and prudent monetary policy....[but] will not resort to massive stimulative measures") seem to confirm our view that Chinese growth may slow a little further, but that the authorities will not allow it to collapse ahead of the Party Congress in the fall. As potential upside catalysts for risk assets we see: a rebound in crude oil prices (driven by a drawdown in inventories over coming months as the OPEC production cuts reduce supply, Chart 8), progress on a U.S. tax cut (which BCA's Geopolitical Strategy still expects to come into effect from early 2018), and further surprises in earnings growth (where analysts continue to revise up their forecasts, Chart 9). Chart 7No Signs Of Global Growth Slipping No Signs Of Global Growth Slipping No Signs Of Global Growth Slipping Chart 8Oil Inventories To Draw Down Oil Inventories To Draw Down Oil Inventories To Draw Down Chart 9Earnings Continue To Be Revised Up Earnings Continue To Be Revised Up Earnings Continue To Be Revised Up Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Why Haven't Inflation And Wages Picked Up? Chart 10Just A Temporary Phenomenon? Just A Temporary Phenomenon? Just A Temporary Phenomenon? Eight years into an expansion, U.S. inflation remains stubbornly below 2% on every measure and has even slowed in recent months (Chart 10, panel 1). And, despite headline unemployment of only 4.3% (below the Fed's estimate of 4.6% for the Nairu), wage growth also remains sluggish (panel 3). The Fed's view is that inflation has been pulled down by special factors: weak auto sales, the introduction of unlimited cell phone data packages (which lower hedonically-adjusted prices), and drugs companies which raised prices before last year's U.S. presidential election (panel 2). We agree that these factors are likely to be temporary. But the recent weak wage growth is more puzzling. Wages have trended up since 2012, suggesting that the Phillips Curve is not dead. But the relationship seems to have weakened. With U6 unemployment (which includes marginally attached workers and those working part-time who would like full-time jobs) currently at only 8.4%, one would have expected wage growth to be 1 ppt higher than it is (panel 4). Changes in the structure of the workforce may partly explain this (the growing proportion of low-wage service jobs, the "gig economy"). Last year's weak corporate profits may also be a factor. But, with the labor market clearly very tight, we expect wages - and therefore core inflation - to pick up again over the next 12 months. What To Do When VIX Is So Low? After two brief spikes earlier in the year, VIX has declined to 11.4, closer to the historical low of 9.3 reached in 1993, than the historical average of 19.5. In fact, asset price volatilities have been low across the board in fixed income, currencies and commodities, even though the latter two are not at the same extreme low levels as equities and fixed income (Chart 11). However, the VIX futures curve is still in steep contango, which means that getting the timing wrong would make it very costly to go long the volatility index. In addition, correlation among the index members of the S&P 500 is very low, and so are cross-market equity correlations. We do not forecast a recession until 2019, so a sharp reversal in VIX is unlikely, but brief spikes are possible, implying possible corrections in S&P 500 given the inverse correlation between the two. As such, we recommend four strategies for investors who are concerned that markets are too complacent: Focus on security selection, and rotate into cheaper sectors from expensive ones without altering the pro-cyclical bias. Our preferred way is to buy the much cheaper Financials by selling the more expensive Tech; Allocate a portion of funds to the minimum volatility style as it has been relatively oversold; Raise cash and buy a call spread on the S&P 500; Buy longer-dated VIX futures and sell shorter-dated futures to mitigate the rolling cost. Chart 11Are Investors Too Complacent? Are Investors Too Complacent? Are Investors Too Complacent? Chart 12Overweight To Neutral Overweight To Neutral Overweight To Neutral Have Technology Stock Run Too Far? Technology stocks have outperformed the broad market by 33% since April 2013 and investors are increasingly skeptical about whether the run-up can continue. In this Quarterly, we cut our weighting in the Tech sector from Overweight, but we believe it deserves no lower than a Neutral weighting for the following reasons: Sales & Earnings: New order growth is improving alongside rising consumer spending on technology (Chart 12, panel 2). Sales are growing at 5% YoY and this is likely to continue. Pricing power has also recovered over the past year. These factors should support margins and earnings growth. Valuations: Investors are worried about valuation. However, the recent rally has not led to an expansion of relative forward