Developed Countries

Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights Social unrest and populism are on a secular rise in the U.S.; However, the "Breitbart clique" has suffered a critical defeat in the current Administration; This will make headway for upcoming tax legislation and resolution of the debt ceiling imbroglio; We continue to stress that domestic politics will not hurt U.S. equities, but more downside to USD may exist this year; India-China military tensions are not strategic or market relevant, yet. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." - Newt Gingrich, January 2, 2001 This is the second time we have begun a report with this classic Gingrich quote from 2001, which now seems to come from a different era. On November 9, 2016 we used it to open our election post-mortem in which we argued that American party identifications were ossifying into tribal markers that could cause run-of-the-mill polarization to mutate into something scarier.1 Chart 1 shows that party identification (Republicans vs. Democrats) is now responsible for the greatest difference in attitudes towards 48 values, something historically determined by race and education. Over the long term, these trends are concerning and may spur further social unrest in the U.S. As we wrote in June, the gulf between America's patricians and plebeians has never been as wide as it is now. It is being complemented by a gulf in ideology and worldview.2 Part of the problem is that migration from the traditionally liberal-leaning coastal America as well as the Great Lakes region have significantly altered the demographic makeup of the American South (Chart 2). The combination of pro-business regulation, low taxes, sunshine, affordable real estate, southern charm, and excellent higher-education institutions has been difficult to resist.3 Thus, an influx of young and educated migrants has altered the political makeup of many traditionally conservative states. There are many cities - much like Charlottesville, Virginia - where these recent migrants will come into conflict with the values and traditions of the south. Chart 1Rise Of A Tribal America Chart 2Internal Migration Is A Risk... Given America's history of internal population movements, these patterns of migration should not be a problem. However, today's polarization is extreme (Chart 3), and it is deepening thanks to radically different information and media streams made available by cable television and especially the Internet (Chart 4). Chart 3... In A Polarized Context... Chart 4... Where 'Fake News' Proliferates What does all of this mean for investors? America is geopolitically very well endowed. It has benign neighbors, strong demographics, and almost all the natural resources it needs. However, hegemons are not born out of plenty, but rather out of need and want. The U.K. built a global empire largely because its rain-drenched island lacked basic materials for superpower status. Spain and Portugal discovered new worlds because stronger empires barred lucrative trading routes. Geography does not preordain hegemony. Strong domestic institutions, luck, and guts and glory do. The USD remains weak despite the fact that the Fed was the first major central bank to start hiking this cycle and despite strong economic data out of the U.S. relative to the rest of the world (Chart 5). Perhaps investors have caught the whiff of something rotten in the American Empire? If so, we may be seeing the beginning of a major USD bear market. Chart 5USD Should Be Outperforming In The Current Global Macro Context BCA's Foreign Exchange Strategy sees the current DXY weakness as temporary. We agree, given that the current trajectory of BCA's ECB months-to-hike measure is discounting way too much hawkishness (Chart 6). The dollar index will likely rally in 2018 as inflation data improves and risks in Europe (Italian election) and Asia (Chinese structural reforms) deepen. Chart 6The ECB Hawkishness Is Overstated The scope and pace of the 2018 USD rally, however, will depend on whether investors have confidence in America's economy and institutions. If the Republican tax reform agenda stalls later this year, and if social unrest continues, sovereign and long-term investors may begin to think about diversifying away from the dollar. The "Trump Put" Continues We do not expect domestic politics to play a role in an equity correction. At least not yet. First, investors seem to be completely discounting any possibility of tax reform judging by the performance of the high tax-rate basket (Chart 7). This is likely a mistake. Tax reform is a major component of both Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Second, the market fell 1.58% after President Trump's combative press conference on August 15. The move was not a reprimand for Trump's rhetoric, but concern that Gary Cohn, the scion of the "Goldman clique" and likely the next Fed Chair, would resign over the comments.4 These concerns have now been allayed by the firing of Stephen Bannon, the White House Chief Strategist and leader of the "Breitbart clique." Bannon's departure puts Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross firmly in charge of economic policy. Meanwhile, three generals are now in charge of foreign and national policy: Defense Secretary James Mattis, National Security Advisor H.R. McMaster, and Chief of Staff John F. Kelly. Between the six of them, and Secretary of State Rex Tillerson, there is not a drop of populism left in the White House. Chart 7What Tax Reform? Although nationalists and populists may be on the retreat, it is still not clear what form tax legislation will take. The only thing that has certainly changed since earlier this year is that the border adjustment tax is officially dead, which would have raised ~$1 trillion in revenue over ten years.5 This requires the GOP either to moderate its tax cuts by the same amount, or to add more to the deficit, which, according to legislative rules, would make the cuts temporary. It is likely at this point that whatever bill the GOP passes, it will expire after a "budget window" of around ten years. The divergence between the White House and Congress remains the same: the White House wants gigantic tax cuts, while Congress wants tax reform, i.e. to broaden the tax base and reduce inefficiencies and distortions. The White House would blow out the budget deficit by more than would the House GOP. There are two key questions that investors want to know from the upcoming tax legislation. First, how significant will the fiscal thrust be? This will determine the impact to the economy and hence will affect the Federal Reserve's response. The GOP Plan: Both the White House and the House GOP claim that they will reduce the budget deficit over the next ten years despite cutting taxes. They project an average budget deficit of 1.3%-1.4% from 2018-2027, down from a 3%-4% baseline. This projection is rationalized via expectations of faster economic growth as well as "dynamic scoring" to capture the macroeconomic feedback of the tax cuts. The White House and GOP claim that economic feedback will reduce the deficit by $1.5-$2 trillion over the ten-year budget window, which is 26%-37% of the total deficit reduction they are proposing (i.e., likely very optimistic).6 The Tax Policy Center Response: Outside analysis of the budget plan argues the opposite. The Tax Policy Center argues that the White House plan, insofar as the details are known, would add a minimum of $3.4 trillion to the deficit over the next ten years, and that the macroeconomic feedback could even be negative (i.e., add to the deficits). The deficit would rise from 3.2% of GDP to 6.4% by 2026, if we factor in the Congressional Budget Office assumptions that a 4% real growth rate leads to a GDP of $26.9 trillion in 2026.7 The GOP Retort: Republicans claim they will reduce the deficit by means of proposed "revenue offsets," or savings measures, over the ten-year period. The Tax Policy Center highlights the following in particular: $1.6 trillion from repealing personal exemptions; $1.5 trillion from abolishing all itemized deductions (other than the politically sensitive mortgage interest deduction and charity deduction); $622 billion from treating some income from pass-through businesses as dividends; $272 billion from repealing corporate tax breaks; $208 billion from repealing the "head of household" status for tax filers; $49 billion from taxing capital gains upon death (above the $5 million threshold). The total is $4.3 trillion in savings, against $7.8 trillion of losses, for a total deficit that is increased by $3.4 trillion over the ten years. This would amount to around $340 billion of "stimulus" each year, with the biggest thrust felt in 2018-19. We very much doubt that the White House will achieve this slate of proposals. It has not shown an inkling of the ability to coordinate such a difficult legislative feat. Therefore, we expect the tax legislation to be watered down. The budget deficit may rise to something closer to 6%, over the next ten years, than to the gigantic 12% of GDP implied by Trump's proposals on the campaign trail (Chart 8). Chart 8Question Of The Year: Will Tax Reform Be Stimulative? The second question asked by investors is about the impact of tax legislation on assets. It is clearly positive for inflation and growth given that even tepid tax cuts will provide economic stimulus when unemployment is already very low. Our colleagues at BCA already believe, without a tax bill, that inflation is likely to surprise to the upside in 2018-19.8 Fiscal stimulus via tax cuts would obviously add to that. The equity market will cheer any promising developments on tax cuts or reform, especially given that so little is currently priced in. However, whether the USD rallies as it did on hopes of tax legislation earlier this year will largely depend on how the Fed reacts to the legislation. There is a lot of uncertainty, particularly if President Trump decides to go with Gary Cohn as the next Fed chair. Bottom Line: Congressional Republicans cannot gamble with tax legislation. The failure to cut taxes, or reform the tax code, would be a major policy misstep ahead of the midterm elections. If legislation passes, we expect that Congress will have had greater control over the plan than the White House, reducing the eventual magnitude of the tax cut and the fiscal stimulus. Congress controls the purse strings and will reassert that authority in the context of an ineffective executive. Should You Care About The Debt Ceiling? Clients are beginning to fret about the upcoming debt ceiling fight. There is good reason to be nervous. The Republican-held Congress has failed to pass legislation, notably on this year's priority item, Obamacare. The last thing Republicans want is to shut down the government or cause a technical default entirely of their own doing! Clients should note that while government shutdowns have occurred in the past, the debt ceiling has never been breached. This is because the debt ceiling is an anachronism. In other countries, when a budget is passed it automatically contains the implicit authority to issue whatever debt is required to finance the resulting deficit.9 To require separate legislation for a budget and an authorized level of debt is a product of politics and has little bearing on the actual financing needs of the U.S. government. At the end of the day, the debt ceiling will almost inevitably be raised in the U.S. because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors (who vote!) or a halt to other entitlement programs. Only a disastrous chain of events resulting from polarization and brinkmanship, even worse than in the Obama years, would lead to such an outcome. Today, given that Republicans control both chambers of Congress and the White House, there is no way for the Republicans to share the blame with the Democrats, as they did under Obama. Investors are therefore mistaking the game-theoretical paradigm: It is not a "game of chicken," but rather a cooperative game given that Republicans in Congress are largely on the same side. Members of the GOP are starting to "get it," including the fiscally conservative House Freedom Caucus. David Schweikert, influential member of the Freedom Caucus who sits on the House Ways and Means Committee, said last week that he is in favor of a clean bill to raise the debt ceiling. Mark Meadows, North Carolina representative who chairs the group, has also said that he is "bullish" on raising the debt limit, although he added that he preferred to attach some reforms to the bill. On August 2, he said "Either that will get done [some spending cuts attached to the debt ceiling bill] or a clean debt ceiling will get done. We will raise the debt ceiling and there shouldn't be any fear of that." Other members of the Caucus, including its founder Jim Jordan of Ohio, have retorted that no debt limit hike without spending cuts should be contemplated, prompting the media to focus on the brinkmanship. But we note that the Freedom Caucus, the most fiscally conservative grouping in the House, is itself considerably divided on the issue. This augurs well for a clean bill since the Republican majority in the House is 22 and the Freedom Caucus has 31 members. If Schweikert and Meadows are indicative of how the group will vote, the fiscal conservatives may not have enough votes to deprive the GOP of a majority. (The latter would force GOP moderates to go to the Democrats for votes, complicating the negotiations and increasing the risk of mistakes.) What about the Democrats in the Senate? To pass a clean bill on the debt ceiling, Republicans would need at least eight Democrat Senators to get to 60 votes, and probably more given that Rand Paul (R-Kentucky) would likely vote against a clean bill. We doubt that Democrats would remain united in voting against a clean bill. It would allow President Trump and Republicans in Congress to accuse them of hypocrisy and holding U.S. credit hostage, much as Democrats did to Republicans between 2011-2016. As such, the market's fear that Democrats could play the spoiler is a red herring. While some grassroots activists in the Democratic Party are sure to want a confrontation, its median voters tend to be educated and well-informed. The worst-case scenario for the market would be a two-week shutdown, between October 1, when the current funding for the government expires, and sometime in mid-October when the debt ceiling is hit, according to the Congressional Budget Office. Odds of such a scenario are probably around 25%. But the contingent probability of a debt ceiling failure following a government shutdown would be reduced, not increased, given that it would focus public attention on Republican incompetence. In other words, if a shutdown occurs on October 1, we would expect the odds of a debt ceiling crisis to be reduced. Finally, our assessment that the "Goldman Sachs clique" has reasserted control over White House economic policy should also be positive for the likelihood of a clean debt ceiling bill. While we have no evidence that Stephen Bannon was in favor of using the debt ceiling for fiscal cuts (given his opposition to government spending cuts in toto), he did say following his resignation that Trump would be "moderated" by remaining White House staffers. He went on to say "I think he'll sign a clean debt ceiling; I think you'll see all this stuff." The only remaining holdover in the White House on the debt ceiling issue is the Office of Management and Budget Director Mick Mulvaney. Mulvaney has suggested earlier in the year that Republicans should try to tie spending restraint to a debt ceiling bill. However, at a meeting between President Trump and GOP leaders in early June, President Trump said that congressional leaders should take Steven Mnuchin's position as the White House position. "Mnuching is that guy," Trump told party leaders at the meeting, according to GOP sources who spoke to Politico in the summer. Mulvaney's office has also confirmed that the Treasury Department "has point on the debt ceiling," i.e., that Mnuchin is in charge. Bottom Line: Concern over the debt ceiling is natural, given the failure of Republican-held Congress to pass any legislation of note this year. However, it is also overstated. The U.S. government would default on its obligations to its voters, first and foremost. Such a scenario - given Republican control of all branches of government - would put the final nail in the coffin of the Republican-held Congress ahead of the midterm elections. Fade any fear of a U.S. default. Will India And China Fight A War? Clients, particularly in China, have shown considerable concern about geopolitical conflict between China and India. Since early June, a border dispute between China and India has flared up in the Doklam region. Doklam, or rather the India-China-Bhutan border region, is one of three main border disputes in the Himalayas that flare-up from time to time - along with Kashmir and Arunachal Pradesh. The 1962 border war between the two Asian behemoths over the latter two areas marked the biggest flare in recent memory. Today, India is fearful of China's growing military and logistical capabilities and concerned about the long-term security of the Siliguri Corridor, the narrow stretch of land connecting the subcontinent to the Northeast (Map 1). Control of the Doklam Plateau and Chumbi Valley would give China access to Siliguri; they are therefore important areas to monitor.10 India is also threatened by China's improving bilateral relations with neighbors like Pakistan,Bangladesh, Sri Lanka, Nepal, and potentially Bhutan. The latter does not have formal relations with China, has always been under India's sphere of influence, and is at the center of the current dispute. And ultimately, India fears that China seeks to create an economic corridor through Bangladesh to the Indian Ocean, which would, in combination with the Pakistan corridor, surround India. Map 1Too Close For Comfort: Tensions Threaten India's Control Over Vital Siliguri Corridor The current dispute ostensibly began - as many do - with contested infrastructure construction. India built some bunkers at a forward outpost in Lalten in 2012; China allegedly bulldozed them on June 6-8 of this year. The same month, Indian troops confronted Chinese troops building a road along the border with Bhutan that would have connected an existing road to a People's Liberation Army outpost and to the border crossing of Doka La. While the territorial dispute is old, China is expanding its pressure tactics on Bhutan, while India has sent troops into disputed Sino-Bhutanese territory in a more assertive defense of Bhutan. Broadly, China is making inroads with infrastructure as it develops its far-flung western regions and seeks to improve connectivity with neighbors via the One Belt One Road (OBOR) initiative. China is capital-rich and can afford to improve its access to regions of strategic value that yield access to key Indian territories or supply water and hydropower to India. India is capital-poor and downstream, so its ability to respond is often limited to military gestures. India also wants to retain its dominance over Bhutanese foreign policy, in place since 1949 and especially 1960, and this dispute is marked by India taking an active military role on Bhutanese territory on Bhutan's behalf. There are several reasons we do not expect this conflict to be market-relevant. First, the Himalayas are isolated and poor, so that China or India would have to make a very dramatic move that poses a genuine strategic threat (e.g., to the Siliguri Corridor, or Chinese control of Tibet, or Indian relations with Pakistan, or Indian water sources) to trigger a larger conflict. Second, while it is true that nationalism is flaring up on both sides, China has a clear interest in pursuing some "rallying around the flag" strategy amid the standoff over North Korea, and ahead of the Communist Party's nineteenth National Party Congress. That it chose to do so in Doklam, where conflict is more easily contained than in the Koreas or the East or South China Seas, suggests that political opportunism and China's desire to make incremental gains, rather than a sweeping Chinese plan to seize strategic territory, is driving the current episode. Meanwhile, India needs to attract capital to build its manufacturing base, and Prime Minister Narendra Modi has reached out to China for this reason. India will undoubtedly defend its strategic interests if attacked, but otherwise it is not eager to clash with China, which has bulked up its military far more than India has done in recent decades. Chart 9India Would Bolster Containment Of China However, we do see India-China relations as fitting into the larger, negative geopolitical dynamic where the U.S. and its allies encourage India as a balance to China, while China suspects the U.S. alliance of using India and others to encircle and entrap China (Chart 9). Not that the U.S. stirred up the current dispute, but that the U.S. (and Japan) will generally seek to improve relations with India and to strengthen its military and economy, and China will use its regional influence to try to keep India off balance.11 This structural dynamic, in addition to China's territorial assertiveness, is likely to keep generating frictions. Bottom Line: A conflict between India and China is only market-relevant if it extends beyond disputed territories in the Himalayas to affect core strategic interests like the Siliguri Corridor, Tibetan stability, the Indo-Pakistani balance of power, or water supply and hydropower. It could also become market-relevant by worsening U.S.-China relations - and delaying Chinese economic reforms - if China should come to feel embattled on all geopolitical fronts. For instance, should an adventurous, "lame duck" Donald Trump attempt to combine with India and other neighbors in ways that threaten to cause problems in China's western regions as well as in its East Asian periphery. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 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. 3 Hook 'em Horns! 4 We recently argued that the White House is torn between two groups, the "Goldman" and the "Breitbart" cliques. The Goldman clique is led by Gary Cohn, Director of the National Economic Council and is pragmatic, un-ideological, and focused on passing tax reform and pro-business regulation. The Breitbart clique is populist, nationalist, and leans to the left on economic matters. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 6 Please see Congressional Budget Office, "An Update to the Budget and Economic Outlook: 2017 to 2027," June 2017, available at www.cbo.gov and U.S. Office of Management and Budget, "Budget of the U.S. Government: A New Foundation For American Greatness, Fiscal Year 2018," available at www.whitehouse.gov. 7 Please see the Tax Policy Center, "The Implications Of What We Know And Don't Know About President Trump's Tax Plan," July 12, 2017, and Benjamin R. Page, "Dynamic Analysis of the House GOP Tax Plan: An Update," June 30, 2017, available at www.taxpolicycenter.org. Using White House growth assumptions of 4.7% would lead to a deficit of 5.7% in 2026. 8 Please see BCA U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long," dated August 8, 2017, and U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 9 Denmark also has a debt ceiling, but it has set it so high that it does not need to be addressed. 10 Please see Sudha Ramachandran, "Bhutan's Relations With China And India," Jamestown Foundation, China Brief (17:6), April 20, 2017, available at Jamestown.org. 11 In fact, Japan already waded into the India-China dispute. The Japanese ambassador to India issued a statement critical of China, which the Chinese Foreign Ministry immediately rebuked.

Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals1 and also from domestic to global-exposed market areas. The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (top panel). Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. The second and third panels highlight different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel). Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade. 1 For a recap of our major portfolio moves since May 1, please see U.S. Equity Strategy Weekly Report "Three Risks" dated August 14, 2017, available at uses.bcaresearch.com

Highlights U.S. Tax Cuts: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. Fed vs. ECB: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. We expect a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. U.S. Corporates vs. EM: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Feature Who's In Charge Here? Table 1A Rough Month For Risk Financial markets are sailing without a rudder at the moment. A clear risk-off flavor has swept over most risk assets, as can be seen in the returns seen so far in August in so many asset classes (Table 1). There have been a number of negative news events for investors to process, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to the North Korean tensions to last week's terror attack in Spain. On top of that, some of the major central banks have become a bit more wishy-washy in their guidance to the markets, even going as far as questioning their own understanding of the inflation process (does the Philips curve even work anymore?). Investors always prefer a clean narrative when it comes to the "big picture" macro backdrop. Right now, they are not getting that from political leaders and policymakers, especially in the U.S. (Chart of the Week). Trump's popularity rating is steadily declining, even now among Republican voters. This has raised concerns that any of his business-friendly policies tax cuts or initiatives to boost growth like infrastructure spending can be successfully enacted. At the same time, and perhaps for similar reasons, the gap between the market expectation and the Fed's projection for the funds rate is widening with only 24bps of hikes priced over the next year. This is driven largely by investors' persistent lack of belief that U.S. inflation will hit to the Fed's target in the next few years. Simply put, the market is saying that the Fed's current tightening cycle is essentially complete unless there is a turnaround in U.S. inflation and/or a sizeable fiscal stimulus enacted in D.C. On that latter point, we think it is critical to monitor measures of U.S. business confidence. The current cyclical upturn in global growth and corporate profits has certainly lifted optimism among business leaders. Yet it is clear that there was also a boost to business sentiment after the U.S. election (Chart 2) last November as it was believed that Trump's victory, and the likely policies that would follow, would be good for American companies. Right now, business optimism remains at strong levels whether looking at small business measures like the NFIB survey (top panel) or the big business series like the Conference Board CEO confidence index of the Duke University/CFO Magazine indicator for confidence among chief financial officers (middle panel). There has been a slight recent pullback from the post-election peak in all the business sentiment indicators, however, and any sign that Trump will have difficulty pushing his tax cuts through Congress could result in a bigger loss of confidence that could impact future hiring and capital spending activity. Our colleagues at BCA Geopolitical Strategy continue to believe that a tax reform package, including significant tax cuts, is still the most likely outcome. Congressional Republicans will not want to go into the 2018 U.S. mid-term elections "empty-handed". With Congress and the White House on the same page, focused by fears of losing seats next year, even an embattled and unpopular president should be able to get his tax cuts implemented. Any fiscal boost in the U.S. can only help to support the current global cyclical economic upturn. While growth indicators like our global PMI index have come off the highs a bit (Chart 3), the OECD's global leading economic indicator is still rising and pointing to rising real developed market bond yields (middle panel). In addition, the global data surprise index has bottomed out, leaving global bond yields exposed to any improvement in economic momentum (bottom panel). Chart of the WeekLosing Faith In##BR##Trump & The Fed Chart 2U.S. Businesses##BR##Are Still Confident Chart 3Global Bond Yields Are##BR##Vulnerable To Faster Growth The fiscal news flow out of D.C. is likely to remain volatile once Congress returns from its summer recess, particularly with regards to tax cut negotiations and the looming debt ceiling. Yet the big news that investors want to hear, regarding U.S. tax cuts, is more likely to be positive for growth and risk assets and negative for bond yields. Bottom Line: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. The Fed & ECB: Still Sticking To Their Script Chart 4Inflation Expectations Are##BR##Stable In The U.S. & Europe The markets continue to underestimate the likelihood of more Fed rate hikes in the next year. The odds of a hike in December now sit at only 32%, while essentially no hikes in 2018 are currently discounted. This is far too low, given the steady (if unspectacular) growth in the U.S. and tightening labor conditions. The market has clearly responded to the dip in realized U.S. inflation since March as a sign that the real fed funds rate is now close to equilibrium - a point that has also been suggested by some FOMC members - and that the Fed's inflation forecasts are hence unlikely to be realized. Yet measures of U.S. inflation expectations, both survey-based and market-based, have been fairly stable at levels consistent with the Fed's inflation target in recent months, even as headline U.S. inflation has slowed (Chart 4, 2nd panel).1 A similar dynamic is playing out in Europe. Both survey-based and market-based measures of inflation expectations have been stable at levels close to the ECB's inflation target of "just below" 2% on headline inflation (bottom panel), despite the dip in realized inflation. Stable inflation expectations are something that central bankers take very seriously as a sign that their monetary policies are seen as credible. If the recent dip in realized inflation also showed up as an equivalent decline in expected inflation, this would give policymakers in D.C. and Frankfurt second thoughts about making any policy changes in a less dovish/more hawkish direction. The latest readings on realized inflation in both the U.S. and Euro Area suggest some stabilization of the current downturn may be underway. Headline CPI inflation ticked higher from 1.6% to 1.7% in July, ending a streak of four consecutive months of deceleration since March. Core CPI inflation has been stable at 1.7% for three consecutive months up to July, after falling for four consecutive months from January. Data released last week for July inflation in Europe showed a similar dynamic, with core HICP inflation ticking up to 1.2%, the third consecutive month of faster year-over-year inflation. With growth on both sides of the Atlantic maintaining a steady, above-potential pace, amid stable inflation expectations and with realized inflation showing signs of bottoming out, we see both the Fed and the ECB sticking with their current messaging and forward guidance. That means one more rate hike this year by the Fed, most likely in December, following an announcement on beginning the process of reducing the Fed's balance sheet at the September FOMC meeting. After that, at least another 25-50bps of hikes in 2018 will be delivered, which is currently not discounted by the market. As for the ECB, expect a shift to a slower pace of asset purchases for 2018, to be announced at either the September or October monetary policy meetings. Chart 5Has The Euro Already Overshot? The Kansas City Fed's annual Jackson Hole conference, set to take place this weekend, is unlikely to produce any major surprises for investors. Both Fed Chair Janet Yellen and ECB President Mario Draghi will give speeches to an audience of their peers - other global central bankers. Much is being made of Draghi's speech, since he has not spoken at Jackson Hole since 2014 when he gave strong indications of the introduction of the ECB's asset purchase plan in 2015. After his speech at the ECB Forum in Portugal in late June of this year - also to an audience of central bankers - where he mentioned a "reflationary" impulse in Europe that could require some "adjustments" to the ECB's policy settings, investors will be on high alert for any indications that the ECB is about to announce a tapering of its asset purchases. The Account of the July ECB meeting released last week suggested some concern within the ECB Governing Council regarding the potential for an "overshoot" of the euro in response to any policy shift.2 Some are interpreting those comments as a sign that the ECB might be getting cold feet over making any changes to its asset purchase program given the 11% rise in the euro seen this year. However, we think that there was too much attention focused on the fears that a strong euro could derail any plans for an ECB taper, for two reasons: The ECB did note in the July Account that the rise in the euro was a reflection of both the relatively stronger growth seen in the Euro Area this year and the reduction in political risk premia after the French presidential elections in the spring. The Account also noted that the ECB was looking at the totality of its monetary policy measures - policy rates, forward guidance & asset purchases - when assessing its policy stance. This specific quote from the Account, shown with our emphasis on the key passages, highlights that the ECB thinks that a tapering of asset purchases, done on its own with no hikes in short-term interest rates, will still leave monetary policy at very accommodative settings: "...the point was made again that the overall degree of accommodation was determined by the combination of all the monetary policy measures implemented by the ECB, and that the Governing Council's assessment of progress regarding a sustained adjustment in the path of inflation should apply to the overall design and direction of the ECB's monetary policy stance as a whole, and not with reference to any particular instrument in isolation, such as the duration and pace of APP asset purchases." Investors should understandably be worried about the impact of the rising in the euro, which was one of the fastest rates of acceleration seen in the currency's history (Chart 5). Yet given that extreme in price momentum, the lack of support from higher short-term Euro Area interest rates, and with speculative positioning on the euro at very bullish levels, it is unlikely that much further gains in the currency can be expected. This is especially true for the euro versus the U.S. dollar if the Fed delivers additional rate hikes, as we expect. Unless there is decisive evidence that the latest rise in the euro was seriously dampening Euro Area economic growth or inflation, which is not currently visible in the data (bottom panel), then the ECB is still likely to downshift to a slower pace of asset purchases in 2018. Bottom Line: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. The Fed and ECB remain on course to shift to a less accommodative policy stance towards year-end. That means a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. Trim EM Debt Exposure Versus U.S. Investment Grade Corporates Emerging market (EM) debt has been one of the strongest performing asset classes so far in 2017. EM USD-denominated sovereign bonds have delivered a total return of 7.5%, while USD-denominated EM corporates have returned 8.7%, according to Bloomberg Barclays index data. These returns have handily surpassed the majority of all other major USD-denominated fixed income sectors. A robust pace of inflows into EM debt, a record $48.6 billion year-to-date to August 9th according to the Wall Street Journal, has helped drive EM debt spreads to tight levels (Chart 6).3 The outperformance of EM debt, both versus its own history and compared with other pro-risk fixed income classes like U.S. corporates, would be justified if EM economic growth was faster than that seen in developed markets. Yet that is not currently the case. An EM (excluding China) PMI Index put together by our colleagues at BCA Emerging Markets Strategy has shown a sharp deceleration of EM growth for most of 2017 (Chart 7, top panel). This stands in sharp contrast to the improving growth seen in both the U.S. and Europe. Chart 6EM Debt Looks##BR##Fully Valued Chart 7Stronger U.S. Growth Favors##BR##U.S. IG Vs EM Sovereigns... The gap between the U.S. and EM (ex China) PMIs has widened to the largest level since 2014. This PMI gap has been a good directional indicator for the spread between U.S. corporate bond spreads (both for Investment Grade and High-Yield) and EM debt spreads (bottom two panels). Right now, it appears that U.S. High-Yield looks fairly valued versus EM USD-denominated sovereign debt but U.S. Investment Grade spreads still look a bit too wide relative to EM sovereigns. A similar story can be told when comparing U.S. corporates to EM USD-denominated corporate debt (Chart 8). Arthur Budaghyan, BCA's Chief Emerging Market strategist, recently made a trade recommendation to go short EM sovereign and corporate debt versus U.S. Investment Grade corporate debt.4 His argument was based on the relatively expensive valuations on EM debt, coming at a time when the outlook for economic growth and corporate profits looks healthier in the U.S. We could not agree more - especially if the Fed begins to hike rates, as we expect, and the U.S. dollar begins to strengthen anew, potentially triggering outflows from EM. Arthur has also pointed out that the gap between the option-adjusted spread (OAS) on EM corporates and U.S. corporates (both Investment Grade and High-Yield) has been an excellent leading indicator of the total return differential between the asset classes (Chart 9). The current relationships show that there is upside potential for U.S. Investment Grade versus EM corporates over the next 12 months, but not for U.S. High-Yield versus EM. Chart 8...And Vs. EM Corporates Chart 9Downgrade EM Debt Vs U.S. IG Corporates Thus, this week, we are cutting our allocations to both EM sovereign and corporate debt in our model bond portfolio, and increasing our allocation to U.S. Investment Grade corporates (see page 12). While this does move us into an asset class with a longer duration, the increase in our overall portfolio duration from this shift is very small given the small weight of EM debt in our custom benchmark. More importantly, U.S. Investment Grade is less risky than EM corporates using the duration-times-spread metric - our preferred measure for spread product risk. Bottom Line: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. We see better value in U.S. higher-quality corporates vs. EM debt at current spread levels. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The inflation expectations data shown in Chart 4 is based off the U.S. Consumer Price Index (CPI) measure of inflation, while the Fed targets growth in the headline Personal Consumption Expenditure (PCE) deflator of 2%. The spread between the two measures have averaged around 50bps in recent years, which suggests that the current CPI-based inflation expectations around 2.5% are in line with the Fed's 2% PCE inflation target. 2 https://www.ecb.europa.eu/press/accounts/2017/html/ecb.mg170817.en.html 3 https://blogs.wsj.com/moneybeat/2017/08/17/emerging-market-bonds-attract-record-inflows/?mg=prod/accounts-wsj 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Focus Is On Profits", dated August 16th 2017, available at ems.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners. This high-octane trade would benefit most from the handoff of global liquidity to economic growth (top and middle panels). Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago1 - pans out in the coming months, then relative share prices should reverse. Our relative EPS models do an excellent job in capturing the different macro forces that drive this trade; at the current juncture, they emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (bottom panel). Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. 1 Please see August 21, 2017 U.S. Equity Strategy Weekly Report titled "Fraying Around The Edges?", available at uses.bcaresearch.com.

Highlights Portfolio Strategy Execute a long S&P energy/short global gold miners pair trade to take advantage of the liquidity-to-growth handoff. Initiate another new trade, long S&P materials/short S&P utilities, to benefit from a shifting macro landscape. Synchronized global growth and commodity inflation are a boon for materials, but a bane for utilities. Recent Changes Initiate a long S&P energy/short global gold miners pair trade today. Initiate a long S&P materials/short utilities pair trade today. Table 1 Feature The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. Nevertheless, a less hawkish Fed should, at the margin, underpin equities with easy monetary and financial conditions complementing the goldilocks equity backdrop (Chart 1). In fact, the St. Louis Fed Financial Stress Index (comprising "18 weekly data series: seven interest rate series, six yield spreads and five other indicators"1) is probing multi-decade lows. This primarily bond market-dependent indicator, has historically done an excellent job in leading the S&P 500 at major turning points at both peaks and troughs (Chart 2A). Recently, it has been more of a coincident indicator with equities, and currently waves the all-clear sign (St. Louis Fed Financial Stress Index shown inverted, Chart 2B). Chart 1Timid Fed Is Supportive Chart 2AExcellent Leading Properties Chart 2BAll Clear Nevertheless, we do not want to sound too complacent and following up from last week's brief discussion of rising geopolitical uncertainty and equity market performance, we are examining key post-WWII geopolitical events in more detail. The first three columns of Table 2, courtesy of BCA's Geopolitical Strategy Service2, update these episodes to mid-2017. While the S&P 500's drawdown from the three-month peak prior to the event to the three-month trough following the event averages out to roughly 10%, drilling beneath the surface is instructive. Table 2Geopolitical Crises And SPX Returns On average, broad equity market returns are muted one and three months post the event. Interestingly, on a six- and twelve-month horizon following the geopolitical incident, the S&P clearly shoots higher rising on average 5% and 8%, respectively (Table 2). Chart 3 shows the average profile of the S&P 500's returns during all of these post-WWII events, three months prior to the incident up to one year forward. Chart 3Geopolitical Opportunity? Two key takeaways stand out from this analysis. First, the coming quarter will likely prove volatile as the dust has yet to settle from the recent North Korea escalation. As a result, tactically buying some portfolio protection when the market is near all-time highs, as we cautioned last week3, is prudent and in order, especially given the seasonally challenging months of September and October. Second, on a cyclical horizon, the S&P 500 will likely resume its advance, ceteris paribus. Thus, if history at least rhymes and barring another major flare up of geopolitical risk, the path of least resistance will be higher for the overall equity market into mid-2018. This week we are executing two market neutral pair trades, one levered to the liquidity-to-growth handoff and the other to the synchronized global growth theme. Liquidity-To-Growth Handoff: Buy Energy/Sell Gold Producers A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners (Chart 4). This high-octane trade would benefit most from the handoff of global liquidity to economic growth. Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago4 - pans out in the coming months, then relative share prices should reverse. Gold prices serve as a global fear proxy, while energy prices move with the ebb and flow of global growth. Importantly, the oil/gold ratio (OGR) hit all-time lows in early 2016 and subsequently enjoyed a V-shaped recovery. But, year-to-date the OGR has relapsed on the back of rising policy uncertainty (policy uncertainty shown inverted, Chart 5). If this geopolitical uncertainty recedes, the upshot is that the OGR will rise in response. Chart 4Ready For A Bounce Chart 5Prefer Black Gold To Bullion Importantly, global trade is reaccelerating, also suggesting that the OGR should resume its advance (Chart 5). Chart 6 shows a simple growth/liquidity gauge using BCA's Global Synchronicity Indicator. Historically, this metric has been closely correlated with relative share price momentum, and the current message is to expect a sharp turn in oversold relative share prices. Moreover, were the liquidity thrust to convert into significantly higher output, then real interest rates should begin to reflect better growth prospects, and further boost the allure of the pair trade. As with bullion, the relative share price ratio is also overly sensitive to changes in real rates. In fact the 10-year TIPS yield does an excellent job in explaining relative share price fluctuation. Even a modest upturn in real interest rates will go a long way for relative share prices (Chart 7). Chart 6Ample Catch Up Space Chart 7Liquidity-To-Growth Beneficiary Meanwhile, on the relative operating front, the tide is also turning, favoring energy stocks versus gold miners. The oil and gas rig count has recovered smartly from the depths of the global manufacturing recession of late 2015/early-2016. On the flip side, demand for safe haven assets should ebb and further weigh on global gold ETF flows. Additional capital inflows into gold ETF funds from current levels would require either a sizable flare up in global geopolitical risk or another downdraft in global growth. Taken together, this relative demand indicator has surged, signaling that a catch up phase looms for the relative share price ratio (bottom panel, Chart 8). Similarly, relative pricing power is on the verge of climbing into expansionary territory. Extremely depressed pricing power for oil & gas field machinery is unlikely to deflate further, as recent anecdotes of new capital expenditure projects provide some glimmers of light for utilization rates. Conversely, bullion prices are pushing $1,300/oz. near the upper bound of the four year trading range, warning that at least a digestion phase lies ahead. The middle panel of Chart 8 shows that relative pricing power has been an excellent leading indicator of relative earnings. Our relative EPS models do an excellent job in capturing all of these different macro forces, and at the current juncture emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (Chart 9). Finally, relative valuations and technicals are both flashing a green light. Relative value is as compelling as it was during the depths of the Great Recession (middle panel, Chart 10), while our Technical Indicator is one standard deviation below the historical mean. Every time such extreme oversold levels are hit, relative performance has catapulted higher in the subsequent 3-6 months. Chart 8Relative Demand And Price Outlooks##br##Favor Energy Stocks Over Gold Miners Chart 9Earnings-Led##br## Outperformance Looms Chart 10Unloved ##br##And Oversold Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. For investors seeking an alternative way to express this trade opportunity levered to the liquidity-to-growth theme, going long the S&P 1500 metals and mining index instead of the S&P energy sector would also produce similar results (bottom panel, Chart 9). New Pair Trade: Materials Vs. Utilities Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals5 and also from domestic to global-exposed market areas. In fact, our relative Cyclical Macro Indicators capture the shifting macro backdrop favoring a more cyclical portfolio tilt (Chart 11). The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (Chart 12). Chart 11Reflation Trade Chart 12U.S. And... Reviving global growth is typically synonymous with rising inflation expectations and bond yields. BCA's view remains that a selloff in the bond markets is the most likely scenario in the coming months. The third panel of Chart 11 shows that relative share price momentum and the bond market are joined at the hip. This makes sense as materials stocks are reflationary beneficiaries, whereas the utilities sector acts as a fixed-income proxy. Not only does the pair trade benefit from rising bond yields in isolation, but also when the stock-to-bond (S/B) ratio is on fire. Currently, a wide gap has opened between the S/B and the materials/utilities ratios that will likely narrow via a catch up phase in the latter. Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. Chart 13 highlights four different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. Materials manufacturers have a sizable export component driving both the top and bottom line. In contrast, utilities are a domestic-only play. As a result, revving global trade and the significant fall in the trade-weighted U.S. dollar will buttress relative EPS prospects (Chart 14). In fact, irrespective of where the greenback ends the year, materials profits will get a lagged bump from a positive FX translation in the back half of the year. Chart 13...Global Growth Favor ##br##Materials Over Utilities Chart 14Cheapened Greenback = ##br##Buy Materials At The Expense Of Utilities The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel, Chart 14). Relative valuations and technical conditions also wave the green flag. Our valuation indicator has corrected back to the neutral zone and the technical indicator has unwound overbought conditions, offering a compelling entry point to the pair trade (Chart 15). Finally, our newly introduced relative EPS models encapsulate all of these diverging forces. Currently, the relative profit models signal that materials earnings are on track to outpace utilities profit generation for the remainder of the year (Chart 16). Chart 15Compelling Entry Point Chart 16Heed The Relative Profit Model Message Consequently, there is an opportunity to execute a long materials/short utilities pair trade in order to benefit from synchronized global growth and looming bond market selloff, and softening U.S. dollar and related commodity inflation. Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade today. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key 2 Please see the August 16, 2017 Geopolitical Strategy Weekly Report titled "Can Pyongyang Derail The Bull Market?", available at gps.bcaresearch.com. 3 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks", available at uses.bcaresearch.com. 4 Please see July 31, 2017 U.S. Equity Strategy Weekly Report titled "Growth Trumps Liquidity", available at uses.bcaresearch.com. 5 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks" for a recap of our major portfolio moves since May 1, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The strong labor market may be holding down wage inflation. The strength in sales and EPS is broad-based and sustainable. July FOMC minutes highlight internal debate at the Fed over inflation. Financial stability is the Fed's Third Mandate. Feature Risk assets struggled again last week but Treasury yields held steady as investors reacted to President Trump's latest controversy, the FOMC minutes, another round of solid economic data for Q3 and the final few earnings reports of the Q2 reporting season. The July FOMC minutes highlighted the internal debate at the Fed about the Phillips curve and financial stability. Nonetheless, we expect the Fed to continue to tighten policy later this year. In this week's report, we examine a study by the San Francisco Fed that highlights the negative impact of a strong labor market on wages. Profit margins continued to expand in Q2 and the BCA EPS model projects a solid 2H performance, driven by both domestic and globally oriented firms. Strong Labor Market, Weak Wages The labor market continues to tighten measures of overall labor market slack suggest that wage inflation should accelerate soon. Still, slack remains in some segments of the labor market and that may be depressing overall wage growth. The overall quit rate (2.1%) is slightly below its all-time peak and 65% of the 11 industry groups have quit rates that are at or close to pre-global financial crisis level (Chart 1). Moreover, fill rates, the ratio of hires to job openings, for most industries are at record lows, and job openings in all but the wholesale trade, information, mining & logging and construction areas have surpassed prior peaks (Chart 2). The implication is that economy-wide, there are more jobs seekers than jobs, which will ultimately force businesses to offer higher salaries. Chart 1Labor Market Strength Is Widespread... Chart 2...With Only A Few Industries Lagging Behind Moreover, wage pressures are mounting, especially for full-time employees. A recent study1 published by the San Francisco Fed found that at 3.4%, the year-over-year change in median weekly earnings was still below the 2007 peak. However, wage gains for continuously employed full-time workers (4.8%) are in line with rates seen a decade ago (Chart 3). Overall wage gains continue to be suppressed by new entrants to the labor force. Growth rates of median weekly earnings for this group are down 1.4%, and have been negative since the overall labor market began to recover in early 2010. The counter-intuitive implication of the SF Fed study is that substantial gains in the labor market may be depressing average wage rates. As individuals learn about better prospects for employment, they choose to join the workforce, either as new entrants (from school) or as reentrants (those who left either voluntarily or involuntarily). These groups, according to the study, have suppressed median weekly earnings growth by between 1.5% and 2.0% (Chart 4). Chart 3Wage Inflation Dragged##BR##Down By New Entrants Chart 41.5% To 2% Drag On Wage Inflation##BR##Due To Compositional Shifts In Workforce In addition, as 10,000 higher paid baby boomers reach 65 years of age each day and leave the labor force, they are replaced by lower wage earners. Bottom Line: The labor market is even tighter than the data suggests and the market's vigor may be understating wage inflation. Investors are mis-pricing the extent of rate hikes in 2017 and 2018. Bond yields are likely headed higher, but the stock market should take this in stride because of the favorable earnings backdrop. Corporate Profits Are Not Only A Weak Dollar Story EPS and sales growth in Q2 ran well ahead of consensus expectations as forecast in our July 3 preview. Moreover, the counter-trend rally in profit margins is still in place. So far, more than 90% of companies have reported results with 74% of companies beating consensus EPS projections, just above the long-term average of 70% (Chart 5). Furthermore, 69% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 6% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to ultimately re-assert itself, perhaps beginning early in 2018. Nonetheless, we saw another quarter of margin expansion in Q2. Average earnings growth (Q2 2017 versus Q2 2016) was strong at 12% with revenue growth at only 5%. The BCA Earnings model predicts EPS growth to hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 6). Measured this way, S&P 500 EPS growth in Q2 will be 18%, compared with 13% in Q1. Chart 5Positive Earnings Surprises Continued In Q2 Chart 6Strong EPS Growth Expected In 2H '17 Importantly, the strength in earnings and revenues is broadly based (Table 1). Earnings per share were higher in Q2 2017 versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Energy revenues surged by 16% in Q2 versus a year ago. Sales gains in technology (8%), materials (7%) and utilities (6%), are notable. Moreover, year-over-year sales gains in Q2 2017 in all but three sectors (telecom, consumer staples and consumer discretionary) ran ahead of nominal GDP (+3.7%) in the same period. Investors will turn their attention to earnings prospects in 2H 2017 and 2018 as the Q2 reporting season ends. Since the start of 2017, the trajectory of EPS estimates for 2017 and 2018 (not shown) has been encouraging. The forecast for 2017 is 11.6%, up from 11% at the outset of the Q2 reporting season and unchanged from the start of the year. Similarly, the 2018 estimate (10.9%) is little changed from estimates made in January 2017. In a typical year, earnings estimates tend to move lower as the year progresses. Like the financial markets, corporate managements have largely ignored President Trump during this earnings season. Trump's name was used only once in Q2 earnings calls held through August 11, down from 9 in Q1 calls and 32 in the Q4 2016 reporting season just after Trump took office (Chart 7). The single mention thus far matches the number of times that CEOs and CFOs cited Trump's name before last November's election. We are inclined to see fading concerns about government policy from the next Beige Book (due in early September) because Trump has managed to slow regulation2 during his first seven months in office, although uncertainty around the president's legislative agenda remains elevated. Table 1S&P 500: Q2 2017 Results* Chart 7Trump Fading As Topic On Earnings Calls BCA's case for improving profits in the second half of 2017 is supported by the August readings on the Empire State and Philadelphia Fed manufacturing indices, along with the June and July readings on industrial production (IP). IP has been a good proxy for sales of S&P 500 companies (Chart 8); a rollover in the 12-month change in IP would challenge BCA's constructive view towards earnings. However, strong readings on the ISM (July), the August Empire State and Philadelphia Fed indices suggest that IP should accelerate in the next six months. Moreover, the weaker dollar has boosted foreign demand for U.S. goods and services. The implication is that foreign demand (rather than domestic consumer or business spending) leads the U.S. manufacturing sector. Consistent with this perspective, the 3- and 12-month changes in the IP indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 9). Chart 8Favorable Backdrop For Earnings And Sales Continues Into Q3 Chart 9U.S. IP Growth Still Lagging##BR##Other Developed Markets... Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, the weaker dollar has allowed profit and sales gains of globally oriented firms to rebound and outpace those of domestically focused businesses. (Table 2 and Chart 10) Margins for U.S. focused companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but are higher than margins of domestic companies. Chart 10Global EPS, Sales Playing Catch Up To Domestic Table 2Q2 Earnings Breakdown Bottom Line: EPS growth will continue to accelerate through 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth (Chart 6). The solid performance of manufacturing at home and overseas sets the stage for EPS growth in firms with both U.S. and global outlooks. BCA's bullish profit story for 2017 is still intact, supporting an overweight stance towards stocks versus bonds. The Fed will not get in the way of the equity rally unless inflation suddenly surges in the coming months (which we do not expect). FOMC Debate Still Centers On Inflation The minutes from July's FOMC meeting indicates little progress on the debate over low inflation and the appropriate monetary policy response. It will require at least a modest rise in inflation to break the deadlock. Policymakers appear to be pleased with the state of economic growth, which has rebounded from a lackluster first quarter. They agree that the expansion will be strong enough that the labor market will continue to tighten. As highlighted in previous minutes, the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike, and how policy should adjust to changing financial conditions. A majority of policymakers seem willing to believe that this year's soft inflation readings are driven by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excessive risk-taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. Therefore, the hawks are anxious to resume tightening, despite the current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. If true, this would mean that the Phillips curve is very flat, or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. Some argued that the recent easing in financial conditions would add little to growth and thus, does not require tighter Fed policy. There was little movement toward capitulation by either camp evident in the minutes. Discussion of the Fed's balance sheet in the recent minutes reinforced that an announcement would likely occur in September, with tapering beginning shortly thereafter. "A number of participants" commented that financial conditions will be key to determining the pace of rate hikes. If the bond market and risk assets react negatively to balance sheet shrinkage, then it would be appropriate to slow rate increases to offset any economic repercussions. Given that only one rate gain is discounted in the money market curve over the next 12 months, it appears that investors are betting that balance sheet shrinkage will largely eliminate the need for higher short-term interest rates. Fed economists recently updated their quantitative assessments of FOMC minutes.3 The note provides a guide (Table 1 in the Fed paper) to the "quantitative words" used in the minutes (one, a couple, a few, etc.). We intend to comment on the findings of this paper in a future Weekly Report. An Update On The Fed's Third Mandate Financial stability remained a concern for Fed policymakers in July and that is why the hawks want to keep tightening even though inflation has not yet met the FOMC's target. BCA views "financial stability" as a third mandate4 for the central bank, along with low and stable inflation, and full employment. Financial stability was discussed at the July meeting by both Fed staff and voting FOMC members. Fed Chair Janet Yellen has elevated financial stability during her tenure, leading discussions or staff briefings in 20 of the 28 meetings she has presided over. Yellen will deliver a speech on financial stability on August 25 at the Fed's Jackson Hole conference. However, the Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in December 2013, but its next judgment (also moderate) was only in January 2016. Since then, Fed staff has provided an assessment of financial stability in 7 of the 13 subsequent meetings. FOMC participants have debated about financial stability at 4 of the 5 meetings this year, and 8 of the 11 since April 2016. As was the case at the June meeting, Fed staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance in July.5 This assessment has not changed since the Fed began to offer opinions on the health of the financial system at its September 2013 meeting. We conclude that the doves want inflation to rise closer to the 2% target before tightening again. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excessive risk-taking in markets according to some on the FOMC. Bottom Line: The FOMC minutes did not change our base case outlook: the FOMC will announce in September that it will begin to shrink the Fed's balance sheet. The next rate bump will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation will edge higher in the coming months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 http://www.frbsf.org/our-district/about/sf-fed-blog/wage-growth-good-news/?utm_source=frbsf-home-sffedblog-title&utm_medium=frbsf&utm_campaign=sffedblog 2 Please see U.S. Investment Strategy Weekly Report, "Still Waiting For Inflation,"August 14, 2017, available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 4 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017, available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/fomcminutes20170726.htm

Highlights The cyclical recovery in global earnings will trump, so to speak, ongoing political developments. Unlike the last three recessions, which resulted from burst asset bubbles, the next U.S. recession will be more akin to those of the 1970s and early 1980s. Those "retro" recessions were caused by the Fed's decision to raise rates aggressively in response to rising inflation. The good news is that it will take a while for inflation to accelerate, suggesting that the next recession will not occur until 2019 at the earliest. The bad news is that once inflation does start rising in earnest, the Fed is likely to find itself flat-footed. Remain overweight global equities for now, favoring European and Japanese stocks over U.S. equities in currency-hedged terms. Look to reduce exposure in the second half of next year. Feature After Charlottesville Political developments continued to cast a pall over markets this week. Last week's worries about escalating tensions in the Korean peninsula subsided on comments from the North Korean regime that it would not launch a preemptive strike against Guam. As that issue moved off the radar screen, a new one emerged. President Trump's comments about the violent protests in Charlottesville generated outrage in many quarters, leading to the disbandment of two of the President's business advisory councils. We agree with those who argue that this latest incident will have far-reaching consequences. However, we disagree about the timeframe over which they will manifest themselves. As with most Trump scandals, this one is likely to fizzle into the background. Republicans in Congress would love nothing more than to change the subject. Plowing ahead with tax cuts is one way to do that. A limited infrastructure bill also remains a possibility - and unlike most issues up for debate, this one could actually attract bipartisan support. The market has essentially priced out any meaningful progress on either taxes or infrastructure, so the bar for success here is fairly low (Chart 1). While the implications of recent events in the U.S. are unlikely to put much strain on markets over the next year or so, the longer-term ramifications could be profound. The Democrats' "Better Deal" agenda moves the party to the left on most economic issues. Historically, the Republicans have been champions of small government. Increasingly, however, many Trump voters are asking themselves why exactly they should support lower business taxes when most companies seem openly hostile to the populist agenda that got Trump elected. In this respect, it is noteworthy that support for free trade among Republican voters has collapsed over the past 10 years (Chart 2). Wall Street, Silicon Valley, and the rest of the business establishment tends to be liberal on social issues and conservative on economic ones. The problem is that very few voters share this configuration of views (Chart 3). This contradiction cannot be ignored indefinitely. Chart 1The Markets Have Given Up On Infrastructure And Taxes Chart 2Republican Support For Free Trade Has Collapsed Chart 3An Absence Of Libertarians We predicted that "The Trumpists Will Win" back in September 2015 when most pundits were still scoffing at the idea that Trump could win the Republican nomination, let alone the election. This prediction was based on the view that "Trumpism" would resonate with American voters more forcefully than most experts thought possible. If the Republican Party does move to the left on economic issues, this could lead to more economic instability and larger budget deficits - and ultimately, much higher inflation. We discussed the reasons why inflation is heading higher over the long haul several weeks ago and encourage readers to review that report.1 Still Chugging Along Over a shorter-term horizon of one or two years, however, things still look reasonably bright. Earnings are in a solid uptrend. The profit recovery has been broad-based across countries and sectors. Our global leading economic indicator is trending higher, as are estimates of global growth (Chart 4). Chart 4Global Growth Estimates Accelerating Despite Stalled U.S. Growth The current economic recovery in the U.S. has now lasted over eight years, making it the third-longest on record. If it continues until July 2019, it will take the top spot from the 1990s expansion. The fact that this expansion has endured for so long is not too surprising. The Great Recession was one of the deepest in history, while the recovery that followed has been fairly drawn out. Such "slow burn" recoveries are typical following financial crises, and this one has not been any different. However, now that the U.S. unemployment rate has returned to pre-recession levels, the question arises whether the curtain may finally be closing on this expansion. Our answer is "not yet." While this expansion is starting to get long in the tooth, the next recession probably won't roll around until 2019 - and perhaps even later. This means that a cyclically bullish stance towards risk assets is still appropriate. Searching For The Smoking Gun As the old saying goes, "Expansions don't die of old age. They are murdered by the Fed." Such a verdict is too harsh, but it does get to an underlying truth: Fed rate hikes have almost always preceded past U.S. recessions (Chart 5). Broadly speaking, post-war recessions can be broken down into two categories. The first consists of recessions that resulted from the bursting of asset bubbles. In those cases, Fed rate hikes were more the instigator of the recession than the cause of it. The second category consists of recessions where the Fed found itself behind the curve in normalizing monetary policy and was forced to raise rates aggressively in response to rising inflation. The last three recessions were all of the first variety. The 1990-91 recession stemmed from the commercial real estate bust and the ensuing Savings and Loan crisis. The 2001 recession was caused by the bursting of the dotcom bubble. And, of course, the Great Recession was largely the product of the housing bust and weak mortgage underwriting standards. Today's financial landscape is far from pristine. Corporate debt is close to record high levels as a share of GDP and asset valuations are stretched across the board (Chart 6). However, while these imbalances are bad enough to exacerbate a recession, they do not appear severe enough to cause one. This suggests that the next downturn may look less like the last three recessions and more like the "classic" or "retro" recessions of the 1960s, 70s, and early 80s. Chart 5Who Kills Economic Expansions? Chart 6Debt Is Rising, As Are Asset Values Inflation Remains Benign ... For Now If we are heading for a retro recession, investors should keep a close eye on inflation. This is simply because the Fed is unlikely to turn very hawkish until inflation starts accelerating. The good news is that inflation should remain dormant for at least the next 12 months. In fact, most measures of consumer price inflation have decelerated since the start of the year (Chart 7). Producer prices also fell unexpectedly in July, the first outright decline in 11 months. The St. Louis Fed's Price Pressures index remains near rock-bottom levels (Chart 8). Chart 7Consumer Inflation Has Decelerated Of Late Chart 8Price Pressures Are Muted... For Now Inflation expectations are still reasonably well anchored and trade unions have less clout than they once did. Shale producers also have the ability to ramp up production in response to higher oil prices. Past episodes of rapidly rising inflation were often accompanied by supply disruptions that led to spiraling energy costs. Moreover, at least for the time being, higher imports can absorb some of the excess in U.S. aggregate demand. The bad news is that once inflation does start rising in earnest, the Fed is likely to find itself flat-footed. Inflation is a highly lagging indicator. As we have noted before, inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 9). Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Chart 9Inflation Is A Lagging Indicator Timing Matters Too Doesn't a very low neutral real rate reduce the risk that the Fed will find itself behind the curve? The answer is "yes," but only to a limited extent. Suppose, for the sake of argument, that the Fed knew the exact level of the neutral real rate. It would still be the case that a major delay in bringing interest rates up to that magic number would cause the unemployment rate to fall below NAIRU, leading to an overheated economy. Such an economy may not generate inflation immediately, but both history and simple logic suggest that a situation where aggregate demand continues to outstrip supply will eventually produce upward pressure on prices. The lesson here is that successful monetary policy does not just require that central banks bring rates to the correct level. They also have to bring rates to the correct level at the right time. That is difficult to do, which is why soft landings following monetary tightening cycles are few and far between. Fed Dots Too Optimistic About Labor Force Growth And Productivity The Fed "dots" foresee the unemployment rate ending the year at the current level of 4.3% and falling marginally to 4.2% in 2018. The Fed also expects real GDP to grow by 2.2% in Q4 of 2017 and 2.1% in Q4 of 2018 over the previous year. This is similar to the average rate of GDP growth since the start of the recovery, a period where the unemployment rate fell by over five percentage points. Thus, the only way the Fed's math can add up is if labor force growth accelerates or productivity growth increases. Neither outcome is likely. The labor force participation rate has been flat for the past four years, despite the fact that an aging population has pushed more people into retirement. Chart 10 shows that the participation rate has fallen by three percentage points since 2008, only 0.3 points less than one would expect based solely on changes in the age distribution of the population. Much of the remaining gap can be explained by the secular decline in participation rates within young-to-middle age cohorts, offset in part by higher participation among the elderly (Chart 11). In particular, the downward trend in participation among less-educated workers appears to be more structural than cyclical in nature (Chart 12). As we noted last week, the growing shortage of workers is already visible in employer surveys and rising wage pressures at the lower end of the skill distribution.2 Thus, far from accelerating, chances are that labor force growth will decelerate as the economy runs out of people who can be persuaded to seek out gainful employment. This could cause the unemployment rate to fall further than the Fed expects. Chart 10Demographic Shifts Explain Most Of The Decline In Participation Rates Chart 11Participation Rates Across Age Cohorts Chart 12Labor Force Participation Has Fallen ##br##The Most Among The Less-Educated Productivity is also unlikely to make a significant rebound. The drop in productivity growth has been broad-based across industries and countries. Moreover, it began several years before the financial crisis, suggesting that the Great Recession was not the main culprit. All this points to underlying structural factors - such as a weaker pace of innovation and flagging educational achievement - as being the key drivers of the productivity slowdown.3 What Goes Down Must Come Up If labor force growth fails to accelerate and productivity growth remains weak, then the current pace of GDP growth of around 2% will push the unemployment rate down from current levels. Needless to say, if GDP growth accelerates above 2%, unemployment will drop even more. Such an outcome is, in fact, quite likely given the significant easing in financial conditions that the U.S. has experienced over the past few months. All this means that the unemployment rate may be on its way to falling below its 2000 low of 3.8% by next summer. This would leave it close to a full percentage point below the Fed's estimate of NAIRU. At that point, the unemployment rate would have nowhere to go but up. And, unfortunately, history suggests that once unemployment starts rising, it keeps rising. In fact, the U.S. has never averted a recession in the post-war era when the three-month average of the unemployment rate has risen by more than one-third of a percentage point (Chart 13). Chart 13Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle The Not-So-Prescient Stock Market If the U.S. does succumb to a recession in 2019 or 2020 because the Fed is forced to hike rates aggressively in response to rising inflation, how quickly will the market sniff out an impending downturn? Chart 14 plots the value of the S&P 500 around the time of past recessions. On average, the stock market has peaked six months before the beginning of a recession. However, there is quite a bit of variation from one episode to the next (Table 1). The S&P 500 peaked only two months before both the Great Recession and the 1990-91 recession. It peaked seven months before the 2001 recession, but that downturn was arguably more the product of the stock market bust than the cause of it. Chart 14Profile Of U.S. Stocks Around Recessions Table 1Stocks And Recession: Case By Case On the whole, the stock market is not particularly good at anticipating recessions triggered by financial sector imbalances. The stock market is more adept at predicting downturns caused by excessively tight monetary policy - although even here, it is difficult to know how much of the weakness in equities leading up to such recessions was due to rising expectations of a downturn and how much was simply the result of higher interest rates. From this, we conclude that the stock market will likely peak a few months before the next recession. If we are correct about the timing of our recession call, this implies the cyclical bull market has another 12-to-18 months left. Cyclical Leading Indicators Still Benign The bond market has generally done a better job of anticipating economic downturns than the stock market. This is especially the case for the yield curve, which has inverted in the lead-up to every single recession over the past 50 years, with only one false positive (Chart 15). While the 10-year/3-month spread has compressed over the past few years, it is still above the level that has warned of recessions in the past. Most other forward-looking cyclical indicators continue to point to an economic expansion that has further room to run. The Conference Board's Leading Economic Indicator (LEI) has consistently fallen into negative territory on a year-over-year basis leading up to past recessions (Chart 16). The LEI has accelerated since last summer, suggesting little risk of a near-term downturn. Chart 15The Yield Curve Has Called 8 Of The Last 7 Recessions Chart 16LEI Also Good At Signaling Recessions A decline in the ISM new orders component in relation to the inventory component has warned that final demand is softening while the stock of unsold goods is piling up (Chart 17). The current gap stands at 10.4, consistent with a robust expansion. Likewise, initial unemployment claims have usually risen going into past recessions (Chart 18). Neither the current level of claims nor hiring intention surveys are signaling trouble ahead. Chart 17Economic Momentum Is Still Positive Based On The ISM Chart 18Initial Claims Claim Everything Is Okay Changes in financial conditions tend to lead GDP growth by around 6-to-12 months. Thus, it is not surprising that recessions have often occurred in the wake of a tightening in financial conditions (Chart 19). As noted above, U.S. financial conditions have eased sharply since the start of the year. Chart 19Recessions Tend To Occur When Financial Conditions Are Tightening Investment Conclusions Historically, recessions and equity bear markets have gone hand in hand. As my colleague Doug Peta likes to emphasize, it simply does not pay to be underweight stocks unless one has legitimate reasons for thinking that another economic downturn is just around the corner (Chart 20).4 Our analysis suggests that another recession is still at least 18 months away. This is confirmed by a variety of recession-timing models, all of which are signaling low risks of an impending downturn in growth (Chart 21). As we noted last week, wage growth is likely to accelerate over the next few quarters. This will prop up consumer spending. July's blockbuster retail sales report was no fluke - there are plenty more where it came from. Stronger U.S. growth will force the market to revise up the miserly 41 basis points in rate hikes that it has priced in over the next two years. This will push up Treasury yields and give the dollar a boost. The greenback has usually strengthened whenever an overheated labor market has caused labor's share of income to rise (Chart 22). We expect the broad trade-weighted dollar to appreciate by about 10% over the next 18 months. Chart 2050 Years Of Recessions And Bear Markets Chart 21No Imminent Risk Of A Recession Chart 22Historically, A Rising Labor Share Has Pushed Up The Dollar A stronger dollar is necessary for tilting U.S. consumption towards foreign-made goods, thereby allowing domestic spending to rise in the face of tighter supply constraints. This is good news for foreign producers in developed economies, but could cause trouble for firms in emerging markets which have taken out large amounts of dollar-denominated debt. We continue to prefer European and Japanese stocks over their U.S. counterparts in currency-hedged terms. In the EM space, Chinese H-shares are our preferred market. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. 2 Please see Global Investment Strategy Weekly Report, "What's The Matter With Wages?," dated August 11, 2017. 3 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 4 Please see Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

When we upgraded the S&P industrial machinery group to overweight, we held back the S&P construction machinery & heavy trucks sibling to a neutral weighting. Our reasoning was threefold: heavy truck sales were very weak, the outlook for agriculture and food prices was shaky and the resource industry was not in a mood to deploy capital into expansion. That rationale has shifted somewhat. First, heavy truck sales have turned a corner and have pushed positively for the first time in two years (second panel). Still, in advance of a surge in orders, manufacturers boosted production earlier this year, likely offsetting a portion of the calendar 2017 earnings expansion. Second, food prices (to which the industry is highly correlated) have rebounded to some extent this year, arresting the general downtrend of the past five years (third panel). This is a sign for optimism, though whether the uptick becomes a trend remains unknown. Lastly, Caterpillar's machine sales to dealers to all regions have finally pulled out of their multiyear contraction (fourth panel), signaling a commodity production rebound. However, the resilience of this rebound is questionable with the recent Chinese fiscal and monetary tightening and a leadership change coming in the fall. Importantly, valuation multiples have fallen well off their peaks (bottom panel) as earnings estimates have surged, while the market has remained skeptical. We side with the market and remain on the sidelines, until some earnings growth validation materializes. Nevertheless, we acknowledge the mild positive macro backdrop shift and the S&P construction machinery & heavy trucks index is now on upgrade alert. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.

Highlights Despite a tightening in Chinese monetary conditions, dollar bloc currencies have continued to rally. Rising global reserves and strong carry inflows into EM prompted by low global financial volatility have created plentiful liquidity conditions in EM, supporting dollar-bloc currencies. The beginning of the Fed's balance-sheet runoff could reverse these dynamics, hurting the AUD, CAD and NZD in the process. Monitor U.S. inflation, cross-currency basis swap spreads, gold, EM currencies and Chinese monetary conditions to judge when a break in dollar-bloc currencies will materialize. Feature The rally in the dollar-bloc currencies since July 2016 has been nothing short of stunning. We did highlight in April last year that commodity currencies had room to appreciate, but we did not anticipate such a prolonged move.1 In fact, the up leg that began in April 2017 caught us by surprise. At this juncture, it is essential to analyze whether or not the bull move in commodity currencies has further to run, or whether it is in its final innings. A principal component analysis of the returns of the AUD, the CAD, and the NZD shows that despite differing central bank postures in the three countries, a simple common factor explains 86% of their variability against the USD since 2010 (Chart I-1). Because of this result, our focus in this week's report are the global forces that may be driving this factor. Today, the key risk to the dollar-bloc currencies is global liquidity tightening. Behind this danger lies the removal of policy accommodation in the U.S., and the risks to carry trades created by the already-very-low volatility of risk assets. A China-Fueled Rebound, But Something Is Amiss... The key reason behind the rally in commodity currencies has been improvement in EM growth relative to DM economies since 2016 (Chart I-2). This growth outperformance has been underpinned by a few factors. Chart I-1One Factor To Drive Them All Chart I-2Commodity Currencies And EM Growth China has played an essential role. As the Chinese economy decelerated in 2015, Beijing implemented a large amount of fiscal stimulus, which saw government spending grow at a 25% annual rate in November 2015. Due to the lags of stimulus on the economy, the full force of that stimulus was felt in 2016. Direct fiscal goosing was not the only road taken by Beijing. The Chinese authorities also applied a considerable amount of monetary pressure on China. After tightening massively through 2015, Chinese monetary conditions eased greatly in 2016 as real borrowing costs collapsed from a peak of 10.5% in the fall of 2015 to a trough of -3.5% earlier this year (Chart I-3). Directed expansion of credit through banking channels was also used to support the economy, resulting in a surge in the Chinese credit impulse. However, in recent months these positives have dissipated. Chinese money growth has slowed, and the combined credit and fiscal impulse has been lessened. Yet EM equity prices, copper prices and commodity currencies are all continuing their rally, and are now re-testing their May 2015 levels - levels last experienced right before EM assets and related plays entered a vicious tailspin that lasted all the way until January 2016 (Chart I-4). Chart I-3China: From Tailwind ##br##To Headwind Chart I-4EM, Copper, Dollar Bloc: ##br##Back To May 2015 Levels Bottom Line: The rally in dollar-bloc currencies that begun in January 2016 was powered by improving growth performance within EM economies. The original driver behind this move was Chinese monetary and fiscal stimulus. However, even once the easing faded, EM plays, including the AUD, the CAD and the NZD continued to appreciate. Another factor is currently at play. ...And This Something Is Global Liquidity Our view is that global liquidity is now the key factor supporting EM plays in general and dollar-bloc currencies in particular. Since the end of 2016, we have seen a rebound in the Federal Reserve's custody holdings - one that has happened as foreign central banks resumed their purchases of Treasury securities (Chart I-5). Fed custodial holdings for other monetary authorities are a key component of our dollar-based liquidity indicator. A rebound in this indicator tends to be associated with a surge in high-powered money globally. The capital outflows from China have dissipated, helping high-powered money find its way into EM plays and the commodity-currency complex. Private FX settlements - a proxy for the Chinese private sector's selling of yuan - was CNY -43 billion in July, a massive improvement compared to the CNY 800 billion in outflows experienced in August 2015 (Chart I-6). Through stringent administrative controls and a lessening of deflation, China gained the upper hand over its capital account. This development has two implications: it means that China does not need to sell reserves anymore, and in fact has been accumulating Treasurys since February 2017. It also means that investors are now less afraid of a sudden devaluation in the CNY, which has heartened risk-taking globally - especially in assets most exposed to China, which includes EM, commodities and dollar-bloc currencies. Chart I-5Easing Global Liquidty In 2017 Chart I-6Chinese Capital Account Under Control The collapse in the volatility of risk assets has been an additional element helping global liquidity make its way into EM plays and commodity currencies. As Chart I-7 illustrates, there is a relationship between the realized volatility of the U.S. stock market and the performance of dollar-bloc currencies. The first hunch is to dismiss the relationship as an artifact of the fact that both stock prices and commodity currencies are "risk-on" instruments. But there is an economic underpinning behind this relationship. As we argued in a Special Report on carry trades last year, the main reason carry trades have been able generate high Sharpe ratios since the 1980s is because they offer investors a risk premium for taking on exposure to unforeseen spikes in volatility.2 As a result, when the volatility of risk assets collapses, as has been the case recently, carry currencies outperform. The opposite holds true when volatility spikes back up. Chart I-7Dollar Bloc Currencies Like Low Vol When carry trades do well, investors end up aggressively buying EM currencies. As a result of these purchases, they inject funds - i.e. liquidity - into these economies. These injections of liquidity end up boosting money growth and supporting their economic activity, which stimulates global trade, commodity prices, and thus commodity currencies - even if these are not currently "high-yielders." Bottom Line: Chinese monetary conditions have deteriorated, creating a handicap for EM assets and the dollar-bloc currencies. Nonetheless, an increase in high-powered money growth, a decline in the risk premium to compensate investors for the risk of sudden new Chinese devaluation, and a collapse in global financial volatility have reinforced each other to create the ideal breeding ground for a rally in the AUD, the CAD and the NZD. The Sweet Spot Is Passing At the current juncture, the sweet spot for the dollar-bloc currencies may be passing. To begin with, commodity currencies are trading at a significant premium to underlying commodity prices, suggesting they are expensive and vulnerable to a decrease in global liquidity (Chart I-8). The AUD and the NZD stand out as especially expensive, while the CAD is only trading at a small premium to its long-term fair value (Chart I-9). This suggests that the Canadian dollar is likely to continue to outperform the Australian and New Zealand currencies, as it has been doing in choppy fashion since November 2016. Chart I-8Dollar Bloc Currencies Are Expensive Chart I-9AUD And NZD Are Expensive Another problem for dollar-bloc currencies is that they have greatly overshot global liquidity metrics. Historically, the commodity currencies have moved in lockstep with the evolution of global central bank reserves - a key measure of global liquidity (Chart I-10). While global reserves have improved, the average of the AUD, the CAD and the NZD has over-discounted this positive, pointing to potential vulnerability once liquidity ebbs. The problem with this overshoot is that liquidity is likely to decline with the imminent reduction in the Fed's balance sheet size. As Chart I-11 shows, the USD has been closely linked to changes in the reserves of commercial banks held at the Fed. As commercial banks accumulate excess reserves, this provides fuel for the repo market and the Eurodollar market, creating a supply of globally available USD for offshore markets. However, mechanically, once the Fed lets the assets on its balance sheet run off (its holdings of Treasurys), a liability will also have to decrease. This liability is most likely to be excess reserves as banks buy the Treasurys sold by the Fed. A fall in the accumulation of reserves of commercial banks in the U.S. is also directly linked with weaker dollar-bloc currencies (Chart I-12). This is because falling reserves push up the dollar and hurt commodity prices - a negative terms-of-trade shock for the AUD, the CAD and the NZD. Moreover, less reserves point to less liquidity making its way into EM economies. This also hurts the expected returns of holding assets in dollar-bloc economies. This therefore means that not only is there less liquidity available to move into these markets, the rationale to do so also dissipates. Without this dollar-based liquidity support, the tightening in Chinese monetary conditions could finally show its true impact on commodity currencies. Chart I-10Commodity Currencies Have##br## Overshot Global Liquidity Chart I-11Falling Excess Bank Reserves##br## Equals Strong Greenback Chart I-12Falling Excess Reserves Equals##br## Falling Commodity Currencies The last worrisome development for the dollar-bloc currencies is the volatility of financial assets. When volatility falls, it creates a wonderful environment for these currencies. But today, historical volatility is near the bottom of its distribution of the past 28 years. Being a highly mean-reverting series, it is thus more likely to rise than fall further going forward. There are three fundamental factors pointing to a potential reversal. First, share buyback activity has been declining, which historically points to rising volatility. Second, the U.S. yield curve slope also points toward a higher level of volatility. Volatility tends to bottom before the stock market peaks, and the stock market tends to peak before the economy enters recession. The yield curve itself tends to invert a year or so before a recession emerges. As a result, the yield curve begins to flatten around two years before volatility picks up (Chart I-13). Third, the anticipated decline in bank reserves - an important factor that has supported risk-taking around the globe - is likely to be the key catalyst supporting the relationship between the yield curve and volatility. If volatility increases, carry trades are likely to perform poorly, which will hurt EM currencies and result in outflows from these markets. This will cause liquidity conditions in EM economies to dry out, hurting their growth outlook. EM M1 growth has already weakened considerably, and is currently pointing to problems for commodity currencies (Chart I-14). The dry out in liquidity resulting from a reversal in carry trades will only amplify this phenomenon. Chart I-13Listen To The Yield Curve: ##br##Volatility Will Pick Up Chart I-14EM M1 Growth Is Becoming ##br##A Headwind For The Dollar Bloc Bottom Line: Global liquidity conditions are set to begin to tighten. While it is probably not enough to cause the bull market in stock prices to end now, it could be enough to affect the area of the global economy most exposed to this risk factor: carry trades and the dollar-bloc currencies. Specifically, commodity currencies are likely to be negatively affected by their elevated valuations, their strong sensitivity to excess bank reserves, and their high responsiveness to changes in financial market volatility. Key Indicators To Monitor After the surge that the dollar-bloc currencies have experienced since the spring and the large increase in the long exposure of speculators to these currencies, they are naturally at risk of experiencing a period of weakness. However, what worries us is not a retracement of 3-4%, but rather a 10-15% move. We suggest monitoring the following: First, watch U.S. inflation closely. The U.S. dollar is only likely to genuinely rally once the market believes the Fed can actually increase rates. So long as inflation remains tepid, investors will continue to second-guess the Fed. The market's response to this week's release of the most recent Federal Open Market Committee minutes only confirmed this. Mentions of debate on inflation within the FOMC was enough to send bond yields and the dollar reeling. However, based on the dynamics in the U.S. velocity of money, we continue to expect inflation to pick up in the second half of 2017 (Chart I-15).3 Second, follow cross-currency basis swap spreads. The cost of hedging U.S. assets back into euro or yen has normalized somewhat after hitting record levels in early 2016 (Chart I-16). If the removal of excess bank reserves in the U.S. system does affect global liquidity conditions, this market will be one of the first to be affected. Third, scrutinize the price of gold. The yellow metal remains a key gauge of global liquidity. Moreover, it is extremely sensitive to real rates and the dollar - two major determinants of the cost of global liquidity. In the summer of 2015, EM and dollar-bloc currencies severely suffered once gold broke below 1150. Today, a break below 1200 would be a sign of danger ahead. Fourth, watch EM currencies. A breakdown in EM currencies would be a key indication that carry trades are being reversed, and that global liquidity is no longer making its way into EM and EM-related plays. Commodity currencies are currently trading at a premium to their historical relationship with EM currencies, suggesting they would be highly vulnerable to such an event (Chart I-17). Chart I-15Watch U.S. Inflation Chart I-16Monitor Cross-Currency Basis Swap Spreads Chart I-17Dollar-Bloc Currencies At The Mercy Of EM FX Finally, keep an eye on Chinese monetary conditions. If Chinese monetary conditions improve from here, it would alleviate some of the negative pressure exercised on dollar-bloc currencies by the upcoming deterioration in global liquidity. However, if Chinese monetary conditions deteriorate further, this would negatively affect commodity prices, EM returns and the commodity currency complex. It would also hurt expected returns on Chinese assets, re-kindling outflows out of China and thus raising the risk premium associated with what would become a growing risk of CNY depreciation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Pyrrhic Victories", dated April 29, 2016, available at fes.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 3 Please see Foreign Exchange Strategy Weekly Report titled, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been mixed this week: The Empire State Manufacturing Index increased to 25.2, a significant jump and beat Retail Sales increased at a 0.5% monthly pace, with the ex. Autos measure increasing at 0.5%, both beating expectations; The Import Price Index increased by 1.5% since last year; Initial jobless claims dropped to 232,000, beating expectations significantly; However, housing starts and building permits both underperformed expectations. While the DXY has rebounded, the FOMC's July minutes discussed the recent shortfall of inflation, which was interpreted bearishly by markets. The Fed is likely to begin normalizing its balance sheet very soon, as well as raising rates again by the end of this year. The greenback will likely continue its ascent when firmer inflation data emerges. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Improving euro area growth prospects have propelled the euro 12% higher since the beginning of the year. However, the market seems to begin questioning the ECB's hawkishness. In its minutes, the ECB expressed worries about a potential euro overshoot. Additionally, rumors emerged that Mario Draghi will not give much guidance in Jackson Hole. Together, these stories have reversed some of the euphoria that had engulfed the euro. The tightening in euro area financial conditions relative to the U.S. has prompted a roll over in relative economic and inflation surprises, justifying these budding doubts. Furthermore, U.S. inflation should begin to meaningfully accelerate in the fall. This is likely to add to the euro's weakness, as the greenback will resume its upward trend. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Data in Japan was mixed this week: Annualized gross domestic product growth grew by 4% on an annualized basis, crushing expectations. Additionally the month-to-month growth of industrial production came in at 2.2%, also beating expectations. However both export and import growth underperformed, coming in at 13.4% and 16.3% respectively. On cue, after we placed a long USD/JPY trade last week, USD/JPY rallied half percentage point, even if it gave up some of the gain now. We continue to be bearish on the yen as we expect U.S. yields to start picking up, in an environment where market expectations are very depressed. But could a correction in EM caused by the rise in the dollar help the yen? Not in the short term, given that historically the yen only gains in very sharp EM selloffs that themselves weigh on bond yields. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data in the U.K. was mixed this week: Retail sales prices increased by 3.6% year-on-year, outperforming expectations. However, The trade balance not only worsened since last month but also came in below expectations, at -4.564 Billion pounds Crucially, most inflation metrics came in below expectations, with headline inflation coming in at 2.6% while PPI core output inflation came in at 2.4%. Overall, we continue to believe that the market's rate expectations for the BoE remain too hawkish. As the pass through from the currency dissipates, inflation should also start to come down. Furthermore, one has to remember that the BoE has a higher hurdle for raising rates than other central banks due to the unique situation in which the U.K. is currently in. Lowered rate expectations will be negative for cable in the short term. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Despite initially weak data, a risk-on environment and increasing copper prices have fueled a rally in the AUD. Data from China has been soft, and Australian data has been neutral: Chinese retail sales increased annually by 10.4%, less than expected; Chinese industrial production also underperformed at 6.4%; Australian wages increased at a 1.9% annual pace, in line with expectations; Australian unemployment dropped to 5.6%; participation rate increased to 65.1%; and a net of 27,900 jobs were filled. However, full-time employment went down by 20,300 while part-time employment increased by 48,200, so hours worked contracted. This development is likely to comfort the RBA in its dovish stance. In its minutes, the RBA discussed its worries concerning the housing market, and that "borrowers investing in residential property had been facing higher interest rates". This further worries the RBA regarding the impact of higher interest rates, limiting the room for more hawkish speeches. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Retail sales and retail sales ex-autos Quarter-on-quarter growth strengthened relatively to the previous quarter, coming in at 2% and 2.1% respectively. Moreover quarter-on-quarter inflation both for producer prices in outputs and inputs outperformed expectations, coming in at 1.3% and 1.4%. Currently, differences in perception adjustment between the dovishness of the RBNZ and the RBA have pushed Australian rate expectations to the point that the market is now pricing a hike in Australia before New Zealand. Overall, this seems like a mispricing, as the kiwi economy is on a stronger footing than the aussie one. Moreover, a slowdown in China would be more harmful for Australia as iron ore is more sensitive to the Chinese industrial cycle than dairy products. Thus we remain bearish on AUD/NZD. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD has regained some composure despite weak oil prices. Even with the U.S. dollar weakening and inventories drawing massively, oil dropped. This dynamic is particularly worrying for oil, as the markets are doubting the durability of the curtailment in global oil production. While this could be worrying for the CAD, we still believe the USD 40-60/bbl equilibrium price level, as postulated by the BoC, will have a limiting effect on the oil-based currency, which has been driven by interest rate differentials. Both central banks are now hiking, but we believe that markets are underpricing Fed hikes. Thus, the CAD should weaken against USD. However, it will outperform other G10 currencies. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data has continued to show a mixed picture for the Swiss economy: Consumer prices inflation, increased slightly from the previous month, coming in at 0.3%, in line with expectations. The unemployment rate also came in in line of expectations at 3.2%, unchanged from the previous month. However, producer prices contracted by 0.1%, underperforming expectations. EUR/CHF has been weakening since its August second overbought extreme. For the moment, we expect the SNB to stand pat in its ultra-dovish monetary policy, at least until inflation and other economic indicators start to strengthen considerably. USD/CHF however might appreciate, given that the euro might fall the ECB minutes this week showed that the ECB is concerned by a potential euro overshoot. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data in Norway this week was mixed: Headline inflation came in at 1.5% in July, outperforming expectations. However, it softened from June's 1.9% reading. Core inflation came at 1.2% in July, in line with expectations, decreasing from 1.6% in June. Moreover, manufacturing output contracted by 0.6% year-on-year. We continue to be bullish on USD/NOK, as the increasing gap in real rate differentials between the United States and Norway should outweigh any oil rally. Indeed, the recent numbers in Norway illustrate the lack of inflationary pressures in this Scandinavian country. This should keep a lid on rates, and thus help USD/NOK. On the other hand EUR/NOK should follow the path of oil. Thus, the OPEC supply cuts will ultimately support oil prices and thus, weigh on this cross. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has had a particularly strong week, as inflation surprised to the upside on both a monthly and a yearly basis, coming in at 0.5% and 2.2% respectively. While it initially appreciated against all currencies, the uptick in commodity currencies on Wednesday made it lose its gains against AUD, CAD, NZD and NOK. As inflationary pressures grow, the SEK is likely to appreciate further, especially against the EUR and GBP. Additionally, with current Riskbank governor Stefan Ingves' term coming to an end by the end of this year, the hawkish rhetoric is likely to only increase. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades