Monetary

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 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 Chart I-3Industrial 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 Chart I-5Some 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 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 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 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 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 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 Chart I-12Earnings 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 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 Chart I-15Deteriorating 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 Chart I-17Net Transfers To Shareholders ##br##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 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... Chart II-2...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 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 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 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 Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average 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 Chart II-7Consumer Staples Chart II-8Energy Chart II-9Financials Chart II-10Health Care Chart II-11Industrials Chart II-12Materials Chart II-13Real Estate Chart II-14Utilities Chart II-15Technology Chart II-16Telecommunication 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 Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen TechnicalsChart III-21Euro/Yen Technicals Chart III-20Euro TechnicalsChart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China

Highlights Strengthening income growth is apparent in DM and EM trade volumes, real wages in the U.S., and industrial commodity prices, chiefly oil and copper. This indicates inflation at the consumer level will move higher in the near future, most likely in 2H2018. We believe 10-year U.S. Treasury Inflation-Indexed securities (TIPS) trading below 0.52 do not reflect the risk of higher inflation and are, therefore, going long at tonight's close. Energy: Overweight. Crude oil prices rallied 4.6% this week, following the OPEC 2.0 meeting in St. Petersburg. Although ministers did not announce additional cuts to the 1.8mm b/d agreed at the end of last year, Saudi Energy Minister Khalid al-Falih said the Kingdom would reduce August exports to 6.6mm b/d, which is more than 300k b/d below May's level, the latest month for which data are available from JODI. Given strong global demand, if this export reduction persists - and if others join the Kingdom - it would speed the drawdown in global inventories. Base Metals: Neutral. Copper pushed through $2.80/lb on the COMEX, a level not seen since May 2015. Underlying strength in EM economic activity - seen most recently in global trading activity (discussed below) - and a weaker USD are supporting base metals. Precious Metals: Neutral. Gold fell below $1,257/oz earlier this week, and was trading ~ $1,250/oz going to press Wednesday. We remain long gold as a portfolio hedge; the position is up 1.7% since it was initiated on May 4, 2017. Ags/Softs: Underweight. Harsh weather is impacting grains. The USDA rated 62% of the U.S. corn crop in the 18 states comprising 92% of total output good or excellent last week, down from 76% in 2016. For beans, the split was 58% last week vs. 71% last year. Feature The expansion in global trade that began toward the end of last year continues, which, based on our modeling, indicates inflation at the consumer level likely will move higher in the short run (Chart of the Week). Trade expansion, particularly in EM economies, is consistent with rising incomes, which, all else equal, will keep industrial commodities - oil and copper, in particular - well supported, given income and demand for these commodities are closely aligned.1 These fundamentals dovetail with other indications of stronger growth, particularly in DM economies, where trade volumes also are growing (Chart 2). In the U.S., for example, wage growth continues to outpace inflation, and monetary conditions remain benign (Chart 3). Our colleagues at BCA Research's Global Investment Strategy believe the Fed actually may be behind the curve in reacting to nascent inflationary pressures emerging in the U.S.2 Chart of the WeekRising EM Trade Volumes Consistent##BR##With Higher U.S. CPI Inflation Chart 2DM Trade Volumes Are Expanding##BR##At ~ 5% Pace ... Chart 3U.S. Labor Market Tightening,##BR##Financial Conditions Remain Loose Trade Growth Supports Higher Inflation U.S. CPI is highly correlated with EM trade volumes (imports and exports) as shown in the Chart of the Week. In recent research into inflation and trade, we also showed EM oil demand and world base metals demand are highly correlated with EM trade volumes.3 Chart 4EM Trade Volumes##BR##Continue To Strengthen Growth EM import growth continues to expand at a faster pace than DM growth (Chart 4). Year-on-year (yoy) EM import growth came in at 7.7%, a full 2 percentage points above DM growth. This is not to minimize DM growth - it finally broke out of its lethargy in May with a sharp advance of close to 6%, which will lift the trend rate of growth (the 12-month moving average, or 12mma) higher going forward. EM export growth in May was only slightly above DM growth for the month - 5.4% yoy vs. 5.2% yoy. These stout monthly trade performances will, in the next few months, offset the lethargic growth seen in EM and DM prior to the expansion begun at the end of 2016, as weaker monthly performance falls off the trend calculations. Over the year ended in May, within EM markets the annual trend in imports (the 12mma to May 2017) has barely grown more than 1% yoy, dragged down by a 6% contraction in the Middle East and Africa (MEA) and a 2.1% contraction in Latin American growth. The trend in EM - Asia's imports is up, rising 3.2% over the same period. For the year ended in May, imports into central and Eastern Europe were mostly flat; however, since November 2016, the trend turned sharply positive with 3.3% yoy growth. The trend in export volumes is expanding for in MEA and Latin America economies - 3.5% yoy trend growth (12mma) in MEA, and 4.4% growth in Latin America, which is slightly higher than the overall 2.2% rate of trend growth in EM exports. Still, lower oil and commodity prices, along with reduced volumes are curtailing an income recovery in these regions. Central and Eastern Europe's rate of export expansion leads EM generally at close to 4% yoy trend growth. Favor Gold And TIPS Ahead Of Higher Inflation As the labor market tightens and real-wage growth continues to outpace productivity growth, we expect U.S. inflation to pick up. Growth in trade volumes also will support growth in EM oil demand and world base metal demand, as noted above. This will feed into U.S. core PCE, the Fed's preferred inflation gauge (Chart 5). As we've highlighted in the past, there is very strong co-movement among these variables: We've found that, all else equal, a 1% increase in the non-OECD oil demand implies an increase in the core PCE of slightly less than 50bp. If the trend in overall EM trade volumes persists, the likelihood we will be increasing our estimate of non-OECD oil consumption for 2H17 and 2018 increases. U.S. CPI and EM trade volumes show similar co-movement properties, as the Chart of the Week shows. A 1% increase in EM import volumes translates into a 0.53% increase in the U.S. CPI, while a 1% increase in EM export volumes implies a 0.49% increase in the CPI. EM import volumes over the January - May 2017 interval have been growing at slightly more than 8% yoy, while exports have been growing at slightly more than 3%. Continued strength in the EM trade data implies U.S. CPI could grow well above what's currently being priced in inflation markets and by Fed policymakers. This leads us to favour gold and TIPS as inflation hedges. If we do get a larger-than-expected move in the U.S. CPI, gold should respond well. The modelling depicted in Chart 6 shows a 1% increase in the CPI translates into a 4.1% increase in gold. Chart 5Core PCE Will Pick Up##BR##As Commodity Demand Grows Chart 6Gold Will Pick Up##BR##Larger-Than-Expected CPI Moves For this reason we recommend getting long U.S. Treasury Inflation-Protected Securities (TIPS), which will appreciate as the U.S. CPI moves higher.4 We will be getting long as of tonight's close. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes. We are up 39.3% and 32.9% on the Brent and WTI positions, respectively, from last week, and 47.2% and 89.2% since inception. U.S. Monetary Policy Remains A Huge Risk To EM Trade As we've noted in the past, U.S. monetary policy can have an outsized effect on EM trade volumes. In an update of an earlier model using U.S. M2 and the broad trade-weighted USD (TWIB), we find a 1% increase in the broad trade-weighted USD translates into a 1.1% drop in EM imports, while a 1% increase in U.S. M2 (broad money) implies an 85bp increase in EM imports (Chart 7).5 Chart 7EM Trade Volumes Highly Sensitive##BR##To U.S. Monetary Policy This demonstrates the feedback loop we've identified between U.S. monetary policy and EM trade. EM trade volumes affect inflation at a global level. We've found inflation in the U.S., EU and China to be co-integrated - i.e., these price gauges all follow the same long-term trend. Inflation and inflation expectations drive Fed policy, which drives the price formation of the USD - i.e., the FX rates included in the USD TWIB - and affect Fed policy on M2. These U.S. monetary variables, in turn, affect EM trade volumes. And so it goes ... Too-aggressive a tightening by the Fed as it normalizes its interest-rate policy regime could destabilize EM economies - either via too-sharp an appreciation in the USD TWIB, a larger-than-expected deceleration in M2 growth, or both - and negatively affect trade flows. At the end of the day, this would redound to the detriment of the U.S. economy, as the different feedback mechanisms kick in. This says the Fed's policy doesn't just affect the U.S. economy, or that EM economies essentially are on their own in the policy tools they deploy to adjust to Fed innovations. Like it or not, the Fed has to consider these types of feedback loops in its decision-making, since the Open Market Committee will be dealing with the fallout of its earlier policies. Bottom Line: EM trade volumes continue to grow yoy, continuing the trend that began at the end of last year. This performance, coupled with a tightening labor market in the U.S. and a still-loose financial backdrop, raises the odds inflation will exceed what's currently priced into market and Fed expectations. We are getting long U.S. 10-year TIPS at tonight's close, and remain long gold as a strategic portfolio hedge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The income elasticity for industrial commodities in EM economies is ~ 1.0, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 2 Please see BCA's Global Investment Strategy Weekly Report titled "Are Central Banks Behind The Curve Or Ahead Of It?," published on July 21, 2017. It is available at gis.bcaresearch.com. Among other things, the Global Investment Strategy team notes labor-market slack is dissipating, real wages are increasing, and easier financial conditions are spurring credit growth. Our colleagues note, "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%." BCA's Global Investment Strategy believes U.S. inflation could move higher by 2H18. 3 Please see BCA Commodity & Energy Strategy Weekly Reports titled "EM Trade Volumes Continue Trending Higher, Supporting Metals" and "Strong EM Trade Volumes Will Support Oil," published June 29, and June 8, 2017. Both are available at ces.bcaresearch.com. 4 U.S. TIPS increase in value as the Consumer Price Index (CPI) rises, and fall in value as the index declines. Please see "TIPS: Rates & Terms" on the UST's TreasuryDirect web page (https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm). 5 This model covers 2000 to the present, using monthly data. The R2 for the cointegrating regression is 0.96. These variables do not explain EM exports, which are not cointegrated with U.S. monetary variables. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) Chart I-9BChina's Growth To Decelerate A Lot (I) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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 Chart 2S&P 500 Does Not##br## 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 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 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 Chart 6Financial Conditions##br## 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? Table 1Characteristics Of Fed Chairs Since 1970 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 Chart 9Market 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 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 Chart 11Bad Loans Rising Chart 12Communism Fails To Redistribute Income 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 Chart 14Anti-Corruption Campaign Hindered##br## 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? 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? Chart 16Ruling 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 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 Diagram 3Super-Majority ##br##Barely Within Reach 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. Chart 20Japanese No Longer ##br##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.

Special Report

Highlights The RBA will not hike as quickly as markets expect. Weak wage growth and high underemployment suggest plenty of spare capacity. Inflation is only barely at the bottom of the central bank's range. Massive household debt levels will make it difficult for consumers to handle higher interest rates. Australian banks, although relatively healthy, are still enormously exposed to Australian housing and interest-only mortgages. House prices have nearly quadrupled since 2000 and exhibit the characteristics of a bubble. Still, it will likely take considerable monetary tightening before the bubble bursts. We do not think this will occur anytime soon. Maintain a neutral exposure to Australian government bonds, but enter into a 2-year/10-year Australian government bond yield curve flattener. Feature Chart 1Diverging Trends In##BR##The Australian Economy Australia remains one of the more difficult bond markets on which to take a decisive investment stance at the moment. The recent Moody's downgrade of Australian banks has put the spotlight back on the housing boom Down Under. With home prices continuing to climb - despite the introduction of macro-prudential measures on mortgage lending and with household indebtedness reaching exorbitant levels - investors are becoming increasingly concerned over a potential housing crash that could have spillover effects on the Australian banking system (Chart 1). At the same time, the domestic economy continues to suffer a hangover from the end of the mining boom earlier this decade, with excess capacity keeping inflation pressures subdued. Naturally, this has put the Reserve Bank of Australia (RBA) in a difficult position. Interest rate cuts in response to low inflation would add further fuel to the housing bubble. On the other hand, any attempt to try and normalize the current accommodative monetary policy settings with rate hikes could trigger an unwanted surge in the Australian dollar and prompt a correction in house prices. The latter could lead to financial instability and raise recession risks with consumers already dealing with negative real wage growth, low savings and massive debt loads. In this Special Report, we examine Australia's monetary policy trajectory, analyze its concentrated banking sector and the potential risks from a downturn in house prices, and revisit our positioning on Australian government debt. Our conclusions still lead us to stick with a neutral duration stance and country allocation on Australian debt, but with a bias towards a flatter government bond yield curve. RBA On Hold... For Now Chart 2Aussie Bonds Caught##BR##In The Global Selloff Earlier this month, the RBA decided to leave the cash rate unchanged at 1.5%. The central bank maintained its fairly neutral rhetoric, though they did cite that the "broad-based pick-up in the global economy is continuing." The central bank upgraded its economic forecasts, with real GDP growth now projected to reach slightly above 3% over the next two years. The minutes from that July 4 monetary policy meeting revealed that a discussion over the ideal level of the real cash rate took place.1 The conclusion was that equilibrium inflation-adjusted rate is now around 1%, meaning that the "neutral" nominal rate is 3.5% after adding an inflation expectation of 2.5% (the middle of the RBA inflation target band). That implies that the RBA has lots of catching up to do on interest rates once the next tightening cycle begins. The timing of that discussion on real rates came shortly after the rebound in global bond yields that began after policymakers in other countries, most notably the European Central Bank and the Bank of Canada, began hinting that a move to dial back the emergency monetary easings of 2015/16 was about to begin (Chart 2). With the RBA possibly sending a similar message, investors responded by raising interest rate expectations and bidding up the Australian dollar (AUD). 30bps of RBA hikes are now priced in over the next year, while our proxy for the market-implied pricing of the terminal (i.e. equilibrium) cash rate - the 5-year AUD overnight index swap rate, 5-years forward - shot up to just over 3%. We believe that this market repricing of potential RBA rate hikes is too optimistic. Australian monetary policy must remain highly accommodative for some time. Our more dovish case is based on our assessment of the RBA's policy mandates, which include full employment, price stability and the 'welfare of the Australian people'. Because of Australia's heavy economic exposure to iron ore prices, its largest export, we also include an outlook on the commodity to aid in our forecast of RBA policy. Employment: The latest readings on the Australian labor market have shown marked improvement so far in 2017 (Chart 3). The unemployment rate now sits at 5.6%. Employment growth is accelerating while the participation rate has edged higher in recent months. The National Australia Bank business confidence index is steadily improving, while job vacancies are at a five-year high. In the statement released after the June monetary policy meeting, RBA governor Philip Lowe stated that "forward-looking indicators point to continued growth in employment in the period ahead." Chart 3Labor Demand##BR##Picking Up... Chart 4...But All Signs Point To Lots##BR##Of Spare Labor Capacity While Governor Lowe also noted that the overall employment picture is 'mixed' in some aspects, we are far more pessimistic (Chart 4). The underemployment rate has been rising and now sits only slightly below its almost 50-year high of 8.8%.2 Part-time workers as a percentage of total employment has experienced a structural increase to nearly 33%, while hours worked have declined. Additionally, nominal wages have been flat and real wages are declining. This suggests that there is plenty of slack in labor markets and that Australia is still far from full employment, even with the headline jobless rate sitting slightly below the OECD's current NAIRU estimate of 5.9%.3 Inflation: Core inflation has been slowing since 2014 and only reached an anemic 1.45% in the first quarter of 2017 (Chart 5). Although headline inflation has rebounded over the past year, at 2.1% it remains only at the bottom of the RBA's 2-3% target range. Additionally, the downtrend in inflation expectations for 2017 appears to be intact. Chart 5Inflation Staying Within The RBA 2-3% Target Chart 6Australian Consumer Spending Slowing Weak productivity growth, leading to lackluster wage growth, is keeping overall inflation subdued. The trade-weighted currency has rallied since June, presenting an additional headwind for consumer prices. Even if the recovery in headline inflation persists and starts to pass through to core readings, policymakers will likely err on the side of caution. A higher realized inflation rate will be tolerated in the near term to ensure expectations stay well within the 2-3% target band - the RBA's definition of "price stability" - before any interest rate increases are considered. Consumer: Australian households face a challenging environment. Real wages are declining, with the wage cost index in a downtrend since 2011. Real retail spending growth has been slowing and is nearing negative territory, while consumer sentiment is quite pessimistic (Chart 6). As income growth is lacking, consumers have had to dip into savings to maintain consumption, with the savings rate collapsing from 10% to 5% over the last few years. Part of that decline is likely due to the rising cost of "essentials" spending, such as utilities, health care, education and transportation. The inflation rates for those sectors have been outpacing overall headline and core readings (Chart 7), suggesting that Australian households are saving less just to "make ends meet." Chart 7Spending More On The "Essentials" Overall, Australian consumers remain incredibly indebted. The household debt-to-income ratio is nearing 200% - the fourth highest figure among the OECD countries.4 Households have been able to handle the massive debt loads (so far) due to record-low interest rates, which have allowed debt service ratios to fall in line with long-term averages. However, hiking interest rates against this backdrop of highly leveraged consumers - especially given the huge exposure of Australian household balance sheets to overvalued house prices - could severely test the 'economic prosperity and welfare of the Australian people' element of the RBA's mandates. In other words, the RBA would need to see decisive signs that the economy was pushing up against inflationary capacity constraints before embarking on a tightening cycle, for fear of the spillover effects of pricking the housing bubble too soon (as we discuss later in this report). Iron Ore: Historically, Australia's growth has been tightly linked to the performance of industrial commodities, in particular iron ore which represents nearly 20% of total Australian exports. Our commodity strategists are neutral on iron ore on a cyclical horizon and bearish on a strategic basis. Chinese iron ore import growth has recently ticked up, but should remain subdued as Chinese inventories are still high (Chart 8). Chinese property construction activity, which accounts for roughly 35% of total Chinese steel demand, remains depressed. Globally, iron ore supply is set to increase throughout the year as many mining projects will come on stream. On a longer-term basis, Chinese demand for metals will likely slow due to the ongoing structural economic shift away from excessive reliance on infrastructure investment and house-building to an economy based on consumption and services. Summing it all up, none of the RBA's policy mandates is being threatened in a way that should force policymakers to begin shifting to a less dovish stance. There is little evidence that Australia has reached full employment, inflation and inflation expectations remain within the RBA target band, growth momentum remains moderate and the housing bubble remains an existential risk to the future health of the economy. Additionally, Australian policymakers will want to keep rates as low as possible to ensure that a weaker currency helps prop up exports, support the economy in its transition away from the heavy reliance on mining investment. Real GDP growth fell below 2% and the output gap is still far in negative territory, suggesting plenty of slack (Chart 9). Our own Australian Central Bank Monitor has rolled over and is now barely in the "tight policy required" zone (bottom panel). Projected fiscal drag over the next few years will also dampen growth. RBA growth forecasts appear highly optimistic relative to median economist estimates. All of these factors point to a delay in rate hikes. Chart 8No Big Boost To Iron Ore Prices From China Chart 9No Pressure On The RBA To Hike Rates Bottom Line: Markets are overpricing the potential for RBA tightening. There is still spare capacity in labor markets, inflation is subdued and consumers cannot handle higher rates. Monitoring The Banks In June, Moody's downgraded all Australian banks, citing a "rise in household leverage and the rising prevalence of interest-only and investment loans" (Chart 10). The downgrade raised concern among investors, with banks being the largest component of the Australian equity market, and short positions have noticeably risen. Despite subdued income growth and enormous household debt levels, escalating house prices have supported consumption through the wealth effect, but this is clearly unsustainable. Political pressures are also building, as evidenced by the introduction of a bank levy in South Australia. Chart 10A Relentless Climb In Household Debt The Chairman of the Australian Prudential Regulation Authority (APRA), Wayne Byres, wants to make bank capital levels "unquestionably strong." His recent comments indicate that Australian banks will need to raise capital before 2020 to adhere to global standards, with some estimates reaching as high as $20bn (in USD). This process is crucial for instilling confidence in markets that banks can meet these targets through organic capital generation or dividend re-investment plans. As the increased capital required is relatively small - only 2% of the capital base of the Australian banks - it should not be difficult to raise that amount. The greatest risk to the financial system is still the exposure to Australian housing. For the four major banks, Australian housing loans make up slightly over 50% of their lending mix, far greater than for U.S. banks prior to the Great Financial Crisis of 2008 (Chart 11). Of those loans, approximately 40% are non-traditional (interest-only, sub-prime, reverse mortgages). Several macro-prudential measures have been implemented by Australian financial regulators to decrease risks within the banking sector. The regulations have been focused on interest-only loans, which are more vulnerable to rate rises. Such loans are riskier, typically shorter in maturity and requiring larger deposit amounts. Banks are tightening their lending standards for these loans and risk weights will likely be increased, thereby requiring more capital. Additionally, the standard variable rate on interest-only loans has increased by 30-35bps and APRA has imposed a 30% cap on interest-only loans as a percentage of new loans. This will cause a meaningful decline in the risk profile of banks' mortgage books, as consumers with interest-only loans will shift to less expensive principal-plus-interest loans. Another source of risk is the Australian banks' increasing reliance on offshore short-term wholesale funding. When credit growth outpaces deposit growth, which has been the case, banks need to balance the equation through increased wholesale funding. This raises the potential for a liquidity crunch, as capital may be unavailable during a crisis. Credit growth to the private sector is slowing, though, reducing the immediate need for this type of funding. Additionally, authorities are prompting banks to substitute away from the heavy reliance on short-term wholesale funding through the implementation of a net stable funding ratio. This is defined as the available amount of stable funding (i.e. core deposits, equity and long-term wholesale funding) over the required regulatory level of stable funding. Banks will have until 2018 to increase this ratio above 100%. As a result, long-term wholesale debt issuance rose sharply in 2016 and that amount is projected to be relatively similar for 2017. Overall, current metrics suggest that Australian banks are fairly healthy, even before the additional capital requirements. Tier 1 capital ratios have gradually increased since 2007 and are fairly strong, non-performing loans are subdued and net interest margins are rising (Chart 12). In fact, Tier 1 ratios are substantially higher in Australia than they were in the U.S. prior to the Global Financial Crisis. Return-on-assets and return-on-capital have bounced slightly, although increasing capital will certainly dampen the earnings prospects for the Australian banks. Chart 11Australian Banks Heavily Exposed##BR##To Risky Mortgage Lending Chart 12Aussie Banks In##BR##Good Shape Right Now... Since the Moody's downgrade, credit default swap spreads for Australian banks have actually declined to near the 2014 lows, suggesting markets are not concerned about the risk of future bank stresses. We remain concerned, however. Macro-prudential measures on mortgage loan sizes and higher capital requirements are certainly welcome and will reduce perceived risks within the banking sector. However, these measures have done little to curb the rise in Australian house prices. Given their huge exposure to Australian housing, the banks will likely not be able to withstand a meaningful decline in house values - the outlook for which depends critically on the RBA's future monetary policy path. Bottom Line: Australia bank metrics are fairly healthy but they will need to raise more capital. This should not be too problematic. However, the banks' massive exposure to Australian housing, elevated number of interest-only mortgage loans and heavy reliance on short-term wholesale funding present substantial risks. Even if the bank capital levels are 'unquestionably strong,' they will not be enough to withstand a meaningful downturn in house prices. When Will The Housing Bubble Burst? House prices in Australia have nearly quadrupled since 2000. With the exception of Perth, house prices in the other major cities have continued their massive run-up over the last year, suggesting macro-prudential measures have done little to cool the market (Chart 13). Price gains have been supported by robust demand, both domestic and foreign. However, the steady rise in debt-fueled speculation (i.e. loans for investment purposes), the magnitude of the price increases, and the lack of any correction in over 25 years, suggest Australian housing is indeed in the midst of a bubble. On the supply side, steadily rising completions over the past decade have not curbed price gains (Chart 14). While construction has slowed since its peak at the end of 2016 and building approvals have declined, we find the argument that there has been a shortage in supply to be fairly weak. In fact, the rate of dwelling completions has outpaced population growth since 2012 and dwelling completions per 1,000 people are much higher in Australia than its G7 counterparts. Chart 13...Just Don't Prick##BR##The Housing Bubble Chart 14Supply Not Rising Enough To##BR##Slow House Price Growth History teaches us that bubbles never deflate calmly. Nevertheless, we view the likelihood of a systemic crash over the next 6-12 months as highly unlikely. While growth estimates may not meet the RBA's lofty goals, Australia will also not experience its first recession in over 25 years, which would crimp housing demand. The two most likely candidates to act as a catalyst for a housing downturn are therefore: a slowdown in capital inflows from Chinese property buyers and/or a shift to restrictive monetary policy from the RBA. It will not require a complete halt in capital inflows from China, simply a considerable slowdown, for the Australian housing market to come under pressure. While there is always a possibility for Chinese authorities to clamp down on outflows, particularly if the RMB comes under pressure, we view this as fairly unlikely. Current capital outflows have eased a bit and a long-term goal is to deregulate the capital account. Continued capital liberalization in China will aid in maintaining capital flows into Australian housing. Additionally, the millionaire class in China is growing and the private sector wants to diversify its assets. While Australian house prices are expensive, prices are far more affordable than those metropolitan areas such as Hong Kong, indicating Chinese money will continue to drift into Australian real estate. Chart 15A Long Way From Restrictive Policy Rates The more likely candidate for a bursting of the housing bubble is through the monetary policy channel. In the case of the U.S., multiple Fed rate hikes in the mid-2000s pushed monetary conditions into restrictive territory, prompting the housing crash. As we previously argued, the RBA will likely stay on hold for an extended period due to a lack of serious inflation pressures. Yet even if the RBA were to begin tightening sooner than we expect, it will take multiple rate hikes before monetary conditions become even close to restrictive. Using a simple measure of the equilibrium RBA cash rate, like a combination of Australian potential GDP growth and a five-year moving average of headline CPI inflation or the Taylor Rule formulation that we introduced in a recent Weekly Report, it is clear that the RBA is a long way from a restrictive policy stance (Chart 15).5 Bottom Line: Australian house prices have nearly quadrupled since 2000 and exhibit the characteristics of a bubble. Still, it will likely take considerable monetary tightening before the bubble bursts. We do not think this will occur anytime soon. Investment Implications We currently hold a neutral recommended stance on Australian government debt, both in terms of duration exposure and country allocation in global fixed income portfolios. Australian bond yields are above the lows seen in 2016 but have yet to break out of the structural downtrend with the benchmark 10-year now at 2.67% (Chart 16). We hesitate to go outright overweight on Australian debt in our model bond portfolio, however, even with our relatively dovish view on the RBA's future policy moves. Without any slowing in house prices, and with realized and expected inflation having clearly bottomed after last year's downturn, a big move lower in Australian bond yields is unlikely. At best, Australian yields will not rise by as much as we expect to see in the U.S. or Euro Area over the next 6-12 months. At the same time, if that view pans out, the Australian currency will likely underperform which will erode into the returns of an overweight Australian bond position (either through currency hedging costs or the outright losses on unhedged currency exposure). We do, however, see an opportunity to enter into an Australian 2-year/10-year yield curve flattening position (Chart 17). As previously mentioned, the short end of the curve will be anchored by an inactive central bank. The long end, however, faces multiple downward pressures. Macro-prudential measures and political pressures will continue to dampen credit growth. While we believe there is scope for realized inflation to grind a bit higher in the coming quarters, longer-term inflation expectations are likely to remain well-anchored. Additionally, the economic surprise index is elevated after several positive data releases and has plenty of scope for disappointment, which will limit any rise in longer-dated bond yields. Chart 16No Bear Market##BR##In Australian Bonds Chart 17Enter A 2yr/10yr##BR##Australian Curve Flattener The added benefit of entering a curve flattener is that the trade will likely work if our RBA view turns out to be wrong in a hawkish direction. If the RBA does indeed begin to hike rates sooner than we expect to deal with an improving economy or to begin deflating the housing bubble, this should put flattening pressure on the curve as the market prices in additional future rate increases. Only in the case of a breakout in longer-term inflation expectations that bear-steepens the curve, or a severe economic downturn that prompts RBA rate cuts and bull-steepens the curve, will a flattening trade underperform. Given our views on Australian growth and inflation, we see more likely scenarios where the curve flattens than steepens, particularly versus the only modest amount of flattening currently priced in the forwards. Bottom Line: Enter into a 2-year/10-year Australian government bond yield curve flattener. The short end of the curve will be anchored by an inactive central bank. On the long end, slowing credit growth, fiscal drag and an elevated economic surprise index will put downward pressure on yields. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 http://www.rba.gov.au/monetary-policy/rba-board-minutes/2017/2017-07-04.html 2 The "underemployed" is defined as full-time workers on reduced hours for economic reasons and part-time workers who would like, and are available, to work more hours. 3 NAIRU = Non-Accelerating Inflation Rate Of Unemployment. 4 https://data.oecd.org/hha/household-debt.htm 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017. Available at gfis.bcaresearch.com.

Highlights The GOP's failure to repeal Obamacare could rev up the Republicans' motivation to move forward on tax cuts. Fed policymakers are taking financial stability seriously. Constructive conditions for consumer spending. Margin expansion continues in early Q2 earnings results. Feature Tax Cuts Still On The Table The Republicans' failure to pass their health care legislation is leading the markets to doubt the prospect for tax cuts. This may be premature but, contrary to conventional wisdom, it may actually increase the chances of tax cuts. Ironically, the inability to jettison Obamacare may turn out to be a blessing for President Trump and the Republican Party. According to the Congressional Budget Office, by 2026, 22 million fewer Americans would have health care if the legislation had been enacted compared with the status quo. The Senate bill also would have led to substantial cuts to Medicaid and deep reductions to insurance subsidies for poor and middle-class families, many of whom voted for Trump. 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. Implications For The Fed Expansionary fiscal policy next year would generate difficulties for the FOMC. The June CPI report underscored that inflation is not a problem for now. Nonetheless, we highlighted in last week's report that pipeline inflationary pressures are gradually building. The unemployment rate is already below the Fed's estimate of the full employment level. Chart 1Inside The Fed's Forecasts... Moreover, unemployment will continue to fall 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. 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 (Chart 1). The implication is that, unless real GDP growth slows, the unemployment rate is soon likely to reach lows not seen since 2000. The FOMC hawks would become even more worried that the Fed is taking too large a risk with inflation and financial stability (see below). Fiscal stimulus in 2018 would place the FOMC even further behind the curve. Policymakers would be forced to tighten aggressively to bump up the unemployment rate. The Fed would hope for a soft landing, but the more likely result is a recession in 2019. That said, it is too early for investors to position for a recession.1 Bonds rallied and the dollar weakened anew following the collapse of the Senate's healthcare bill on the view that hopes for fiscal stimulus are all but dead. We still believe that bond yields and the dollar have more upside potential, even in the absence of fresh fiscal stimulus. Last week's report2 highlighted that a global monetary policy recalibration is under way because central bankers have decided that "emergency" levels of monetary accommodation are no longer required. Moreover, the maximum level of policy divergence has not yet been reached between the Fed and other major central banks, which means that the dollar will have one last leg higher. The U.S. stock market has weathered the fiscal disappointment, seemingly moving out of sync with dollar and bond market action in the past several months. The equity market appears to have been given a "free pass" because earnings have been very supportive. The combination of robust earnings growth, steady real GDP growth near 2%, and low bond yields, all have been bullish for stocks. It will be tougher sledding when profit growth peaks. Fortunately, the earnings backdrop is still constructive at the moment (see below). A Third Mandate? Financial stability has become a third mandate for the Fed, and is one of the reasons the hawks want to keep tightening despite the fact that the FOMC has not yet met the inflation target. The topic has been mentioned by either Fed staff or FOMC members in 27 of the 39 meetings since September 2012. Fed Chair Yellen has elevated financial stability during her tenure, leading discussions or staff briefings in 19 of the 27 meetings she has presided over. The topic merited only passing mention in Fed deliberations prior to 2012. At the June meeting, Fed staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance.3 This assessment has not changed since the Fed began to offer opinions on the health of the financial system at its September 2013 meeting. However, the Fed does not provide a financial stability grade at every meeting. In December 2013, Fed staff described financial conditions as moderate, but its next judgment (also moderate) was only in January 2016. Since then, Fed staff has provided an assessment of financial stability in half of the 12 subsequent meetings. Another indication that Fed policymakers are paying particular attention to financial market risk is that the issue has become a key part of the Monetary Policy Report (MPR).4 Before the onset of the GFC, financial stability warranted only a few paragraphs in the MPR, but since 2013 the report has included a special section on the topic. Chart 2FOMC Closely Monitoring Financial Stability The four primary areas that the Fed monitors to assess financial stability are: Vulnerabilities stemming from maturity and liquidity transformation in the financial sector (Chart 2, panel 1); Valuation pressures across a range of assets, including Treasury securities, equities, corporate bonds and commercial real estate (panel 2); Leverage in the household and business sectors (panel 5); and Regulatory burden (not shown). Some FOMC members are worried that if rates are not normalized soon, then valuation will become even more stretched in bond and equity markets, which could potentially lead to financial stability issues. This is a reason why a few of the central bankers want to hike rates even though inflation is still too low. This group believes it is better to tighten slowly, rather than wait and raises rates sharply in the future when financial valuations may be even more stretched. Nonetheless, others at the Fed are concerned that higher rates may trigger an equity correction, which if significant enough, would spark a slowdown in the U.S. economy via the wealth channel. In this case, greater financial instability would push the Fed to pause its rate hike regime prematurely. We intend to return to this scenario in a future Weekly Report. The monetary authority is also concerned by negative term premiums in the bond market. We expect only minimal impact on Treasury bond yields linked to the reduction in the Fed's balance sheet.5 That said, a big sell-off in bond prices that leads to a sudden correction in equity prices or a widening of credit spreads would tighten financial conditions, impact the real economy and prompt the Fed to rethink its path for the fed funds rate and its balance sheet. Bottom Line: The conditions that foster financial stability matter to the central bank almost as much as maintaining low and stable inflation, and full employment. The doves want to see inflation rise closer to the 2% target before tightening even more. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excess risk-taking in the financial markets. Conditions Still Favor The Consumer June's reading on retail sales released in mid-July was disappointing, but the conditions that cultivated increased consumer spending are still in place. Core retail sales dipped by 0.1% month-over-month in June, and both the 3-month and 12-month rates of change have been on a downward trajectory since the start of the year (Chart 3, panel 1). Moreover, auto sales have stagnated near all-time highs in recent months, adding to the market's consumer concerns (panel 2). The only positive is that consumer spending looks better in real terms because inflation has moderated (panel 3). Nominal retail sales have softened, but inflation-adjusted spending is what feeds into the construction of GDP. Even so, conditions are in place for a rebound in spending in the coming months. Consumer confidence readings are still near cycle peaks; home values are elevated and rising; household net worth is at an all-time high and expanding rapidly, financial conditions are easy, and accelerating income growth is supported by the tightening labor market. When these economic circumstances prevailed in the past, consumer spending almost always sped up (Chart 4). Chart 3Soft Patch In Retail Sales##BR##And Inflation Continues Chart 4Conditions Conducive For##BR##Consumer Spending Bottom Line: The soft patch in consumer spending is lingering longer than expected, which challenges our view that U.S. economic growth will be stronger in the second half of the year relative to the first half average. Nevertheless, we anticipate that GDP growth will permit economic output to hit the Fed's low target for the year and keep the monetary authority on track to tighten policy at a faster pace than is discounted in the bond market. The resulting bond sell-off will not derail the equity bull run as long as profits remain supportive. Q2 Earnings Update: Margin Expansion Continues Chart 5Positive Earnings Surprises Continue The Q2 earnings reporting season is off to a strong start, with both EPS and sales running well ahead of consensus expectations as forecasted in our July 3 preview. Moreover, the counter trend rally in profit margins is still in place. Just under 20% of companies have reported results so far with 74% of companies beating consensus EPS projections, right at the long-term average of 70% (Chart 5). In addition, 74% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 5% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the initial results imply that Q2 will see another quarter of margin expansion. Average earnings growth (Q2 2017 versus Q2 2016) is strong at 9% with revenue growth at 5%. The BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 6). Measured on this basis, S&P 500 EPS growth so far in Q2 is 18%, compared with 12% in Q1. The strength in earnings and revenue is broad based (Table 1). Earnings per share are up in Q2 2017 versus Q2 2016 in 10 of 11 sectors; the lone exception is the utilities sector. EPS results are particularly strong in energy, technology and financials. Energy revenues surged by 15% in Q2 versus a year ago. Sales gains in technology (7%), materials (6%), utilities (5%), and real estate (5%), are notable. The upward trajectory of EPS estimates for 2017 and 2018 (Chart 7) since the start of 2017 is encouraging. We will provide an update on the Q2 earnings season in the August 7 Weekly Report. Chart 6Strong EPS##BR##Growth Ahead Table 1S&P 500:##BR##Q2 2017 Results* Chart 7Estimates For '17 & '18 Have Moved##BR##Higher Since Start Of The Year Bottom Line: EPS growth will continue to accelerate through the end of 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth. The elevated level of ISM sets the stage for EPS growth to gather speed in the second half of 2017. Firm readings on ISM are an indication that our bullish profit story for 2017 is still intact. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report "Waiting For The Turn", dated June 26, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report "Global Monetary Policy Recalibration", dated July 17, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/fomcminutes20170614.htm 4 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 5 Please see BCA's U.S. Bond Strategy Weekly Report "Two Challenges For U.S. Policymakers", dated May 23, 2017. Available at usbs.bcaresearch.com.

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 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 Chart 2Financial Conditions Have Eased Chart 3Credit 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 Chart 5A Stronger Labor Market Will Lead To Faster Wage Growth Chart 6Real 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 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 Chart 9Housing 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... Chart 11... 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. Chart 13Euro 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 Chart 15Long 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 Chart 17The 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 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 China's strong second-quarter growth numbers released early this week confirmed the synchronized global growth upturn within the major economies. Our model is predicting an imminent increase in the PBoC's benchmark lending rate. Higher rates in China are reflective rather than restrictive. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. The latest MFWC pledges "re-regulation" of the financial industry and remains committed to developing capital markets. Increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space. Feature The Bank of Canada hiked its policy rate by 25 basis points last week, the second major central bank to tighten after the Federal Reserve in the current cycle. While it is unclear whether central bankers maintain secret communication channels, effectively there appears to be a "coordinated recalibration" of monetary policies among major central banks, due largely to a synchronized growth upturn within the major economies. China's strong second-quarter growth numbers released early this week fit with this broad theme. There are rising odds that the People's Bank of China (PBoC) will join the proverbial global party with rate hikes. In addition, the Chinese authorities have pledged a tougher stance on the financial industry. Reflective Or Restrictive? China's latest data have shown across-the-board strength of late. Most indicators have surprised to the upside, rectifying our positive assessment.1 With the latest growth numbers, our model is predicting an imminent increase in the PBoC's benchmark lending rate (Chart 1). The model follows a modified version of "Taylor's Rule," in which external factors are also considered for open economies. In China's case, both improvement in growth and the Fed's interest rate hikes have played a strong role in setting the stage for higher policy rates in China. The model currently predicts 50 to 75 basis points in rate hikes by the PBoC. Historically, our interest rate model has done a reasonably good job in capturing the major turning points in China's policy rate cycles. This time around, the country's interest rate reforms may have complicated the model's predicting power. In short, the PBoC is in the process of diminishing the importance of the benchmark lending rate, while promoting market-based interest rates. The central bank has theoretically fully liberalized commercial bank interest rates since 2015, and therefore it is unclear whether it will abandon benchmark policy rates, which is viewed as an outdated tool. Instead, the PBoC has been trying to build an interest rate "corridor" in which it uses monetary and liquidity measures to guide market interest rates. The upper band of the interest rate corridor appears to be the interest rates of the PBoC's lending facilities - the cost for financial institutions to borrow from the central bank - while the lower band is the interest rate the PBoC pays on commercial banks' excess reserves (Chart 2). In this vein, the 6-month Medium Term Lending Facilities (MLF) interest rate has already been raised by 20 basis points since late last year, and interbank rates have been guided higher. Chart 1Rising Odds Of PBoC Rate Hikes Chart 2Interest Rate Corridor' ##br##Has Been Lifted Higher Chart 3Bank Loan Rate Is On The Rise Nonetheless, the upturn in our interest rate model justifies higher rates engineered by the PBoC. Regardless of whether the PBoC explicitly raises its policy lending rate, interest rates in China have already moved higher (Chart 3). Tighter liquidity and higher bond yields since late 2016 suggest that average bank lending rates should have increased by probably 50 basis points in recent months. Higher rates in China are a reflection of stronger growth rather than policy tightening to tame business activity, at least for now. After all, China's nominal GDP growth has rebounded from 6.4% in late 2015 to 11.1% in the second quarter of 2017 - a sharp turnaround in nominal business activity that calls for higher interest rates. Similarly, recent hawkish - or less dovish - rhetoric from other central banks all reflect improving growth where "emergency" levels of monetary accommodation are no longer needed (Chart 4). With the exception of Japan, BCA Central Bank Monitors, which measure pressure on central bankers to raise or reduce interest rates, have mostly climbed above zero of late, underscoring the need for tighter money among most developed countries. By the same token, it is premature to conclude that any policy tightening by the PBoC will lead to major growth problems in China. Chart 4Emergency' Levels Of Accommodation No Longer Needed Where does the RMB fit in? The PBoC's tightening bias suggests there is less incentive to target a lower exchange rate, both against the dollar and in trade-weighted terms. The central bank will continue to intervene to smooth out volatility. From investors' perspectives, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction: we doubt there is meaningful upside in the RMB against the dollar in the near term, but the odds of significant RMB/USD depreciation have been further reduced. In other words, the RMB/USD exchange rate is still largely dominated by broader dollar performance, and the RMB is not a "high beta" currency to play the dollar. In short, we maintain our positive view on China's growth outlook, as discussed in greater detail in last week's bulletin. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. Financial Reforms And Markets As growth has mostly surprised to the upside, policymakers' focus appears to have shifted to controlling financial risks, as highlighted by the key messages from the 5th National Financial Work Conference (NFWC) this past weekend. The NFWC convenes twice a decade, and usually sets the policy tone for the following years. Compared with the previous meeting five years ago that featured "deepening reforms and promoting development" as the key theme of the financial industry, the current session clearly strikes a more conservative tone. Top leadership declared that the financial sector must serve the needs of the "real economy," and that preventing systemic financial risks is the government's "eternal theme." Importantly, a cabinet level committee has been established to coordinate regulatory oversight on the financial industry - a task currently shared between the central bank and three regulators. The overall message from the latest NFWC is consistent with the regulatory crackdown on financial excesses since late last year.2 Overall, we share policymakers' sentiment that China's financial sector deregulation in recent years has gone too far.3 The dramatic leverage-fueled equity market boom-bust cycle in 2015 offered a crude awakening to the authorities against imprudent financial deregulation. Meanwhile, reform measures also ushered in a proliferation of institutions that prolonged financial intermediation channels. Without proper regulatory coordination, the authorities' attempts to reduce excesses has typically pushed speculative activity off the books of financial institutions, making it even more difficult to monitor and regulate. In fact, regulations on the financial sector have already been tightened of late. Derivatives, internet-based financing firms and asset-backed securities have all been put under much tighter regulatory scrutiny. The macro-prudential assessment (MPA) on financial institutions has been adopted since earlier this year - the latest MFWC suggests that "re-regulation" of the financial industry will continue in the coming years. The long-term impact of tighter control over the financial sector on the economy and financial markets remains to be seen. On one hand, imprudent financial deregulation and prolonged financial intermediation channels have done little to address the financing needs of small private enterprises, but have amplified risks and raised funding costs for the overall corporate sector - a suboptimal outcome that needs to be corrected. On the other hand, China's vast domestic savings need to be properly intermediated to the economy. We have long held the view that so long as the banking sector and debt instruments play the dominant role in financial intermediation, the accumulation of debt in the overall economy is all but inevitable.4 In this vein, any attempt to block financial intermediation aimed at "deleveraging" will prove both ineffective and counterproductive, with unintended consequences. An easier bet is that the authorities will remain committed to developing capital markets, both equities and corporate bonds, to provide alternative funding sources for the corporate sector. Procedures for initial public offerings (IPOs) and debt issuances will be simplified. The share of debt and equities in total social financing will continue to grow from a structural point of view (Chart 5). From investors' perspective, increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space, where multiples are unsustainably high and will continue to be de-rated (Chart 6). There are certainly some compelling growth stories among small caps that are worth cherry-picking, but overall investors should remain cautious for this asset class. Chart 5Debt And Equity Issuance##br## On A Structural Uptrend Chart 6Domestic Small Caps##br## Will Continue To Derate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China Outlook: A Mid-Year Revisit," dated July 13, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Legacies Of 2015," dated December 16, 2015, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate Sweden's Riksbank. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar. Bond investors should underweight Swedish government bonds versus a European or global benchmark, currency hedged. Equity investors should remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. The risk of persistent inflation will rise only after the next severe global downturn. Feature "Is the 2% inflation target still a very realistic aim?" - Ewald Nowotny, ECB Governing Council member As the ECB Governing Council gathers for its latest monetary policy meeting, some voices within its ranks are starting to question the ECB's first commandment: the 2% inflation target. Respected and influential ECB Governing Council member, Ewald Nowotny, has asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." Across the Baltic Sea, Sweden's Riksbank is one step ahead. Recently, it suggested (re)introducing a variation band of 1% either side of the 2% inflation target1 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve (Chart of the Week). More concerning, the single-minded pursuit of 2% inflation creates risks and instabilities. The Riksbank's inflation target has forced it into an absurd position: with inflation undershooting for over five years, the policy interest rate is now at -0.5% when Swedish GDP growth was recently running at a world-beating 4.5% clip (Chart I-2). Chart I-1Mission Impossible:##br## 2% Inflation Chart I-2Absurd: Interest Rate At -0.5% ##br##When Growth Is At 4.5% Hence, Riksbank Governor, Stefan Ingves, recently proposed that "central banks should also have the explicit responsibility for financial stability." The former governor of the Bank of Japan, Masaaki Shirkawa agrees. "My worry with setting a precise number (of 2%) is that it can crowd out other very important considerations, such as financial stability." What's So Special About 2% Inflation Anyway? Given the almost religious significance of the 2% inflation target for central banks, you would think that there is a well-established theoretical and empirical basis both for inflation targeting and for the 2% number. But you would be wrong. As we explained two years ago in our special report Mission Impossible: 2% Inflation,2 inflation targeting only became established in the 1990s, and the magic 2% number was pulled out of the air. Chart I-3The Riksbank Has Undershot ##br##Its 2% Inflation Target For 5 Years At the Federal Reserve's July 1996 policy meeting, Chairman Alan Greenspan argued that if the aim of inflation targeting was a truly stable price level, it entailed an inflation target of 0-1% (because measured inflation slightly overstates true inflation.) But one of the persons present was not so sure. The dissenter was a Fed governor called Janet L. Yellen. She countered that if inflation ended up at 0-1%, the zero-bound of interest rates would prevent "real interest rates becoming negative on the rare occasions when required to counter a recession." Yellen's pragmatism won the day, and Greenspan summarized "we have now all agreed on 2%" Meanwhile in Europe, the ECB's original inflation target of below 2% was close to Greenspan's proposal of 0-1%. But in 2003 the ECB changed its inflation target to its current "below but close to 2%". The reason, according to Mario Draghi: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%." Hence, the Fed, ECB and other central banks are targeting inflation at a low but arbitrary number, 2%, to always allow some leeway for negative real rates; and in the case of the ECB, to allow easier convergence among disparate euro area economies. But as the Riksbank and other central banks have now acknowledged, trying to hit and hold inflation at a point target of 2% is both futile and dangerous (Chart I-3). Why 2% Inflation Is A Mission Impossible The crux of the issue is that inflation is a notoriously non-linear phenomenon. A defining feature of a non-linear phenomenon is that you cannot just turn it up or down like the volume dial on your music system. Non-linear phenomena experience sudden and violent phase-shifts from stability to instability, making it very difficult to hit and hold a point target like 2%. To experience this difficulty for yourself, try pulling a brick across a table using an elastic band. Initially, the brick doesn't move because of the friction with the table. But at a tipping point the brick does move, and the friction simultaneously decreases, self-reinforcing the brick's acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability - the brick doesn't move - to violent instability - the brick hits you in the face! Try as hard as you might, it is near-impossible to pull the brick across the table at a constant speed of, say, 2mph. A very similar dynamic applies to inflation. The system suddenly phase-shifts from stability - near-zero inflation - to violent instability. It is near-impossible to keep inflation at an arbitrary constant of, say, 2%. To understand why, consider the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. Theoretically and empirically, both M and V are notoriously non-linear phenomena (Chart I-4, Chart I-5, Chart I-6, Chart I-7) - because they are subject to the same conditions as the brick pulled by an elastic band: inertia, then self-reinforcement with delayed controlling feedback. Chart I-4The Velocity Of Money... Chart I-5...Is A Non-Linear Phenomenon Chart I-6The Money Multiplier... Chart I-7...Is A Non-Linear Phenomenon As policymakers try to take inflation away from its natural state of near-zero, nothing happens at first. But at a tipping point, the self-reinforcement of inflation expectations becomes explosive. Whereupon, the money supply, M, gaps up because it becomes rational for banks to lend as much as possible. And its velocity, V, also gaps up because it becomes rational to spend the money - both newly created and pre-existing balances - as quickly as possible. Hence, the product MV experiences an even sharper non-linearity. Well-intentioned policymakers would think they could apply a controlling feedback to MV. But how? Economic and monetary data are noisy, imprecise and take time to collect and parse. As we have shown, inappropriate and/or delayed feedback just adds to the system's instability. Seen in this light, inflation-targeting in the 1990s worked because central banks were just helping economies move from an unnatural state - uncontrolled inflation - towards a natural state - price stability (Table I-1 and Chart I-8). But now that economies have reached a natural near-zero inflation rate, point targeting an unnatural inflation rate is both futile and dangerous. Table I-1For 700 Years U.K. Inflation ##br##Averaged Near-Zero Chart I-8Excluding Wars, Persistent Inflation Was ##br##Very Unusual... Until The Late 20th Century The Investment Implications The ECB's Nowotny argues that "the 2% inflation target should include a certain flexibility." The Riksbank's Ingves agrees, and adds that extreme and unprecedented loose monetary policy endangers financial stability. Central banks tend not to volte-face as it damages their credibility. But to us, it is clear that the ECB and Riksbank are switching their focus from sub-2% inflation to their economies' robust growth. And to the risk that ultra-accommodative policy poses to financial stability and market distortion. Hence, the era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate the Riksbank whose policy has inevitably mirrored Frankfurt - for fear of a sharp appreciation of the Swedish krone versus the euro. Our currency mantra this year has been "euro first, pound second, dollar third." The strategy has performed extremely well, and into this mix we can add the Swedish krone. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar (Chart I-9). Chart I-9Long SEK/USD Is An Alternative ##br##To Long EUR/USD Chart I-10Underweight Swedish Bonds Is An Alternative To Underweight German Bunds The bond market corollary is to underweight Swedish government bonds - just like German bunds - versus a European or global benchmark, currency hedged (Chart I-10). The equity market implication is to remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. Finally, given that inflation could ultimately phase-shift to violent instability, when should we worry about it? Not yet. To expand the broad money supply, someone has to borrow money. So if policymakers really want to create rampant inflation, the government has to borrow and spend money at will,3 with the central bank creating it. In other words, the central bank loses its independence and fiscal policy becomes irresponsibly loose. The risk of this remains low until the next severe downturn - when policymakers may be forced into desperate measures for a desperate situation. Until then, own some bonds. Our preference is Spanish Bonos and U.S. T-bonds. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 2 Published on August 20, 2015 and available at eis.bcaresearch.com. 3 For example, by giving all public sector workers a 50% pay rise! Fractal Trading Model* The sell-off in Spanish media (Mediaset Espana Comunicacion) is technically overdone. This week's trade is to go long Mediaset Espana Comunicacion versus the market with a 5% profit-target and symmetric stop-loss. In other trades, long FTSE100/short IBEX35 hit its 4% profit-target, while short EUR/USD hit its 2% stop-loss For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Monetary Policy: The Fed is still on track to start winding down its balance sheet in September, and will lift rates again in December if inflation starts to move higher. If the Fed continues to lift rates in the face of low inflation, then the real fed funds could soon overtake its estimated neutral level. TIPS: We attribute this year's decline in breakevens to the combination of disappointing realized inflation and the fact that they had appeared too wide on our TIPS Financial Model. Inflation: Core inflation disappointed once again in June. The pass-through from a depreciating dollar and accelerating wages should cause this weakness to reverse in the months ahead. Feature Chart 1Bond Bear Takes A Pause Globally, a shift toward less accommodative monetary policy remains the dominant market theme. However, the U.S. bond selloff did pause last week following some disappointing macro data and comments from Fed policymakers that were interpreted as dovish. The market is now discounting 30 bps of rate hikes during the next 12 months, down slightly from the recent peak of 36 bps (Chart 1). The dovish comments came from Governor Lael Brainard in a July 11 speech1 and were echoed one day later by Fed Chair Janet Yellen in her semi-annual testimony to Congress.2 Both comments related to the stance of monetary policy in relation to its neutral (or equilibrium) level. In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term. If that is the case, we would not have much more additional work to do on moving to a neutral stance. - Fed Governor Lael Brainard Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance. - Fed Chair Janet Yellen Contextualizing "Neutral" Contrary to how many have interpreted the above remarks, neither Chair Yellen nor Governor Brainard meant to suggest that the rate hike cycle is close to finished. In fact, Yellen went on to say in her testimony that: ...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... This is the first important piece of context needed to understand how the Fed views the neutral rate. The Fed views the neutral rate as variable, and sees it increasing over time. This becomes clear when we look at the Fed's Summary of Economic Projections and note that 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. Second, the Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart 2 shows this estimate of the neutral rate alongside the real federal funds rate - deflated using 12-month trailing core PCE. We observe that the real fed funds rate has risen sharply during the past seven months, in part because the Fed lifted rates three times but also because inflation weakened. Chart 2Real Fed Funds Rate Getting Closer To Neutral We calculate that if the Fed lifts rates once more this year and core inflation stays flat, then the real fed funds rate would end 2017 at 0.02%, 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. In sum, the LW neutral rate is a useful tool for assessing the path of Fed policy. If the real fed funds rate gets too close to neutral, then the Fed will probably need to see inflation rise before it delivers another hike. This would appear to be the situation we are in at the moment. We continue to expect that the Fed will start to unwind its balance sheet in September, but will need to see some signs that core inflation is increasing before lifting rates again. Our forecast still calls for higher core inflation during the next few months and another Fed rate hike in December (see section titled "Inflation: Chalk Up Another Bad Month" below). A related issue is why the Fed thinks the neutral rate will rise during the next few years. In arguments that date back to Ben Bernanke's tenure,4 the Fed maintains that headwinds related to household deleveraging and balance sheet repair have depressed the neutral rate since the Great Recession and financial crisis. There is some evidence to support this stance. The LW neutral rate correlates quite strongly with the growth rate of household debt (Chart 3). Although the neutral rate hasn't kept pace so far this cycle, household debt is growing off an unusually low base (Chart 3, bottom panel) and that may mean it takes longer for the neutral rate to rise. There is one final important application for the neutral fed funds rate, and it relates to the timing of the corporate credit cycle (Chart 4). Typically, excess returns to corporate bonds do not start to decline until the following three criteria are met: Chart 3Household Leverage And The Neutral Rate Chart 4Neutral Rate Important For Credit Cycle Deteriorating corporate balance sheet health (Chart 4, panel 2) Restrictive monetary policy i.e. the fed funds rate above its neutral level (Chart 4, panel 3) Tightening bank lending standards (Chart 4, bottom panel) Notice that in the prior two cycles the real fed funds rate actually rose above the LW neutral level before our Corporate Health Monitor started to signal deteriorating corporate health. In contrast, corporate balance sheets have already aggressively added leverage this cycle and accommodative policy is the sole support for spreads. In this environment, we view inflation and the stance of Fed policy as the most important factors determining the medium term outlook for corporate bond returns.5 Policy Wildcard: A New Fed Chair In 2018 One potential wrinkle in our outlook for monetary policy is that Janet Yellen's term as Fed Chair will end in February 2018. If history is any guide, we should expect to learn the identity of the new Fed Chair sometime this fall. While we would not completely rule out the possibility that Janet Yellen is re-appointed, recently, the chatter is that Gary Cohn, the Chairman of President Trump's National Economic Committee, is the frontrunner for the position (see Box). Box 1: Fed Chairs Since 1970 Gary Cohn does not have any experience as a central banker, but that does not preclude him from holding the position. Since the late 1970s, Presidents have tended to select the Fed Chair based on their trust relationship with a candidate (Table 1). Table 1Characteristics Of Fed Chairs Since 1970 Arthur Burns (Chair from 1970 - 1978) was head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to President Nixon. William Miller (1978 - 1979) worked for the presidential campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987 - 2006) served as the Chair of Ronald Reagan's Social Security Commission in the early 1980s, was the Chair of President Ford's CEA and advised President Nixon's campaign in 1968. Ben Bernanke (2006-2014) was George W. Bush's chief economist in 2005 and 2006 before Bush chose him to lead the Fed. Janet Yellen (2014 - present) was Chair of Bill Clinton's CEA in the late 1990s, when she worked with many of Obama's economic team. Paul Volcker (1979 - 1987) was the lone exception to this rule, he worked for Nixon, but not Carter, before becoming Fed Chair. Volcker, Bernanke and Yellen, all held posts in the Federal Reserve System before their appointments as Chair. However, Miller was an outside director for the Boston Fed, and Burns and Greenspan had no prior experience at the monetary authority. Party identification is one area where Gary Cohn would stand out. Since at least 1970, the party affiliation of a new Fed Chair has matched that of the President. However, Presidents have crossed party lines to reappoint sitting Fed Chairmen to additional terms. Volcker, Greenspan and Bernanke were all reappointed to lead the Fed by Presidents from opposing political parties. Chart 5Yellen Vs. Summers Drove Markets In 2013 To see how the timing of the Fed Chair appointment can matter for markets in the short-term, we need only look back to the autumn of 2013 when two candidates - Larry Summers and Janet Yellen - were in the running for the position. Rightly or wrongly, Summers was viewed as the more hawkish candidate and once 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 expectation of a more dovish Fed (Chart 5). Bottom Line: The Fed is still on track to start winding down its balance sheet in September, and will lift rates again in December if inflation starts to move higher. If the Fed continues to lift rates in the face of low inflation, then the real fed funds could soon overtake its estimated neutral level. What's Driving The TIPS Breakeven Rate? We maintain an overweight position in TIPS relative to nominal Treasury securities on the view that long-maturity TIPS breakeven inflation rates will eventually settle into a range between 2.4% and 2.5%, once core inflation gets back to the Fed's 2% target. At the time of publication the 10-year TIPS breakeven inflation rate was 1.76%. In that sense, we view the medium to longer-run driver of TIPS breakevens as the path of inflation itself. However, we also acknowledge that breakevens are highly correlated with other financial asset prices, which can explain many of the near-term moves (Chart 6). In fact, our TIPS Financial Model - a model of the 10-year TIPS breakeven rate based on the oil price, the dollar and the stock-to-bond total return ratio - was flagging that breakevens were far too wide earlier this year (Chart 6, panel 1). Through this lens, the year-to-date decline in breakevens can be attributed simply to overvaluation being wrung out of the market. Digging a little deeper into the model, we find that breakevens have maintained their strong positive correlation with energy prices this year (Chart 6, panel 2), while non-energy commodity prices exhibit a weaker positive correlation (Chart 6, panel 3). Interestingly, the negative correlation between breakevens and the trade-weighted dollar has broken down during the past year (Chart 6, bottom panel). If dollar weakness persists, we would eventually expect it to translate into higher realized inflation - via higher import prices - and also wider breakevens. Other pipeline inflation measures, which tend to correlate with breakevens, are sending mixed signals. Core PPI inflation for intermediate goods remains elevated (Chart 7, panel 2), while the supplier deliveries component of the ISM manufacturing survey is trending higher (Chart 7, panel 3). The prices paid component of the ISM manufacturing survey has followed breakevens lower (Chart 7, bottom panel). Chart 6TIPS Breakevens: Financial Drivers Chart 7TIPS Breakevens: Pipeline Inflation Drivers Bottom Line: We attribute this year's decline in breakevens to the combination of weak realized inflation data (Chart 7, panel 1) and the fact that they had appeared too wide on our Financial Model. Going forward, we expect TIPS breakevens to increase as the realized inflation data bounce back. Inflation: Chalk Up Another Bad Month Core CPI increased just 0.12% month-over-month in June, marking the fourth consecutive downside surprise. The year-over-year growth rate also moderated from 1.74% to 1.71%, and the weakness was once again broad based across the four major components (Chart 8). The cost of shelter continues to decelerate from a high level, and our model - based largely on the rental vacancy rate - forecasts further moderation in the months ahead (Chart 8, panel 1). Core goods prices continue to deflate, though dollar weakness should filter through to higher core goods prices in the coming months (Chart 8, panel 2). In last week's report we showed that non-oil import prices have already moved higher in response to the weaker exchange rate.6 The big drag on inflation in recent months has been the failure of core services inflation (excluding shelter and medical care) to respond to rising wage pressures. The third panel of Chart 8 shows that core services inflation (excluding shelter and medical care) correlates strongly with the employment cost index. Further, the employment cost index itself has been accelerating since 2010 alongside improvement in the prime-age employment-to-population ratio (Chart 9). Chart 8Core CPI Components Chart 9Wages Will Grow As Labor Market Heals We expect wages will continue to accelerate as the labor market remains on a steadily improving path. Eventually this will bleed into core services inflation, as it has in the past. In the near term, the employment cost index for the second quarter will be a crucial input for the direction of both inflation and monetary policy. It will be released on July 28. Bottom Line: Core inflation disappointed once again in June. The pass-through from a depreciating dollar and accelerating wages should cause this weakness to reverse in the months ahead. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20170711a.htm 2 https://www.federalreserve.gov/newsevents/testimony/yellen20170712a.htm 3 Laubach, Thomas, and John C. Williams. 2003. "Measuring the Natural Rate of Interest," Review of Economics and Statistics, 85(4), November, 1063-1070. 4 https://www.federalreserve.gov/newsevents/speech/bernanke20121120a.htm 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification