Trade

Highlights The 2018 outlook for both economic growth and corporate profits remains constructive for risk assets, although evidence is gathering that global growth is peaking. Some measures of global activity related to capital spending have softened in recent months. Nonetheless, the G3 aggregate for capital goods orders remains in an uptrend, suggesting that it is too soon to call an end in the mini capital spending boom. Our global leading indicators are not heralding any major economic slowdown. The dip in early 2018 in the Global ZEW index likely reflected uncertainty over protectionist trade action. Economic growth in the major countries outside of the U.S. may have peaked, but will remain robust at least through this year. The potential for a trade war is a key risk facing investors. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy. That said, there are hopeful signs that the latest trade skirmish will not degenerate into a full-blown trade war and thereby cause lasting damage to risk assets. Stay overweight equities and corporate bonds. President Trump will announce on May 19 whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Stay long oil and related investments. The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated. EPS growth is peaking in Europe and Japan, but has a bit more upside in the U.S. later this year. Cross-country equity allocation is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. Rising U.S. corporate leverage is not an issue now, but could intensify the next downturn as ratings are slashed, defaults rise and banks tighten lending standards. The bond bear market remains intact, although the consolidation phase has further to run. By Q1 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below NAIRU. Policymakers will then try to nudge up the unemployment rate, but the odds of avoiding a recession are very low. Feature Investors are right to be concerned following the March 23 U.S. announcement of tariffs on about $50 billion of Chinese imports. The President is low in the polls and needs a victory of some sort heading into midterm elections. Getting tough on trade plays well with voters, and the President faces few constraints from Congress on this issue. Trump wants a raft of items from China, including opening up to foreign investment and a crackdown on intellectual theft. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy.1 That said, we do not expect the latest trade skirmish to degenerate into a full-blown trade war. First, China has already signaled it wants to avoid significant escalation. Beijing has offered several concessions, and its threat of retaliatory trade action has been measured so far. On the U.S. side, the fact that the Administration has decided to bring its case against China to the World Trade Organization (WTO) shows that the Americans are willing to proceed through the normal trade-dispute channels. The bottom line is that, while we cannot rule out escalating trade action that causes meaningful damage to the equity market, it is more likely that the current round of tensions will be limited to brief flare-ups. Investors should monitor the extent of European involvement. If Europe joins the U.S. effort to force China to change its trade practices via the WTO, then China will have little choice but to give in without a major fight. In terms of other geopolitical risks, North Korea should move to the back burner for a while now that the regime has agreed to negotiations. Of greater near-term significance is May 19, when Trump will announce whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Oil prices would benefit if the May deadline for issuing waivers on Iran sanctions passes. Trade penalties against Iran would reduce its oil production and exports. The U.S. is also considering sanctions on Venezuela's oil industry. Moreover, Russia and Saudi Arabia are reportedly considering a deal to greatly extend their alliance to curb oil supply. While there are downside risks as well, our base case outlook sees the price of Brent reaching US$74 before year end. Global Growth: Some Mixed Signs Also facing investors this year is the risk that the recent softening in the economic data morphs into a serious growth scare. The 2018 outlook for both the economy and corporate profits remains constructive in our view, but evidence is gathering that global growth is peaking. Investors may begin to question recent upward revisions to the growth outlook for this year and next. Industrial production has softened and the manufacturing PMI has shifted lower in most of the advanced economies (Chart I-1). Bad weather in North America and Europe in early 2018 may be partly to blame, but Korean exports, a leading indicator for the global business cycle, have also softened. The Chinese economy is decelerating and we believe the growth risks are underappreciated. President Xi has cemented his power base and there has been a shift toward accelerated reform. Chinese leaders recognize that leverage in the system is a problem, and the regime is tightening policy on a multi-pronged basis. Structural reforms are positive for long-term growth, but are negative in the short term. The tightening in financial conditions is already evident in the Chinese PMI and the sharp deceleration in the Li Keqiang index (although the latest reading shows an uptick; not shown). A hard landing is not our base case, but the risks are to the downside because the authorities will err on the side of tight policy and low growth. It is also disconcerting that some of our measures of global activity related to capital spending have softened in recent months, including capital goods imports and industrial production of capital goods (Chart I-2). Nonetheless, the fact that the G3 aggregate for capital goods orders remains in an uptrend suggests that it is too soon to call an end in the mini capital spending boom. Consumer and business confidence continues to firm in the major economies. Chart I-1Some Signs Of A Peak In Global Growth Some Signs Of A Peak In Global Growth Some Signs Of A Peak In Global Growth Chart I-2A Soft Spot For Capital Spending A Soft Spot For Capital Spending A Soft Spot For Capital Spending Our global leading indicators are not heralding any major economic slowdown (Chart I-3). BCA's Global LEI remains in an uptrend and its diffusion index is above the 50 line. In contrast, the global measure of the ZEW investor sentiment index plunged in March. We attribute the decline to the announcement of steel and aluminum tariffs and the subsequent market swoon, suggesting that the ZEW pullback will prove to be temporary. Turning to the U.S., retail sales disappointed in January and February, especially considering that taxpayers just received a sizable tax cut. Nonetheless, this probably reflects lagged effects and weather distortions. Our U.S. consumer spending indicator continues to strengthen as all of the components remain constructive outside of auto sales. Household balance sheets are the best that they have been since 2007; net worth is soaring and the aggregate debt-to-income ratio is close to the lowest level since the turn of the century (Chart I-4). Given robust employment growth and the tightest labor market in decades, there is little to hold U.S. consumer spending back. We expect that the tax cut effect on retail sales will be revealed in the coming months, helping to sustain the healthy backdrop for corporate profits. Chart I-3Global Leading Indicators Mostly Positive Global Leading Indicators Mostly Positive Global Leading Indicators Mostly Positive Chart I-4U.S. Consumers In Good Shape U.S. Consumers In Good Shape U.S. Consumers In Good Shape Global Margins Still Rising The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated (Chart I-5). Earnings-per-share surged in the early months of the year in both the U.S. and Japan, although they languished in the Eurozone according to IBES data (local currencies; not shown). Relative equity returns in local currency tend to follow relative shifts in 12-month forward EPS expectations over long periods, and bottom-up analysts have lifted their U.S. earnings figures in light of the fiscal stimulus (Chart I-6). Chart I-5Global Margins Still Rising Global Margins Still Rising Global Margins Still Rising Chart I-6EPS And Relative Equity Returns EPS And Relative Equity Returns EPS And Relative Equity Returns The key question is: can the U.S. market outperform again in 2018 now that the tax cuts have largely been priced in? One can make a compelling case either way. Growth: Global growth will remain robust for at least the next year, and the Eurozone and Japanese markets are more geared to global growth than is the U.S. However, the impressive fiscal stimulus in the pipeline means that economic growth momentum is likely to swing back toward the U.S. this year. GDP growth in Europe and Japan will remain above-trend, but it has probably peaked for the cycle in both economies. Valuation: Our composite measure of valuation suggests that Europe and Japan are on the cheap side relative to the U.S. based on our aggregate valuation indicator, which takes into consideration a wide variety of yardsticks (Chart I-7). That said, one of the reasons why European stocks are on the cheap side at the moment is that export-oriented German exporters are quite exposed to rising international tariffs. Earnings: Previous currency shifts will add to EPS growth in the U.S. in the first half of the year, but will be a drag in Europe and Japan (Chart I-8). However, these effects will wane through the year unless the dollar keeps falling. Indeed, we expect the dollar to firm modestly over the next year, favoring the European equity market at the margin. In contrast, we expect the yen to strengthen in the near term, which will trim Japanese EPS growth. Chart I-7Valuation Ranking Of Nonfinancial ##br##Equity Markets Relative To The U.S. April 2018 April 2018 Chart I-8Impact Of Currency Shifts On EPS Growth Impact Of Currency Shifts On EPS Growth Impact Of Currency Shifts On EPS Growth Chart I-9 updates the forecast from our top-down earnings models. The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up. Narrowing margins are less of a risk in Europe. U.S. EPS growth should be above that of Europe in 2018, but will then fall to about the same pace in 2019. We expect Japanese profit growth to remain very strong this year and next, given Japan's highly pro-cyclical earnings sensitivity. However, this does not incorporate the risk of further yen strength. Earnings expectations will also matter. Twelve-month bottom-up expectations are higher than our U.S. forecast ('x' in Chart I-9 denotes 12-month forward EPS expectations). In contrast, expectations are roughly in line with our forecast for the European market. It will therefore be more difficult at the margin for U.S. earnings to surprise to the upside. Monetary Policy: The relative shift in monetary policies should favor the European and Japanese markets to the U.S. The FOMC will continue tightening, with risks still to the upside on rates in absolute terms and relative to the other two economies. Sector Performance: Sector skews should work in Europe's favor. Financials are the largest overweight in Euro area bourses, while technology is the largest overweight in the U.S. We are constructive on the financial sector in both markets, but out-performance of the sector will favor the Eurozone broad market. Meanwhile, tech companies are particularly sensitive to changes in discount rates, since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening. The Japanese market has a relatively high weighting in industrials and consumer discretionary. The market will benefit if the global mini capex boom continues, but this could be counteracted by softness in global auto sales and further yen strength. It is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. We continue to avoid the Japanese market for the near term because of the potential for additional yen gains. As for the equity sector call, investors should remain oriented toward cyclicals versus defensives. Our key themes of a synchronized global capex mini boom, rising bond yields and firm oil prices favor the industrials, energy and financial sectors. Chart I-10 highlights four indicators that support the cyclicals over defensives theme, the dollar and the business sales-to-inventories ratio. Telecom, consumer discretionary and homebuilders are underweight. Chart I-9Profit Forecast Profit Forecast Profit Forecast Chart I-10These Indicators Favor Cyclical Stocks These Indicators Favor Cyclical Stocks These Indicators Favor Cyclical Stocks We will be watching the indicators in Chart I-10 to time the shift to a more defensive equity sector allocation. Leverage And The Next Recession As the economic expansion enters the late stages, investors are focused on where leverage pressure points may lurk. Last month's Special Report on U.S. corporate vulnerability to higher interest rates and a recession raised some eyebrows. For our sample of 770 companies, we estimated how much interest coverage for the average company would decline under two scenarios: (1) interest rates rise by 100 basis points across the curve; and (2) interest rates rise by 100 basis points and there is a recession in which corporate profits fall by 25% peak to trough. Given all the client inquiries, we decided to delve deeper into the results. We were concerned that our sample of high-yield companies distorted the overall results because it includes many small firms and outliers. We are more comfortable with the results using only the investment-grade firms, shown in Chart I-11. The 'x' marks the interest rate shock and the 'o' marks the combined shock. Nonetheless, the main qualitative message is unchanged. The starting point for interest coverage is low, considering that interest rates are near the lowest levels on record and profits are extremely high relative to GDP. This is the result of an extended period of corporate releveraging on the back of low borrowing rates. Chart I-12 shows that the interest coverage ratio has declined even as profit margins have remained elevated. Normally the two move together through the cycle. Chart I-11Corporate Leverage Will Take A Toll Corporate Leverage Will Take A Toll Corporate Leverage Will Take A Toll Chart I-12The Consequences Of Rising Leverage The Consequences Of Rising Leverage The Consequences Of Rising Leverage The implication is that the next recession will see interest coverage fare worse than in previous recessions. Of course, there are many other financial ratios and statistics that the rating agencies employ, but our results suggest that downgrades will proliferate when the agencies realize that the economy is turning south. Moreover, banks may tighten C&I lending standards earlier and more aggressively because they will also be finely attuned to the first hint of economic trouble given the leverage of the companies in their portfolio. Recovery rates may be particularly low in the next recession because the equity cushion has been squeezed via buybacks, which will intensify widening pressure in corporate spreads. Tighter lending standards would generate more corporate defaults, even wider spreads and a greater overall tightening in financial conditions. Corporate leverage could therefore intensify the pullback in business spending in the next recession. The good news is that we do not see any other major macro-economic imbalances, such as areas of overspending, that could turn a mild recession into a nasty one. As long as growth remains solid, the market and rating agencies will ignore the leverage issue. Indeed, ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart I-13). We remain overweight U.S. investment-grade and high-yield bonds within fixed-income portfolios for now. The European corporate sector is further behind in the leverage cycle (Chart I-14). Europe does not appear to be nearly as vulnerable to rising interest rates. Nonetheless, our European Corporate Health Monitor (CHM) has deteriorated over the past couple of years due to some erosion in profit margins, debt coverage and the return on capital. Meanwhile, the U.S. CHM has improved in recent quarters because the favorable earnings backdrop has temporarily overwhelmed rising leverage (top panel of Chart I-14). For the short-term, at least, corporate health is moving in favor of the U.S. at the margin. Chart I-13Ratings Migration Is Constructive For Now Ratings Migration Is Constructive For Now Ratings Migration Is Constructive For Now Chart I-14Corporate Health Trend Favors U.S. Corporate Health Trend Favors U.S. Corporate Health Trend Favors U.S. The implication is that, while we see trouble ahead for the U.S. corporate sector in the next economic downturn, in the short term we now favor the U.S. over Europe in the credit space. We are watching our Equity Scorecard, bank lending standards, the yield curve and our profit margin proxy in order to time our exit from both corporate bonds and equities (see last month's Overview section). We are also watching for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will get more aggressive in leaning against above-trend growth and a falling unemployment rate. Powell Doesn't Rock The Boat The Fed took a measured approach when reacting to the fiscal stimulus that is in the pipeline. The FOMC lifted rates in March and marginally raised the 'dot plot' for 2019 and 2020. Policymakers shaved the projection for unemployment to 3.6% by the end of 2019. This still appears too pessimistic, unless one assumes that the labor force participation rate will rise sharply. Table I-1 provides estimates for when the unemployment rate will reach 3½% based on different average monthly payrolls and participation rates. Our base case scenario, with 200k payrolls per month and a flat participation rate, sees the unemployment rate reaching 3½% by March 2019. Table I-1Dates When 3.5% Unemployment Rate Threshold Is Reached April 2018 April 2018 The soft-ish February reports for consumer prices and average hourly earnings took some of the heat off the FOMC. Core CPI, for example, rose 'only' 0.2% from the month before. Still, when viewed on a 3-month rate-of-change basis, underlying inflation remains perky; the core CPI inflation rate increased from 2.8% in January to 3% in February (Chart I-15). Inflation in core services excluding medical care and shelter, as well as in core goods, have also surged on a 3-month basis. We expect the latter to continue to pressure overall inflation higher, following the upward trend in import prices. The recent downtrend in shelter inflation should also stabilize due to the falling rental vacancy rate. Chart I-15U.S. Inflation Is Perky U.S. Inflation Is Perky U.S. Inflation Is Perky Moreover, the NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. The ISM manufacturing survey shows that companies are paying more for their inputs and experiencing delays with suppliers. This describes a late-cycle environment marked with rising inflationary pressures. We expect that core inflation will grind up to the 2% target by early next year. By the first quarter of 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below its estimate of the non-inflationary limit. Policymakers will then attempt a 'soft landing' in which they tighten policy enough to nudge up the unemployment rate. Unfortunately, the Fed has never been able to generate a soft landing. Once unemployment starts to rise, the next recession soon follows. Our base case is that the next recession begins in 2020. Bond Bear In Hibernation For Now The bond market showed that it can still intimidate in February, but things have since calmed down as the U.S. mini inflation scare ebbed, some economic data disappointed and trade friction created additional macro uncertainty. Bearish sentiment and oversold technical conditions suggest that the consolidation period has longer to run. Nonetheless, unless inflation begins to trend lower, the fact that even the doves on the FOMC believe that the headwinds to growth have moderated places a floor under bond yields. Fair value for the 10-year Treasury is 2.90% based on our short-term model, but we expect it to reach the 3.3-3.5% range before the cycle is over. Both real yields and long-term inflation expectations have room to move higher. Private investors will also have to absorb US$680 billion worth of bonds this year from governments in the U.S., Eurozone, Japan and U.K., the first positive net flow since 2014 (see last month's Overview). Yields may have to fatten a little in order for the private sector to make room in their portfolios for that extra government supply. In the Eurozone, the net supply of government bonds available to the private sector will still be negative this year, even if the ECB tapers to zero in September as we expect. Some investors are concerned about a replay in the European bond markets of the Fed's 'taper tantrum' of 2013, when then-Chair Bernanke surprised markets with a tapering announcement. The ECB has learned from that mistake and has given several speeches recently highlighting that policymakers will be making full use of forward guidance to avoid "...premature expectations of a first rate rise."2 We think they will be successful in avoiding a similar tantrum, but the flow effect of waning bond purchases will still place some upward pressure on the term premium in Eurozone bonds (Chart I-16).3 Chart I-16ECB: End Of QE Will Pressure Term Premium ECB: End Of QE Will Pressure Term Premium ECB: End Of QE Will Pressure Term Premium The bottom line is that monetary policy will undermine global bond prices in both the U.S. and Eurozone, but we expect U.S. yields to lead the way higher this year. Japanese bond prices will be constrained by the 10-year yield target. Investors with a horizon of 6-12 months should remain overweight JGBs, at benchmark in Eurozone government bonds and underweight Treasurys within hedged global bond portfolios. We recommend hedging the currency risk because we continue to expect the dollar to rebound this year. This month's Special Report, beginning on page 18, discusses the cyclical factors that will support the dollar: interest rate differentials, a rebound in U.S. productivity growth and a shift in international growth momentum back in favor of the U.S. In terms of the longer-term view, the Special Report makes the case that the U.S. dollar's multi-decade downtrend will persist. This does not mean, however, that long-term investors will make any money by underweighting the greenback. The 30-year U.S./bund yield spread of 190 basis points means that the €/USD would have to rise to more than 2.2 to offset the yield disadvantage of being overweight the euro versus the dollar over the next 30-years. Indeed, once it appears that the U.S. yield curve has discounted the full extent of the Fed tightening cycle (perhaps 12 months from now), it will make sense for long-term investors to go long U.S. Treasurys versus bunds on an unhedged basis. Conclusion Recent data releases suggest that global growth is peaking, especially in the manufacturing sector. Nonetheless, we do not believe that this heralds a slowdown in growth meaningful enough to negatively impact the profit outlook in the major countries. Indeed, the major fiscal tailwind in the U.S. will lift growth and extend the runway for earnings to expand at least through 2019. That said, fiscal stimulus at this stage of the U.S. business cycle will serve to accentuate a boom/bust cycle, where stronger growth in 2018/19 gives way to higher inflation a hard landing in 2020. The Fed is willing to sit back and watch the impact of fiscal stimulus unfold in the near term. But by early 2019, the Fed will find itself behind the curve with rising inflation and an overheating economy. The monetary policy risk for financial markets will then surge, setting up for a classic end to this expansion. The consequences of years of corporate releveraging will come home to roost. This year, trade skirmishes will be a headwind for risk assets and will no doubt generate further bouts of volatility. Nonetheless, recent signals from both the U.S. and China suggest that the situation will not degenerate into a trade war. The bottom line is that, while the economic expansion and equity bull market are both in late innings, investors should stay overweight risk assets and short duration for now. Stay overweight cyclical stocks versus defensives, overweight corporate bonds versus governments, overweight oil-related plays, and modestly long the U.S. dollar against most currencies except the yen. Our checklist of items to time the exit from risk is not yet flashing red. We would change our mind if our checklist goes south, our forward-looking indicators turn sharply lower or U.S. inflation suddenly picks up. We are also watching closely the situation in Iran, the U.S./China trade spat and NAFTA negotiations. Mark McClellan Senior Vice President The Bank Credit Analyst March 29, 2018 Next Report: April 26, 2018 1 For more information on why we believe that Sino-American conflict will be a defining feature of the 21st century, please see BCA Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com 2 ECB President Mario Draghi. Speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_1.en.html 3 For more information, please see BCA's Global Fixed Income Strategy Weekly Report "Bond Markets Are Suffering Withdrawal Symptoms," dated March 20, 2018, available at gfis.bcaresearch.com II. U.S. Twin Deficits: Is The Dollar Doomed? In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart II-1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. Chart II-1At Full Employment, Import Tariffs Raise Rates April 2018 April 2018 The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up, as we discuss in the Overview section. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart II-1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart II-2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart II-2A Replay Of The Nixon Years? A Replay Of The Nixon Years? A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... The two deficits don't always shift in the same direction. In fact, Chart II-3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. Chart II-3Twin Deficits And The Dollar Twin Deficits And The Dollar Twin Deficits And The Dollar The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart II-3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. Chart II-4Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart II-4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next (see the Overview section). (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart II-5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Chart II-5Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart II-6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart II-7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart II-6U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns Chart II-7Composition Of Net International ##br##Investment Position April 2018 April 2018 A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart II-6, top panel). In Chart II-8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart II-8Primary Investment Balance Simulations Primary Investment Balance Simulations Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart II-8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart II-9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart II-9 reveals. Chart II-9U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart II-1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010. III. Indicators And Reference Charts The earnings backdrop remains constructive for the equity market. In the U.S., bottom-up forward earnings estimates and the net earnings revisions ratio have spiked on the back of the tax cuts. Unfortunately, many of the other equity-related indicators in this section have moved in the wrong direction. The monetary indicator is shifting progressively into negative territory as the Fed gradually tightens the monetary screws. Valuation in the U.S. market improved a little over the past month, but our composite Valuation Indicator is still very close to one sigma overvalued. Technically, our Speculation Indicator is still in frothy territory, but our Composite Sentiment Indicator has pulled back significantly toward the neutral line. Our Technical Indicator broke below the 9-month moving average in March (i.e. a 'sell' signal). These are worrying signs. Nonetheless, at this point we believe they are a reflection of the more volatile late-cycle period that the market has entered. An equity correction could occur at any time, but a bear market would require a significant and sustained economic downturn that depresses earnings estimates. Our checklist does not warn of such a scenario over the next 12 months. It is also a good sign that our Willingness-to-Pay indicator is still rising, at least for the U.S. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. While this suggests that investor flows remain positive for the U.S. equity market, the WTP appears to have rolled over in both Europe and Japan. This goes against our overweight in European stocks versus the U.S. in currency hedged terms (see the Overview section). Our Revealed Preference Indicator (RPI) remained on its bullish equity signal in March. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. So far, the indicator has not flashed 'red'. Treasurys are hovering on the 'inexpensive' side of fair value, but are not cheap based on our model. Extended technicals suggest that the period of consolidation will persist for a while longer. Value is not a headwind to a continuation in the cyclical bear phase. Little has changed on the U.S. dollar front. It is expensive by some measures, but is on the oversold side technically. We still expect a final upleg this year, before the long-term downtrend resumes. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The current U.S.-China trade skirmish is essentially the beginning of a new cold war. The U.S. and China are engaged in a struggle for supremacy, so trade conflicts will persist. The conflict could evolve into a "game of chicken" - the most dangerous type of game. The U.S. needs Europe's help against China - but an adventure in Iran could cost it that help. Geopolitical risks will cap the rise in bond yields over the next six months, push up oil, and give a tailwind to global defense stocks. Feature The opening salvo of the U.S.-China trade war has caught the investment community by surprise as the market is quickly repricing the odds of a global trade war.1 Nervousness over the breakdown of globalization comes at the same time as our key China view - that Beijing's structural reforms will constrain growth - are beginning to have an impact on global growth (Chart 1).2 Chart 1China Reforms Dragging On Global Growth China Reforms Dragging On Global Growth China Reforms Dragging On Global Growth Fortuitously, we found ourselves in Asia at the onset of "hostilities" and were thus able to see regional investors' reactions in real time. Our clients focused their questions on the economic impact of the announced tariffs (yet to be determined, in our view), constraints facing President Trump (minimal as well), and potential Chinese retaliation (understated). The focus, however, should be on the big picture. The March 23 U.S. announcement of tariffs on around $50 billion worth of Chinese imports is not just the opening salvo of a trade war. Rather the emerging trade war is the opening salvo of a new cold war, a global superpower competition between the U.S. and China that will define the twenty-first century. Put simply, the U.S. and China are now enemies. Not rivals, competitors, or sparing partners. Enemies. It will take the market some time for investors to internalize this idea and price it properly. Meanwhile, in the short term, fears of a full-born global trade war are overblown. The trade tensions are really only about two countries, with uncertain global implications. Investors are right to be cautious, but risks to global earnings are overstated at this time. How Did We Get Here? The ongoing trade tensions are not merely a product of a nationalist Trump administration that decided to call out China for decades of unfair trade practices. They are also the product of the geopolitical context, which we have defined through three "big picture" themes. These three themes allowed us to correctly forecast that the defining feature of the twenty-first century would be a Sino-American conflict. We would be thrilled to see this culminate merely in a trade war. The themes are: Multipolarity (Chart 2)3 Apex of globalization (Chart 3)4 The breakdown of laissez-faire economics (Chart 4)5 Chart 2Multipolarity Is Messy And Volatile Multipolarity Is Messy And Volatile Multipolarity Is Messy And Volatile Chart 3When Hegemony Declines, Globalization Declines When Hegemony Declines, Globalization Declines When Hegemony Declines, Globalization Declines Chart 2 elucidates a key lesson of history: the collapse of British hegemony at the end of the nineteenth century ushered in two world wars. Political science, game theory, and history teach us that periods of multipolarity are rarely peaceful.6 Today's world is not exactly multipolar, as the U.S. remains the preeminent global power. However, regional powers - such as China, the EU, Russia, India, Japan, Iran, and perhaps Turkey and Brazil - have a lot more room to maneuver within their spheres of influence. This means that global rules written by the U.S. at the conclusion of the Second World War are being rewritten for regional contexts. Normatively there is nothing wrong with this process. But practically, multipolarity means that "challenger powers" - such as China today or the German empire in the late nineteenth century - seek to undermine rules and norms of behavior that they had little or no say in setting up. And such rules are necessary to underpin geopolitical stability and grease the wheels of globalization. As Chart 3 shows, trade globalization peaked in the past when the hegemon could no longer enforce global rules. We have therefore emphasized to clients since 2014 that, if we are right that the world is multipolar, then we are essentially at the apex of globalization. A parallel process has seen the breakdown of the laissez-faire consensus, which underpinned the expansion of trade in goods, labor, and capital across sovereign borders. Economic globalization has lifted many boats around the world, but outsourcing - combined with technological innovation - has seen the lower middle class in developed nations face diminishing returns (Chart 4). Chart 4Globalization: No Friend To Developed-Market Middle Class We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now That said, a revolt against globalization and "globalists" is thus far mainly an Anglo-Saxon phenomenon, and particularly an American one. Why? Because the particularities of the U.S. laissez-faire economic model, with its scant social protections, laid its middle class bare to the vagaries of globalization and technological change (Chart 5). However, there is no guarantee that other DM countries will not succumb to the same pressures down the line. Chart 5The 'Great Gatsby' Curve: Or, How Anglo-Saxons Turned Against Laissez Faire We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now This background is important for investors because merely blaming a nationalist Trump administration or a mercantilist Beijing for today's tensions ignores the underlying context. President Trump can change his mind on a dime, but the geopolitical context can only evolve slowly.7 Mercantilism is here to stay; it is a feature, not a bug, of a multipolar world. Contrast today's tensions with those of the 1970s and 1980s between the U.S. and its major trade partners. The 1971 Smithsonian Agreement and the 1985 Plaza Accord ended overt trade protectionism by the U.S. (in 1971), and threats thereof (in 1985), by securing the compliance of these trade partners with Washington's currency and trade demands. Japan further conceded to U.S. demands in 1989 after a two-year trade war. Today, the U.S. and China are not geopolitical allies huddled under the same nuclear umbrella for protection against an ideologically fueled rival. They are ideological rivals. The reason it took a decade for the conflict to erupt is two-fold. First, the U.S. became entangled in the global war on terror after 9/11, which took its focus off of its emerging competitor in Asia. Second, the consensus view - that China would asymptotically approach a Western democracy as it embraced capitalism - has proven to be folly.8 Bottom Line: The China-U.S. trade conflict is a product of today's particular geopolitical context. At heart, it is a conflict for geopolitical primacy in the twenty-first century and thus unlikely to end quickly. Sino-American Conflict Is Intractable The current U.S.-China trade tensions are more of a skirmish than a war. We think that there is considerable room for a step-down in tensions over the next 12 months. First, the Trump administration has not launched an economic war against China. Not only has the U.S. restricted its list of Chinese goods under tariff consideration to just $50 billion of imports - roughly 12% of total Chinese exports to the U.S. - but it has decided to bring a case against China to the World Trade Organization (WTO). The latter is hardly a move by a mercantilist administration dead-set on across-the-board economic nationalism. Second, China has responded almost immediately by offering several concessions, including renewing pledges to open its economy to inward investment and to protect intellectual property (IP) rights. While these may seem like boilerplate concessions that Beijing has floated before, the current context of trade tensions and domestic structural reforms makes it more likely that Chinese policymakers will follow through on their promises. As such, we can see the current round of tensions tapering off, especially after the U.S. midterm elections. However, we doubt that the structural trajectory of Sino-American relations will be significantly altered even if current tensions subside. First, from China's perspective, its extraordinary economic ascent (Chart 6) is merely the return of the millennium's status quo (Chart 7). The last 180 years - roughly from the beginning of the First Opium War in 1839 to today - were the aberration. During this short period of Chinese weakness, the West - with Britain and then the U.S. at the helm - conspired to restructure global rules and norms of geopolitical and economic behavior without input from the Middle Kingdom. Chart 6China's Economic Rise Has Been Extraordinarily Fast... We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Chart 7China Sees Its Success As A Return To The Status Quo We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now As such, China's influence in key post-WWII economic institutions like the WTO and the IMF is limited while its military has second-class status even in its own "Caribbean Sea," the South China and East China Seas. From the U.S. perspective, China's growth over the past two decades was made possible by U.S. hegemony. The U.S. secured the global rules and norms that enabled China to integrate seamlessly into the global marketplace and then compete its way to the top. Not only did the U.S. allow China to access its credit-fueled markets, but the U.S. Navy protected China's maritime trade, including vital energy supplies transiting from the Middle East. As a thank you for these efforts, China reneged on its WTO commitments, periodically suppressed its currency, stole American intellectual property, and withheld market access from U.S. corporations via tariff and non-tariff barriers to trade. Washington policymakers, and not only Trump's hawkish advisors, are turning against China. There is an emerging consensus among the U.S. foreign policy, defense, intelligence, and economic policy elites that: Sino-American economic symbiosis is over (Chart 8); Chart 8U.S.-China ##br##Symbiosis Is Dead U.S.-China Symbiosis Is Dead U.S.-China Symbiosis Is Dead Chart 9The U.S. Is Least##br## Exposed To Trade The U.S. Is Least Exposed To Trade The U.S. Is Least Exposed To Trade Chart 10China's Share Of Global##br## Exports Has Skyrocketed China's Share Of Global Exports Has Skyrocketed China's Share Of Global Exports Has Skyrocketed The U.S. can afford to confront China over trade because it is the least exposed major economy to global trade (Chart 9); The Chinese have acquired a massive share of global exports without a commensurate opening of their domestic market (Chart 10); Arresting Chinese technology transfer and intellectual property theft is a national security issue (Chart 11); The U.S. can confront China because it has emerged victorious from every global conflagration in the past (Chart 12). Chart 11China Imports Conspicuously Little U.S. IP We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Chart 12America Is Chaos-Proof America Is Chaos-Proof America Is Chaos-Proof Fundamentally, American policymakers want to see China's rapid economic growth slow, they want to see China's capital markets and companies constrained by openness to global competition, and they want to put a leash on China's catch-up in the technological and manufacturing value chain (Chart 13). This is not their stated objective as it would imply that the U.S. wants to see China weakened, and the Chinese leadership miss its decade and century economic development goals. But this is precisely what the U.S. establishment wants. As such, the political and economic visions of American and Chinese policymakers are directly at odds with one another. What does this mean for investors? Over the past several years we have developed a reputation of being sanguine about geopolitics. While many of our peers in the political analysis industry overstate the probability of geopolitical risk, we have (successfully) bet against the worst-case scenario in several prominent crises.9 We like to think that this is because we combine game theory with an understanding of the underlying power dynamics. By emphasizing constraints, we have successfully identified how power dynamics constrain the worst-case outcome.10 When it comes to Sino-American tensions, however, we have always been alarmists. This is because we believe the constraints to conflict are overstated, not understated. Furthermore, the potential market impact of a new cold war is unclear and potentially very large. Both the U.S. and China fundamentally think they can win a trade war. This means that they are engaged in a "regular game of chicken," named after the 1950s practice of racing hot rods head-on in order to prove one's manhood.11 Game theory teaches us that a game of chicken is the most unpredictable game because it can create an equilibrium in which all rational actors have an incentive to keep driving head on - to stick to their guns - despite the risks. In Diagram 1, we can see that continuing to drive carries the greatest risk, but also the greatest reward, provided that your opponent swerves. Chart 13China's Steady Climb Up##br## The Value Ladder Continues We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Diagram 1A Regular ##br##Game Of Chicken We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. In the current context, this means that the U.S. assumes that China is driven by economic rationality and will not dare face off against the U.S., which has far less to lose given its modest exposure to global trade. Chinese policymakers, however, also think they can win. They look over the Pacific and see a country riven by political polarization (Chart 14) where half of the country thinks the other is "a threat to the nation's well-being" (Chart 15).12 China, meanwhile, has just consolidated its political leadership and feels confident enough in its domestic stability to dabble with growth-constraining economic reforms. Beijing can use any trade tensions with the U.S. to further justify painful reforms. Chart 14Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 15Live And Let Die We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Who is right? We do not know. And that scares us as it means that the most sub-optimal equilibrium - the bottom-right quadrant of Diagram 1 - is more probable than people think. An important difference maker, one that would alter Beijing's risk calculus considerably, is Europe. Despite being highly leveraged to China's growth, the EU still exports nearly double the value of goods to the U.S. than China (Chart 16). In addition, Europe's trade surplus with the U.S. mostly pays for its deficit with China (Chart 17). Chart 16The EU Exports More To U.S. Than China The EU Exports More To U.S. Than China The EU Exports More To U.S. Than China Chart 17EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China Over the next several months, investors will be able to gauge whether the Trump administration is filled with ideological nationalists who believe in Fortress America or wily realists who know how to get things done. The key question is whether Trump will embrace America's traditional transatlantic alliance with Europe and harness it for the trade war with China. If he embraces it, we will predict that the combined forces of U.S. and Europe will successfully force China to concede to the pressure. If Trump fails, however, we could have a prolonged U.S.-China trade war. Early indications are optimistic. The U.S. gave the EU an exemption from tariffs on steel and aluminum imports on March 22, a delay that will end on May 1. This followed a March 21 meeting between EU Commissioner for Trade Cecilia Malmström and U.S. Secretary of Commerce Wilbur Ross. We suspect, but have no evidence, that the U.S. asked the EU to join in its effort to force China to change its trade practices at the WTO. As an exporting bloc, the EU has a lot more to lose from attacking China than the U.S. But it also has much to lose from unabated Chinese mercantilism and technological theft, and much to gain if China opens its doors wider. As such, we posit that Europe will, in the end, join the U.S. and Japan in a concerted effort to pressure China. This will increase the probability that Beijing ultimately gives in to trade pressure. In the long term, it will also ensure that President Trump does not break the critical transatlantic alliance with Europe, which would be paradigm shifting. But, on the other hand, it will set China and the West on a collision course. China's and the West's suspicions of each other will ossify. Bottom Line: In the short term, trade tensions are likely overstated as U.S. actions against China are largely muted and restrained. In the long term, the U.S.-China trade war could potentially devolve into a "game of chicken," the most dangerous type of conflict. The key variable will be whether the U.S. administration is savvy enough to arrange European collaboration against China. If the U.S. treats the EU harshly and ignores its transatlantic ally on other issues - such as conflict with Iran, discussed below - we could be in for a wild ride in the coming months and years. Either way, Europe stands to gain from a conflict between China and the U.S. Both sides are likely going to try to enlist the EU on their side. As such, we are opening a long Europe industrials / short U.S. industrials trade. Meanwhile, growing trade tensions, policy-induced slowdown in China, and repricing of geopolitical risks in East Asia and the Middle East should cap global bond yields over the next six months. We take 50.4bps and 54.4bps profits on our short U.S. 10-year government bond vs. German bund and short Fed Funds December 2018 futures trades. Iran: The Next Target Of Trump's "Maximum Pressure" Policy President Trump's North Korea policy worked brilliantly in 2017. The policy of "maximum pressure" combined military maneuvers, economic sanctions, and extremely bellicose rhetoric to convince Pyongyang and regional powers that the U.S. has lowered its threshold for full-scale war on the Korean peninsula. China reacted swiftly, starving North Korea of hard currency through economic sanctions (Chart 18). The result was a declaration by Pyongyang in late November that it had finally completed its quest to obtain a nuclear deterrent (an exaggeration at best), an olive branch for the Olympics, and an offer by Supreme Leader Kim Jong Un to meet with President Trump. Chart 18China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump The policy of "maximum pressure" yielded such extraordinary results with North Korea that President Trump is now eager to trademark the process and apply it to Iran and potentially other global issues. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has replaced two establishment advisors with hawks. Secretary of State Rex Tillerson has been replaced with CIA Director and noted Iran-hawk Mike Pompeo. Meanwhile, National Security Advisor H.R. McMaster has been replaced by conservative pundit (and former U.S. Ambassador to the UN) John Bolton. Bolton is on record arguing that the U.S. should bomb Iran. The role of the national security advisor varies with the president. Some presidents rely on the position more than others. However, given this administration's inexperience with foreign policy, the role is critical in shaping the White House worldview. The national security advisor manages the staff of the National Security Council (NSC), whose role is to coordinate with the vast network of U.S. intelligence agencies and filter information to the president. Given how large America's foreign, defense, and intelligence establishment is, and given the nature of human and signals intelligence, U.S. presidents often have to act upon diametrically opposing pieces of intelligence. As such, the national security advisor and the NSC can play a critical role in deciding what intelligence makes it to the president's desk and in what context. Staffers in the National Security Council (NSC) are often apolitical. We have been told that several current experts are leftovers from the Obama administration. It is likely that an ideological pundit like John Bolton, who served briefly in the George W. Bush administration, will set out to quickly eliminate non-partisan staffers on the NSC and tilt the information flow away from the empirical to the conspiratorial. With Bolton and Pompeo effectively in charge of U.S. foreign policy it is possible that the U.S. will misapply "maximum pressure" policy to Iran and bungle the complicated coordination with geopolitical allies on China. In particular, the U.S. has to endear itself to the EU if it wants a global economic alliance against China. But the EU also does not want to renegotiate Iran sanctions. Abrogating the 2015 nuclear deal - the Joint Comprehensive Plan of Action (JCPA) - would throw the tentative Middle East equilibrium into chaos. While Iran has played a role in preserving the regime of Bashar al-Assad in Syria, it has largely kept its vast network of Shia militias and allies in check, particularly in Lebanon and Iraq. Ironically, it was the Obama administration's "flawed" JCPA that has allowed Trump to focus on China in the first place. As we argued when the deal was signed, the conservative critics of the deal itself were correct. The JCPA did not degrade Iran's nuclear capability but merely arrested it.13 The point of the deal was implicitly to give Iran a sphere of influence in the Middle East so that the U.S. could extricate itself and focus on China. The Obama administration assessed, in our view non-ideologically, that the U.S. cannot fight two wars at the same time. If the Trump administration decides not to waive sanctions on May 12, it will be in abrogation of the deal. Unlike North Korea, however, Iran has multiple levers it can deploy against the U.S. and its allies' interests in the region. As such, the policy of "maximum pressure" will create much greater risks when applied to Iran. At the very end, it could be as successful as when applied to North Korea, but our conviction view is much lower (and to remind clients, we were optimists about the strategy when applied to North Korea!).14 Furthermore, and again unlike North Korea, Iran is beset with domestic risks. This actually makes it less likely that Tehran will cooperate with the U.S. North Korea is a simple domestic political system where Kim Jong Un can alter policy on a whim without much domestic pushback. In Iran, the dovish and moderate President Hassan Rouhani has to contend for power with hawks who have been critical of the JCPA. Meanwhile, the restive youth population could rise up at the first sign of elite division or weakness. This complicated domestic dynamic is why we cautioned clients back in January that Iran would likely add geopolitical risk premium to the oil markets.15 Bottom Line: It appears that President Trump, motivated by the success of his "maximum pressure" strategy against North Korea, now thinks he can apply it as successfully to Iran. This raises the prospect that Trump will discontinue the waiver of economic sanctions on May 12, effectively re-imposing a slew of economic sanctions against Iran and foreign companies looking to conduct business with it. Geopolitical risks are likely to rise in the Middle East as a result of U.S.-Iran tensions. As we go to publication, Saudi authorities have intercepted another Houthi missile heading towards Riyadh just days after Saudi Crown Prince Mohammad Bin Salman visited Washington, D.C. The White House appears to relish the opportunity to fight a war on two fronts, a trade war with China and a geopolitical war with Iran. Expect volatility and an elevated geopolitical risk premium in oil markets. Stay overweight global defense companies across markets. 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 Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: Norton, 2001). 7 Would President Hillary Clinton have avoided a trade war with China? We do not think so. Secretary Clinton was considered a "China Hawk" while at the State Department and pushed for the "Pivot to Asia." Jennifer Harris, the lead architect of Clinton's economic statecraft agenda in the U.S. State Department, recently penned a book that called for greater use of economic tools for geopolitical ends. The book, War By Other Means, introduces the term geoeconomics and calls for the U.S. to use economic instruments to promote and defend national interests. Please see BCA Geopolitical Strategy Blog, "We Read (And Liked)... War By Other Means," dated July 13, 2016, available at gps.bcaresearch.com. 8 In 2000, while campaigning on behalf of China's WTO entry, President Bill Clinton remarked, "economically, this agreement (China's WTO entry) is the equivalent of a one-way street. It requires China to open its markets ... to both our products and services in unprecedented new ways. All we do is to agree to maintain the present access which China enjoys ..." Please see "Full Text of Clinton's Speech On China Trade Bill," dated March 9, 2009, available at nytimes.com. 9 To name just a few: the risk of an Israeli attack against Iran, the risk of a full-scale Russian invasion of Ukraine, the risk of Euro Area collapse, the risk of Saudi-Iranian war, the risk of Russian-Turkish war, etc. 10 For the best example of how game theory is combined with our constraint-based paradigm, please see BCA Geopolitical Strategy Special Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 11 See James Dean in Rebel Without A Cause. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, "North Korea: Beyond Satire," dated April 19, 2017, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, and "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com.