P/E, which is below the historical average (panel 4). Sector relative performance over the past four years has moved in line with its superior return on equity. Breadth: Improving breadth suggests that relative outperformance should be sustainable. An increasing number of firms are participating in the rally, as seen by the improving advances/declines ratio (panel 3). However, we also have some concerns. For example, a handful of large-cap technology firms have generated the bulk of the stock price performance. However, these firms currently trade at 23x.2 earnings compared to 60x.3 for the top firms at the peak of the TMT bubble in 2000. Additionally, the five largest stocks in the sector comprise only 13% of the index, compared to 16% at the peak of the 2000 bubble. Our recommendation, then, is that investors should hold this sector in line with benchmark. Are Canadian Banks At Risk Due To The Housing Bubble? Chart 13Canadian Housing Puzzle Canadian Housing Puzzle Canadian Housing Puzzle The recent problems at Home Capital Group have drawn investors' attention to the Canadian housing market. Home Capital's shares fell by 70% in April after regulators accused the mortgage lender of being slow to disclose fraud among its brokers. However, the issue is unlikely to have wider consequences: the event took place two years ago and had no impact on the lender's assets. Home Capital lends only to individuals with reliable collateral, and accounts for only 1% of total mortgage loans. We don't see imminent risks to the housing and banking sectors, since the economy is recovering and monetary policy remains loose. Vancouver and Toronto home prices have surged for almost a decade (Chart 13, panel 1). After Vancouver introduced a 15% foreign buyer tax in July 2016, house prices initially pulled back but quickly recovered. A similar tax in Ontario this April is also likely to have limited impact. Cautious macro-prudential rules should ensure banks' health: mortgage insurance is required for down-payments under 20%, and the gross debt service ratio (total housing costs over household income) cannot exceed 32%. However, the rise in house prices has caused household debt to run up (Chart 13, panel 2). Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, hinted in a speech in June that the central bank may soon raise rates. Tighter monetary policy could hurt mortgage borrowers who have enjoyed low interest payments for years (Chart 13, panel 3). Over the longer-term, therefore, we are concerned about the level of household debt, and recommend a cautious stance toward Canadian bank stocks. Global Economy Overview: Goldilocks continues, with global growth prospects still good (PMIs in developed economies generally remain around 55 - see Chart 14 panel 2 and Chart 15 panel 1), but inflation surprising on the downside in recent months. The wild card is China, where growth has slowed since Q1, when GDP reached 6.9%, and it is unclear whether the authorities will ease fiscal and monetary tightening to cushion the slowdown. Chart 14Growth Prospects Generally Remain Good Growth Prospects Generally Remain Good Growth Prospects Generally Remain Good Chart 15But Inflation Expectations Have Fallen But Inflation Expectations Have Fallen But Inflation Expectations Have Fallen U.S.: Growth has been weaker than the over-heated consensus expected, pushing down the Citigroup Economic Surprise Indexes (CESI) sharply (Chart 14, panel 1). However, prospects remain positive for the next 12 months: the Manufacturing ISM is at 54.9, retail sales are growing at 3.8% YoY, and capex has begun to reaccelerate (Chart 14, panel 5). The Fed's Nowcasts point to Q2 GDP growth at 1.9%-2.7% QoQ annualized. With expections now lowered, the CESI is likely to bottom around here. Euro Area: Growth has been stronger than in the U.S, with the PMI continuing to accelerate to 57.3. However, this is largely due to the euro area's strong cyclicality and exposure to global growth. Domestic momentum remains weak in most countries, with region-wide wage growth only 1.4% YoY. European PMIs are likely to roll over in line with the U.S. ISM. But GDP growth for the year is not likely to fall much from the 1.9% achieved in Q1. Japan remains a dual-paced economy, with international sectors doing well (exports rose by 14.9% YoY in May and industrial production by 5.7%) but domestic sectors stagnating, as wage growth remains sluggish (up just 0.5% YoY). Bank of Japan policy will remain ultra-easy, but there is scant sign of fiscal stimulus or structural reform. Emerging Markets: China is showing clear signs of slowdown, with the Caixin Manufacturing PMI falling below 50 (Chart 15, panel 3). The PBoC has tightened monetary policy, causing corporate bond yields to rise by 100 bps since the start of the year and the yield curve to invert. However, with the 19th Communist Party Conference scheduled for the fall, the authorities will prioritize stability: there are signs they are increasing fiscal spending. Elsewhere, many emerging markets are characterized by sluggish growth but falling inflation, which may allow central banks to cut rates. Interest rates: Inflation has softened recently, with U.S. core PCE inflation slowing to 1.4% and euro zone core CPI to 1.1%. We agree with the Fed that the recent weak inflation was caused by temporary factors and, with little slack in the labor market, core PCE will rise to 2% by next year, causing the Fed to hike in line with its dots. In the euro zone, however, the output gap remains around -2% of GDP and countries such as Italy could not bear tightening, so the ECB will taper only gradually next year and not raise rates soon. Chart 16Powered by Earnings and Margin Improvement! Powered by Earnings and Margin Improvement! Powered by Earnings and Margin Improvement! Global Equities In Q2 2017 the price gain in global equities was driven entirely by earnings growth, as forward earnings grew by 3.5% while the forward PE multiple barely changed. This is distinctively different from the equity rally in 2016 when multiple expansion dominated earnings growth (Chart 16). The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also come in very strong, with 90% of sectors registering positive earnings growth. Margins improved in both DM and EM. Equity valuation is not cheap by historical standards but, as an asset class, equities are still attractively valued compared to bonds given how low global bond yields are. We remain overweight equities versus bonds even though we are a little concerned about the extremely low volatility in all asset classes (see "What Our Clients Are Asking" on page 8). Within equities, we maintain our call to favor DM versus EM despite the 7% EM outperformance year-to-date, which was supported by attractive valuations and the weak U.S. dollar. BCA's house view is that the USD will strengthen versus EM currencies over the coming 12 months. Within EM, we have been more positive on China and remain so on a 6-9 month horizon, in spite of China's 6.7% outperformance versus EM. Our upgrade of euro area equities to overweight at the expense of the U.S. in our last Quarterly Portfolio Outlook proved to be timely as the euro area outperformed the U.S. by 641 bps in Q2. We continue to like Japan on a currency hedged basis (see next page). Sector-wise, we maintain a pro-cyclical tilt. However, we are taking profit on our overweight in Technology (downgrade to neutral) and upgrading Financials to overweight from neutral. Japanese Equities: Maintain Overweight, With Yen Hedge We upgraded Japanese equities to overweight in June 2016 (please see our Quarterly Report, dated June 30, 2016 and our Special Report, dated June 8, 2016) on a currency hedged basis. These positions have worked very well as the yen is down by 10% and MSCI Japan has gained 32% in yen term, outperforming the global benchmark by 12% in local currency terms, but in line with benchmark in USD (Chart 17). Going forward, we recommend clients continue to overweight Japanese equities in a global portfolio and hedge the JPY exposure. Reasons: First, since December 2012 when Abenomics started, MSCI Japanese equities have gained 82% in yen terms, but earnings have risen by much more, with a 180% increase. Valuation multiples have contracted, in stark contrast to other major equity markets where multiple expansion has led to stretched valuations. Second, divergent monetary policy between the BOJ and the Fed will put more downside pressure on the JPY. More importantly, weak fundamentals, as evidenced by falling inflation and a slowing in GDP growth, are likely to push the BOJ to resort to more extraordinary policy measures, such as debt monetization, which would further weaken the JPY, boosting exports and therefore the export sector dominated Japanese equity market. Note that our quant model is still underweight Japan, but has become slightly less so compared to six months ago. We have overridden the model because 1) the model is unhedged in USD terms and, more importantly, 2) the model cannot capture potential policy action such as debt monetization. Chart 17Japanese Equities: Remain Overweight Japanese Equities: Remain Overweight Japanese Equities: Remain Overweight Chart 18Financials Vs Tech: Trading Places Financials Vs Tech: Trading Places Financials Vs Tech: Trading Places Sector Allocation: Upgrade Financials to Overweight by Downgrading Tech to Neutral. We have been overweight Technology since July 2016 (please see our Monthly Update, July 29, 2016) and the sector has outperformed the global benchmark by 11.8%, of which 9% came this year. In line with our general concern on asset valuations, we are taking profit on the Tech overweight and use the proceeds to fund an overweight in the much cheaper Financials sector. As shown in Chart 18, the relative total return performance of Financials vs. Technology is back to extreme levels (panel 1), while the relative valuation of Financials measured by price to book has reached an extremely cheap level (panel 2). Also, Financial shares offer a good yield pick-up over Tech even though this advantage is in line with the historical average (panel 3). BCA's house view calls for higher interest rates and steeper yield curves over the next 9-12 months. Financial earnings benefit from a steepening yield curve. If history is any guide, we should see more aggressive analysts' earnings revisions going forward in favor of Financials (panel 4). Overall, our sector positioning retains its tilt towards cyclicals vs. defensives. (Please see Recommended Allocation table on page 1), in line with the tilt from our quant model. Within the cyclical sectors, however, we have overridden the model on Financials and Tech since the momentum factor is a major driver in the model and we judge that momentum has probably run too far. Chart 19MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance Smart Beta Update: In Q2, an equal-weighted multi-factor portfolio outperformed the global benchmark (Chart 19, top panel). Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - quality and momentum factors continued the Q1 trend of outperformance, while value continued to underperform. It's worth noting that the underperformance of minimum volatility stabilized in the last two months of the quarter, indicating that the extremely low market vol has caught investor attention and some investors have started to seek protection by moving into the low vol space, albeit gradually. Value has continued to underperform growth, and small caps to underperform large caps. We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying themes given the historically close correlation between styles and cyclicals versus defensives (bottom two panels). As show in Table 1, however, even though value has underperformed growth across the globe, small caps in Japan and the euro area have consistently outperformed large caps year-to-date, the opposite to that in the U.S., in line with the higher beta nature of these two markets. Table 1Divergence In Style Quarterly - July 2017 Quarterly - July 2017 Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q2 to below fair value levels in response to weaker "hard data" (Chart 20, top panel). But weakness in Q1 U.S. GDP was concentrated in consumer spending and inventories, both of which are likely to strengthen in the months ahead. In addition, after the June rate hike, we expect the Fed to deliver another rate hike by year end, while the market is pricing in only 14 bps of rate rise. Maintain overweight TIPS vs. Treasuries. As the nominal 10-year yield fell, so did 10-year TIPS breakeven inflation. In terms of relative valuation, now TIPS is fairly valued vs. the nominal bonds (panel 2). However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target later this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Overweight Inflation-linked JGBs (JGBi) vs. Nominal JGBs. Inflation in Japan has been falling despite strong GDP growth. However, the labor market has not been this tight since the mid-1990s, with the unemployment rate at 3.1% and jobs-to-applicants ratio at 1.49, both post-1995 extremes (Chart 21, panel 2). BCA Foreign Exchange Strategy service believes that wage pressures, in addition to the inflationary effect of a weakening yen, could lead inflation higher. Accordingly, inflation-linked JGBs offer good value relative to nominal JGBs (Chart 21, panel 1). Chart 20Inflationary Pressures Are Building Inflationary Pressures Are Building Inflationary Pressures Are Building Chart 21Overweight JGBi Vs JGB Overweight JGBi Vs JGB Overweight JGBi Vs JGB Corporate Bonds Given our expectations that global growth will remain robust over the coming 12 months, pushing the U.S. 10-year Treasury yield above 3%, we continue to favor credit over government bonds. However, U.S. corporate health has deteriorated further in the past two quarters (Chart 22) and so, when the next recession comes, returns from corporate credit may be particularly bad. We cut our double overweight in investment grade debt to single overweight. The spread over Treasuries of U.S. IG credit has fallen to around 100 bps. Given high U.S. corporate leverage currently, it is unlikely that the spread will tighten any further to reach previous lows (Chart 23), so investors will benefit only from the carry. Moreover, the ECB is likely to reduce its bond buying from January 2018 and, though it is unclear whether it will taper corporate as well as sovereign purchases, this represents a potential headwind for European credit. Remain overweight high yield debt. U.S. junk bonds have been remarkably resilient in the face of falling oil prices and the subsequent blowout in energy bond spreads. The default-adjusted spread is just over 200 bps (Chart 24), based on Moody's default assumption of 2.7% over the next 12 months and a recovery rate of 47%. Historically, a spread of this size has produced an excess return over the following year 74% of the time, for an average of 84 bps. Chart 22U.S. Corporate Health Deteriorating U.S. Corporate Health Deteriorating U.S. Corporate Health Deteriorating Chart 23IG Spreads Unlikely To Tighten Further IG Spreads Unlikely To Tighten Further IG Spreads Unlikely To Tighten Further Chart 24Junk Spreads Give Sufficient Reward Junk Spreads Give Sufficient Reward Junk Spreads Give Sufficient Reward Commodities Chart 25Mixed Feelings Towards Commodities Mixed Feelings Towards Commodities Mixed Feelings Towards Commodities Secular Perspective: Bearish: We continue to hold a negative secular outlook for commodities (Chart 25). A gradual shift towards a service-led economy in China, combined with sluggish global growth, will prevent demand from rising further. This lack of demand, together with record high inventory levels for major commodities, keep us from turning bullish. Cyclical Perspective: Neutral We are positive on oil because we believe that inventories will continue to draw. We are negative on base metals due to weak demand and excess supply. We are somewhat bullish on precious metals based on the political uncertainties ahead. Energy: Bullish OPECextended its production cuts for another nine months, carrying the cuts through to Q1, when the oil price is typically seasonally weak. We expect demand growth will increasingly outpace production growth in 2017, producing inventory drawdowns. The current weakness in the crude price is largely due to investors' concerns over shale production. However, the OPEC cut of 1.2 MMb/d, supplemented by an additional 200,000 - 300,000 b/d of voluntary restrictions on non-OPEC oil, are enough to offset any spurt in shale production. Base metals: Bearish China is slowly tightening monetary policy and, following the 19th Communist Party Congress later this year, reflationary stimulus will probably continue to wind down. We have seen a cooling in the Chinese property market along with a slowdown in the manufacturing sector. The Caixin manufacturing PMI, a key indicator for metals demand, fell below 50 in May for the first time in 11 months. At the same time, inventories for copper and iron ore have risen. Precious metals: Long-term Bullish Inflation has not picked up as we expected, which may prevent the gold price from rising further in 2017. However, we expect inflation to move higher going into 2018. As a safe haven, gold is also a good hedge against geopolitical risks. We believe that the political risks in 2018 are underestimated, especially the Italian general election (probably in March or April). Currencies Chart 26Fed Will Support The Dollar Fed Will Support The Dollar Fed Will Support The Dollar In 2017, the U.S. dollar (Chart 26) has weakened by 5% on a trade-weighted basis. However, we believe that the soft patch in inflation and wage data that caused this weakness is temporary and that underlying economic momentum remains strong. Following its rate hike in June, the Fed kept its forecast for core PCE in 2018 and 2019 at 2%. As inflation and wage pressures return, market expectations will converge with the Fed's forecast. The subsequent improvement in relative interest rates will support the dollar. Euro: The euro is up by 8% versus the dollar so far this year. The ECB is likely to continue to set policy for the weakest members of the euro zone, in the absence of a major pickup in inflation. While economic activity has improved, inflation has recently fallen back again, along with the oil price. The ECB is particularly sensitive to political uncertainty surrounding the upcoming Italian elections and the fragility of the Italian banking system. This suggests that the ECB will only gradually taper its asset purchases starting early next year, but will not move to raise rates until at least mid-2019. This is likely to cause the euro to weaken over the coming months. Yen: The yen has strengthened by 4% versus the dollar year to date. With core core inflation in Japan struggling to stay above 0%, we think it highly likely that the BOJ will continue its yield curve control policy. If, as we expect, U.S. long-term interest rate trend up in the coming months, relative rates will put downward pressure on the yen. Our FX strategists expect the USD/JPY at 125 within 12 months. EM Currencies: With Chinese growth likely to remain questionable over the coming months, emerging market currencies will lack their biggest tailwind. Terms of trade will continue to turn negative as commodity prices weaken. EM monetary authorities will mostly be easing policy in order to support growth. With rates kept low, relative monetary policy is likely to will force EM currencies, especially those for commodity exporters, to depreciate from current levels. Alternatives Chart 27Attractive Risk-Return Profile Attractive Risk-Return Profile Attractive Risk-Return Profile Return Enhancers: Favor private equity vs. hedge funds In 2016, private equity returned 9%, whereas hedge funds managed only a 3% return (Chart 27). Strong performance led to private equity funds raising $378 bn last year, the highest level of capital secured since the Global Financial Crisis. By contrast, hedge funds have underperformed global equities and private equity since the financial crisis of 2008-09. However, investors have become increasingly concerned with valuation levels in private markets. Our recommendation is that investors should continue to overweight private equity vs hedge funds, since we do not see a recession as likely over the next 12 months. Within the hedge fund space, we would recommend overweighting event-driven funds over the cycle, and macro funds heading into a recession (please see our Special Report, dated June 16, 2017). Inflation Hedges: Favor direct real estate vs. commodity futures In 2016, direct real estate returned 9%, whereas commodity futures achieved 12%. Given the structural nature of this recommendation, investors need to look past recent short-term moves in commodity prices. Low interest rates will keep borrowing cheap, making the spread between real estate and fixed income yields continue to be attractive. Moreover, with 48% of institutional investors currently below their target allocation for real estate, there is a lot of potential for further capital allocations to the asset class. With regards to the commodity complex, the long-term transition of China to a services-based economy will lead to a structural decline in commodity demand. Investors should continue to overweight direct real estate vs commodity futures on a 3-5 year target horizon. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2016, farmland and timberland returned 9% and 3% respectively, whereas structured products returned 2%. Farmland and timberland will continue to benefit from favorable global demographic trends, as a growing population and improving prosperity in the developing world increase food consumption. However, increased volatility in lumber and agriculture prices have made investors concerned about cash flows. With regards to structured products, increasing rates and deteriorating credit quality in the auto loan market will slow credit origination. Given that the Fed will start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. Risks To Our View We explained the two alternative scenarios to our main view in the Overview section of this Quarterly. There are three other specific areas where our views differ notably from the consensus: Strong dollar. Our view is predicated on the Fed tightening policy more than the market currently expects, and the ECB less. Interest rate differentials (Chart 28) certainly point to a stronger USD, and speculative positions have reversed from being very dollar-long at the start of the year. But the euro momentum could continue for a while, especially given mixed messages from Mario Draghi, for example when he said in late June that "the threat of deflation is gone and reflationary forces are at play." Crude oil back at $55. Our Energy strategists believe that the oil price is currently being driven by supply, not demand. They argue that OPEC production cuts will hold and cause inventories to draw down rapidly over the coming six months. However, speculative positioning in oil has shifted from very long to significantly short since the start of the year. The risk is that U.S. oil production continues to accelerate (Chart 29), as fracking technology improves and availability of capital for oil producers remains easy. Negative on EM. Our 12-month EM view is predicated on a stronger dollar, higher U.S. interest rates, slowing Chinese growth, and falling commodity prices. We could be wrong about these drivers. Falling inflation in emerging markets such as Brazil (Chart 30) could allow central banks to cut rates aggressively, which might temporarily boost growth. Chart 28Rate Differentials Suggest Strong Dollar Rate Differentials Suggest Strong Dollar Rate Differentials Suggest Strong Dollar Chart 29Oil Bears Point To U.S. Output Oil Bears Point To U.S. Output Oil Bears Point To U.S. Output Chart 30Sharp Fall In Brazilian Inflation Sharp Fall In Brazilian Inflation Sharp Fall In Brazilian Inflation 1 Our U.S. Bond Strategists explain the detailed thinking behind these three scenarios in their Weekly Report "Three Scenarios for Treasury Yields In 2017," dated June 20, 2017, available at usbs.bcaresearch.com 2 Market-cap weighted average of Apple, Alphabet, Microsoft, Amazon and Facebook. 3 Market-cap weighted average of Microsoft, Cisco Systems, Intel, Oracle and Lucent. Recommended Asset Allocation