Highlights The China-specific tariffs proposed by the Trump administration last week represent a great escalation in U.S. protectionism, but the actual measures may be smaller than what was initially announced. The proposed tariffs, if applied as stated, would likely shave 2% off of China's export growth over the coming 6-12 months. This would prevent an acceleration that we would have otherwise expected given the strength of the global economy. A 2% deceleration in export growth is not in and of itself a significantly negative event for China's economy, but the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We recommend that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. The recent weakness in the Hong Kong dollar is not a sign of any major economic weakness or financial market instability that should concern investors. However, the prospect of tighter monetary policy is a potential threat to the highly leveraged Hong Kong economy that needs to be monitored. Feature The Trump administration doubled down on its protectionist agenda last week, by announcing its intention to levy US$50 billion in tariffs against a variety of imports from China. This follows the administration's decision earlier in the month to impose a tariff on all steel and aluminum imports, which we discussed at length in our March 7 Weekly Report.1 While the China-specific tariffs represent a great escalation in protectionism relative to those on steel and aluminum imports, there are several important factors for investors to take into consideration: Chart 1President Trump Can Ill-Afford ##br##Any Major Economic Turmoil Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Chinese Stocks: Trade Frictions Make For A Tenuous Overweight The decision on Chinese import tariffs is not yet final, as the White House will propose a list of Chinese goods potentially subject to tariffs for public comment and consultations. This opens the door for an enormous lobbying effort from U.S. retailers and negotiations with Chinese officials, signaling that the end result is not set in stone. China's very muted retaliation (so far) increases the odds of a benign, negotiated outcome. Following the initial announcement of the steel and aluminum tariffs, the Trump administration significantly watered down the measures by granting Canada and Mexico an exemption and allowing exemption applications from other countries. This could suggest that the final tariffs to be applied against Chinese imports will be considerably smaller than what the administration signaled last week. Finally, given that the U.S. midterm election will be occurring later this year and that the administration can ill-afford to lose control of the legislative process, President Trump's actions on trade may be designed to maximize the perception of serious trade reform without threatening to substantially impact U.S. or global ex-U.S. economic momentum (Chart 1). This perspective would further support the notion that the bark of China-specific tariffs will be worse than the ultimate bite. The Impact Of Proposed Tariffs On Growth Still, investors cannot assume that the tariffs will be significantly watered down, meaning that it is important to have a forecast for the impact of the proposed tariffs on Chinese growth. We take a simple approach to judging the economic impact on nominal export growth, by calculating an aggregate tariff rate as if the amount of proposed tariffs applied equally across all Chinese exports to the U.S. We then multiply that rate by an estimate of U.S. import price elasticity, and again by the weight of U.S. exports as a share of total Chinese exports. Table 1 presents a list of import elasticity estimates for the G7 countries, both over the short- and long-term. Given that the short-run is our primary concern when modeling the likely cyclical impact on Chinese exports, we use the 0.6 elasticity estimate for the U.S. as a starting point for our analysis. We shock this estimate upwards to 0.8, for two reasons: To generate a relatively conservative estimate of the impact on Chinese export growth It is not clear whether the demand for goods from China is more or less price elastic than goods from other countries. However, given that the majority of Chinese exports to the U.S. are consumer-oriented (and thus less differentiated than highly specialized industrial goods), it is plausible that the price elasticity of Chinese imports is higher than it is on average. Table 1U.S. Short-Run Import Price Elasticity Is Not Trivial Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Given that US$50 billion is roughly 10% of annual U.S. imports from China, our simple approach suggests that the proposed tariffs would cause China's total export growth to decelerate about 1.6% (10% effective tariff rate times -0.8 import price elasticity times 20% export weight). Including the effect of Chinese re-exports to the U.S. via other major trading partners would slightly increase this estimate, meaning that 1.5 - 2.0% is a conservative range of estimates for the tariff impact. When applied to the current growth rate of Chinese exports, the impact of this estimate would be minimal. Chart 2 shows that Chinese nominal export growth recently accelerated to 22% even when shown as a 3-month moving average, suggesting that a U.S. import tariff would be coming at a time of considerably strong export momentum. In fact, China's February export data was so positive that it raised the Citigroup economic surprise index for China to a 9-year high (Chart 3). Chart 2At First Blush, Chinese Export Growth ##br##Has Accelerated Significantly At First Blush, Chinese Export Growth Has Accelerated Significantly At First Blush, Chinese Export Growth Has Accelerated Significantly Chart 3The Pop In Export Growth Has##br## Turbocharged The Surprise Index The Pop In Export Growth Has Turbocharged The Surprise Index The Pop In Export Growth Has Turbocharged The Surprise Index However, our view is that the growth rates of China's nominal imports and exports do not currently reflect the underlying pace of trade, with both series likely overstating the recent pace of growth. On the import side, we have highlighted in previous reports that import demand has recently outpaced what the Li Keqiang index would suggest. On the export side, a model of global US$ imports from China regressed against extrapolated global industrial production growth has an extremely strong fit over the past several years, and implies that the underlying pace of Chinese export growth is closer to 10%. Chart 4 illustrates this estimate of underlying export growth (based on global imports from China) along with the impact of the proposed tariffs, and highlights that a 2% export growth shock would simply prevent the 2% acceleration in underlying growth that we would normally expect over the coming months given the recent pickup in our global LEI. Chart 4If Enacted, The Proposed Tariffs Will ##br##Prevent An Acceleration In Export Growth Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Bottom Line: The import tariffs proposed by the Trump administration, if applied as stated, would likely shave about 2% off of China's export growth over the coming 6-12 months. This would prevent an acceleration that we would have otherwise expected given the strength of the global economy. The Implications For Chinese Stock Prices A 2% deceleration in export growth is not a significantly negative event for China's economy, especially if underlying export growth was set to trend higher due to strong global activity. But it does have the strong potential to mute a source of positive economic momentum, at a time when the industrial sector is clearly slowing. We presented our decision tree for Chinese stocks (Chart 5) in our first report of the year,2 and referenced it again in our March 7th report. The decision tree lays out four key questions for investors to answer over the coming 6-12 months in order to decide on the ideal allocation to Chinese equities within a global portfolio: Is The Global Economy Slowing Significantly? Is Significant Further Monetary Policy Tightening Likely? Is The Pace Of Renewed Structural Reforms Likely To Be Too Aggressive? Is The Existing Slowdown In China's Growth Momentum Metastasizing? Chart 5The Chinese Equity 'Decision Tree' Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Chinese Stocks: Trade Frictions Make For A Tenuous Overweight While the answer to questions 2 and 3 remains "no", Trump's shift towards protectionism certainly raises the risk of an eventual "yes" to the first question, especially given that our analysis has assumed no retaliation or counter-retaliation. Regarding the issue of China's industrial sector slowdown, the Li Keqiang index is not falling sharply, but it remains in a downtrend and is set to decline further according to our BCA Li Keqiang Leading Indicator (Chart 6). At best, the answer to question 4 is a lukewarm "no". We have previously noted that the uptrend in Chinese ex-tech stock prices vs their global peers over the past two years suggests that investors should have a high threshold for reducing exposure to China. We continue to agree with that assessment, but we must also acknowledge that the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We are not yet changing our investment recommendations, but we are putting Chinese ex-tech stocks on downgrade watch for Q2. An outright recommendation to cut exposure to neutral will likely occur in response to a technical breakdown which, for now, does not appear to be imminent (Chart 7). Chart 6China's Industrial Sector Is Set To Slow Further China's Industrial Sector Is Set To Slow Further China's Industrial Sector Is Set To Slow Further Chart 7Still In An Uptrend, For Now Still In An Uptrend, For Now Still In An Uptrend, For Now Bottom Line: A 2% deceleration in export growth is not in and of itself a significantly negative event for China's economy, but the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We recommend that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. An Update On The Hong Kong Dollar The Hong Kong dollar (HKD) has been weakening for the better part of a year, but recently it has fallen quite sharply relative to its history and now trades very close to the weak side of the peg (7.85 Hong Kong dollars to 1 U.S. dollar). The pace of recent weakness has caught the attention of investors and market participants, in part because it would be the first time in 12 years since the HKD threatened to decline below the lower end of the peg. In our view, both the HKD's weakness over the past year and the recent slide have been caused largely by technical factors, and are not in and of themselves signs of any major economic weakness or financial market instability that should concern investors. As highlighted in Chart 8, the significant rise in USD/HKD (a depreciation in the Hong Kong dollar) can be explained by a sizeable rise in the 3-month U.S. LIBOR / Hong Kong HIBOR spread. Panel 2 shows that the first portion of the rise in LIBOR vs HIBOR can be explained on the Hong Kong side. 3-month HIBOR itself has fallen quite substantially relative to the base rate, which has risen in lockstep with the Fed funds rate. This decline in 3-month HIBOR suggests that there is a supply-demand imbalance in the Hong Kong interbank market (in favor of excess supply), and that the Hong Kong Monetary Authority (HKMA) is likely to reduce the aggregate balance maintained by commercial banks in the days and weeks ahead (after having reduced it by HKD 80 billion in the second half of 2017; Chart 9) in order to defend the peg. Chart 8HKD Weakness Caused By Factors##br## On Both Sides Of The Pacific HKD Weakness Caused By Factors On Both Sides Of The Pacific HKD Weakness Caused By Factors On Both Sides Of The Pacific Chart 9To Raise 3-Month HIBOR, ##br##The HKMA Has To Tighten Interbank Liquidity To Raise 3-Month HIBOR, The HKMA Has To Tighten Interbank Liquidity To Raise 3-Month HIBOR, The HKMA Has To Tighten Interbank Liquidity Panel 3 of Chart 8 highlights that the second portion of the LIBOR/HIBOR spike is due to events completely unconnected with Hong Kong's monetary policy or its banking system. As discussed in detail in last week's U.S. Bond Strategy,3 the sharp rise in 3-month LIBOR relative to the Fed funds rate (the opposite of what is occurring in Hong Kong) appears to be driven by the U.S. Treasury rebuilding its cash balance following the recent extension of the debt ceiling, the money market effect of U.S. corporations repatriating U.S. dollars, and the Fed's ongoing balance sheet contraction. The combination of these two factors has created incentives for investors to sell the Hong Kong dollar and buy the U.S. dollar, which explains the weakness of the former. While these factors are technical in nature and are likely to dissipate over time, they are both significantly rooted in the fact that the U.S. is tightening its monetary policy. This will be discussed in more depth in next week's report, as the combination of tighter monetary conditions, the ongoing slowdown in China's industrial sector, and the extremely high levels of leverage in Hong Kong's private sector legitimately raises the odds of a smashup over the coming 1-2 years. We will gauge how bearish investors should be on Hong Kong and will present a new indicator that investors can use to monitor whether tighter monetary policy is likely to tip the economy into a debt-driven downturn. Stay tuned. Bottom Line: The recent weakness in the Hong Kong dollar is not a sign of any major economic weakness or financial market instability that should concern investors. However, the prospect of tighter monetary policy is a potential threat to the Hong Kong economy that needs to be monitored. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation," dated March 7, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The "Decision Tree" For Chinese Stocks," dated January 4, 2018, available at cis.bcaresearch.com. 3 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR," dated March 20, 2018, available at usbs.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights After the March FOMC Meeting, market pricing for short-term rates is largely consistent with the Fed's forecasts. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. However, the U.S. / China trade disputes will now take center stage. How can investors prepare for the trough in Citigroup Economic Surprise Index? Investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. Feature The S&P 500 fell more than 2% last Thursday after President Trump announced a new round of tariffs aimed at China. Treasury yields drifted modestly lower, and the trade weighted dollar fell 1%. Credit spreads widened. The trade tensions and the softer dollar drove gold up by nearly 3%. Meanwhile, another drawdown in oil inventories drove WTI oil nearly 5% higher. The VIX climbed last week, and has more than doubled since the start of the year. The market largely ignored last week's FOMC meeting. Fed Chair Powell stuck to the script at his first post-meeting press conference, but noted that trade was a topic of discussion. The "...For Inflation" section of this week's report provides more detail on Fed's view of the economy and rates. U.S. risk assets also sold off last week as market participants reacted negatively to Trump's political woes and trade policies. BCA's view is that investors should fade the former and focus on the later. We discuss Trump's political situation, as well as the trade tensions in the second section of this week's report ("...For the Next Tweet"). Nearly all the data in last week's sparse economic calendar exceeded expectations. At 1.8%, the Atlanta Fed GDPNow estimate for Q1 finished the week where it started. An unusual run of harsh winter weather in the Northeastern U.S. in March will keep downward pressure on the Citigroup Economic Surprise Index for the next month or so. We provide more detail on the Citigroup Economic Surprise Index and the performance of risk assets as the index rises and falls in the "...For The Washout" section of this week's report. Moreover, in the final section of the report ("...For The Labor Market"), we discuss how the unemployment rate can get to BCA's target of 3.5% in the next 12 months. ... For Inflation As widely expected, the FOMC last week delivered its sixth rate hike of the cycle and Fed members were more optimistic on the economic outlook. However, U.S. trade policy is a cloud over the outlook. The Fed downgraded its assessment of current economic conditions, but upgraded the outlook. The current pace of economic activity was described as "moderate" and opposed to "solid" in the previous FOMC statement. This reflects some disappointing data releases, which is also apparent in the Atlanta Fed's GDPNow model forecasting just 1.8% growth in Q1. But the Fed does not expect the softness to persist and noted that "the economic outlook has strengthened" (details below in "...For the Washout"). This was reflected in the updated economic projections. GDP growth forecasts were revised to 2.7% and 2.4% for 2018 and 2019, respectively (Chart 1). That's up from 2.5% and 2.1%, and comfortably above the Fed's 1.8% estimate for potential growth. As a consequence, the Fed expects the unemployment rate to drop to 3.6% in 2019, which would be well below the Fed's revised 4.5% estimate of full employment (details below in "...For the Labor Market"). Despite growth being above-trend and the jobless rate falling far below NAIRU, FOMC participants are not forecasting a major acceleration in inflation. From 1.9% in 2018, core PCE inflation is seen fairly steady at 2.1% in 2019 and 2020. To some degree, the upward pressure on inflation will be mitigated by a higher path for the Fed funds rate. Although the median projection remains for three rate hikes this year, the Fed expects slightly faster rate hikes in 2019 and 2020 (Chart 2). The Fed funds rate is now expected to end 2020 at 3.375%, up from 3.125% expected in December. This will put monetary policy on the tighter side of the Fed's 2.875% estimate of the neutral rate. Chart 1The FOMC'S Latest Forecasts The FOMC'S Latest Forecasts The FOMC'S Latest Forecasts Chart 2Market And The Fed In Agreement On Rates Market And The Fed In Agreement On Rates Market And The Fed In Agreement On Rates Of course, the path of the Fed funds rate will depend on the degree of slack in the economy and the resulting inflationary pressures. The Fed could be underestimating the inflationary pressures associated with a jobless rate that will be nearly 1% below NAIRU. Alternatively, a rising participation rate could slow the decline in the unemployment rate, or the Fed's estimate of NAIRU could get revised much lower. Finally, while the fiscal stimulus is behind the Fed's more optimistic outlook, U.S. trade policy is a growing downside risk (details below in "...For the Next Tweet"). During his press conference, Fed Chair Powell said that FOMC members were aware of the risk, but it was not incorporated into their forecasts. President Trump announced tariffs on China last week. China may then retaliate with its own tariffs. As we've said before, nobody wins from trade wars. Economic activity will be weaker and prices will be higher. A full blown trade war could jeopardize the Fed's rosy forecasts. Bottom Line: Market pricing for short-term rates is largely consistent with the Fed's forecasts. Therefore, the outcome of last week's FOMC meeting is not very market relevant. Investors are more focused on trade policy for now. ... For The Next Tweet BCA is looking beyond any market volatility induced by President Trump's political scandals.1 The decision to impeach President Trump is a purely political decision that rests with the House of Representatives. Under GOP control, Trump will not likely be impeached if he continues to fire his White House aides or members of his cabinet. That is his purview as President. However, relieving Special Counsel Mueller of his duties would probably be a red line for House Republicans and lead to impeachment. That said, it is very difficult to see the impeachment in the House lead to Trump's removal by the Senate, given his elevated approval ratings among GOP voters (Chart 3). Trump's support with GOP voters, our Geopolitical Strategy service's critical measure of whether Trump can stay in power, is back at 2016 election levels with GOP voters (Chart 3). Furthermore, conviction in the Senate (and removal from office), requires 67 votes. If the Democrats take the House, they are likely to impeach Trump in 2019. But even if the Democrats retake the Senate this fall, they would fall far short of that 67-vote threshold for conviction. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. Equity markets performed well when the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s. In the early 1970s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 4A). Likewise, surges in equity market volatility amid political scandals were related more to economic and financial events than politics (Chart 4B). Chart 4AFor Markets,##BR##Economy Matters More Than Politics For Markets, Economy Matters More Than Politics For Markets, Economy Matters More Than Politics Chart 4BMarket Volatility During##BR##U.S. Political Scandals Market Volatiltiy During U.S. Political Scandals Market Volatiltiy During U.S. Political Scandals Today's environment - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, above-trend economic growth, escalating inflation, three more Fed rate hikes this year, and higher Treasury bond yields. Moreover, none of the issues that investors care about (tax cuts, deregulation, lifting of the spending caps, etc.) can be reversed by Trump's impeachment. Even a Democratic wave in this fall's mid-term Congressional elections will not deliver the opposition party a veto-proof majority (Chart 5). Thus, in the current economic cycle, we expect pro-market forces at the legislative and executive branches of government to persist. Chart 5Democrats's Lead in Generic Congressional##BR##Ballot Has Moved Lower This Year Democrats's Lead in Generic Congressional Ballot Has Moved Lower This Year Democrats's Lead in Generic Congressional Ballot Has Moved Lower This Year However, Trump's political scandals may cost the GOP the House in this fall's mid-term elections. Table 1 and Chart 6 show that political gridlock is not positive for stock prices after controlling for important macro factors.2 The average monthly return on the S&P 500 is considerably higher when the executive and legislative branches are unified. The worst outcome for equity markets, by far, is when the President faces a split legislature. BCA's Geopolitical Strategy service noted that while the market has cheered the limited scope of tariffs imposed earlier this month, investors may be underestimating the political shifts that underpinned Trump's move. There is little reason to think that protectionism will fade when Trump leaves office. The Administration's decision late last week to introduce sanctions aimed at China represents another escalation of the trade spat initiated in early March. Increased trade tensions with China represent a near-term risk to the markets.3 However, BCA's Geopolitical Strategy team notes that the latest round of tariffs suggests that Trump has made a bid to increase negotiation leverage with China rather than launch a protectionist broadside. This is good news in the short term, relative to the worst fears given Trump's lack of legal/constitutional constraints. But in the long term, Trump's latest move on trade policy support's our view that geopolitical risk is moving to East Asia and the U.S. / China conflict is a high-risk scenario that markets are now going to have to start pricing in.4 Table 1Divided Government Is, In Fact, Bad For Stocks Waiting... Waiting... Chart 6A Unified Congress Is A Boon For Stocks Waiting... Waiting... Bottom Line: Investors should dismiss the risk of domestic political scandals interrupting the market-friendly policy back drop. However, U.S. / China trade disputes will take center stage. China is motivated to prevent a trade war through significant compromises that Trump can advertise as wins to his audience this November. If Trump accepts these concessions, then the risk of a trade war with China will likely be removed until the next race for President in 2020. ... For The Washout The U.S. economic data have disappointed so far this year, as illustrated by Citigroup Economic Surprise Index (Chart 7). The Index peaked at 84.5 in December 2017 and subsequently has moved lower for 64 days. Since early 2011, there were six other episodes when the Surprise Index behaved similarly. These phases lasted an average of 86 days; the median number of days from peak to trough was 66 days. The implication is that the trough in the Citigroup Economic Surprise reading may be a month or two away. However, the relatively low economic expectations at end-2017 suggest that the disappointment may be truncated. On the other hand, the Tax Cut and Jobs Act of 2017, along with the lifting of budgetary spending caps in early 2018, have likely raised economists' near-term projections. Chart 7U.S. Financial Markets As Economic Surprise Index Declines U.S. Financial Markets As Economic Surprise Index Declines U.S. Financial Markets As Economic Surprise Index Declines The performance of key financial markets and commodities since the Economic Surprise Index crested in December 2017 matches the historical record, with a few notable exceptions (Table 2 and Charts 7 and 8). As the Index rolled over in late 2017, stocks beat bonds, credit outperformed Treasuries and the dollar fell, matching previous episodes. However, counter to the historical trend, gold and oil prices have increased and small caps have underperformed in the past three months. Table 2Financial Market Performance As The Economic Surprise Index Falls Waiting... Waiting... Chart 8Economic Surprise Approaching A Turning Point Economic Surprise Approaching A Turning Point Economic Surprise Approaching A Turning Point Based on BCA's research,5 tactical investors should add to their risk positions as the Citigroup Economic Surprise Index bottoms and begins to climb. As the Economic Surprise Index rises, stocks beat bonds by an average of 8700 bps and in six of the seven episodes since 2011 (Table 3). Furthermore, the performance of stock-to-bond ratio is better when the Economic Surprise Index is accelerating. Table 3 again shows that all asset classes also perform better when the Index climbs. After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected - the Citigroup Inflation Surprise index rolled over again (Chart 9, top panel) through year end 2017. Reports on the CPI, PPI and average hourly earnings continued to fall short of consensus forecasts despite tightening of the labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods when prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Table 3Financial Market Performance As The Economic Surprise Index Rises Waiting... Waiting... Chart 9The Fed Cycle And Inflation Surprise The Fed Cycle And Inflation Surprise The Fed Cycle And Inflation Surprise Moreover, the Citigroup Inflation Surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 9). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. An increase in the Citigroup Inflation Surprise Index also accompanied most of the Fed's rate hikes from mid-1999 through mid-2000. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. Bottom Line: The disappointing run of economic data will not end for another few months. The unusually harsh winter weather in March in the Northeastern exacerbates the situation. However, the weakness in the economic data is not a sign that a recession is at hand. We expect that the inflation surprise index will continue to grind higher, as unemployment dips further into 'excess demand' territory (details below in "...For The Labor Market"). After the Citigroup Economic Surprise Index forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb. Stay overweight stocks versus bonds, long credit and underweight duration. ... For The Labor Market BCA expects the unemployment rate to hit 3.5% by late 2018 or early next year, the first time since December 1969. Our base case assumes that the economy will generate 200,000 nonfarm payroll jobs per month and that the labor force participation rate will remain at 63%. The unemployment rate was 4.1% in February 2018 and bottomed at 4.4% in 2006 and 2007; the rate reached a 30-year low at 3.8% in 2000. As noted in the first section of this week's report, at the conclusion of last week's meeting, the FOMC nudged down its view of this year's unemployment rate to 3.8%. The FOMC also slightly adjusted its long-term forecast of the unemployment rate to 4.5%. The implication is that BCA and the FOMC expect the U.S. economy to continue to run below full employment this year. Nonetheless, investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. In Table 4 we look at various scenarios (monthly increases in payrolls, annual percentage change in participation rate) to show when the unemployment rate will dip below 3.5%. In the past three months, total nonfarm payroll employment increased by 242,000 per month, and in the past year, the average monthly increase was 190,000. The participation rate was 63% in February, little changed from a year ago as an improved labor market offset demographic factors that continue to drive down this rate. Our calculations assume that the labor force will expand by 0.9% per year, matching the growth rate in the past 12 months. Chart 10 shows the history of the unemployment rate and several scenarios in the next two years that assume the participation rate stays at 63%. Table 4Dates When 3.5% Unemployment Rate Threshold Is Reached Waiting... Waiting... Chart 10The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios Bottom Line: BCA's view is that the FOMC's forecast for the unemployment rate at the end of 2018 (3.8%) is too high and only marginally lower than the current 4.1% rate. This is inconsistent with real GDP growth well in excess of its supply-side potential. The macro backdrop will likely justify the FOMC hiking more quickly than the March 2018 dots forecast. The risks are skewed to the upside. BCA expects the 2/10 Treasury yield curve to steepen through mid-year and then flatten by year-end, spending most of 2018 between 0 and 50 bps. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Policies Are Stimulative Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report "The South China Sea: Smooth Sailing?," dated March 28, 2017, available at gps.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Reports, "Solid Start," dated January 8, 2018 and "The Revenge Of Animal Spirits," dated October 30, 2017. Both available at usis.bcaresearch.com.

Highlights Portfolio Strategy Synchronized global growth, a soft U.S. dollar, our resurgent Boom/Bust Indicator and avoidance of a Chinese economic hard landing, are all signaling that it still pays to overweight cyclicals at the expense of defensives. Economically hyper-sensitive transports also benefit from synchronous global growth and capex. We expect a rerating phase in the coming months. Within transports, we reiterate our overweight stance in the key railroads sub-index as enticing macro tailwinds along with firming operating metrics underscore that profits will exit deflation in calendar 2018. Recent Changes There are no portfolio changes this week. Table 1 Staying Focused On The Dominant Macro Themes Staying Focused On The Dominant Macro Themes Feature The S&P 500 continued to consolidate last week, still digesting the early February tremor. Policy uncertainty is slowly returning and sustained Administration reshufflings are becoming slightly unnerving (bottom panel, Chart 1). Nevertheless, the dual themes of synchronized global growth and budding evidence of coordinated tightening in global monetary policy, i.e. rising interest rate backdrop, continue to dominate and remain intact. Importantly in the U.S., the latest non-farm payrolls (NFP) report was a goldilocks one. Month-over-month NFPs surpassed the 300K hurdle for the first time since late-2014, on an as-reported-basis, while wage inflation settled back down. The middle panel of Chart 2 shows that both in the 1980s and 1990s expansions, NFPs were growing briskly, easily clearing the 300K mark. The 2000s was the "jobless recovery" expansion and likely the exception to the rule. In all three business cycle expansions wage growth touched the 4%/annum rate before the recession hit. The yield curve slope also supports this empirical evidence, forecasting that wage inflation will likely attain 4%/annum before this cycle ends (wages shown inverted, Chart 3). Chart 1Watch Policy Uncertainty Watch Policy Uncertainty Watch Policy Uncertainty Chart 2Goldilocks NFP Report... Goldilocks NFP Report... Goldilocks NFP Report... Chart 3...But Wage Growth Pickup Looms ...But Wage Growth Pickup Looms ...But Wage Growth Pickup Looms One key element in the current cycle is that the government is easing fiscal policy to the point where both NFPs and wages will likely surge in the coming months as the fiscal thrust gains steam, likely extending the business cycle. This is an inherently inflationary environment, especially when the economy is at full employment and the Fed in slow and steady tightening mode. Last autumn, we showed that the SPX performs well in times of easy fiscal and tight money iterations, rising on average 16.7% with these episodes, lasting on average 16 months (Table 2).1 The latest flagship BCA monthly publication forecasts that the current fiscal impulse will last at least until year-end 2019, contributing positively to real GDP growth. Thus, if history at least rhymes, SPX returns will be positive and likely significant for the next couple of years (Chart 4). With regard to the composition of the equity market's return, we reiterate our view - backed by empirical evidence - that EPS will do the heavy lifting whereas the forward P/E multiple will continue to drift sideways to lower.2 Not only will rising fiscal deficits cause the Fed to remain vigilant and continue to raise interest rates and weigh on the equity market multiple (Chart 5), but also heightened volatility will likely suppress the forward P/E multiple. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Staying Focused On The Dominant Macro Themes Staying Focused On The Dominant Macro Themes Chart 4Stimulative Fiscal Policy##br## Extends The Business Cycle... Stimulative Fiscal Policy Extends The Business Cycle... Stimulative Fiscal Policy Extends The Business Cycle... Chart 5...But Weighs On ##br##The Multiple ...But Weighs On The Multiple ...But Weighs On The Multiple This week we revisit our cyclical versus defensive portfolio bent and update the key transportation overweight view. Cyclicals Thrive When Global Growth Is Alive And Well... While retaliatory tariff wars are dominating the media headlines, global growth is still resilient. Our view remains that the odds of a generalized trade war engulfing the globe are low, and in that light we reiterate our cyclical over defensive portfolio positioning, in place since early October.3 Global growth is firing on all cylinders. Our Global Trade Indicator is probing levels last hit in 2008, underscoring that cyclicals will continue to have the upper hand versus defensives (Chart 6). Synonymous with global growth is the softness in the U.S. dollar. In fact, the two are in a self-feeding loop where synchronized global growth pushes the greenback lower, which in turn fuels further global output growth. Tack on the rising likelihood that the trade-weighted dollar has crested from a structural perspective, according to the 16-year peak-to-peak cycle4 (Chart 7) and the news is great for cyclicals versus defensives (Chart 8). Chart 6Global Trade Is Alright Global Trade Is Alright Global Trade Is Alright Chart 7Dollar The Great Reflator... Dollar The Great Reflator... Dollar The Great Reflator... Chart 8...Is A Boon For Cyclicals Vs. Defensives ...Is A Boon For Cyclicals Vs. Defensives ...Is A Boon For Cyclicals Vs. Defensives Related to the greenback's likely secular peak is the booming commodity complex, as the two are nearly perfectly inversely correlated. Commodity exposure is running very high in the deep cyclical sectors and thus any sustained commodity price inflation gains will continue to underpin the cyclicals/defensives share price ratio. BCA's Boom/Bust Indicator (BBI) corroborates this upbeat message for cyclicals versus defensives. The BBI is on the verge of hitting an all-time high and, while this could serve as a contrary signal, there are high odds of a breakout in the coming months if synchronized global growth stays intact as BCA expects, rekindling cyclicals/defensives share prices (Chart 9). Finally, if China avoids a hard landing, and barring an EM accident, the cyclicals/defensives ratio will remain upbeat. Chart 10 shows that China's LEI is recovering smartly from the late-2015/early-2016 manufacturing recession trough, and the roaring Chinese stock market - the ultimate leading indicator - confirms that the path of least resistance for the U.S. cyclicals/defensive share price ratio is higher still. Chart 9Boom/Bust indicator Is Flashing Green Boom/Bust indicator Is Flashing Green Boom/Bust indicator Is Flashing Green Chart 10China Is Also Stealthily Firming China Is Also Stealthily Firming China Is Also Stealthily Firming Bottom Line: Stick with a cyclical over defensive portfolio bent. ...As Do Transports, Thus... Transportation stocks have taken a breather recently on the back of escalating global trade war fears. But, we are looking through this soft-patch and reiterate our barbell portfolio approach: overweight the global growth-levered railroads and air freight & logistics stocks at the expense of airlines that are bogged down by rising capacity and deflating airfare prices (Chart 11). Leading indicators of transportation activity are all flashing green. Transportation relative share prices and manufacturing export expectations are joined at the hip, and the current message is to expect a reacceleration in the former (top panel, Chart 12). Similarly, capital expenditures, one of the key themes we are exploring this year, are as good as they can be according to the regional Fed surveys, and signal that transportation profits will rev up in the coming months (middle panel, Chart 12). The possibility of an infrastructure bill becoming law later this year or in 2019 would also represent a tailwind for transportation EPS. Not only is U.S. trade activity humming, but also global trade remains on a solid footing. The global manufacturing PMI is resilient and sustaining recent gains, suggesting that global export volumes will resume their ascent. This global manufacturing euphoria is welcome news for extremely economically sensitive transportation profits (Chart 13). All of this heralds an enticing transportation services end-demand outlook. In fact, industry pricing power is gaining steam of late and confirms that relative EPS will continue to expand (Chart 12). Under such a backdrop, a rerating phase looms in still depressed relative valuations (bottom panel, Chart 13). Chart 11Stick With Transports Exposure Stick With Transports Exposure Stick With Transports Exposure Chart 12Domestic... Domestic... Domestic... Chart 13...And Global Growth/Capex Beneficiary ...And Global Growth/Capex Beneficiary ...And Global Growth/Capex Beneficiary ...Stay On Board The Rails Railroad stocks have worked off the overbought conditions prevalent all of last year, and momentum is now back at zero. In addition, forward EPS have spiked, eliminating the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (Chart 14). The track is now clear and more gains are in store for relative share prices in the coming quarters. Despite trade war jitters, we are looking through the recent turbulence. If the synchronized global growth phase endures, as we expect, then rail profits will remain on track. In fact, BCA's measure of global industrial production (hard economic data) is confirming the euphoric message from the global manufacturing PMI (soft economic data) and suggests that rails profits will overwhelm (Chart 15). Our S&P rails profit model also corroborates this positive global trade message and forecasts that rail profit deflation will end in 2018 (bottom panel, Chart 15). Beyond these macro tailwinds, operating industry metrics also point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (second panel, Chart 15). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (second panel, Chart 16). Chart 14Unwound Both Overbought Conditions And Overvaluation Unwound Both Overbought Conditions And Overvaluation Unwound Both Overbought Conditions And Overvaluation Chart 15EPS On Track To Outperform EPS On Track To Outperform EPS On Track To Outperform Chart 16Intermodal Resilience Intermodal Resilience Intermodal Resilience The significant intermodal segment that comprises roughly half of all shipments is on the cusp of a breakout. The retail sales-to-inventories ratio is probing multi-year highs on the back of the increase in the consumer confidence impulse and both are harbingers of a reacceleration in intermodal shipments (Chart 16). Coal is another significant category that takes up just under a fifth of rail carload volumes and bears close attention. While natural gas prices have fallen near the lower part of the trading range in place since mid-2016 and momentum is back at neutral, any spike in nat gas prices will boost the allure of coal as a competing fuel for energy generation (middle panel, Chart 17). Keep in mind that coal usage is highly correlated with electricity demand and the industrial business cycle, and the current ISM manufacturing survey message is upbeat for coal demand. Tack on the whittling down in coal inventories at utilities and there is scope for a tick up in coal demand (third panel, Chart 18). Finally, the export relief valve has reopened for coal with the aid of the depreciating U.S. dollar, and momentum in net exports has soared to all-time highs, even surpassing the mid-1982 peak (bottom panel, Chart 18). Chart 17Key Coal Shipments Underpin Selling Prices Key Coal Shipments Underpin Selling Prices Key Coal Shipments Underpin Selling Prices Chart 18Upbeat Leading Indicators Of Coal Demand Upbeat Leading Indicators Of Coal Demand Upbeat Leading Indicators Of Coal Demand All of this suggests that coal shipments will make a comeback later in 2018, and continue to underpin industry pricing power, which in turn boost rail profit prospects (bottom panel, Chart 17). Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Financial market volatility in general and FX market volatility in particular is set to increase because of the following three factors: Rising U.S. inflation will make the Federal Reserve increasingly hawkish, and the European Central Bank is moving away from maximum accommodation; The Chinese economy is not accelerating; And geopolitical tensions are growing. While EM and commodity currencies will suffer, safe havens like the yen and Swiss franc will benefit. The euro may correct at first, but it remains on an upward trajectory. Feature Chart I-1Low And High Growth Sentiment##br## Are Linked Low And High Growth Sentiment Are Linked Low And High Growth Sentiment Are Linked A defining feature of global financial markets over the past two years has been the outright collapse of volatility. However, in late January the VIX rebounded, recording readings not seen since 2015. Currency volatility also hit three-year lows before the same wake-up call, causing a sharp but temporary increase in FX volatility. It is important to understand whether this recent rebound in volatility was just a blip or a symptom of something more profound - a sign that volatility is back on an uptrend and will continue to rise as it did from 1996 to 2002, or again from 2007 to 2009. This matters because volatility is an important determinant of FX returns. High-yielding carry currencies perform well when volatility is low. While low-yielding funding currencies like the Swiss franc or the yen suffer in periods of calm, their returns improve once volatility rises. Moreover, low-volatility environments are often associated with buoyant expectations about global growth among international investors (Chart I-1). Thus, a return of volatility could fray the edges of global growth sentiment, which is currently ebullient. This would hurt EM and commodity currencies. Our view is that volatility is making a comeback as global monetary policy is becoming less accommodative, China's path is becoming rockier and global geopolitical risks are rising. These dynamics will hurt EM and commodity currencies, while at the margin, help safe-haven currencies like the yen and Swiss franc. Monetary Policy In DM Economies Monetary policy in the advanced economies is not yet tight, but is moving away from the large accommodation implemented in the wake of the Great Financial Crisis. Historically, a removal of accommodative policy tends to be associated with rising volatility, especially in the FX space. The link is not that clear-cut though. Policy tightening tends to lead to higher volatility. However, it only does so once we enter the latter innings of the business cycle. Only when inflation begins to gain enough momentum to force the Fed to increase rates fast enough to raise the specter that policy will soon begin to hurt growth, does volatility start rising durably. We are getting closer to this moment in the U.S. The U.S. is increasingly showing signs of late-stage business expansion. For one, the yield curve has flattened to 53 basis points. This level of slope has historically been associated with full employment and rising wage pressures. Surveys corroborate this picture. The NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. This normally marks rising wage pressures, the hallmark of full employment (Chart I-2). Moreover, the ISM manufacturing survey shows that companies are paying more for the price of their inputs and experiencing delays with suppliers. Normally, this also describes a late-cycle environment marked with rising inflationary pressures (Chart I-3). Chart I-2Late Cycle Dynamics##br## In The U.S. Late Cycle Dynamics In The U.S. Late Cycle Dynamics In The U.S. Chart I-3Firms Are Facing Budding##br## Inflationary Pressures Firms Are Facing Budding Inflationary Pressures Firms Are Facing Budding Inflationary Pressures Other variables are generally pointing toward an acceleration of U.S. inflation. Because aggregate U.S. capacity utilization - which incorporates both labor market conditions and the Fed's own capacity utilization measure - highlights a notable absence of slack, and because the change in the velocity of money in the U.S. is accelerating, our models forecast a sustained uptick in U.S. core inflation to 2% and above (Chart I-4). U.S. CPI excluding food and energy data for February is also pointing toward budding inflationary pressures. While the annual core inflation rate was flat compared to January, the annualized three-month rate of change has surged to 3%. The muted year-on-year comparison is being depressed by some base effect. In 2017, inflation started to weaken significantly in March. Therefore, beginning in March 2018, consumer price inflation in the U.S. will likely accelerate more noticeably than it has until now. Shelter inflation too is moving from a headwind to a tailwind. Shelter inflation represents 42% of the core CPI basket, and it has been on a decelerating trend for 14 months. However, the model developed by our U.S. Bond Strategy colleagues shows that U.S. shelter inflation is now set to start bottoming (Chart I-5, top panel). Chart I-4Core Inflation Will Rise Core Inflation Will Rise Core Inflation Will Rise Chart I-5Other Inflationary Pressures Other Inflationary Pressures Other Inflationary Pressures Core goods prices are also regaining some vigor. This is not much of a surprise. The strength of the global economy along with the weakness of the U.S. dollar have filtered through to higher import prices. Historically, import prices tend to lead core goods prices in the U.S. (Chart I-5, bottom panel). We could see rising inflationary pressures on the services front as well. The employment cost index - the cost component used to compute unit labor costs - is still displaying a tight positive correlation with the employment-to-population ratio for prime-age workers (Chart I-6). BCA estimates that employment gains above 123,000 new jobs a month will push this ratio up, and consequently labor costs. But as Chart I-7 illustrates, the strength in the Conference Board Leading Credit Index highlights that employment growth in the U.S. is likely to remain robust. This suggests the key driver of service inflation - wages - will continue to improve. Chart I-6Wages Will Keep Rising... The Return Of Macro Volatility The Return Of Macro Volatility Chart I-7...As Employment Growth Will Stay Strong ...As Employment Growth Will Stay Strong ...As Employment Growth Will Stay Strong Thus, it seems the stars are already aligning to foment a rise in U.S. core CPI. The Trump administration throwing in some large-scale fiscal stimulus into the mix is only akin to throwing fuel on a fire. Accordingly, we expect the Fed to upgrade its interest rate forecasts for 2019. Markets are not yet ready for this scenario, anticipating only five rate hikes between now and the end of 2019. Thus, the most important central bank for setting the global cost of capital will likely surprise in a hawkish fashion over the coming 21 months. But what about the other big DM central bank, the ECB? The ECB too has begun to remove monetary accommodation, as it has started to taper its purchases of securities. It aims to be done this in September. Moreover, the narrowing gap between the unemployment rate and NAIRU in the euro area points to budding inflationary pressures (Chart I-8). This would argue that the ECB will begin lifting interest rates toward the summer of 2019. In fact, the shadow policy rate for the euro area has already begun to turn higher (Chart I-9), suggesting European policy is already starting to move away from its accommodative extremes. This combination is very important for volatility. As Chart I-10 illustrates, the average shadow policy rate for the U.S., the euro area, the U.K., and Japan leads financial markets and FX volatility. While Japanese rates may remain at low levels, the path for Europe and the U.S. is clearly up, suggesting volatility will rise. Chart I-8Growing Wage Pressures In Europe Growing Wage Pressures In Europe Growing Wage Pressures In Europe Chart I-9ECB Policy Is Already Less Accommod ECB Policy Is Already Less Accommod ECB Policy Is Already Less Accommod Chart I-10Tighter Global Policy Leads To Higher Volatility Tighter Global Policy Leads To Higher Volatility Tighter Global Policy Leads To Higher Volatility Bottom Line: The U.S. is increasingly displaying symptoms that its business cycle expansion is at an advanced stage. With inflationary pressures growing more intense, the Fed will need to ratchet up its tightening path. The ECB too has begun removing accommodation. This means that two of the three most important price setters for the cost of money are either fully tightening policy or beginning to remove accommodation. This has historically marked the point when global financial market volatility begins to rise. China Uncertainty China is another factor pointing toward a rise in global financial volatility. China has exerted a benign influence on global growth from the second half of 2016 and through most of 2017. In response to a large easing in monetary conditions and a hefty dose of fiscal stimulus, Chinese growth had until recently regained vigor, with the Li Keqiang index - our preferred measure of Chinese industrial activity - swinging from -2.6 sigma to 0.5 sigma in 15 months. A key gauge of Chinese activity - the average of the new orders and backlog of order subcomponents of the PMIs surveys - captured these dynamics very well. This indicator also explains the gyrations in various measures of asset markets volatility well (Chart I-11). Currently, it points to a rise in global financial market volatility. Going forward, the key question for investors is whether or not Chinese orders continue to deteriorate, flagging a further rise in volatility. We are inclined to say yes. Chinese monetary conditions have continued to deteriorate, and administrative measures to slow down the growth of total social financing are starting to bite. Chart I-12 shows that the issuance of bonds by small financial intermediaries has slowed significantly. Based on this message, the early slowdown in total debt growth should continue over the coming months. Optimists about China often highlight that this should have a limited impact on economic activity. After all, 62% of fixed asset investments in China are financed by internally generated funds. However, the biggest problem for China is the misallocation of capital. As Chart I-13 shows, construction as a percentage of total capex has been linked to population growth. However, after 2008, these two series decoupled: population growth has been stagnating while construction activity has been skyrocketing, despite a slowdown in the rate of migration from rural to urban areas. This suggests that post-2008, China has been building too many structures. Chart I-11China To Affect ##br##Volatility China To Affect Volatility China To Affect Volatility Chart I-12Administrative Tightening Will ##br##Weigh On Chinese Credit Administrative Tightening Will Weigh On Chinese Credit Administrative Tightening Will Weigh On Chinese Credit Chart I-13After The GFC, Chinese ##br##Construction Took Off After The GFC, Chinese Construction Took Off After The GFC, Chinese Construction Took Off When capital is misallocated, even if the share of debt financing is low, tight monetary conditions and administrative measures to limit excesses in the economy can bite sharply. This raises the risk that Chinese growth will not pick up much going forward, and that in fact, capex and industrial activity will struggle. Jonathan LaBerge, who writes BCA's Chinese Investment Strategy, has built a list of some of the key indicators he follows to track the evolution of the Chinese economy. Table I-1 shows that all but the Caixin/Markit manufacturing PMI index are in a downtrend, and that 11 out of the 14 variables have been deteriorating in recent months.1 Moreover, as Chart I-14 illustrates, the strength in the Caixin PMI is likely to be an aberration. When the spread between the Caixin and the official measure is as wide as it currently is, the following quarters tend to be followed by a fall in the average of the two series. Table I-1No Convincing Signs Of An Impending##br## Upturn In China's Economy The Return Of Macro Volatility The Return Of Macro Volatility Chart I-14The Caixin PMI Is Probably##br## The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal We would therefore expect Chinese economic momentum to slow further. Since Chinese policymakers still want to engineer some deleveraging, the Chinese industrial sector will decelerate. This will contribute to the rise in financial market volatility for the remainder of the business cycle, especially as global monetary policy in the G-10 is becoming less accommodative. Bottom Line: The Chinese economy contributed to low levels of volatility in financial markets from 2016 to late 2017. However, China still suffers from a large misallocation of capital, which is making its economy vulnerable to both monetary and administrative tightening. With most key gauges of Chinese economic activity still pointing south, industrial activity could deteriorate further. This will contribute to a rise in global financial market volatility, especially as DM central banks are removing monetary accommodation. Rising Geopolitical Tensions The last factor pointing toward rising financial market volatility are growing global geopolitical tensions. As Marko Papic has highlighted in BCA's Geopolitical Strategy service, the world's unipolar moment under the umbrella of U.S. dominance is over. The world is increasingly becoming a multi-polar environment, where multiple powers vie for local dominance. As the early 20th century and the 1930s showed, when the world becomes multi-polar, geopolitical risks rise (Chart I-15). Chart I-15Geopolitical Risk Is The Outcome Of Global Multipolarity Geopolitical Risk Is The Outcome Of Global Multipolarity Geopolitical Risk Is The Outcome Of Global Multipolarity Today's increasingly multi-polar world may not be headed for an imminent global war, but tensions are likely to increase. This means policies could become more erratic. Additionally, domestic politics are under stain as well. Rising inequality and social stagnation in the U.S. are fomenting public discontent (Chart I-16). Moreover, U.S. citizens are not champions of free trade; in fact, they view unfettered trade with a rather suspicious eye, as do the citizens of Italy, Japan or France (Chart I-17). Chart I-16The U.S. Is Unequal And Ossified The Return Of Macro Volatility The Return Of Macro Volatility Chart I-17America Belongs To The Anti-Globalization Bloc The Return Of Macro Volatility The Return Of Macro Volatility Practically, this means tensions such as those experienced two weeks ago around the imposition of tariffs on steel and aluminum imports into the U.S. are likely to continue. The White House is already discussing the possibility of imposing a 15% tariff on Chinese imports to the U.S. totaling US$60 billion. As we highlighted last week, alleged intellectual property theft by China will likely remain a hot-button topic that could result in painful sanctions, prompting swift retaliation by Beijing. Additionally, NAFTA negotiations are not over, pointing to continued headline risk in the space. Moreover, relations with Russia are tense, and the Iran deal looks increasingly fraught with uncertainty. These two spots could easily morph into yet another source of risk. Bottom Line: The global geopolitical environment has become a multi-polar system - an environment historically prone to serious tensions. The rise of populism in the U.S. only makes this risk more salient, especially with respect to global trade. As a result, the threat of a trade war, especially between the U.S. and China, is increasing. This means shocks to global trade and global growth could become more frequent. This will likely create another source of financial market volatility, compounding the impact of economic fundamentals like global monetary policy and China's economic risks. Investment Implications Carry trades should fare especially poorly in this environment, as they abhor rising volatility.2 Hence, the performance of EM high-yielders like the BRL, TRY, and ZAR could progressively deteriorate. Moreover, because rising volatility often hurts economic sentiment, this increase in volatility could weigh on growth-sensitive currencies like the KRW in the EM space or the AUD and the NZD in the DM space. The SEK would normally suffer when global growth sentiment deteriorates. Yet this time may play out differently. Swedish short rates are -0.5%, making the SEK a funding currency. If carry trades do suffer, the need to buy back funding currencies could put a bid under the SEK. In this context, the JPY and the CHF could be the great winners. Both currencies have been used as funding vehicles. Moreover, both Switzerland and Japan sport outsized net international investment positions equal to 126% and 65% of their respective GDPs. If volatility does rise, some Swiss and Japanese investors will likely repatriate funds from abroad, generating purchases of yen and Swiss francs in the process. Moreover, from an empirical perspective, both these currencies continue to react well when global volatility spikes. Chart I-18The Euro Is Vulnerable To Higher Vol The Euro Is Vulnerable To Higher Vol The Euro Is Vulnerable To Higher Vol However, both Japan and Switzerland are still experiencing weak inflation. The BoJ and the SNB will therefore try to lean against currency strength caused by exogenous volatility shocks. The JPY and the CHF could be caught between these forces. The currency depreciation these central banks try to engineer will be occasionally interrupted by sharp rallies when financial market volatility spikes. This means that monetary policy in these two countries will have to stay extremely accommodative. For now, it is still too early to bet against the yen's current strength. Finally, the impact of rising volatility on the euro's outlook is more nebulous. The euro is neither a carry currency nor a funding currency, but it generally appreciates when global growth sentiment improves. Thus, since long positioning in the euro is very stretched, a renewed spike in volatility would likely hurt the euro, especially as European economic surprises are plummeting relative to the U.S. (Chart I-18). Nonetheless, this pain will be a temporary phenomenon. The euro is still cheap, and one of the factors driving global volatility higher is the ECB abandoning its accommodative monetary policy stance. Moreover, as terminal interest rate expectations in Europe are still well below their historical average relative to the U.S., there is still ample room for investors to upgrade their assessment of where the European policy rate will end up vis-à-vis the U.S. at the end of the cycle. Bottom Line: Any negative impact of rising global financial markets volatility will be felt most acutely by carry and growth-sensitive currencies like the BRL, TRY, ZAR, AUD, and KRW. Contrastingly, funding currencies underpinned with large positive net international investment positions such as the JPY and the CHF will be beneficiaries. The impact on the euro may be negative at first, as speculators are massively long the euro despite a collapse in euro area economic surprises. However, the long-term impact should prove to be more muted as the euro's fundamentals are still improving. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7,2018, available at cis.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was generally positive for the dollar: Headline and core CPI came in line with expectations, growing at 2.2% and 1.8% annually, respectively; NFIB Business Optimism Index was hit 107.6, beating expectations of 107.1; Continuing jobless claims came in at 1.879 million, beating the expected 1.9 million; Initial jobless claims came in line with expectations at 226,000; However, retail sales came in weaker than expected, contracting by 0.1% monthly. Despite this generally positive tone to the data, the dollar was still soft this week. However, downward momentum has slowed, paving the way for a short-term counter trend rally. This is consistent with a global growth slowdown. Report Links: Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was disappointing: Industrial production contracted in monthly terms by 1% and also grew at only 2.7% yearly, less than the expected 4.7% pace; German CPI grew at a 1.4% yearly pace, with the harmonized index growing by 1.2%, both in line with expectations. In a speech on Wednesday, President Draghi clarified that "monetary policy will remain patient, persistent and prudent" as there is still a need for "further evidence that inflation dynamics are moving in the right direction". As global growth is downshifting, the euro could experience a significant correction before resuming its bull market. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth came in at 2.9%, outperforming expectations. However, domestic corporate goods inflation surprised to the downside, coming in at 2.5%. Moreover, the tertiary industry Index month-on-month growth also underperformed expectations, coming in at -0.6%. Finally, labor cash earnings yearly growth came in line with expectations at 0.7%. Last Friday, the BoJ decided to leave its interest rate benchmark unchanged at 0.1%. In its minutes, the board members shared the view that CPI will reach their 2% in fiscal 2019. Overall, we expect that rising global interest rates will cause a rise in currency volatility. This will result in a positive environment for the yen for now, but one that could prevent Japanese inflation from hitting that 2% objective in 2019. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial production yearly growth underperformed expectations, coming in at 1.6%. Manufacturing production also underperformed expectations, coming in at 2.7%. However, the trade balance outperformed expectations, coming in at -3.074 billion pounds. The pound has been relatively flat this week against the U.S. dollar. Overall, we believe that the upside to the British pound against the dollar is limited, as there are already 40 basis points of interest rate hikes priced for the BoE this year. Given that inflation is set to ease following last year's rally in the pound, it is unlikely that the pound will raise rates more than what is currently priced. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was mixed: Home loans fell by 1.1%; Investment lending for homes increased by 1.1%; The NAB Confidence survey declined to 9 from 11 but was in line with expectations; The NAB Conditions survey increased to 21, outperforming expectations; The Westpac Consumer Confidence increased from -2.3% to 0.2%. Elevated Household debt and the absence of wage growth are still at the forefront of Australian policymaker's minds. The RBA is reluctant to raise rates in order to avoid a deflationary spiral which would set the economy back severely. The AUD will most likely suffer this year because of this. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: The current account surprised to the downside, coming in at -2.7% of GDP. Moreover, GDP yearly growth also underperformed expectations, coming in at 2.9%. However, it did improve from last quarter growth of 2.7%. Finally, Food Price Index monthly growth decline from last month, coming in at -0.5%. The New Zealand dollar has been flat this week against the U.S. dollar. We believe that NZD/USD and NZD/JPY are likely to suffer moving forward, as financial markets volatility is set to rise in the coming months due to the rise in global interest rates and the possibility of a slowdown in China. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian employment figures remain strong, with the ADP employment change coming in at 39,700, above the 10,700 experienced last month. Canada's export growth should improve further as the White House is adding large amounts of fiscal stimulus in the U.S. economy, Canada's largest trading partner. This will help the BoC stick to its hiking path. However, risks are high. While Canada has so far been able to avoid the U.S. steel and aluminum tariffs, NAFTA negotiations still remain a danger for the Canadian economy. Furthermore, the housing market still remains overheated and the debt load is at risk of spiraling when mortgages begin to be refinanced at higher rates. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The SNB left its reference rate unchanged at -0.75%. The Swiss central bank reiterated that the negative rates as well as foreign exchange intervention "remain essential". Moreover, the SNB decreased its inflation forecast for this year form 0.7% to 0.6%. The SNB also changed its forecast for 2019 from 1.1% to 0.9%. Overall, the SNB is likely to maintain a very dovish stance, given the headwinds to Swiss inflation. This will continue to put upward pressure on EUR/CHF. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Headline inflation surprised to the upside, coming in at 2.2%. It also increased from 1.6% the previous month. Meanwhile, core inflation also outperformed expectations, coming in at 1.4%. It also increased from 1.1% the previous month. USD/NOK has depreciated by roughly 1.4% this week. On Thursday, the Norges Bank left its policy rate unchanged at 0.5%. In its monetary policy report the central bank highlighted that the outlook for the Norwegian economy suggests that "it will soon be appropriate to raise rates". Overall, we believe that the krone is likely to outperform other commodity currencies, given that there are only 18 basis points priced for the next 12 months, which is less than is warranted given the strength of the economy and BCA's outlook for oil prices in 2018. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 While Swedish inflation came in line with expectations, with consumer prices growing at a 0.7% monthly pace and a 1.6% yearly pace, Sweden's unemployment came in at a much lower level than anticipated. The krona is finally strengthening after EUR/SEK traded above the critical 10.00 level. This trend should continue as the euro weakens from overbought levels. Furthermore, the eventual resurgence of inflation in Sweden will propel the SEK to stronger levels as markets reprice the Riksbank's likely policy path. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights There are many things that central bankers know they don't know. "Known unknowns" include the outlook for growth (both actual and potential), NAIRU, the neutral rate of interest, and the true shape of the Phillips curve. "Unknown unknowns" are, by definition, unknowable, but are often at the heart of economic downturns. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around, most likely in 2020. Keep a close eye on credit spreads. Stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Feature Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones. - Donald Rumsfeld, former Secretary of Defense under George W. Bush Uncertainty Galore Central bankers know many things. They know that growth is currently strong across most of the world, unemployment is falling and inflation, while still low, has been slowly trending higher. Unfortunately, there are also many things they don't know. These include things they know they don't know, as well as things that are not even on their radar screens - the "unknown unknowns" that Donald Rumsfeld famously warned about. Known Unknowns Let's start with five "known unknowns." 1. Will Growth Stay Strong? Global growth has likely peaked, but should remain comfortably above-trend over the remainder of this year (Chart 1). The OECD's Global Leading Economic Indicator (LEI) has leveled off, while the diffusion index, which tabulates the share of countries with rising LEIs, has dropped below 50 percent. A fall in the diffusion index has often foreshadowed outright declines in the composite LEI. Consistent with this prognosis, the Citi global Economic Surprise Index has swooned, the Chinese Keqiang index has decelerated, and Korean export growth - a leading indicator for global trade - has slowed. Global manufacturing PMIs have also edged off their highs (Chart 2). The one exception is the U.S., where the ISM index continues to power higher. Despite the occasional blip such as this week's retail sales report - which was probably depressed by tax refund delays - recent U.S. economic data have been reasonably upbeat. Goldman Sachs' Current Activity Indicator remains near cycle highs, implying strong momentum going into the second quarter. Chart 1Global Growth Has Peaked ##br##But Will Remain Above Trend Global Growth Has Peaked But Will Remain Above Trend Global Growth Has Peaked But Will Remain Above Trend Chart 2Global Manufacturing PMIs ##br##Are Off Their Highs Global Manufacturing PMIs Are Off Their Highs Global Manufacturing PMIs Are Off Their Highs Changes in financial conditions tend to lead growth by about six-to-nine months. U.S. financial conditions have eased a lot more since the start of 2017 than elsewhere (Chart 3). In addition, U.S. fiscal policy is likely to be much more expansionary over the next two years than in the rest of the world (Chart 4). All this suggests that the composition of global growth will shift in favor of the U.S. over the coming months. Chart 3Composition Of Global ##br##Growth Will Shift To The U.S. ... Composition Of Global Growth Will Shift To The U.S. ... Composition Of Global Growth Will Shift To The U.S. ... Chart 4U.S. Fiscal Policy Will Become More ##br##Expansionary Than In R.O.W. What Central Bankers Don't Know: A Rumsfeldian Taxonomy What Central Bankers Don't Know: A Rumsfeldian Taxonomy 2. Will Potential Growth Accelerate? The U.S. unemployment rate has declined from a high of 10% in 2009 to 4.1% in February 2018, even though real GDP growth has averaged a meager 2.2% over this period. Extremely weak productivity growth explains why the output gap has managed to contract in the face of subdued GDP growth. Sluggish capital spending has exacerbated the productivity downturn, but probably did not cause it. Chart 5 shows that productivity growth began to decelerate well before the financial crisis erupted. The slowdown has been pervasive across countries and sectors. Economists have a poor track record of predicting productivity trends. Not only did they fail to predict the productivity revival in the late 1990s, but because of data lags and subsequent revisions, they did not even know it had happened until the early 2000s. It is too early to say whether robotics and AI will yield the same sort of productivity windfall that the Internet did. My colleagues, Mark McClellan and Brian Piccioni, have cast a skeptical eye on some of the alleged revolutionary breakthroughs in both fields.1 If it turns out that the late 1990s was the exception rather than the rule, and that we are going back to the lackluster productivity performance of the 1970s, this will make life more challenging for central bankers. 3. What Is The True Level Of NAIRU? Spare capacity has diminished in most countries, but questions linger over how much slack remains. No one truly knows where NAIRU - the so-called Non-Accelerating Inflation Rate of Unemployment - really stands. The Fed and the Congressional Budget Office believe that NAIRU has fallen from over 6% in the late 1970s to around 4.5%-to-4.7% today (Chart 6). Chart 5Productivity Growth Slowdown ##br##Has Been Pervasive Productivity Growth Slowdown Has Been Pervasive Productivity Growth Slowdown Has Been Pervasive Chart 6NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards An aging workforce has reduced frictional unemployment because older workers are less likely to switch jobs than younger ones. The internet has also made it easier for employers to find suitably qualified workers. On the flipside, globalization, automation, and the opioid crisis have likely made it difficult for a growing list of workers to hold down a job for long. Our best guess is that the U.S. economy is operating at close to full employment. This is confirmed by various employer surveys, which show that companies are struggling to find qualified workers (Chart 7). The fact that the share of people outside the labor force who want a job has fallen to pre-recession levels also suggests that labor slack is running thin (Chart 8). Chart 7U.S. Economy: Operating At ##br##Close To Full Employment U.S. Economy: Operating At Close To Full Employment U.S. Economy: Operating At Close To Full Employment Chart 8Few People Left Who Are Eager ##br##To Rejoin The Labor Force Few People Left Who Are Eager To Rejoin The Labor Force Few People Left Who Are Eager To Rejoin The Labor Force There is more slack outside the United States. Labor underutilization is still 2.5 percentage points higher in the euro area than it was in 2008. Taking Germany out of the picture, labor underutilization is nearly six points higher (Chart 9). A number of major emerging markets, most notably Brazil and Russia, also have a lot of excess cyclical unemployment. The Japanese labor market has tightened significantly in recent years, but there is probably a fair amount of hidden underemployment left, particularly in the service sector (factoid of the week: there are more police officers in Tokyo than in New York City).2 4. Where Is The Neutral Rate Of Interest? One of the most vexing questions facing central banks is how high interest rates can go before they move into restrictive territory. There are a variety of reasons for thinking that the neutral real rate of interest - the rate consistent with full employment and stable inflation - is lower today than it was in the past. Trend real GDP growth has fallen. This has reduced the need for firms to expand capacity. The shift to a capital-lite economy - where value-added increasingly takes the form of bits and bytes rather than factory output - has further reduced the need for fresh investment. Meanwhile, a reluctance to take on new debt has restrained spending. Rising inequality has shifted more wealth into the hands of people who tend to save a lot. Globally, savings must equal investment. If desired savings go up and desired investment goes down, interest rates must fall to push down the former and push up the latter (Chart 10). Chart 9Euro Area: There Is Still Labor ##br##Market Slack Outside Of Germany Euro Area: There Is Still Labor Market Slack Outside Of Germany Euro Area: There Is Still Labor Market Slack Outside Of Germany Chart 10Interest Rates Must Fall If Desired Savings ##br##Increase And Desired Investment Declines What Central Bankers Don't Know: A Rumsfeldian Taxonomy What Central Bankers Don't Know: A Rumsfeldian Taxonomy None of these forces are immutable, however. Investment demand appears to be picking up, as judged by capex intention surveys (Chart 11). Consumer credit is rising anew. The U.S. personal saving rate is back near an all-time low (Chart 12). A tighter labor market is likely to cause labor's share of income to rise, just like it did in the late 1990s (Chart 13). This should boost aggregate demand. An unprecedented increase in the U.S. budget deficit should help absorb much of the savings from cash-rich corporations (Chart 14). Meanwhile, savings are likely to decline over the long haul as well-paid baby boomers retire en masse. All this is causing the neutral rate to move higher. Chart 11Upswing In Global Capex Is Underway Upswing In Global Capex Is Underway Upswing In Global Capex Is Underway Chart 12U.S. Consumer Credit Revival U.S. Consumer Credit Revival U.S. Consumer Credit Revival Chart 13Tight Labor Market And Rising Labor ##br##Share Of Income: A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Chart 14Now Is The Time For Fiscal Consolidation, Not Profligacy Now Is The Time For Fiscal Consolidation, Not Profligacy Now Is The Time For Fiscal Consolidation, Not Profligacy 5. What Is The Shape Of The Phillips Curve? Central bankers assume that dwindling spare capacity will lead to higher inflation, a relationship immortalized by the so-called Phillips curve. The fact that inflation has barely risen over the past few years is an obvious challenge to this theory. It may simply be that the Phillips curve is "kinked" at very low levels - it only steepens when the economy has gone beyond full employment. The fact that it has taken this long to reach the kink could explain why inflation has not taken off sooner. The success that central banks have enjoyed in anchoring long-term inflation expectations is another reason why the Phillips curve has become flatter. Chart 15An Overheated Economy Led To ##br##Rising Inflation In The 1960s An Overheated Economy Led To Rising Inflation In The 1960s An Overheated Economy Led To Rising Inflation In The 1960s The problem is that there is no God-given reason why inflation expectations should stay well anchored. Core inflation was remarkably low and stable in the first half of the 1960s. However, the combination of low real interest rates and increased fiscal spending associated with Lyndon Johnson's Great Society programs and the Vietnam War led to a surge in inflation starting in 1966 (Chart 15). Inflation kept climbing thereafter, rising to 6% in 1970. This was three years before the first oil shock occurred, suggesting that an overheated economy, rather than OPEC, was the main inflationary culprit. Unknown Unknowns Then there are the things central bankers are not even thinking about, or even worse, the things they think are true but aren't.3 In the lead-up to the Great Recession, U.S. policymakers blithely assumed that house prices could not fall at the nationwide level. This caused them to turn a blind eye to soaring home prices and the deterioration of underwriting standards in the mortgage market. Warren Buffet once said, "Only when the tide goes out do you discover who's been swimming naked." Our guess is that rising rates will expose a lot of things one would rather not see in the corporate debt market. In the latest issue of the Bank Credit Analyst, my colleague Mark McClellan estimated that the interest coverage ratio for U.S. companies would drop from 4 to 2.5 if rates increased by 100 basis points across the corporate curve. Such a move would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 16A and Chart 16B).4 Consumer staples, tech, and health care would be the most adversely affected. Chart 16AU.S. Interest Coverage Ratio ##br##Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) Chart 16BU.S. Interest Coverage Ratio ##br##Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) Political shocks are also very difficult for policymakers to foresee. President Trump's decision to impose steel and aluminum tariffs spooked the markets. NAFTA negotiations remain stalled and the odds are high that the U.S. will pursue trade sanctions against China for alleged intellectual property theft. That said, as we noted last week, an all-out trade war would cause equities to crater.5 Trump remains focused on the value of the stock market as a gauge of the success of his presidency. This will curb his hawkishness. Unemployment is also very low these days, which limits the attractiveness of protectionist policies. The specter of trade wars will escalate if a recession causes stocks to tumble and unemployment to rise in key midwestern swing states. Other "unknown unknowns" include another flare-up in sovereign debt markets in Europe, a hard landing in China, and a supply-induced spike in oil prices. Investment Conclusions It may be tempting to think that central banks can calibrate monetary policy as events unfold in order to keep economies on an even keel. If only it were so easy. Monetary policy affects the economy with a lag of 12-to-24 months. By the time it is clear that either more or less monetary stimulus is needed, it is often too late to act. Central bankers have to work with incomplete or inaccurate data. One of the reasons that inflation spiraled out of control in the 1970s was because the Federal Reserve systematically overstated the size of the output gap (Chart 17). This led the Fed to falsely conclude that slower growth was the result of inadequate demand rather than a deceleration in the economy's supply-side potential. It is impossible to know what mistakes central banks will make in the future, but it is almost certain that something will go awry. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around. As we discussed several weeks ago, the next recession is most likely to arrive in 2020.6 Investors should stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Similar to the 1970s, investors should expect inflation and bond yields to make a series of "higher highs" and "higher lows" with every boom/bust episode (Chart 18). Chart 17The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Chart 18A Template For The Next Decade? A Template For The Next Decade? A Template For The Next Decade? Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Technology Sector Strategy Special Report, "The Coming Robotics Revolution," dated May 16, 2017; The Bank Credit Analyst, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017; and The Bank Credit Analyst, "The Impact Of Robots On Inflation," dated January 25, 2018. 2 "As crime dries up, Japan's police hunt for things to do," The Economist, May 18, 2017. 3 Mark Twain is often credited for saying that "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." It's a great quote, but there's only one problem: There is no evidence that he ever said it. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 5 Please see Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018. 6 Please see Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," dated February 23, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Escalating trade tensions - most notably between the U.S. and China, and the U.S. and its NAFTA partners - threaten the outperformance ags posted in 1Q18, which was driven by unfavorable weather and transportation disruptions in major producing regions, along with a weak dollar. Energy: Overweight. The IPO of Saudi Aramco apparently will be delayed into 2019, according to various press reports. New York, London and Hong Kong remain in contention for the foreign listing of KSA's national oil company. Base Metals: Neutral. China's iron ore and copper imports in January - February 2018 were up 5.4% and 9.8% y/y, respectively. China's year-to-date (ytd) steel product exports are down 27.1% y/y, while ytd aluminum exports are up 25.8% y/y. The aluminum data are consistent with our assessment that the global aluminum deficit will likely ease this year.1 Precious Metals: Neutral. A global trade war would boost gold's appeal, and we continue to recommend it as a strategic portfolio hedge. Ags/Softs: Underweight. Weather and transport disruptions boosted global ag markets in 1Q18. However, this outperformance is under threat as global trade tensions build (see below). Feature Chart of the WeekAgs Are Off To A Good Start Ags Are Off To A Good Start Ags Are Off To A Good Start Weather concerns in highly productive regions of South America as well as the U.S. have supported ag prices since the beginning of the year (Chart of the Week). Corn and wheat bottomed in mid-December, and have since gained 14.8% and 25.4%, respectively, while soybeans bottomed mid-January and have since gained 10.6%. This pushed the Grains and Oilseed CCI up 12.6% since the beginning of the year. Drought ... And Flooding In The U.S. Erratic weather in the U.S. could affect yields. The chief areas of concern are the U.S. mid-South and lower Midwest, which have recently experienced flooding, and are raising fears of lower yields of winter wheat. At the same time, the area from Southwestern Kansas to Northern Texas experienced unusually dry weather, causing winter grains to suffer. On top of that, high water levels in the Ohio River also led to shipping disruptions. Although the U.S. Department of Agriculture (USDA) did not lower its 2017/18 estimates of U.S. wheat yields in its latest World Agricultural Supply and Demand Estimates (WASDE), yield estimates stand significantly lower than those of the last crop year (Chart 2). In addition, American wheat farmers are expected to harvest the smallest area recorded in the history of the series, which dates back to the 1960/61 crop year. U.S. wheat production is expected to be the lowest since 2002/03 - a 25% year-on-year (y/y) drop in output. As a result, the U.S. supply surplus will likely be the smallest since 2002, weighing on U.S. exports. The U.S. generally accounts for only ~8% of global wheat production, and increases elsewhere, primarily in Russia and India, are expected to more than offset the fall in U.S. output. Despite the poor conditions in the U.S., global supply is expected to continue growing this year with the wheat market in surplus and inventories swelling to record levels (Chart 3). Chart 2Depressed Yield, Record Low Acreage In U.S. Depressed Yield, Record Low Acreage In U.S. Depressed Yield, Record Low Acreage In U.S. Chart 3World Remains Well Supplied World Remains Well Supplied World Remains Well Supplied Drought In Argentina Supporting Soybean, And To A Lesser Extent Corn Prices In addition to the unfavorable North American weather, warm and dry weather in Argentina have resulted in a fall in estimated yields of Argentine corn and soybeans.2 Argentina accounts for 14% and 3% of global soybean and corn production, respectively. The USDA cut back its estimate of Argentine soybean production by 13% in the latest WASDE, causing a downward revision of ~4 mm MT in global inventories (Chart 4). Although Argentina's estimated corn output was also reduced, the resulting decline in its exports is expected to be picked up by U.S. exports. American farmers thus are benefitting from the unfavorable weather in Argentina. As is the case with soybeans, the net effect on corn is a 4 mm MT downwards revision to global inventories. In addition, grain exports from Argentina's main agro-export hub of Rosario were stalled last month due to a truckers' strike. While the strike has now eased, it led to transportation bottlenecks and contributed to limited global supply earlier this year. Back in the U.S., the Trump administration's lack of clarity regarding where it stands on the Renewable Fuel Standard (RFS), which mandates refiners blend biofuels like corn-based ethanol into the nation's fuels, is worrying farmers. While the energy industry is unsatisfied with the current policy, claiming that the RFS is unfair and costly, it gives a lifeline to corn farmers with excess stock. Bottom Line: Unfavorable weather and transportation disruptions, primarily in the U.S. and Argentina, have been bullish for ags since the beginning of the year. Lower production is expected to push both soybeans and corn to deficits in 2017/18 (Chart 5). The longevity of the impact of these forces hinges on whether the weather will improve between now and harvest, causing yields to come in better-than-expected. Chart 4Weather Weighs On Soybean And Corn Yields Weather Weighs On Soybean And Corn Yields Weather Weighs On Soybean And Corn Yields Chart 5Corn And Soybeans In Deficit This Year Corn And Soybeans In Deficit This Year Corn And Soybeans In Deficit This Year "We Can Also Do Stupid"3 In addition to the impact of his domestic immigration policy on the availability of farm workers, President Trump's controversial trade policies are threatening to spill into ags.4 In direct response to the 25% and 10% tariff Trump slapped on steel and aluminum imports, several of America's key ag trading partners have already reacted by communicating the possibility of imposing similar tariffs on their imports of American goods - chiefly agricultural goods. Among the commodities rumored to be at risk are Chinese soybean, sorghum and cotton imports, and EU agriculture imports including corn and rice imports. While President Trump's stated aim is to make America great again by reviving industries hurt by cheap imports and unfair trade, his strategy is proving risky as many of the trade partners he is threatening to rock ties with are in fact major consumers of U.S. agricultural products (Chart 6). In fact, the top three importers of U.S. ag products - collectively accounting for 42%, or $58.7 billion worth of U.S. ag exports in 2017 - are Canada, China, and Mexico (Charts 7A and 7B). Chart 6Risky Strategy, Mr. President Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio Chart 7ASoybeans Appear To Be At Risk... Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio Chart 7B... As Is Cotton Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio However, when it comes to the bulk commodities we cover, China is by far the U.S. ag industry's biggest customer - importing more than 30% of all U.S. exports, equivalent to $14.9 billion. Thus, China appears to have significant leverage in the case of a trade war, and U.S. farmers are worried of the impact from trade disputes. China has already indicated that it is investigating import restrictions on sorghum. Chinese trade restrictions - if implemented - will have a significant impact on U.S. sorghum farmers. In value terms, sorghum exports contributed less than 1% to U.S. agricultural product exports last year, but exports to China made up more than 80% of all U.S. sorghum exports. Sino-American Trade Dispute Would Hurt U.S. Ags...But Not As Much As Is Feared Chart 8Relatively Low Soybean Inventories Relatively Low Soybean Inventories Relatively Low Soybean Inventories The biggest fear among U.S. farmers is not the loss of sorghum exports, but that China will impose restrictions on its imports of U.S. soybeans. Soybeans are the U.S.'s largest ag export - contributing 16% to the value of all agricultural product exports. Nearly 60% of U.S. soybean exports, and more than a third of U.S. soybeans, end up in China. Thus it may appear that China has some leverage there. In fact, Brazil, which is already China's top soybean supplier, has already communicated that it would be willing to supply China with more soybeans. However, China's ability to find alternative suppliers is questionable. While China imported ~32 mm MT of soybeans from the U.S. last year, Brazil's total soybean inventories stand at ~22 mm MT. Brazil simply does not have enough excess supply to cover all of China's needs. In fact, global soybean inventories are ~95 mm MT - only three times the amount of China's annual imports from the U.S. On top of that, although China generally tries to shield itself from supply shocks by building large inventories, its soybean inventories - measured as stocks-to-use - are significantly lower than that of other ags (Chart 8). In fact, Beijing has already tightened its scrutiny on U.S. soybeans, announcing at the beginning of the year that it would no longer accept shipments with more than 1% of foreign material. Half of last year's shipments reportedly would have failed this criterion, and the net effect of this new policy is higher costs for U.S. farmers. Cotton is another agricultural commodity that China has indicated may be caught up in a trade dispute. 16% of U.S. cotton exports went to China last year, but although the U.S. is the dominant global cotton exporter, its value accounts for less than 5% of total U.S. agricultural products exports. Given that China's inventories are extremely high - enough to cover a year's worth of consumption - and that Chinese imports from the U.S. are equivalent to ~3% of global inventories, there is significant opportunity for China to diversify its imports and find an alternative supplier to the U.S. Bottom Line: Although China would be better able to implement restrictions on cotton imports from the U.S. compared to soybeans, the impact on U.S. farmers would be less painful given that they are not as dependent on China as U.S. soybean farmers are. U.S. Ags Dominate Exports, But Substitutes Abound The U.S. is the world's top exporter of corn and cotton, and the second largest exporter of wheat and soybeans. While it remains a dominant player in global export markets, its share of global agriculture exports has been declining sharply over time (Chart 9). While in levels, the general trend for U.S. agriculture exports - with the exception of wheat - appears to be upward, the share of U.S. exports as a percentage of global exports has actually been falling. Compared to the year 2000, the global share of U.S. corn and wheat exports has almost halved, going from 64% to 36%, and 29% to 14%, respectively. In the soybean market, U.S. soybean exports now account for 37% of exports, down from half of global trade. Lastly, U.S. rice exports now account for 7% of global exports, a fall from 11% in 2000. Unlike most other ag commodities, U.S. cotton has captured a larger share of the global market - currently at almost 50%, from 26% in 2000. Russian, Canadian, and European wheat farmers have been tough competitors. This crop year, Russia is expected to surpass the U.S. as the top wheat exporter for the first time (Chart 10). In addition, while the U.S. was the dominant wheat exporter just 10 years ago, more recently, Canada and the EU have on some occasions exported more wheat than the U.S. Chart 9U.S. Exports Relatively Less Attractive U.S. Exports Relatively Less Attractive U.S. Exports Relatively Less Attractive Chart 10U.S. Exports Face Growing Competition Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio In the case of soybeans, Brazilian exports have grown significantly since 2010, consistently exporting more than the U.S. since 2012. Brazilian corn exports are also catching up to the U.S., as are Argentine corn exports which have been growing steadily. If these trade disputes prove to be an ongoing trend, we see two potential scenarios panning out: U.S. farmers could move away from farming crops most impacted by trade restrictions, and instead increase the farmland allocated to crops that are consumed domestically, and thus insulated from the Trump administration's trade policy decisions. In this scenario, the longer term impact would be an increase in the supply of locally consumed ags and a decrease in the U.S. supply of exportable ags. Global ag trade flows could shift, such that U.S. allies begin importing more of their ag products from the U.S., while countries that are in trade disputes with the U.S. switch to other ag suppliers. NAFTA Is Still At Risk The ongoing re-negotiation of NAFTA ultimately could lead to an abrogation of the treaty. Should this evolve with no superseding bilateral trade agreements, it would mark a significant blow to the U.S. agricultural industry. Mexico is the second-largest destination for U.S. agricultural exports after China, accounting for 13% of all U.S. exports of agricultural bulks, while Canada makes up a much smaller 2% share. Nearly 30% of U.S. corn exports and 23% of U.S. rice exports end up in Mexico. As a result, these two bulks are especially vulnerable in the event of a treaty abrogation. Wheat, cotton and soybeans - Mexico accounts for 14%, 7%, and 7% of these exports, respectively - would also be impacted by a trade dispute. In the interest of diversifying its sources of ag imports, Mexico has already started exploring other suppliers from South America. Its corn imports from Brazil are reported to have increased 10-fold last year. Furthermore, government officials and grain buyers have been visiting Brazil and Argentina to investigate other ag suppliers for Mexico. BCA Research's Geopolitical Strategy service assign a 50/50 probability to a breakdown in the NAFTA negotiations. In the event of a NAFTA abrogation, they assign a 25% chance of a failure to strike bilateral agreements - resulting in a conditional probability of only 12.5%. Bottom Line: The shrinking role of the U.S. as a global ag supplier at a time when global storage facilities are well-stocked will - in most cases - allow its global consumers to diversify away from U.S. exports. In the case of soybeans, however, this is less certain. A Weaker USD Also Helped Buoy Ag Prices In 1Q18 Chart 11A Stronger Dollar Would Weigh On Ags A Stronger Dollar Would Weigh On Ags A Stronger Dollar Would Weigh On Ags A weaker dollar has been supportive of commodities prices so far this year (Chart 11). The recent bout of U.S. import restrictions has investors expecting the USD to further weaken on the back of a trade war. However, our FX Strategists believe the current set of tariffs will have a muted effect on the dollar.5 In fact, given that the U.S. economy is currently at full employment, and their expectation that the Fed will be proactive, tariffs will likely generate inflationary pressures, causing the tighter monetary policy, which does not support further weakening of the USD. Bottom Line: A pick-up in the dollar along with an escalation in trade disputes or the scrapping of NAFTA would be bearish for ags. For now, bullish weather forecasts prevail, and are keeping prices well supported. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Global Aluminum Deficit Set To Ease," dated March 1, 2018, available at ces.bcaresearch.com. 2 Soybean and corn plantings are reported to be half their typical height. Please see "Argentina Drought Bakes Crops Sparks Grain Price Rally," available at reuters.com. 3 As expressed by EU Commission President Jean-Claude Juncker's about the potential tit-for-tat retaliatory measures in response to steel and aluminum import tariffs. 4 According to Chuck Conner, president of the National Council of Farm Cooperatives, and former deputy agriculture secretary during the George W. Bush administration, roughly 1.4 million undocumented immigrants work on U.S. farms each year, or roughly about 60% of the agriculture labor force. 5 Please see BCA Research's Foreign Exchange Strategy Weekly Report titled "Are Tariffs Good Or Bad For the Dollar?," dated March 9, 2018, available at fes.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio Trades Closed in 2018 Summary of Trades Closed in 2017 Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio

Highlights The protectionist option in U.S. policy is here to stay; President Trump is likely to impose punitive measures on China before the U.S. midterm elections; The U.S. Section 301 investigation into China's intellectual property theft is about national security more than trade; China's NPC session suggests the Communist Party is downshifting growth rates; The North Korean diplomatic breakthrough is real ... stay focused on U.S.-China tensions. Feature "I won't rule out direct talks with Kim Jong Un. I just won't ... As far as the risk of dealing with a madman is concerned, that's his problem, not mine." - U.S. President Donald J. Trump, March 4, 2018 Two of our key 2018 views came to the fore over the past two weeks. First, U.S. President Donald Trump took protectionist action that rattled the markets.1 Second, North Korean diplomacy surprised to the upside, with Trump accepting an invitation to meet with Kim Jong Un by this May.2 The nuclear program is allegedly up for discussion. Markets recovered quickly from Trump's steel and aluminum tariffs, with the VIX falling and American and global equities continuing to rally (Chart 1). Trump's formal tariff proclamation was not as disruptive as some had feared. He provided exemptions for entire countries - rather than merely companies - based on an appeals process that will include economic as well as geopolitical criteria. But while he struck an optimistic note on NAFTA (on which Canada's and Mexico's exemptions will depend), he struck a pessimistic note on trade talks with China. Chart 1Markets Shrugged Off Protectionism Markets Shrugged Off Protectionism Markets Shrugged Off Protectionism China is quickly becoming the foremost political and geopolitical risk of the year, as we discuss in this report. First, diplomacy with North Korea will not remove the risk of serious U.S. protectionism toward China.3 Second, China's domestic reforms are proceeding, posing downside risks to Chinese imports and hence global growth. We conclude with a brief word on why investors should take the North Korean diplomacy as a hugely positive development. There may be some volatile episodes during the upcoming negotiations, but U.S.-China relations are the real risk and North Korea remains largely a derivative of the emerging "Warm War" between the two global behemoths. "Death By China" In the past few weeks, the Trump administration has moved swiftly to begin implementing its protectionist platform.4 Trump's formal announcement of global tariffs on steel and wrought and unwrought aluminum products marked the shift, although investors got a foreshadowing with the January announcement of washing machine and solar panel tariffs. The latest tariffs are insignificant in macroeconomic terms. They will affect less than 0.3% of global exports and less than 2% of U.S. imports.5 The market has thus far cheered the limited scope of the tariffs and the numerous exemptions that will surely follow. But the danger is that investors are underestimating the political shifts that underpin Trump's move. In fact, there is little reason to think that protectionism will fade when Trump leaves office: Americans are susceptible to it, according to opinion polling (Chart 2). Now that the seal has been broken - and that by a president who hails from the "pro-free trade" Republican Party - the danger is what happens when the next recession occurs. Politicians of all stripes will be more likely to propose protectionist solutions. The long trend of decline in U.S. tariffs since the 1930s may gradually begin to reverse (Chart 3), confirming our key decade theme that globalization has reached its apex. Chart 2Americans Not Immune To Protectionism Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 3U.S. Tariffs: Nowhere To Go But Up! U.S. Tariffs: Nowhere To Go But Up! U.S. Tariffs: Nowhere To Go But Up! How far will the protectionist threat go in the short term? Investors should focus on two bellwethers. First, the outcome of NAFTA re-negotiations.6 Second, a decision by the Trump administration on how to respond to the U.S. Trade Representative Section 301 of the Trade Act of 1974 investigation into China's practices on technology transfer, intellectual property, and innovation, discussed below. China is an industrial powerhouse that is becoming more technologically adept, which threatens the core advantage of the United States in what could soon become a "Warm War" between the two global hegemons. Trump was elected on a pledge to get aggressive on China and is relatively unconstrained on trade policy (Table 1). U.S.-China economic interdependency has declined, reducing the two countries' ability to manage tensions.7 Table 1Trump Lacks Legal Constraints On Trade Issues Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Moreover, Trump is relatively unpopular - which jeopardizes the GOP Congress in November - and he will need to take actions to remain relevant ahead of the November 6 midterm elections (Chart 4). The U.S. and China are currently bickering about the size of the trade imbalance (Chart 5), not to mention the causes and solutions. What will the U.S. demand? This was the question of Xi Jinping's top economic adviser, Politburo member Liu He, when he visited Washington D.C. on March 1-3 for emergency meetings with the U.S. administration. He was rebuffed with the announcement on tariffs. Washington has been arguing that high-level dialogues with China - that investors cheered after the Mar-a-Lago Summit - have failed and that punitive measures will go forward unless China makes quick and concrete improvements to the trade balance, starting with $100 billion worth of new imports.8 Chart 4Trump's Low Approval Jeopardizes Control Of Congress In November Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 5U.S.-China: Disagreeing Even On The Facts U.S.-China: Disagreeing Even On The Facts U.S.-China: Disagreeing Even On The Facts In response, Liu has promised that China will redouble its economic "reform and opening up" process and has asked the United States for an official list of demands. Our sense is that there are broadly two types of demands: Cyclical demands: Beijing often does one-off purchases of big-ticket items to ally Washington's ire over trade. This time, it would have the added benefit for Trump of coming right ahead of the midterm election. Trump's request on March 8 for an immediate $100 billion reduction in the trade deficit could fall in this category. Structural demands: If Trump seeks to be a game changer in the U.S.-China relationship, then he will demand accelerated structural reforms: for instance, a lasting decrease in the deficit due to a permanent opening of market access. He could also begin pushing a "mirror tax" on trade (reciprocal tariffs) so as to reduce the gap between the U.S. and China, which is less justifiable now that China is an economic juggernaut (Chart 6). Trump could also demand action on several long-standing U.S. requests: Chart 6Not All That Much Daylight On U.S.-China Tariff Rates Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Opening foreign investment access to a broad range of sectors (beyond finance), such as transportation, logistics, information technology, or even telecommunications; The right to operate wholly U.S.-owned companies in China; An open capital account and truly free-floating currency; Subsidy cuts for state-owned enterprises (SOEs); Full digital access for U.S. tech companies; An improved arbitration system for legal disputes. Since rapidly implementing many of these demands could threaten China's stability or even undermine the Communist Party, Trump may have to use the threat of sweeping tariffs to try to force them through. The current news flow suggests that Trump is favoring cyclical solutions. At the same time, we expect China to make at least some significant structural compromises: China does not want a trade war. China is more exposed to the U.S. than the U.S. is to China (Chart 7). Moreover, China's political system is rigid and opposed to mass unemployment. The last time China allowed mass layoffs was in 1999, and even then the state controlled the process. A trade war, by contrast, would threaten 223 million manufacturing employees with uncontrolled job losses. The central government is focused on stability; while it will insist on "saving face" internationally through tit-for-tat measures, it will go to great lengths to avoid a negative spiral. This will require compromises. China wants structural reform. Xi Jinping is rebooting a reform agenda that requires transitioning away from old industries. These reforms are long overdue and Xi can parlay many of them to pacify Trump. For instance, China has improved the market-orientation of the renminbi, causing Trump to cease his complaints about currency manipulation (Chart 8). China currently claims it is about to increase imports and open its financial sector further to foreign investment. Chart 7China More Exposed To U.S., But Not By Much Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 8China: Structural Reform As Trade Concession China: Structural Reform As Trade Concession China: Structural Reform As Trade Concession The jury is still out on the deepest structural issues. We expect Xi's latest reform push to surprise to the upside, but it is not clear how far he will go. For instance, while Beijing might begin to ease capital controls imposed in 2016, it would be a shock if it agreed to rapidly liberalize the capital account. The same goes for granting extensive access to strategic sectors, downgrading state support for SOEs, or moderating cyber controls that punish U.S. companies. Any promises of gradual progress on these issues will likely be seen by the U.S. as no different from past promises to past presidents. Hence everything depends on whether Trump will be satisfied by token Beijing actions that look good ahead of the midterms. It is ominous that China has already drastically cut steel and aluminum overcapacity, and yet Trump imposed tariffs anyway. This kind of delayed retribution could become a pattern. Bottom Line: China has the means to prevent a trade war through significant compromises that Trump can advertise as "wins" to his domestic audience this November. If Trump accepts these concessions, the risk of trade war will effectively be removed until the next major electoral test in 2020. However, Trump lacks constitutional and legal constraints on the use of tariffs, which means that he can override China's offers and instigate a trade war anyway. This risk has a fair probability, given midterm politics and the fact that overall U.S.-China interdependency, the key economic constraint to conflict, has eroded over the past decade. A Bellwether: The Intellectual Property Investigation The immediate bellwether for the Trump administration's appetite for trade war will be Trump's handling of the Section 301 investigation on technology transfer, intellectual property (IP), and innovation. A ruling is due no later than August 18, but reports indicate action could come quickly.9 Section 301 of the U.S. Trade Act of 1974 is the prime law by which the U.S. seeks to enforce trade agreements, resolve disputes, and open markets. Under this law, the U.S. executive - i.e. the president - can impose trade sanctions against countries deemed to be violating trade agreements or engaging in unreasonable or discriminatory trade practices. The law is specific in addressing intellectual property violations and closed market access, and yet broad in giving the executive leeway to interpret "unjustifiable" practices and mete out punishment. It does, however, require negotiations with the foreign trading partner to remedy the situation before the U.S. imposes duties or other remedies. We expect the U.S. to draw a hard line. A close look reveals that this Section 301 probe is primarily addressing strategic problems, not trade problems. To be fair, the U.S.'s trade grievances have merit. Clearly there is room for China to improve the IP trade balance. The ratio of IP receipts versus IP payments shows that the U.S. is a world-leader, while China is an extreme IP laggard, as one would expect (Chart 9). And yet the U.S. barely runs a trade surplus with China in IP, and far less of a surplus than with Taiwan and Korea, which are more advanced than China and thus ought to be more competitive with the U.S. than China (Chart 10). The U.S. appears particularly disadvantaged in the Chinese market when it comes to computer software and trademarks (Chart 11), judging by its IP exports to similar Asian partners. Chart 9China Is An Innovation Laggard... Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 10... Yet Its IP Deficit With U.S. Is Small Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Also, in many cases Chinese companies have gained a dominant share of new markets, like e-commerce, where the U.S. would have a larger share if it had been allowed to compete fairly in the nascent stages. The U.S. wants to prevent this from happening again. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices, and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners (Chart 12). China will have to compromise on this program to stave off tariffs. Chart 11China Skirting Fees On U.S. Software? Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 12China's High-Tech Protectionism Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Nevertheless, China is a large and growing market for U.S. high-tech goods, intellectual property, and services exports (Chart 13). A comparison with Taiwan and South Korea suggests that China could open up greater access to these U.S. exports (Chart 14). The truth is that, unlike with staunch ally Japan, the U.S. harbors deep misgivings about China's strategic intentions. This is why it limits high-tech exports to China - which, as Beijing often points out, creates an abnormal imbalance in this column of the trade book (Chart 15). Chart 13U.S. Tech And IP Exports To China Growing Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 14China Could Give U.S. More Market Share Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 15U.S. Deficit Due To Security Concerns Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Thus while the trade concerns above are not to be scoffed at, the Section 301 probe is clearly about U.S. security. The main practices under investigation are: Forced technology transfer by means of joint-venture (JV) requirements, ownership caps, government procurement, and administrative or regulatory interventions; Unfair licensing and contracting pricing, and abuses of proprietary technology; State-backed investment and/or acquisitions in the U.S. to acquire cutting-edge tech and IP; Cyber-espionage and intrusion to acquire tech and IP. Only one of these is about market pricing. The others speak to the U.S. belief that the Communist Party has orchestrated a "techno-nationalist" agenda that combines aggressive and illegal acquisitions with domestic protectionism. In particular, Chinese companies have made strategic acquisitions in the U.S. through shell companies with state funds or state guidance to access critical technologies and IP, while forcing American companies operating in China to transfer over the same as a precondition to operate there.10 Washington fears that if Beijing' strategy continues unabated, high-tech Chinese companies will be able to gain the best western technology, grow uninhibited in the massive domestic market with state financial support, and then launch competitive operations on a global scale. Moreover, the lack of division between China's ruling party, state apparatus, and corporate sector means that technologies acquired by Chinese companies can be directly appropriated by the country's military and intelligence apparatus to the detriment of the strategic balance with the U.S. How will the U.S. retaliate? We are unsure, and therein lies the risk for the market.11 Trump has floated the idea of levying a large "fine" or indemnity on China for past IP violations. The U.S. believes that IP theft amounts to a "second trade deficit" with China, with estimates of annual losses ranging from $200 billion to nearly $600 billion.12 U.S. remedies will become clearer when the USTR offers its recommendations. Bottom Line: The Section 301 probe is not about the trade deficit alone. It is about the growing tension between U.S. and China in a broader strategic context. We would expect the USTR to propose trade remedies that are more significant than the recent steel and aluminum tariffs. And we would expect Trump to impose some punitive measures. This is a source of near-term risk to markets, as the U.S. and China are less likely to manage their disputes smoothly than in the past. We are short China-exposed U.S. stocks relative to their domestic-oriented peers. China's NPC Session: On Track For Downside Risk Surprises Chart 16Downward Revisions In Chinese Growth Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin China's NPC session is not yet over but some preliminary takeaways are in order. The headlines focused on Xi Jinping's power grab, but for us the real relevance was economic policy. Signs of economic policy tightening are not as hawkish as we expected, but the bias remains in favor of slower growth and tighter monetary, fiscal, and financial policy. The 6.5% GDP growth target was not a surprise. China has various economic targets to meet in 2020 under existing economic plans; only after that does it say it will scrap GDP targets altogether. The GDP target is a fabrication but the point is that the direction is down. Local government GDP targets suggest downward revision as well (Chart 16). To put a point on it, there is no evidence that China's cyclical slowdown is on the cusp of reversing (Table 2).13 Table 2No Convincing Signs Of An Impending Upturn In China's Economy Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin In this context, it is notable that the government got rid of official targets for monetary growth (M2). This confirms the view of our colleagues at BCA's Emerging Markets Strategy that China has been targeting interest rates instead of the quantity of money since 2015 (Chart 17).14 This means that M2 growth can rise or fall as high or as low as necessary to meet the PBoC's interest rate targets. The takeaway for now is that M2 growth can go lower than the recent 8%-9% range in which it has been moving, since the current policy is to "control" money growth and avoid systemic risk. The new leadership at the People's Bank of China will have a challenge to establish its credibility, which means that accommodative compromises may not come as quickly as some expect. Chart 17A New Monetary Policy Regime A New Monetary Policy Regime A New Monetary Policy Regime On the fiscal front, China implied some tightening by lowering its official budget deficit target to 2.6%. Past reports show that China always meets its budget deficit targets perfectly (Chart 18), suggesting that the target is either meaningless or Beijing has a steely discipline unseen in the rest of the world. The IMF publishes an augmented budget deficit which, at 12% of GDP, gives a better indication of why authorities want to maintain control, if not outright tighten the reins (Chart 19).15 The Finance Ministry rushed to dampen speculation that this budget deficit reduction would amount to austerity. Approximately 550 billion yuan of additional "special purpose bonds" - issued by local governments to finance infrastructure projects - will be issued in 2018. This could amount to new spending worth 2% of last year's total spending, i.e. not a negligible sum. The purpose may be to smooth over the conclusion of the local government debt swap program that began in 2014. The debt swap program was a "game changer" by allowing local governments to exchange high-interest or short-term debt for low-interest, long-term, government-backed debt. Now Beijing is winding down the program and telling local governments that new bond issuance will not have the implicit guarantee of the central government, and will face higher interest rates. Chart 18China's Budget Deficit Target Is Meaningless Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 19China's Real Budget Deficit Is Large Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Similarly, Beijing has been attempting to provide formal banks more freedom to lend to offset its crackdown on shadow banks. Pursuant to this goal, it announced that required provisions for non-performing loans (NPLs) will be reduced from 150% of NPLs to 120%. Banks are already holding excess provisions, and provisions have been trending upwards. Meanwhile China's official NPL count is unbelievably low, warranting higher provisions. So it is not clear to what extent banks will lend more as a result of lower requirements. January and February credit numbers imply that credit policy remains tight even aside from the wind-down of the local government debt swap (Chart 20). The dust has not yet settled on the NPC session and we will soon examine some of the other policy announcements, like tax cuts for small businesses and infrastructure spending reductions. However, the implication so far is that the Communist Party wants to keep the fiscal deficit and total social financing flat this year. If this policy were executed faithfully, the fiscal and credit impulse would be zero this year. Simultaneously, new data revealed that, in keeping with the reform reboot, the Xi administration is allowing creative destruction to improve efficiency in the corporate sector. Bankruptcies rocketed upward in 2017 and this trend should continue (Chart 21). This is a notable development given the widespread perception that China does not know how to deal with social consequences of structural reforms. It suggests that policymakers have a higher threshold for economic pain. Chart 20Credit Growth Is Slowing Credit Growth Is Slowing Credit Growth Is Slowing Chart 21Creative Destruction Is Rising Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Finally, the new anti-corruption super-ministry, the National Supervisory Commission, has now received legislative clearance. It is still unclear how the new body will operate in practice. We maintain that on the margin it should be negative for economic growth due to the micro-level impact of corruption probes on local government officials and local state enterprises. Notably, some of the provinces whose GDP-weighted economic growth targets were the most aggressively revised downwards (Tianjin, Chongqing, Inner Mongolia) are also provinces that have been hit heavily with anti-corruption probes, accusations of falsifying data, and canceled infrastructure projects over the past year. The anti-corruption campaign is a tool for enforcing central party dictates more effectively, and at present those dictates call for minimizing systemic financial risk, including misallocation of capital by local authorities (Chart 22). Chart 22Anti-Corruption Campaign Encourages Downward GDP Revisions? Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Bottom Line: Policy settings in China will continue to constrain growth this year. Now that the policy shift toward accelerated reform is more evident, the downside risks of that move will become apparent. We are closing our long China H-shares versus EM trade for a gain of 3%. North Korea: This Time Is Different A brief concluding word on North Korea. While we did not expect that Trump and Kim would arrange to meet so soon, we are not surprised by the fact that the diplomatic track is moving forward. As we wrote in January, Trump demonstrated a credible military threat, forcing China to implement sanctions, which subsequently caused North Korea to stop testing missiles. Trump effectively called Kim Jong Un's bluff, daring him to go beyond missile and nuclear device tests. Instead of ratcheting up tensions, Kim declared victory on the nuclear deterrent and proclaimed the end of the crisis. This is the "Arc of Diplomacy" about which we have written (Chart 23).16 We reject the view in the media that Trump's policy has been erratic and that China is getting left on the sidelines of a Trump-Kim meet-up. China has cut off exports to North Korea (Chart 24), which in turn has cut off the regime's access to hard currency. Because of China, Kim literally cannot afford not to negotiate. Chart 23Credible Threat Cycle: North Korea Mirrors Iran Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 24China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump For the same reason, Kim is not likely to be bluffing or stalling: with limited conventional military capabilities, Kim cannot dial up and dial down the level of tensions at will. If he provokes the U.S. anew, he risks provoking a war that would destroy his regime. Moreover, from the moment he came to power, Supreme Leader Kim established a desire to elevate the importance of economic reforms within state policy, which is impossible without dealing with China and the U.S. to create a favorable international setting. From the U.S. side, Trump has likely notched up a major national security victory that will enhance his credibility in the 2018 midterms and especially 2020 elections. A clear risk to our view that Trump will take protectionist action toward China this year is that he will need China's continued cooperation, as it could relax sanctions enforcement. However, the strategic significance of the Section 301 investigation means that Trump cannot afford to sacrifice his trade agenda so soon. While bad news from North Korea seldom has a substantial impact on markets, our South Korean curve steepener benefited. So far it has returned 2.9%. The JPY/EUR has fallen back from a strong February rally, but we remain long. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, and Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 In September we highlighted that the North Korean threat cycle had peaked. Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, and Special Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 The Apprentice-style personnel reshuffle that has seen Peter Navarro, director of the National Trade Council, elevated above the departed Gary Cohn, has signaled the return of the protectionist agenda. 5 Please see BCA Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Not $1 billion, as Trump erroneously tweeted! 9 One year after the date of initiation is likely August 18, the date used in the USTR's description in the Federal Register, although President Trump signed off on August 14 which could mark an earlier deadline. Please see Andrew Restuccia and Adam Behsudi, "Trump Eyes Another Trade Crackdown," Politico, March 7, 2018, available at www.politico.com. Note that according to the text of the law, by late May, the U.S. Trade Representative could report that China is making sufficient progress and further action unnecessary (but this is unlikely). The recent handling of the Section 232 investigation into steel and aluminum suggests that punitive measures will be foreshadowed by public statements from U.S. officials. 10 For detailed assessments, please see USTR, "2017 Special 301 Report," which puts China at the top of the priority watch list; USTR, "2017 Report To Congress On China's WTO Compliance," January 2018; U.S.-China Economic and Security Review Commission, "2017 Report To Congress," November 2017. 11 As a frame of reference, in the dispute over U.S. beef exports to the EU, a prominent Section 301 case, the U.S. imposed 100% ad valorem tariffs on 34 products from the EU in 1999 until 2009. However, Trump's actions are likely to go well beyond this due to the strategic nature of the dispute. Not only can he impose tariffs on 100 or more specific goods - since Chinese IP violations run the gamut - but also he can impose restrictions on Chinese investment through the Committee on Foreign Investment in the U.S. (CFIUS), which is tightening scrutiny on China in general. 12 The $600 billion "high water mark" estimate comes from the former Director of National Intelligence Dennis C. Blair and former director of the National Security Agency Keith Alexander. They also emphasize that the U.S. has additional retaliatory options (outside of the 1974 trade law) under the Economic Espionage Act, Section 5 of the Federal Trade Commission Act, and the National Defense Authorization Act. Please see "China's Intellectual Property Theft Must Stop," The New York Times, August 15, 2017, available at www.nytimes.com. 13 Please see BCA China Investment Strategy Weekly Report, "China And The Risk Of Escalation," dated March 7, 2018, available at cis.bcaresearch.com. 14 Please see BCA Emerging Markets Strategy Special Report, "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com. 15 At the same time, the government issued guidelines suggesting that scrutiny of local government budgets, and specifically expenditures, will get stricter. The cancellation of subway/metro projects is already a trend that is well underway, but other inefficient projects and capital misallocation could be targeted next. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. Geopolitical Calendar

Dear Client, Following up on last week's report, my colleagues Caroline Miller, Mathieu Savary, and I held a webcast on Wednesday to discuss the outlook for the dollar along with recent events. If you haven't already, I hope you find the time to listen in. Best regards, Peter Berezin, Chief Global Strategist Highlights Protectionism is popular with the American public in general, and Trump's base specifically. The sabre-rattling will persist, but an all-out trade war is unlikely. Trump is focused on the stock market, and equities would suffer mightily if a trade war broke out. The Pentagon has also warned of the dangers of across-the-board tariffs that penalize America's military allies. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. That's not the case today. The equity bull market will eventually end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Feature Q: What prompted Trump's announcement? A: Last week began with President Trump proclaiming that he would seek re-election in 2020. Then came a slew of negative news, including the resignation of Hope Hicks, Trump's White House communications director, and the downgrading of Jared Kushner's security clearance. All this happened against the backdrop of the ever-widening Mueller probe. Trump needed to change the subject. Fast. However, it would be a mistake to think that the tariff announcement was simply a distractionary tactic. Turmoil in the White House might have been the immediate trigger, but events had been building towards this outcome for some time. The Trump administration had imposed tariffs on washing machines and solar panels in January. Hiking tariffs on steel and aluminum - two industries that had suffered heavy job losses over the past two decades - was a logical next step. In fact, the 25% tariff on steel and 10% tariff on aluminum were similar to the 24% and 7.7% tariff rates, respectively, that the Commerce Department proposed as one of three options on February 16th.1 Protectionism is popular with the American public. This is especially true for Trump's base (Chart 1). Indeed, it is safe to say that Trump's unorthodox views on trade are what handed him the Republican nomination and what allowed him to win key swing (and manufacturing) states such as Ohio, Michigan, and Pennsylvania. Trump made a promise to his voters. He is trying to keep it. Q: Wouldn't raising trade barriers hurt the U.S. economy, thereby harming the same workers Trump is trying to help? A: That's the line coming from the financial press and most of the political establishment, but it's not as clear cut as it may seem. An all-out trade war would undoubtedly hurt the U.S., but a minor skirmish probably would not. The U.S. does run a large trade deficit. Economists Katharine Abraham and Melissa Kearney recently estimated that increased competition from Chinese imports cost the U.S. economy 2.65 million jobs between 1999 and 2016, almost double the 1.4 million jobs lost to automation.2 This accords with other studies, such as the one by David Autor and his colleagues, which found that increased trade with China has led to large job losses in the U.S. manufacturing sector (Chart 2).3 Chart 1Trump Is Catering ##br##To His Protectionist Base Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Chart 2China's Ascent Has Reduced##br## U.S. Manufacturing Employment China's Ascent Has Reduced U.S. Manufacturing Employment China's Ascent Has Reduced U.S. Manufacturing Employment Granted, China does not even make it into the top ten list of countries that export steel to the United States. But that is somewhat beside the point. As with most commodities, there is a fairly well-integrated global market for steel. Due to its proximity to Asian markets, China exports most of its steel to the rest of the region (Chart 3). That does not stop Chinese overcapacity from dragging down prices around the world. Chart 3Most Of China's Steel Exports Don't Travel That Far Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Q: Wouldn't steel and aluminum tariffs simply raise prices for American consumers, thereby reducing real wages? A: That depends. If Trump's gambit reduces the U.S. trade deficit, this will increase domestic spending, putting more upward pressure on wages. As far as prices are concerned, the U.S. imported $39 billion of iron and steel in 2017, and an additional $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. And even that would be a one-off hit to the price level, rather than a permanent increase in the inflation rate. In practice, it is doubtful that prices would rise by the full amount of the tariff (if they did, what would be the purpose of retaliatory measures?). Most econometric studies suggest that producers will absorb about half of the tariff in the form of lower profit margins. To the extent that this reduces the pre-tariff price of imported goods, it would shift the terms of trade in America's favor. Chart 4Does Trade Retaliation Make Sense ##br## When Most Trade Is In Intermediate Goods? Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A There is an old economic theory, first elucidated by Robert Torrens in the 19th century, which says that the optimal tariff is always positive for countries such as the U.S. that are price-makers rather than price-takers in international markets. Put more formally, Torrens showed that an increase in tariffs from very low levels was likely to raise government revenue and producer surplus by more than the loss in consumer surplus. So, in theory, the U.S. could actually benefit at the expense of the rest of the world by imposing higher tariffs.4 Q: This assumes that there is no trade retaliation. How realistic is that? A: That's the key. As noted above, a breakdown of the global trading system would hurt the U.S., but a trade spat could help it. Trump was trying to scare the opposition by tweeting "trade wars are good, and easy to win." In a game of chicken, it helps to convince your opponent that you are reckless and nuts. Trump's detractors would say he is both, so that works in his favor. Trump has another thing working for him. Most trade these days is in intermediate goods (Chart 4). It does not pay for Mexico to slap tariffs on imported U.S. intermediate goods when those very same goods are assembled into final goods in Mexico - creating jobs for Mexican workers in the process - and re-exported to the U.S. or the rest of the world. The same is true for China and many other countries. This does not preclude the imposition of targeted retaliatory tariffs. The EU has threatened to raise tariffs on Levi's jeans and Harley Davidson motorcycles (whose headquarters, not coincidently, is located in Paul Ryan's Wisconsin district). We would not be surprised if high-end foreign-owned golf courses were also subject to additional scrutiny! But if this is all that happens, markets won't care. The fact that the United States imports much more than it exports also gives Trump a lot of leverage. Take the case of China. Chinese imports of goods and services are 2.65% of U.S. GDP, but exports to China are only 0.96% of GDP. And nearly half of U.S. goods exports to China are agricultural products and raw materials (Chart 5). Taxing them would be difficult without raising Chinese consumer prices. Simply put, the U.S. stands to lose less from a trade war than most other countries. Chart 5China Stands To Lose More From A Trade War With The U.S. Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Q: Couldn't China and other countries punish the U.S. by dumping Treasurys? A: They could, but why would they? Such an action would only drive down the value of the dollar, giving U.S. exporters an even greater advantage. The smart, strategic response would be to intervene in currency markets with the aim of bidding up the dollar. Chart 6Slowing Global Growth Is Bullish##br## For The Dollar Slowing Global Growth Is Bullish For The Dollar Slowing Global Growth Is Bullish For The Dollar Q: So the dollar could strengthen as a result of rising protectionism? A: Yes, it could. This is a point that even Mario Draghi made at yesterday's ECB press conference. If higher tariffs lead to a smaller trade deficit, this will increase U.S. aggregate demand. The boost to demand would be amplified if more companies decide to relocate production back to the U.S. for fear of being shut out of the lucrative U.S. market. The U.S. economy is now operating close to full employment. Anything that adds to demand is likely to prompt the Fed to raise rates more aggressively than it otherwise would. That could lead to a stronger greenback. Considering that the U.S. is a fairly closed economy which runs a trade deficit, it would suffer less than other economies in the event of a trade war. A scenario where global growth slows because of rising trade tensions, while the composition of that growth shifts towards the U.S., would be bullish for the dollar (Chart 6). Q: What are the implications for stocks and bonds? A: Wall Street will dictate what happens to stocks, but Main Street will dictate what happens to bonds. The stock market hates protectionism, so it is no surprise that equities sold off last week. It is this fact that ultimately got Trump to soften his position. Trump is used to taking credit for a rising stock market. If stocks flounder, this could make him think twice about pushing for higher trade barriers. As far as bonds are concerned, they will react to whatever happens to growth and inflation. As noted above, a trade skirmish could actually boost growth and inflation. Given that the economy is near full capacity, the latter is likely to rise more than the former. This, too, could cause Trump to cool his heels. After all, if higher inflation pushes up bond yields, this will hurt highly-levered sectors such as, you guessed it, real estate. Q: In conclusion, where do you see things going from here? A: Trade frictions will continue. As my colleague Marko Papic highlighted in a report published earlier this week, NAFTA negotiations are likely to remain on the ropes for some time.5 The Trump administration is also investigating allegations of Chinese IP theft. The U.S. is a major exporter of intellectual property, but these exports would be much larger if U.S. companies were properly compensated for their ingenuity. Chinese imports of U.S. intellectual property were less than 0.1% of Chinese GDP in 2017, an implausibly small number (Chart 7). If China is found to have acted unfairly, this could lead the U.S. to impose across-the-board tariffs on Chinese goods and restrictions on inbound foreign direct investment. Nevertheless, as noted above, worries about a plunging stock market will constrain Trump from acting too aggressively. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. Today, firms are struggling to find qualified staff (Chart 8). This suggest that Trump will stick to doing what he does best, which is taking credit for everything good that happens under the sun. Chart 7China Is Importing More IP From The U.S., ##br##But The "True" Number Is Probably Higher China Is Importing More IP From The U.S., But The "True" Number Is Probably Higher China Is Importing More IP From The U.S., But The "True" Number Is Probably Higher Chart 8Protectionism Makes Less Sense ##br##When The Labor Market Is Strong Protectionism Makes Less Sense When The Labor Market Is Strong Protectionism Makes Less Sense When The Labor Market Is Strong Ironically, the latest trade skirmish is occurring at a time when the Chinese government is taking concerted steps to reduce excess capacity in the steel sector, and the profits of U.S. steel producers are rebounding smartly (Chart 9). In fact, the latest Fed Beige Book released earlier this week highlighted that "steel producers reported raising selling prices because of a decline in market share for foreign steel ..."6 Chart 9Chinese Steel Exports Falling, U.S. Steel Profits Rising Chinese Steel Exports Falling, U.S. Steel Profits Rising Chinese Steel Exports Falling, U.S. Steel Profits Rising Meanwile, German automakers already produce nearly 900,000 vehicles in the U.S., 62% of which are exported. In fact, European automakers have a smaller share of the U.S. market than U.S. automakers have of the European one.7 A lot of what Trump wants he already has. The Pentagon has also warned that trade barriers imposed against Canada and other U.S. military allies could undermine America's standing abroad. This is an important point, considering that Trump invoked the rarely used Section 232 of the Trade Expansion Act of 1962, which gives the President broad control over trade policy in matters of national security, to justify raising tariffs. Trump tends to listen to his generals, if not his other advisors. He probably was not expecting their reaction. All this suggests that a major trade war is unlikely to occur. As we go to press, it appears that the White House will temporarily exclude Canada and Mexico from the list of countries subject to tariffs. We suspect that the EU, Australia, South Korea, and a number of other economies will get some relief as well. White House National Trade Council Director Peter Navarro has also said that some "exemptions" may be granted for specific categories of steel and aluminum products that are deemed necessary to U.S. businesses. That is a potentially very broad basket. The bottom line is that the equity bull market will end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances met with restrictive monetary policy, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Secretary Ross Releases Steel and Aluminum 232 Reports in Coordination with White House," U.S. Department of Commerce, February 16, 2018. 2 Katharine G. Abraham, and Kearney, Melissa S., "Explaining the Decline in the U.S. Employment-to-Population Ratio: A Review of the Evidence," NBER Working Paper No. 24333, (February 2018). 3 David H. Autor, Dorn, David and Hanson, Gordon H., "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 4 A graphical illustration of this point is provided here. 5 Please see BCA Geopolitical Strategy, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018. 6 Please see "The Beige Book: Summary of Commentary on Current Economic Conditions By Federal Reserve District,"Federal Reserve, dated March 7, 2018. 7 Please see Erik F. Nielsen, "Chief Economist's Comment: Sunday Wrap," UniCredit Research, dated March 4, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades