Global

Fiscal Stimulus To Prolong The Expansion The market swoon in early February should not induce investors to lower risk. The stock market correction (the first for almost two years) was triggered by a couple of inflation and wage readings that came in slightly above expectations, and was exacerbated by some technical factors such as automated trading by volatility-target funds. But, significantly, it was not accompanied by the usual signals of rising risk aversion: for example, credit spreads barely widened and the gold price was stable (Chart 1). Volatility is likely to remain high but, as our U.S. Investment Strategy service recently found, the VIX has not been a useful indicator of recessions and bear markets: many times over the past 30 years it has spiked higher without risk assets producing negative returns over the subsequent 12 months (Chart 2).1 Recommended Allocation Chart 1Sell-Off Didn't Trigger Risk Signals Chart 2Spike In Vix Is Not A Sell Signal Fiscal policy moves in the U.S. make us believe, rather, that the current economic expansion will last longer than we previously forecast. A combination of tax cuts plus recent spending proposals (including $165 billion on the military and $45 billion on disaster relief) will boost GDP by about 0.8% of GDP this year and 1.3% next, compared to the IMF's earlier forecast of a fiscal contraction this year (Chart 3).2 Add to that the boost from the 8% trade-weighted depreciation of the U.S. dollar over the past 12 months (which should add 0.3% to growth over two years), and it is difficult to imagine U.S. GDP growth turning down any time soon. Accordingly, BCA has shifted its recession call from the second half of 2019 to sometime in 2020. Of course, this is not all good news. The U.S. budget deficit is likely to increase to 5½% of GDP in 2019, which will put upward pressure on interest rates. The fiscal impulse will hit an economy already at full capacity, and so will be inflationary. The scenario we envisage is boom-and-bust, leading to a nastier recession than we had previously expected. Nonetheless, the boost to growth should be positive for risk assets over the next 12 months. Our model of earnings growth now suggests that U.S. EPS should continue to grow at close to a 20% rate for the rest of this year (Chart 4). Chart 3Fiscal Boost To U.S. Growth Chart 4Earnings Growth Gets A Boost Too How quickly will the Fed push back against the potentially inflationary implications of this higher growth? We have found a remarkable turnaround in investors' perceptions of inflation over the past few weeks. Whereas last year most argued that structural forces (online shopping, the gig economy etc.) meant that inflation would stay depressed, now many worry that it will quickly shoot above 2% and force the Fed to tighten policy aggressively. This has caused them to over-react, for example, to the (rather obvious) statement from the last FOMC minutes that "participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate." Our view remains that core PCE inflation - the Fed's favorite measure - is likely to move back gradually to 2% (from 1.5% currently), but not accelerate dramatically. Unit labor costs remain subdued (Chart 5), the continued rise in the participation rate means there is more slack in the labor market than implied by headline unemployment (Chart 6), and inflation expectations remain low. This should allow new Fed chair Jerome Powell to continue to withdraw accommodation at a measured pace. The market has already priced in that the Fed will tighten this year at least in line with its dots (Chart 7). We expect four, rather than the Fed's projected three, hikes this year, but this should not be too hard for the market to absorb. Chart 5Unit Labor Costs Don't Point To Jump In Inflation Chart 6 Still Some Slack In Labor Market Chart 7Market Has Caught Up To The Fed We have for some months now advised long-term, more risk-averse investors to consider dialing back risk, and the volatility in February was a good example of why. We would expect further such bouts of volatility. However, with a recession still probably two years away, and a combination of stronger-than-expected growth and a Fed reluctant to accelerate tightening, the next 12 months should remain positive for equities and other risk assets. Fixed Income: We now expect the 10-year U.S. Treasury bond yield to rise to 3.3-3.5%. This will come from a further 40 BP increase in inflation expectations (taking them back to a level compatible with the Fed achieving its inflation target) plus a rise in the real yield, as markets start to price in the end of secular stagnation (Chart 8). The rise in global yields will be exacerbated by increasing net supply, as fiscal deficits rise and central banks wind down QE (Chart 9). We are, accordingly, underweight duration, and prefer inflation-linked bonds to nominal ones. We will likely reduce our exposure to credit before we turn defensive on equities. But, for now, strong economic growth and higher oil prices mean spread product is likely to outperform government bonds. Chart 8Inflation Expectations And Real Yields To Rise Chart 9Net Government Bond Supply To Increase Currencies: Rising interest rate differentials have failed to cause the dollar to rally (Chart 10). FX markets are trading, rather, on valuations (the euro and yen are, indeed, undervalued), on current account positions (the euro zone and Japan have large surpluses), and on the narrative that U.S. twin deficits historically caused the dollar to weaken. Our FX strategists find this is true only when, as in 2001-3, U.S. real rates were falling; after the Reagan tax cuts in 1981, real rates rose, pushing up the dollar (Chart 11). The key, therefore, is how quickly the Fed reacts this time. The dollar currently has strong downward momentum (especially against the yen) and this could continue. But as global growth slows relative to the U.S., relative interest rates are likely to reassert themselves as a factor, causing the dollar to strengthen again. Chart 10Rising Rate Differentials Fails To Boost Dollar Chart 11Do Twin Deficits Matter For Dollar? Equities: Given the macro environment, we continue to recommend pro-cyclical equity tilts, with overweights in higher beta markets such as the euro zone and Japan, and cyclical sectors such as financials, energy, and industrials. Our underweight on EM equities is based on the risk of a slowdown in China (where tighter financial conditions point to a slowing of the industrial sector, Chart 12), the possibility of a U.S. dollar rebound, and the vulnerability of highly leveraged foreign-currency EM borrowers to a rise in U.S. interest rates. Commodities: Our energy team has further revised up their oil price forecast, on expectations that the OPEC agreement will be extended, which will cause a greater draw-down in oil inventories (Chart 13).3 They see Brent crude averaging $74 a barrel this year, with spikes above $80. However, the response of the U.S. shale industry will begin to kick in, pushing the price down to below $60 by end-2019. We are neutral on industrial commodities, which will benefit from stronger global growth but are at risk in the event of dollar appreciation and slowdown in China. Chart 12Tighter Monetary Conditions In China Chart 13Oil Inventories To Draw Down Further Please note that, due to the Easter holidays in some countries, the GAA Quarterly Portfolio will be published one day later than usual, on April 3. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Late Innings," dated 26 February 2018, available at usis.bcaresearch.com 2 For details, please see The Bank Credit Analyst, "March 2018," available at bca.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0: Getting Comfortable With Higher Prices," dated 22 February 2018, available at ces.bcaresearch.com GAA Asset Allocation

Highlights Seasonal environmental restrictions on Chinese aluminum output are due to ease going into spring, which will restore some of the output taken off line when inefficient smelters were shuttered last year. Global demand likely will slow later this year, largely because we expect GDP growth in China, which accounts for more than half of global aluminum consumption, to moderate in 2H18. In addition, expected U.S. tariffs and quotas will limit imports and revive output in that market. This will contribute to the easing of a tight global balance, and take some of the pressure off prices, but we do not expect a significant move lower. We remain neutral. Energy: Overweight. Our long Dec/18 $65/bbl Brent calls vs. short Dec/18 $70/bbl calls - recommended last week on the back of our updated price forecast - closed with a 3.1% gain on Tuesday. We took profits on our long 4Q19 $55/bbl Brent puts vs. short 4Q19 $50/bbl Brent puts, realizing a 20.7% gain since it was recommended January 18, 2018. Base Metals: Neutral. We are expecting a secular increase in aluminum supplies this year, on the back of Chinese environmental policies and more difficult global trading conditions. Precious Metals: Gold markets awaited Fed Chair Powell's Humphrey-Hawkins testimony beginning Tuesday, as vice chair for financial supervision, Randal Quarles, warned U.S. economic growth could exceed expectations the day before. Ags/Softs: Underweight. Argentina's drought looks like it will stress that country's grain harvests, and tighten markets at the margin. Feature Chart of the WeekAluminum In Large Deficit Last Year Easing of winter supply restrictions in China, as well as tighter controls on U.S. aluminum imports, will dominate the aluminum market in the near term. In both cases, the net effect likely will be an increase in global supply. The latter would also support aluminum's price in the U.S. market - as measured by the U.S. Midwest premium. These events will ease the global physical deficit in aluminum, which last year came in at its widest since 1995 (Chart of the Week). The current tight conditions are driven by Beijing's elimination of overcapacity, which, along with environmental reform policies implemented last year, led to a reduction in China's output. The price dynamics that dominated the aluminum market over the past couple years will shift as a result. This already can be seen in the behavior of prices on the LME and the SHFE: LME prices have been gyrating around $2,200/MT, while SHFE prices have dipped by more than 5% since the beginning of the year. Unwinding China's Supply-Side Policies? At first blush, it may not be apparent China's primary aluminum production sector experienced significant changes last year. After stalling at 1% year-on-year (y/y) growth in 2016, output grew 1.2% y/y in 2017, a sharp deceleration from the 16% y/y average growth rates registered between 2010 and 2015. However, the annual gain masked a 10% y/y increase in output in 1H17, which was almost completely reversed by the negative impacts of China's environmental policies and its efforts to eliminate overcapacity. These policy-led initiatives ultimately caused output to fall 7% y/y in 2H17 (Chart 2). The resulting 1 mm MT of production cuts in the second half of last year reflects China's 2017 supply-side policies. Beijing's strategy is two-fold: Chart 2Sharp Fall In 2H17 Output From China ... Eliminate outdated and unlicensed capacity by forcing it to close. This has removed an estimated 3-4 mm MT of annual capacity. The policy targets capacity lacking proper building and expansion permits, as well as the smelters that do not meet strict environmental standards. However, not all the shutdowns are permanent. Among this shuttered capacity is 2 mm MT of outdated smelter capacity belonging to China Hongqiao, which the company plans to replace with new capacity.1 The other major supply-side policy implemented by Beijing last year is a restriction on smelter activity during the mid-November to mid-March period. As is the case in the steel sector, this winter-curtailment policy seeks to reduce pollution during the smog-prone winter months. Aluminum smelters in the cities targeted in the winter plan were ordered to cut output by ~ 30% during this period. This policy is expected to be an annually recurring event until 2020. However, while 3 mm MT of annualized capacity would have been closed during the winter if the full 30% curtailment target had been met, reports surfaced in mid-December that compliance was low, and suggested only ~ 0.6 mm MT of capacity (just 20% of the goal, or 6% of the curtailment target) had been closed.2 The total aluminum annual capacity affected by both the winter environmental curtailments and capacity-reduction policies implemented last year could potentially reach 7 mm MT. China's total smelting capacity was a reported 40 mm MT in 2016. Lower Chinese Production ... And Consumption On a year-on-year basis, global primary aluminum production has been falling since August. This is, for the most part, true on a month-on-month basis, as well. The 12-month moving average for global aluminum production peaked in July, and has been coming down consistently since then. Although 2017 production came in higher than the previous year, this is due to a ~ 6% y/y increase in the first half, which preceded a ~ 4% y/y decline in output in the second half of the year. These dynamics are driven by China, which accounts for 55% of global primary production. Chinese firms raised primary output in 1H17, which was followed by a sharp contraction in 2H17. Chinese primary aluminum production peaked in June, recording an all-time record of 2.98 mm MT before falling in the subsequent months. On the other hand, primary production from the rest of the world has remained largely unchanged over the past two years, at 26 mm MT. Data from the International Aluminum Institute shows month-on-month production increases in China in December and January; however, output is still lower vs. the same period a year earlier. Chinese production drove global aluminum production higher in the past, but falling output from the world's leading producer now is causing global primary aluminum supply to contract. The impact of China's supply curtailments has been muted by lower demand for the metal (Chart 3). Again, lower consumption has been driven by the top-demand market - China - which typically consumes ~ 55% of the primary metal. Chinese primary consumption and production each came down by more than 1 mm MT y/y in the second half of last year. Falling aluminum demand in China is consistent with a slowdown in Chinese automobile production as well as fixed asset investments in infrastructure and transportation (Chart 4). Furthermore, China's scrap aluminum imports increased in 2H17, reflecting a preference for the secondary metal as the price of primary aluminum increased. Chart 3... Coincided With Falling Chinese Consumption Chart 4Slowdown In Chinese Demand A Divergence In Global Dynamics ... Despite the improved balance in China, the global primary aluminum balance in the rest of the world recorded a large deficit last year - the largest since 1995 (Chart 5). While both consumption and production in China came down by more than 1 mm MT in 2H17, consumption in the rest of the world increased by ~ 0.4 mm MT, even as production remained largely unchanged. This tightened the global market, as more stringent aluminum production policies in China meant that there was no flooding of Chinese aluminum to ease the deficit. In fact, the world excluding China deficit is the largest at least since the World Bureau of Metal Statistics (WBMS) started collecting data in 1995. ... Is Reflected In Inventory Dynamics This also coincides with rising aluminum stocks on the Shanghai Futures Exchange and falling inventory on the LME. In fact, Chinese aluminum imports have been falling and were down almost 30% y/y in 2H17. At the same time, Chinese net exports picked up slightly (Chart 6). Chart 5Record Aluminum Deficit Outside China Chart 6Chinese Net Exports On The Rise In response to lower output, LME inventories have been falling since 2Q14, and they continued their descent last year, ending 2017 at roughly the same level as mid-2008. On the other hand, stocks at the SHFE have been rising steeply since the beginning of last year and are at record highs (Chart 7). Whether the tight global market fundamentals will persist depends on whether China's outdated capacity cuts prove to be temporary or permanent. Chart 7Dynamics Reflected In Stock Changes U.S. Tariffs And Quotas Would Offset Tight Markets In what appears to be an effort to revive U.S. aluminum and steel production, the U.S. Commerce Department launched an investigation into these domestic industries late last year. Last month, Commerce proposed tariffs and quotas that would impact all aluminum imports with the exception of aluminum scrap and aluminum powders. There appear to be two main objectives of this investigation: 1. Increase capacity utilization in the U.S. aluminum and steel industries; and 2. Penalize China for subsidizing its aluminum sector at the expense of those in other countries. Among the Commerce proposals: 1. A 7.7% tariff on all aluminum imports to the U.S. 2. A 23.6% tariff on all aluminum imports from certain countries, while other countries would be subject to quotas equal to 100% of their 2017 exports to the U.S.3 3. A quota on all aluminum imports from other countries equal to a maximum of 86.7% of their 2017 exports to the U.S. In a memo issued last week, the U.S. Department of Defense expressed its support for the targeted tariffs (option 2 above), as well as a recommendation to postpone action on the aluminum sector. President Trump has until April 19 to make a decision on the aluminum recommendations. While he may not stick to the exact details outlined in the three options, our Geopolitical Strategists expect him to go through with implementing protectionist measures to limit aluminum imports. U.S. production of primary aluminum is at its lowest level since 1951 (Chart 8). To reach the 80% target of smelter capacity utilization envisioned by Commerce, the U.S. will have to add ~ 0.67 mm MT of supply. This represents just ~ 1.16% of world supply in 2016. Imports currently make up 90% of U.S. primary aluminum consumption. Chart 8U.S. Producers Took A Big Hit In fact, even if this amount of aluminum was supplied domestically in the U.S. last year, the world aluminum market would have remained in deficit. Furthermore, this additional supply would pale in comparison to the cuts China has already implemented in its aluminum sector last year. China's primary production in the August to December period last year came in 1.15 mm MT below the same period in 2016. Annual smelter capacity in the U.S. is estimated to be a combined 1.82 mm MT. Of this capacity, Alcoa has 0.34 mm MT of idle capacity, Century Aluminum has 0.27 mm MT, while ARG International's Missouri plant has 0.27 mm MT of idle capacity. U.S. producers have started communicating plans to restart idled capacity. According to Century Aluminum's CEO, the company's eastern Kansas operation, which shuttered more than half of its production, could ramp output at one of its smelters to full capacity of up to 0.27 mm MT by early next year. Similarly, Alcoa has committed to partially restarting production at its Warwick, Indiana, facility, which would bring 0.16 mm MT of capacity online by the second quarter of this year. However, imports are not the sole reason output in the U.S. aluminum sector is falling. High power costs also have contributed, but this is not addressed in the Department of Commerce's report. In any case, we would not be surprised to witness an increase in aluminum imports by U.S. consumers before a final decision is made. If import controls do in fact fall into place, prices in the U.S. - as reflected by the U.S. Midwest transaction premium - will likely increase. Bottom Line: Supply- and demand-side developments, mostly in China, which accounts for more than half of global production and consumption, will combine to ease a global supply deficit this year. Expected U.S. tariffs and quotas will limit imports and revive output in that market. This will take some pressure off prices, but, we do not expect levels to move significantly lower. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "China Hongqiao says to cut 2 mln T/year of outdated aluminum capacity," published on August 2, 2017, available at reuters.com. 2 Please see "Aluminum Under Pressure After China Smog Cutbacks Fall Short," published on December 20, 2017, available at reuters.com. 3 The countries noted are China, Hong Kong, Russia, Venezuela, and Vietnam. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Chart 6Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.

Highlights We are shifting our U.S. recession call from late-2019 to 2020. A cheap dollar and fiscal support will give the Fed more scope to raise rates before monetary policy moves into restrictive territory. The fiscal impulse will fall sharply in 2020. By then, financial conditions will be tighter and economic imbalances will be more pronounced. As is usually the case, a downturn in the U.S. will infect the rest of the world. Emerging markets with large current account deficits and high debt levels are most vulnerable. A cyclical overweight to global equities is still appropriate, but long-term investors should begin to scale back risk exposure. Feature Records Are Meant To Be Broken The NBER Business Cycle Dating Committee, which contrary to popular belief does not serve as a matchmaking service for lonely-heart economists, estimates that the current economic expansion is going on nine years. If it makes it to July 2019, it will be the longest in history (Chart 1). Considering that records begin in 1854 - encompassing 33 business cycles - that will be an impressive achievement. Chart 1Nine Years And Still Going Strong There is an old adage that says "Expansions do not die of old age. They are murdered by the Fed." A year or so ago, it looked like the Fed would pull the trigger sometime in 2019. Now, however, it looks more likely that the deed will be committed in 2020. Two things have changed since the start of last year. First, the real trade-weighted dollar has fallen by 8%. According to the Fed's SIGMA macroeconomic model, this should boost growth by about 0.3% over the next two years. Chart 2U.S. Fiscal Policy Has Become##BR##Much More Stimulative Second, U.S. fiscal policy has become much more stimulative, a point very much in keeping with our Geopolitical Strategy team's long-standing view that age of austerity is giving way to a new age of populism.1 My colleague Mark McClellan estimates that the U.S. fiscal impulse will reach 0.8% of GDP in 2018 and 1.3% of GDP in 2019, up from -0.4% and 0.3%, respectively, in the IMF's October 2017 projections (Chart 2). Mark's calculations incorporate the CBO's assessment of the tax cuts, the recent Senate deal to raise the caps on defense and nondefense expenditures, and $45 billion in hurricane relief. He assumes some delay between when the bill is passed and when the spending takes place. According to the Congressional Budget Office, a little more than half of the expenditures in the 2013 and 2015 spending bills occurred in the same year the funding was authorized. These fiscal measures will cause the federal budget deficit to swell by about 2.3 percentage points to 5.6% of GDP in FY2019. Even that may be an understatement, as this does not include any additional infrastructure spending nor the possible restoration of "earmarks"- the widely criticized practice that allows members of Congress to add appropriations to unrelated bills to fund what often turn out to be politically motivated projects in their districts - which could add a further $25 billion in annual spending. Meanwhile, federal government revenue is coming in below target, which the Office of Management and Budget (OMB) has attributed to lower-than-expected taxable income from pass-through businesses and capital gains realizations. This problem could worsen over the next few years as creative accountants find new loopholes to exploit in the recently passed tax bill. Too Much, Too Late All this stimulus is arriving when the economy least needs it. The unemployment rate currently stands at 4.1%, 0.5 points below the level the Fed regards as consistent with full employment. It has been stuck at that number for four straight months, largely because job growth in the Household survey (which the unemployment rate is based on) has lagged the Establishment survey by a considerable margin. Given the underlying strength in GDP growth, it is likely the job gains in the Household survey will rebound strongly over the course of 2018, taking the unemployment rate down to 3.5% by year-end, well below the Fed's end-2018 projection of 3.9%. A lower-than-projected unemployment rate will permit the Fed to raise rates four times this year, one more hike than currently implied by the dots. The Fed will probably also hike rates three or four times next year. Yet, even those additional rate hikes will not come close to offsetting all the fiscal stimulus coming down the pike. In the absence of a sustained increase in productivity or labor force growth - neither of which appear forthcoming - the economy will continue to overheat. Inflation is a highly lagging indicator. It typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 3). The Fed knows this perfectly well, but has chosen to let the economy run hot for fear that a premature tightening will sow the seeds for a deflationary spiral. Chart 3Inflation Is A Lagging Indicator By the time the next recession rolls around, inflation will be higher and financial and economic imbalances will be greater. The fiscal impulse will also fall back towards zero in 2020 as the budget deficit stabilizes at an elevated level. It is the change in the budget balance that is correlated with GDP growth. If output is already being constrained by a lack of spare capacity going into late-2019, the subsequent decline in the fiscal impulse in 2020 could push growth below trend, leading to rising unemployment. And, as we have often noted, once unemployment starts rising, it keeps rising. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point that was not associated with a recession (Chart 4). Chart 4Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle A recent IMF report highlighted that changes in U.S. financial conditions strongly influence growth abroad.2 As the U.S. falls into a recession, equity prices will tumble and credit spreads will widen. Financial conditions will tighten, transmitting the downturn to the rest of the world. Emerging markets with large current account deficits and high debt levels will be the most vulnerable. The only saving grace is that interest rates will be higher in 2020 than they would have been if the recession had begun in 2019. This will give the Fed a bit more scope to ease monetary policy again. As discussed last week, this will likely set the stage for a stagflationary episode following the recession.3 For Now, Leading Indicators Look A-Okay While our baseline view is that the next recession will occur in 2020, this is more of an educated guess than a firm prediction. Many things, including an overly aggressive Fed, a sharp appreciation in the dollar, and a variety of political shocks, could cause the recession to occur sooner than anticipated. As such, we continue to watch a wide swathe of data to help guide our investment recommendations. The good news is that right now, none of our favorite leading economic indicators such as the level of ISM manufacturing new orders minus inventories, capital goods orders, initial unemployment claims, and building permits are flashing red (Chart 5). Many of these indicators appear in The Conference Board's LEI, which is still rising at a healthy 5.5% y/y pace. Historically, a decisive break below zero in the year-over-year change in the LEI has been a reliable recession indicator (Chart 6). We are still far from that point. Chart 5U.S. Leading Indicators Looking A-OKAY Chart 6U.S. LEI Is Not Flashing Red The same goes for leading financial variables such as credit spreads and the yield curve. The yield curve has inverted in the lead-up to every recession over the past 50 years (Chart 7). The fact that the 10-year/3-month slope has steepened by 30 basis points since the start of the year gives us some comfort that the next recession is still some time away. Chart 7An Inverted Yield Curve Has Often Been A Harbinger Of A Recession Keep An Eye On Credit Credit spreads remained well contained during the recent bout of market turbulence but we continue to watch them closely. Credit typically starts to underperform before equities do, which makes it a good leading indicator for the stock market. This is likely to be especially the case over the next two years. If there is one area where financial imbalances have accumulated to worrying levels, it is in the corporate debt arena. This month's issue of the Bank Credit Analyst estimates that the interest coverage ratio for U.S. companies would drop from 4 to 2½ if interest rates were to increase by 100 basis points across the corporate curve.4 This would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 8). Consumer staples, tech, and health care would be the most affected. Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (I) Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (II) We currently maintain an overweight to equities and spread product but expect to move to neutral later this year and to underweight sometime in 2019. Long-term investors should consider paring back exposure to both asset classes already, given that valuations have become stretched. The Dollar And The Return Of "Twin Deficits" Bigger budget deficits will drain national savings. Since the current account balance is simply the difference between what a country saves and what it invests, the U.S. current account deficit is likely to increase. How the emergence of these twin deficits will affect the dollar is a tough call. Historically, there is no clear relationship between the sum of the fiscal and current account balance and the value of the trade-weighted dollar (Chart 9). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a decline in the household saving rate from the booming housing market. Much depends on what happens to real interest rates. If investors come to believe that persistently large budget deficits will lead to higher inflation, long-term real yields could decline, pushing the dollar lower. In contrast, if investors conclude that the Fed will raise rates by enough to keep inflation from spiraling upwards, real yields could rise. U.S. real yields have gone up across all maturities since the start of the year. As a result, real rate differentials have widened between the U.S. and its developed market peers (Chart 10). However, some of the increase in U.S. real rates has been due to a rising term premium, with the rest reflecting an upward revision to the expected path of policy rates. The latter is good for the dollar. The former is not, because it means that investors are starting to worry about the ability of the market to absorb the increasing supply of Treasurys. Meanwhile, rising interest rates threaten to put further pressure on the U.S. current account deficit. The U.S. net international investment position has deteriorated from -10% of GDP to -40% of GDP since 2007 (Chart 11). The U.S. owes the rest of the world about 68% of GDP in debt - almost all of which is denominated in dollars - but holds only 23% of GDP in foreign debt. Thus, a synchronized increase in global bond yields would cause U.S. net interest payments to rise. If yields in the U.S. increase more than elsewhere, net payments would rise even more. Chart 9Twin Deficits And The Dollar:##BR##No Clear-Cut Relationship Chart 10Real Rate Differentials Have##BR##Widened Between The U.S. And Its DM Peers Chart 11Deterioration In U.S. Net##BR##International Investment Position America's status as a major net external debtor could also constrain the extent to which the dollar appreciates. If the greenback were to strengthen, the dollar value of U.S. external assets would decline, as would the dollar value of interest or dividend payments that the U.S. receives from abroad. This would result in a deterioration in the current account balance and in a worsening in the U.S. net international investment position. Some Positives For The Greenback While the discussion above is bearish for the dollar, it needs to be put into some context. The U.S. current account deficit stands at 2.3% of GDP, down from almost 6% of GDP in 2006 (Chart 12). Much of the improvement in the U.S. balance of payments can be traced back to the plunge of almost 70% in net oil imports, a development that is likely to be permanent given the shale boom. Furthermore, the U.S. trade balance should benefit over the coming quarters from the lagged effects of a weaker dollar. And while we estimate that the primary income balance will deteriorate by about 0.6% of GDP over the next two years, it should still remain in positive territory and above the levels from a decade ago (Chart 13). Chart 12U.S. Balance Of Payments:##BR##Improvement Due To Sinking Oil Imports Chart 13Primary Income Balance Will Decline,##BR##But Will Remain In Positive Territory On the fiscal side, the projected rise in U.S. government debt levels at a time when the economy is booming is concerning. Nevertheless, the U.S. debt profile still compares favorably to countries such as Japan and Italy, two economies with worse growth prospects than the U.S. Italian 30-year bond yields are actually lower than in the United States. If one of the two countries is going to have a debt crisis over the next decade, our guess is that it will be Italy and not the U.S. A Cresting In Global Growth Could Help The Dollar Our preferred explanation for why the dollar began to weaken in 2017 focuses on the role of global growth as well as on technical factors. Chart 14USD Is A Momentum Winner Strong global growth - especially when concentrated outside the U.S., as was the case last year - tends to hurt the dollar. There are a number of reasons for this. First, a robust global economy pushes up natural resource prices, which boosts the terms of trade for commodity-exporting economies. Second, manufacturing represents a smaller share of the U.S. economy than it does in most other countries. Since manufacturing activity is quite cyclically-sensitive, faster global growth benefits economies such as Germany, Sweden, Japan, China, and Korea more than the U.S. Third, stronger global growth tends to boost risk appetites. This has translated into large inflows into EM funds and peripheral European debt markets. The latter have also seen an ebbing of political risk, which has translated into sharply lower sovereign spreads. The acceleration in global growth came at a time when long dollar positions had reached elevated levels. As those positions were unwound, the dollar began to tumble. At that point, the strong upward momentum that fueled the dollar rally following the U.S. presidential election was replaced by downward momentum. The U.S. dollar is one of the most momentum-driven currencies out there (Chart 14). Weakness led to even more weakness. It is impossible to know when the dollar's downward momentum will exhaust itself. What can be said is that speculative positioning has become increasingly dollar bearish. This raises the odds of a short-covering dollar rally (Chart 15). Chart 15Speculative Positioning Has Gotten Increasingly Dollar Bearish Perhaps more importantly, global growth may be peaking. China's economy has slowed, as gauged by the Li Keqiang index, which combines electricity production, freight traffic, and bank lending (Chart 16). Growth in Europe and Japan has also likely reached top velocity. U.S. financial conditions have eased sharply relative to the rest of the world (Chart 17). This, in conjunction with an easier U.S. fiscal policy, suggests that the composition of global growth will shift back towards the U.S. over the coming months. If this were to happen, the dollar could recoup some its losses. Chart 16Chinese Economy##BR##Has Slowed Chart 17U.S. Financial Conditions Have##BR##Eased Sharply Relative To ROW Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016. 2 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, April 2017. 3 Please see Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. Available at bca.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights This past week, oil ministers from the Kingdom of Saudi Arabia (KSA) and Russia - OPEC 2.0's putative leaders - separately indicated increased comfort with higher prices over the next year or so.1 This suggests they are converging on a common production-management strategy, which accommodates KSA's need for higher prices over the short term to support the IPO of Saudi Aramco, and Russia's longer term desire to avoid reaching price levels where U.S. shale-oil production is massively incentivized to expand. We believe OPEC 2.0's production cuts will be extended to year-end, given signaling by Khalid Al-Falih, KSA's energy minister. As a result, we expect Brent and WTI crude oil prices to average $74 and $70/bbl this year, respectively (Chart Of The Week). These expectations are up from our previous estimates of $67 and $63/bbl, which were premised on curtailed production slowly being returned to market beginning in July. For next year, the extended cuts could lift Brent and WTI to $67 and $64/bbl, up from our previous expectations of $55 and $53/bbl, respectively. Extending OPEC 2.0's production cuts will accelerate OECD inventory draws, which have been faster than expected. Higher prices caused by maintaining the cuts will lift U.S. shale production more than our earlier estimates. Backwardations in both Brent and WTI forward curves will remain steep in this regime, muting the impact of Fed policy on oil prices. Energy: Overweight. We are getting long Dec/18 $65/bbl Brent calls vs. short Dec/18 $70/bbl calls on the back of our updated price forecast. We also are taking profits on our long 4Q19 $55/bbl Brent puts vs. short 4Q19 $50/bbl Brent puts, which were up 27.4% as of Tuesday's close. Base Metals: Neutral. The U.S. Commerce Department proposed "Section 232" tariffs and quotas on U.S. aluminum and steel imports, following national security reviews. President Trump has until mid-April to respond, and we expect him to go through with one of the three proposed options. Precious Metals: Gold remains range-bound around $1,350/oz, as markets wrestle with the likely evolution of the Fed's rate-hiking regimen. Ags/Softs: Underweight. USDA economists project grain and soybean prices to slowly rise over the next 10 years, according to agriculture.com. Feature Chart Of The WeekBCA Lifts Oil Price Forecasts Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with maintaining OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year, and possibly next. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0's leaders that the world economy can absorb higher prices without damaging demand over the short term is not clear. Markets have yet to receive what we could consider definitive forward guidance from OPEC 2.0 leadership, indicating that recent signaling could be foreshadowing the coalition's new policy. We are raising the odds that it is, and are moving our Brent and WTI forecasts higher for this year and next. Lifting 2018 Brent, WTI Forecasts To $74 And $70/bbl Maintaining OPEC 2.0's production cuts to end-2018 will lift average Brent and WTI crude oil prices to $74 and $70/bbl, respectively, this year, based on our updated supply-demand balances modeling (Chart Of The Week). This is not definitive OPEC 2.0 policy guidance: KSA's and Russia's oil ministers indicated they expect such an outcome in separate statements, and not, as has been the case with previous announcements, at a joint press conference.2 We are assuming the odds strongly favor such an outcome, and give an 80% weight to it. The remaining 20% reflects our previous expectation that OPEC 2.0's production cuts would cease at end-June, and curtailed volumes would slowly be restored over 2H18. Resolving this in favor of the former expectation would lift our price expectations to $76 and $73/bbl for Brent and WTI this year, and $70 and $68/bbl next year. These expectations are up from our previous estimates of $67 and $63/bbl for Brent and WTI prices this year, which were premised on curtailed OPEC 2.0 production slowly returning to market beginning in July, and a subsequent OECD inventory rebuilding. By maintaining production cuts to year-end, supply-demand balances remain tighter, which keeps inventories drawing for a longer period of time (Chart 2). Higher inventories would have increased the sensitivity of oil prices to the USD, which we showed in research on February 8th 2018. With OPEC 2.0's production cuts maintained throughout the year, OECD inventories will be more depleted by year-end (Chart 3). Extending OPEC 2.0's production cuts to end-2018 would result in an additional 130mm bbls reduction to OECD inventories versus our prior modeling. This means Brent and WTI forward curves will be more backwardated than they would have been had the barrels taken off the market at the beginning of 2017 been slowly restored starting in July of this year, as we earlier expected. Chart 2Fundamental Balances Remain In Deficit Longer Chart 3Maintaining Production Cuts Depletes Inventories Even More A steeper backwardation in oil forward curves - i.e., the front of the curve trades premium to the deferred contracts - reduces the USD effects on oil, all else equal. In other words, supply-demand fundamentals dominate the evolution of oil prices when forward curves are more backwardated, and the influence of financial variables -the USD in particular - is muted.3 For next year, we assume the volumes cut by OPEC 2.0 are slowly restored to the market over 1H19, lifting Brent and WTI to $67 and $64/bbl on average, up from our previous expectations of $55 and $53/bbl, respectively.4 Higher Shale Output, Strong Global Demand We expect U.S. shale production increases by 1.15mm b/d from December 2017 to December 2018, and another 1.3-1.4mm b/d during calendar 2019. This dominates non-OPEC production growth this year and next (Chart 4, top panel). Due to the supply response of the shales to higher prices in 2018, global production levels would see a net increase from March 2019 and beyond. Our assumption OPEC 2.0 production cuts will be maintained through 2018 puts our OPEC production assessment 0.14mm b/d below U.S. EIA's estimates (Chart 4, bottom panel). On the demand side, we continue to expect non-OECD (EM) growth to push global oil consumption up by 1.7mm b/d this year and 1.6mm b/d next year, respectively (Chart 5). Non-OECD demand is expected to account for 1.24mm b/d and 1.21mm b/d of this growth in 2018 and 2019, respectively (Table 1). Chart 4U.S. Shales Dominate Non-OPEC Supply Growth Chart 5Non-OECD Demand Growth Continues Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Aramco IPO Driving OPEC 2.0's Short-Term Agenda In previous research, we noted what appeared to be a relatively minor divergence between the goals of KSA and Russia when it comes to the level prices each would prefer over the short term. Recent press reports - unattributed, of course - suggest Saudi Aramco officials prefer a Brent price closer to $70/bbl further along the forward curve (two years out) to support their upcoming IPO.5 This obviously would bolster Aramco's oil-export revenues - some 7mm b/d of its 10mm b/d of production are exported - and income, which shareholders would welcome. However, until this past week, Russia's energy minister, Alexander Novak, was signaling a range of $50 to $60/bbl works better for his constituents, i.e., shareholder-owned Russian oil companies. Novak recently amended his range to $50 to $70/bbl for Brent.6 These positions are not irreconcilable. One is shorter term (2 years forward) and the other is longer term, attempting to balance competitive threats over a longer horizon - e.g., from U.S. shale-oil producers, electric vehicles, etc. This most recent indication the leadership of OPEC 2.0 is comfortable with higher prices over the short term is an indication - at least to us - that these issues are being dealt with in a way that allows markets to incorporate forward guidance into pricing of crude oil over the next two years. Beyond that, however, markets will need to hear an articulated strategy containing a post-Aramco IPO view of the world, so that capital can be efficiently allocated. KSA and Russia are in a global competition for foreign direct investment (FDI), and having a fully articulated strategy re how they will manage their production in fast-changing markets - where, for example, shale-oil approaches becoming a "just-in-time" supply option - will be critical. Signing a formal alliance by year-end would support this, but that, too, will require a level of cooperation that runs deeper than what OPEC 2.0 has so far demonstrated, impressive though it may be. Bottom Line: OPEC 2.0 leadership is signalling production cuts will be maintained for the entire year, not, as we expected, left to expire at end-June with curtailed barrels slowly returned to the market over 2H18. While this does not appear to be official policy of the producer coalition yet, we are revising our price expectations in line with tighter markets this year, lower OECD inventories and continued backwardation in Brent and WTI forward curves. OPEC 2.0's shorter-term agenda, driven by KSA's IPO of Saudi Aramco, and its longer-term agenda - maintaining oil's competitive edge and accommodating U.S. shale-oil production (but not too much) - appear to be getting reconciled. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com  1 OPEC 2.0 is the name we coined for OPEC/non-OPEC coalition led by KSA and Russia, has removed some 1.4 to 1.5mm b/d of oil production from the market beginning in 2017. 2 Please see, "Brent crude settles flat, U.S. oil up on short covering," published by reuters.com on February 15th 2018, in which KSA's oil minister Khalid Al-Falih indicated OPEC would maintain production cuts throughout 2018. See also, "On the air of the TV channel 'Russia 24' Alexander Novak summed up the participation in the work of the Russian investment forum 'Sochi-2018,'" published by Ministry of Energy of the Russian Federation on February 15th 2018. Lastly, please see "Saudi Arabia Is Taking a Harder Line on Oil Prices," published by bloomberg.com on February 19th 2018. 3 We discuss this in "OPEC 2.0 vs. The Fed," which was published on February 8th 2018 by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 4 These expectations are highly conditional. Toward the end of this year, KSA and Russia are indicating the OPEC 2.0 coalition will become a more formal organization, with members signing a long-term alliance. Among other things, OPEC 2.0 members would be expected to build buffer stocks to address any sudden supply outages, in order to maintain orderly markets. Please see "Oil producers to draft long-term alliance deal by end-2018: UAE minister," published by reuters.com on February 15th 2018. 5 Please see "For timing of Aramco IPO, watch forward oil price curve," published by reuters.com on February 19th 2018. 6 Please see reference in footnote 3 and "Russia's Novak says current oil price is acceptable," published by reuters.com on February 15th 2018. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2018 Summary Of Trades Closed In 2017

Bank Credit Analyst

Highlights The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. Fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. Tax cuts and the spending deal will result in fiscal stimulus of about 0.8% of GDP in 2018 and 1.3% in 2019. The latest U.S. CPI and average hourly earnings reports caught investors' attention. However, most other wage measures are consistent with our base-case view that inflation will trend higher in an orderly fashion. If correct, this will allow the FOMC to avoid leaning heavily against the fiscal stimulus. Stronger nominal growth and a patient Fed are a positive combination for risk assets such as corporate bonds and equities. The projected peak in S&P profit growth now occurs later in the year and at a higher level compared with our previous forecast. The bad news is that the fiscal stimulus and budding inflation signs imply that investors cannot count as much on the "Fed Put" to offset negative shocks. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range, partly reflecting the U.S. fiscal shock. That said, extreme short positioning and oversold conditions suggest that a consolidation phase is likely in the near term. Loose fiscal and tight money should be bullish for the currency. However, angst regarding the U.S. "twin deficits" problem appears to be weighing on the dollar. We do not believe that fiscal largesse will cause the current account deficit to blow out by enough to seriously undermine the dollar. We still expect a bounce in the dollar, but we cannot rule out further weakness in the near term. Fiscal stimulus could extend the expansion, but the more important point is that faster growth in the coming quarters will deepen the next recession. For now, stay overweight risk assets (equities and corporate bonds), and below benchmark in duration. Feature The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. This has not come as a surprise to BCA's Geopolitical Strategy, which has been flagging the shift away from fiscal conservatism and towards populism for some time, particularly in the U.S. context.1 The move is wider than just in the U.S. In Germany, the Grand Coalition deal was only concluded after Chancellor Merkel conceded to demands for more spending on everything from education to public investment in technology and defense. The German fiscal surplus will likely be fully spent. There is no fiscal room outside of Germany, but the austerity era is over. Japan is also on track to ease fiscal policy this year. The big news, however, is in the U.S. President Trump is moving to the middle ground in order to avoid losing the House in this year's midterm elections. Deficit hawks have mutated into doves with the passage of profligate tax cuts, and Congress is now on the brink of a monumental two-year appropriations bill that will add significantly to the Federal budget deficit (Chart I-1). The deficit will likely rise to about 5½% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast for that year. This includes the impact of the tax cuts, as well as outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. A deal on infrastructure spending would add to this already-lofty total. Chart I-1U.S. Budget Deficit To Reach 5 1/2 % In 2019 There is also talk in Congress of re-authorizing "earmarks" - legislative tags that direct funding to special interests in representatives' home districts. Earmarks could add another $50 billion in spending over 2018 and 2019. While not a major stimulative measure, earmarks could further reduce Congressional gridlock and underscore that all pretense of fiscal restraint is gone. Chart I-2Substantial Stimulus In The Pipeline Chart I-2 presents an estimate of U.S. fiscal thrust, which is a measure of the initial economic impulse of changes in government tax and spending policies.2 The IMF's baseline, done before the tax cuts were passed, suggested that policy would be contractionary this year (about ½% of GDP), and slightly expansionary in 2019. Incorporating the impact of the tax cuts and the Senate deal on spending, the fiscal impulse will now be positive in 2018, to the tune of 0.8% of GDP. Next year's impulse will be even larger, at 1.3%. These figures are tentative, because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. A lot can change in the coming months as Congress hammers out the final deal. Moreover, the impact on GDP growth will be less than these figures suggest, because the economic multipliers related to tax cuts are less than those for spending. Nonetheless, the key point is that fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. The Fed's Dilemma Chart I-3U.S. Inflation Green Shoots Textbook economic models tell us that the combination of expansionary fiscal policy and tightening monetary policy is a recipe for rising interest rates and a stronger currency. However, it is not clear how much of the coming pickup in nominal GDP growth will be due to inflation versus real growth, given that the U.S. already appears to be near full employment. How will the Fed respond to the new fiscal outlook? We do not believe policymakers will respond aggressively, but much depends on the evolution of inflation. January's 0.3% rise in the core CPI index grabbed investors' attention, coming on the heels of a surprisingly strong average hourly earnings report (AHE). The 3-month annualized core inflation rate surged to 2.9% (Chart I-3). Among the components, the large rent and owners' equivalent rent indexes each rose 0.3% in the month, while medical care services jumped by 0.6%. Also notable was the 1.7% surge in apparel prices, which may reflect 'catch up' with the perky PPI apparel index. More generally, it appears that the upward trend in import price inflation is finally leaking into consumer prices. That said, investors should not get carried away. Most other wage measures, such as unit labor costs, are not flashing red. This is consistent with our base-case view that inflation will trend higher in an orderly fashion over the coming months. Moreover, the Fed's preferred measure, core PCE inflation, is still well below 2%. If our 'gradual rise' inflation view proves correct, it will allow the FOMC to avoid leaning heavily against the fiscal stimulus. We argued in last month's Overview that the new FOMC will strive to avoid major shifts in policy, and that Chair Powell has shown during his time on the FOMC that he is not one to rock the boat. It is doubtful that the FOMC will try to head off the impact of the fiscal stimulus on growth via sharply higher rates, opting instead to maintain the current 'dot plot' for now and wait to see how the stimulus translates into growth versus inflation. Stronger nominal growth and a patient Fed is a positive combination for risk assets such as corporate bonds and equities. Chart I-4 provides an update of our top-down S&P operating profit forecast, incorporating the economic impact of the new fiscal stimulus. We still expect profit growth to peak this year as industrial production tops out and margins begin to moderate on the back of rising wages. However, the projected peak now occurs later in the year and at a higher level compared with our previous forecast, and the whole profile is shifted up. Most of this improvement in the profit outlook is already discounted in prices, but the key point is that the earnings backdrop will remain a tailwind for stocks at least into early 2019. Chart I-4The Profile For S&P EPS Growth Shifts Up The End Of The Low-Vol Period That said, the U.S. is in the late innings of the expansion and risk assets have entered a new, more volatile phase. We have been warning of upheaval when investor complacency regarding inflation is challenged, because the rally in risk assets has been balanced precariously on a three-legged stool of low inflation, depressed interest rates and modest economic volatility. All it took was a couple of small positive inflation surprises to spark a reset in the market for volatility. The key question is whether February's turmoil represented a healthy market correction or a signal that a bear market is approaching. The good news is that the widening in high-yield corporate bond spreads was muted (Chart I-5). This market has often provided an early warning sign of an approaching major top in the stock market. The adjustment in other risk gauges, such as EM stocks and gold, was also fairly modest. This suggests that equity and volatility market action was largely technical in nature, in the context of extended investor positioning, crowded trades and elevated valuations. There has been no change in the items on our checklist for trimming equity exposure. We presented the checklist in last month's Overview. Our short-term economic growth models for the major countries remain upbeat and our global capital spending indicators are also bullish (Chart I-6). Industrial production in the advanced economies is in hyper-drive as global capital spending growth accelerates (Chart I-7). Chart I-5February's Volatility Reset Chart I-6Near-Term Growth Outlook Still Solid... Chart I-7... Partly Due To Capex Acceleration Nonetheless, it will be difficult to put the 'vol genie' back into the bottle. The surge in bond yields has focused market attention on the leverage pressure points in the system. One potential source of volatility is the corporate bond space. This month's Special Report, beginning on page 17, analyses the vulnerability of the U.S. corporate sector to rising interest rates. We conclude that higher rates on their own won't cause significant pain, but the combination of higher rates and a downturn in earnings would lead to a major deterioration in credit quality. Moreover, expansionary fiscal policy and recent inflation surprises have limited the Fed's room to maneuver. Under Fed Chairs Bernanke and Yellen, markets relied on a so-called "Fed Put". When inflation was low and stable, economic slack was abundant and long-term inflation expectations were depressed then disappointing economic data or equity market setbacks were followed by an easing in the expectations for Fed rate hikes. This helped to calm investors' nerves. We do not think that the Powell FOMC represents a regime shift in terms of the Fed's reaction function, but the rise in long-term inflation expectations and the January inflation report have altered the Fed's calculus. The new Committee will be more tolerant of equity corrections and tighter financial conditions than in the past. Indeed, some FOMC members would welcome reduced frothiness in financial markets, as long as the correction is not large enough to undermine the economy (i.e. a 20% or greater equity market decline). The implication is that we are unlikely to see a return of market volatility to the lows observed early this year. Bonds: Due For Consolidation Chart I-8Market Is Converging With Fed 'Dots' A lot of adjustment has already taken place in the bond market. Market expectations for the Fed funds rate have moved up sharply since last month (Chart I-8). The market now discounts three rate hikes in 2018, in line with the Fed 'dot plot'. Expectations still fall short of the Fed's plan in 2019, but the market's estimate of the terminal fed funds rate has largely converged with the Fed's dots. Meanwhile, the latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in U.S. and global bond yields will correct before the bear phase resumes. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range. The 10-year TIPS breakeven rate has jumped to 2.1% even as oil prices have softened, signaling that the market is seeing more evidence of underlying inflationary pressure. This breakeven rate will likely rise by another 30 basis points and settle back into its pre-Lehman trading range of 2.3-2.5%. Importantly, the latter range was consistent with stable inflation expectations in the pre-Lehman years. The upward revision to our 10-year nominal yield target is due to a higher real rate assumption. In part, this reflects the fact that we have been impressed by last year's productivity performance. We are not expecting a major structural upshift in underlying productivity growth, for reasons cited by our colleague Peter Berezin in a recent report.3 Nonetheless, capital spending has picked up and Chart I-9 suggests that productivity growth should move a little higher in the coming years based on the acceleration in growth of the capital stock. Equilibrium interest rates should rise in line with slightly faster potential economic growth. Should we worry about a higher fiscal risk premium in bond yields? In the pre-Lehman era, academic studies suggested that every percentage point rise in the government's debt-to-GDP ratio added three basis points to the equilibrium level of bond yields. We shouldn't think of this as a 'default risk premium', because there is little default risk for a country that can print its own currency. Rather, higher yields reflect a crowding-out effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Plentiful economic slack negated the need for any crowding out as government debt exploded in aftermath of the Great Recession. Moreover, quantitative easing programs soaked up more than all of net government issuance for the major economies. Chart I-10 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative in each of 2015, 2016 and 2017. The flow will swing to a positive figure of US$957 billion this year and US$1,127 billion in 2019. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private sector issuance for available savings. Chart I-9U.S. Productivity Should Improve Modestly Chart I-10Government Bond Supply Is Accelerating The bottom line is that duration should be kept short of benchmarks within fixed-income portfolios, although we would not be surprised to see a consolidation phase or even a counter-trend rally in the near term. Dollar Cross Currents As mentioned earlier, standard theory suggests that loose fiscal policy and tight money should be bullish for the currency. However, the U.S. situation is complicated by the fact that fiscal stimulus will likely worsen the "twin deficits" problem. The current account deficit widened last year to 2.6% of GDP (Chart I-11). The fiscal measures will result in a jump in the Federal budget deficit to roughly 5½% in 2019, up from 3½% in last summer's CBO baseline projection. As a ballpark estimate, the two percentage point increase will cause the current account deficit to widen by only 0.3 percentage points. Of course, this will be partly offset by the continued improvement in the energy balance due to surging shale oil production. The poor international investment position is another potential negative for the greenback. Persistent U.S. current account deficits have resulted in a huge shortfall in the country's international investment account, which has reached 40% of GDP (Chart I-12). This means that foreign investors own a larger stock of U.S. financial assets than U.S. investors own abroad. Nonetheless, what matters for the dollar are the returns that flow from these assets. U.S. investors have always earned more on their overseas investments than foreigners make on their U.S. assets (which are dominated by low-yielding fixed-income securities). Thus, the U.S. still enjoys a 0.5% of GDP net positive inflow of international income (Chart I-12, bottom panel). Chart I-11A U.S. Twin Deficits Problem? Chart I-12U.S. Net International Investment Interest income flowing abroad will rise along with U.S. bond yields. This will undermine the U.S. surplus on international income to the extent that it is not offset by rising returns on U.S. investments held abroad. We estimate that a further 60 basis point rise in the U.S. Treasury curve (taking the 10-year yield from 2.9% to our target of 3½%) would cause the primary income surplus to fall by about 0.7 percentage points (Chart I-13). Adding this to the 0.3 percentage points from the direct effect of the increased fiscal deficit, the current account shortfall would deteriorate to roughly 3½% of GDP. While the deterioration is significant, the external deficit would simply return to 2009 levels. We doubt this would justify an ongoing dollar bear market on its own. Historically, a widening current account deficit has not always been the dominant driver of dollar trends. What should matter more is the Fed's response to the fiscal stimulus. If the FOMC does not immediately respond to head off the growth impulse, then rising inflation expectations could depress real rates at the short-end of the curve and undermine the dollar temporarily, especially in the context of a deteriorating external balance. The dollar would likely receive a bid later, when inflation clearly shifts higher and long-term inflation expectations move into the target zone discussed above. At that point, policymakers will step up the pace of rate hikes in order to get ahead of the inflation curve. The bottom line is that we still believe that the dollar will move somewhat higher on a 12-month horizon, but we can't rule out a continued downtrend in the near term until inflation clearly bottoms. It will also be difficult for the dollar to rally in the near term in trade-weighted terms if our currency strategists are correct on the yen outlook. The Japanese labor market is extremely tight, industrial production is growing at an impressive 4.4% pace, and the OECD estimates that output is now more than one percentage point above its non-inflationary level (Chart I-14). Investors are betting that a booming economy will give the monetary authorities the chance to move away from extraordinarily accommodative conditions. Investors are thus lifting their estimates of where Japanese policy will stand in three or five years. Chart I-13U.S. Fiscal Stimulus ##br##Impact On External Deficit Chart I-14Yen Benefitting From ##br##Domestic And Foreign Growth Increased volatility in global markets is also yen-bullish, especially since speculative shorts in the yen had reached near record levels. The pullback in global risk assets triggered some short-covering in yen-funded carry trades. Finally, the yen trades at a large discount to purchasing power parity. A strong Yen could prevent dollar rally in trade-weighted terms in the near term. Finally, A Word On Oil Oil prices corrected along with the broader pullback in risk assets in February. Nonetheless, the fundamentals point to a continued tightening in crude oil markets in the first half of 2018 (Chart I-15). Chart I-15Oil Inventory Correction Continuing OPEC's goal of reducing OECD inventories to five-year average levels will likely be met late this year. OPEC and Russia's production cuts are pretty much locked in to the end of June, when the producer coalition will next meet. Even with U.S. shale-oil output increasing, solid global demand will ensure that OECD inventories will continue to draw through the spring period. Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with extending OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year and possibly next year. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0 that the world economy can absorb such prices without damaging demand too much, is not clear. Markets have yet to receive forward guidance from OPEC 2.0 leadership indicating this is the coalition's new policy, but our oil analysts are raising the odds that it is, and will be adjusting their forecast accordingly this week. Investment Conclusions The combination of an initially plodding Fed and faster earnings growth this year provides a bullish backdrop for the equity market. Treasury yields will continue to trend higher but, as long as the Fed sticks with the current 'dot plot', the pain in the fixed-income pits will not prevent the equity bull phase to continue for a while longer. Nonetheless, the fiscal stimulus is arriving very late in the U.S. economic cycle. The fact that there is little economic slack means that, rather than extending the expansion and the runway for earnings, stimulus might simply generate a more exaggerated boom/bust scenario; the FOMC sticks with the current game plan in the near term, but ends up falling behind the inflation curve and then is forced to catch up. The implication is 'faster growth now, deeper recession later'. Timing the end of the business cycle keeps coming back to the inflation outlook. If the result of the fiscal stimulus is more inflation but not much more growth, then the Fed will be forced to step harder and earlier on the brakes. Our base case is that inflation rises in a gradual way, but it has been very difficult to forecast inflation in this cycle. The bottom line is that our recommended asset allocation is unchanged for now. We are overweight risk assets (equities and corporate bonds), and below benchmark on duration. We will continue to watch the items in our Exit Checklist for warning signs (see last month's Overview). We are likely to trim corporate bond exposure within fixed-income portfolios to neutral or underweight in advance of taking profits on equities. The dollar should head up at some point, although not in the near term. The yen should be the strongest currency of the majors in the next 3-6 months. In currency-hedged terms, our fixed-income team still believes that JGBs are the best place to hide from the bond bear market. Gilts and Aussie governments also provide some protection. The worst performers will likely be government bonds in the U.S., Canada and Europe. Mark McClellan Senior Vice President The Bank Credit Analyst February 22, 2018 Next Report: March 29, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percent of GDP. 3 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. II. Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector We estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator. The re-leveraging of the corporate sector has been widespread across industries and ratings. The credit cycle has entered a late stage and we are biased to take profits early on our overweight corporate bond positioning. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. Nonetheless, the starting point for interest coverage ratios is low. The interest coverage ratio for the U.S. non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning south. Our profit indicators are more likely to give an early warning sign than the economic data. We remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. February's "volatility" tremors focused investor attention on leveraged pressure points in the financial system, at a time when valuation is stretched and central banks are turning down the monetary thermostat. The market swoon may have simply reflected the unwinding of crowded volatility-related trades, but the risk is that there are other landmines lurking just ahead. The corporate sector is one candidate. Equity buybacks have not been especially large compared to previous cycles after adjusting for the length of the expansion (i.e. adjusting for cumulative GDP over the period, Chart II-1).1 But the expansion has gone on for so long that cumulative buybacks exceed the previous three expansions in absolute terms (Chart II-1, bottom panel). One would expect a lot of financial engineering to take place in an environment where borrowing costs are held at very low levels for an extended period. But, of course, one should also expect there to be consequences. Chart II-1Cycle Comparison: Corporate Finance Trends Chart II-2Corporate Bond Spreads And Leverage As Chart II-2 shows, corporate spreads tend to follow the broad trends in leverage, albeit with lengthy periods of divergence. The chart suggests that current spreads are far too narrow given the level of corporate leverage. Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, this will change as interest rates rise and investors begin to worry about the growth outlook rather than squeezing the last drop of yield out of spread product. In this Special Report, we estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. But first, we review recent trends in leverage and overall balance sheet health. BCA's Corporate Health Monitors BCA's top-down Corporate Health Monitor (CHM) has been a workhorse for our corporate bond strategy for almost 20 years (Chart II-3). It is based on six financial ratios constructed from the U.S. Flow of Funds data for the entire non-financial corporate sector (Table II-1). The top-down CHM shifted into "deteriorating health" territory in 2014 on the back of rising leverage and an eroding return on capital.2 Chart II-3Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs The downward trend in the return on capital since 2007 is disturbing, as it suggests that there is a surplus of capital on U.S. balance sheets that is largely unproductive and not lifting profits. This can also be seen in the run-up in corporate borrowing in recent years that has been used to undertake share buybacks. If a company's best investment idea is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the expected internal rate of return on investment must be quite low. This is a longer-term problem for corporate health. Alternatively, financial engineering may reflect misaligned incentives, such as stock options, rather than poor investment opportunities. The good news is that profit margins bounced back in 2017, which was reflected in a small decline in our top-down CHM toward the zero line over the past year (although it remained in 'deteriorating' territory). While the top-down CHM has been a useful indicator to time bear markets in corporate bond relative performance, it tells us nothing about the distribution of credit quality. In 2016 we looked at the financials of 1,600 U.S. companies to obtain a more detailed picture of corporate health. After removing ones with limited history or missing data, our sample shrank to a still-respectable 770 companies from across the industrial and quality spectrum. We then constructed an overall Corporate Health Monitor for all companies in the sample, as well as for the nine non-financial industries. We refer to these indicators as bottom-up CHMs, which we regard as complements to our top-down Health Monitor. The companies selected for our universe provided a sector and credit-quality composition that roughly matched the Barclays corporate bond indexes. In our first report, published in the February 2016 monthly Bank Credit Analyst, we highlighted that the financial ratios and overall corporate health looked only a little better excluding the troubled energy and materials sectors. The level of debt/equity was even a bit higher outside of the commodity industries. The implication was that, at the time, corporate credit quality had deteriorated across industrial sectors and levels of credit quality. Profitability Drove Improving Health In 2017... An update of the bottom-up CHMs shows that corporate financial health improved in 2017 for both the investment-grade (IG) and high-yield (HY) sectors (Chart II-4 and Chart II-5). The IG bottom-up Monitor remains in "deteriorating health" territory, but HY Monitor moved almost all the way back to the neutral line by year end. Leverage continued to trend higher last year for both IG and HY, but this was more than offset by a strong earnings performance that was reflected in rising operating margins, interest coverage and debt coverage. Chart II-4Bottom-Up IG CHM Chart II-5Bottom-Up HY CHM These improvements were particularly evident in the sub-investment grade universe. Our industry high-yield CHMs fell significantly in 2017 from elevated (i.e. poor) levels all the way back to the neutral line for Consumer Discretionary, Energy, Industrials, Materials and Utilities (not shown). The high-yield Technology and Health Care sector CHMs are also close to neutral. ...But The Earnings Runway Is Limited Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. While interest coverage (EBIT divided by interest payments) improved last year for most industries, it remains depressed by historical standards. This is despite ultra-low borrowing rates and a robust earnings backdrop. U.S. companies are not facing an imminent cash crunch that would raise downgrade/default risk, but depressed interest coverage suggests that there is less room for error than in previous years. Table II-2Widespread Re-Leveraging Now that government bond yields have bottomed for the cycle and the "green shoots" of inflation are beginning to emerge, it begs the question of corporate sector exposure to rising interest costs. The sensitivity is important because Moody's assigns a weight of between 20% and 40% for the leverage and coverage ratios when rating a company, depending on the industry. Downgrade risk will escalate if corporate borrowing rates continue rising and, especially, if the U.S. economy enters a downturn. Comparing the level of debt or leverage across industries is complicated by the fact that some industries perpetually carry more debt than others due to the nature of the business. Moody's uses different thresholds for leverage when rating companies, depending on the industry. Thus, the change in the leverage ratio is perhaps more important than its level when comparing industries. Table II-2 shows the change in the ratio of debt to the book value of equity from our bottom-up universe of companies from 2010 to 2017. Leverage rose sharply in all sectors except Utilities. The worse two sectors were Communications and Consumer Discretionary, where leverage rose by 81 and 104 percentage points, respectively. Highest Risk Sectors We expect a traditional end to the business cycle; the Fed overdoes the rate hike cycle, sending the economy into recession. The industrial sectors with the poorest financial health and the greatest earnings "beta" to the overall market are most at risk in this macro scenario. We first estimate earnings betas by comparing the peak-to-trough decline in EPS for each sector to the overall decline in the non-financial S&P 500 EPS, taking an average of the last two recessions (we could not include the early 1990s recession due to data limitations). Not surprisingly, Materials, Technology, Consumer Discretionary and Energy sport the highest earnings beta based on this methodology (Chart II-6). Chart II-6Earnings Beta Chart II-7 presents a scatter plot of 2017 leverage versus the industry's earnings beta. Consumer Discretionary stands out on the high side on both counts. Materials and Energy are also high-beta industries, but have lower leverage. Communications is a high-debt industry with a medium earnings beta. These same industries stand out when comparing the earnings beta to the interest coverage ratio (the lower the interest coverage ratio the more risky in Chart II-8). Chart II-7Leverage Vs. Earnings Beta Chart II-8Interest Coverage Ratio Vs. Earnings Beta Of course, a sector's sensitivity to rising interest rates will depend on both the level of debt and its maturity distribution. Higher rates will not have much impact in the near term for firms that have little debt to roll over in the next couple of years. Chart II-9 presents the percentage of total debt that will come due over the next three years by industry. Consumer Discretionary, Tech, Staples and Industrials are the most exposed to debt rollover. To further refine the analysis, we estimate the change in the interest coverage ratio over the next three years for a 100 basis point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt. We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. For the universe of our companies, the interest coverage ratio would drop from about 4 to 2½, well below the lows of the Great Recession (denoted as "x" in Chart II-10). The Consumer Staples, Tech and Health Care are affected most deeply (Chart II-11 and Chart II-12). Chart II-9Debt Maturing In Next ##br##Three Years (% Of Total) Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Recession Shock Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. Looking again at Charts II-10 to II-12, "o" denotes the combination of a 100 basis point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. We estimate the decline in EPS based on the industry's earnings beta to the overall market. The overall interest coverage ratio falls even further into uncharted territory below two. The additional shock of the earnings recession makes little difference to earnings coverage for the low beta sectors such as Consumer Staples and Health Care. The coverage ratio falls sharply for the Communications and Industries, although not to new lows. It is a different story for Consumer Discretionary and Materials. The combination of elevated debt and a high earnings beta means that the interest coverage ratio would likely plunge to levels well below previous lows for these two industries. Corporate bond investors and rating agencies will certainly notice. Signposts Our top-down Corporate Health Monitor is one of the key indicators we use to identify cyclical bear phases for corporate bond excess returns. A shift from "improving" to "deteriorating" health has been a reliable confirming indicator for periods of sustained spread widening. The other two key indicators are (Chart II-13): Chart II-13Key Cyclical Drivers Of Corporate Excess Returns Bank lending standards for Commercial & Industrial loans: Banks begin to tighten up on lending standards when they realize that the economy is slowing and credit quality is deteriorating as a result. By making it more difficult for firms to roll over bank loans or replace bond financing, more restrictive standards reinforce the negative trend in corporate credit quality. We traditionally view lending standards as a confirming indicator for a turn in the credit cycle, since tightening standards are typically preceded by deteriorating corporate health and restrictive monetary policy. Restrictive monetary policy: This is the most difficult of the three indicators for which to determine critical values. We had a good idea of the level of the neutral real fed funds rate prior to 2007. Since then, our monetary compass is far less certain because the neutral rate has likely declined for cyclical and structural reasons. The real fed funds rate has moved just slightly into restrictive territory if we take the Laubach-Williams estimate at face value (Chart II-13, third panel). That said, we would expect the 2/10 Treasury yield curve to be closer to inverting if real short-term interest rates are indeed in restrictive territory. Taking the two indicators together, we conclude that monetary policy is not yet outright restrictive. Historically, all three indicators had to be flashing red in order to justify a shift to below-benchmark on corporate bonds within fixed-income portfolios. Only the CHM is negative at the moment, but this time we are unlikely to wait for all three signals to take profits. Poor valuation, lopsided positioning, financial engineering and uncertainty regarding the neutral fed funds rate all argue in favor of erring on the side of caution and not trying to closely time the peak in excess returns. The violent unwinding of short-volatility trades in January highlighted the potential for a quick and nasty repricing of corporate bonds spreads on any disappointments regarding the default rate outlook. Conclusion Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator as businesses continued to pile up debt and return cash to shareholders. Our sample of individual companies reveals that the re-leveraging of the corporate sector has been widespread across industries and ratings. We have clearly entered the late stage of the credit cycle. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. However, debt levels are elevated and the starting point for interest coverage ratios is low. This means that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. The interest coverage ratio for the non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning and the profit boom is over. Last month's Overview listed the top economic indicators we are watching in order to time our exit from risky assets. Inflation expectations will be key; A rise in the 10-year inflation breakeven rate above 2.3% would be a warning that the FOMC will need to ramp up the speed of rate hikes to avoid a large inflation overshoot. While we are also watching a list of economic indicators, they have not provided any lead time for corporate spreads in the past (since the latter are themselves leading indicators). Our profit indicators are probably more likely to give an early warning sign than the economic data. Indeed, the profit outlook will be particularly important in this cycle because of the heightened sensitivity of corporate financial health changes in the macro backdrop. None of our earnings indicators are flashing a warning sign at the moment. A recent Special Report on corporate pricing power found that almost 80% of the sectors covered are lifting selling prices, at a time when labor costs are still subdued.3 These trends are captured by our U.S. Equity Strategy service's margin proxy, which remains in positive territory (Chart II-14). The margin proxy fell into negative territory ahead of the start of the last three sustained widening phases in U.S. corporate bonds. Chart II-14For Corporate Spreads, Watch Our Margin Proxy The bottom line is that we remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. We expect to pull the trigger later this year but the timing is uncertain. Mark McClellan Senior Vice President The Bank Credit Analyst 1 The accumulation of equity buybacks, net equity withdrawal, dividends and capital spending are all adjusted by the accumulation of GDP during the expansion to facilitate comparison across business cycles. 2 The Monitor is an average of six financial ratios that are used by rating agencies to rate individual companies. We have applied the approach to the entire non-financial corporate sector, using the Fed's Flow of Funds data. To facilitate comparison with corporate spreads, the ratios are inverted so that a rising CHM indicates deteriorating health. The CHM has a very good track record of heralding trend changes in investment-grade and high-yield spreads over many cycles. 3 Please see BCA U.S. Equity Strategy Service Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. III. Indicators And Reference Charts Volatility returned to financial markets in February. The good news is that it appears to have been a healthy technical correction that has tempered frothy market conditions, rather than the start of an equity bear phase. The VIX has shot from very low levels to above the long-term mean, indicating that there is less complacency among investors. This is confirmed by the pullback in our Composite Sentiment Indicator, although it remains at the high end of its historical range. Our Composite Speculation Indicator is also still hovering at a high level, suggesting that frothiness has not been fully washed out. Similarly, our Equity Valuation Indicator has pulled back, but remains close to our threshold for overvaluation at +1 standard deviations. Our Equity Technical Indicator came close, but did not give a 'sell' signal in February (i.e. it remained above its 9-month moving average). Our Monetary Indicator moved slightly further into 'restrictive' territory in February. We highlight in the Overview section that monetary policy will become a significant headwind once long-term inflation expectations have fully normalized. It is constructive that the indicators for near-term earnings growth remain upbeat; both the net revisions ratio and the earnings surprise index continue to point to further increases in 12-month forward earnings estimates. Our Revealed Preference Indicator (RPI) returned to its bullish equity signal in February, following a temporary shift to neutral in January. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are bullish on stocks in the U.S., Europe and Japan. However, the WTP for the U.S. market appears to have rolled over, suggesting that flows are becoming less constructive for U.S. stocks. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. At the margin, the WTP indicator suggest that flows favor the European and Japanese markets to the U.S. Treasurys moved closer to 'inexpensive' territory in February, but are not there yet. Extended technicals suggest a period of consolidation, but value is not a headwind to a continuation in the cyclical bear phase. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The ascent in Treasury yields is likely to flatten out over the coming months, now that rate expectations have almost converged to the Fed dots. This should provide some near-term support for stocks. The structural outlook for bonds remains quite bearish, however. Exploding budget deficits, a retreat from globalization, and the withdrawal of well-paid baby boomers from the labor force will all combine to push up inflation. As inflation increases, the positive correlation between bond yields and stock prices will break down. This will cause bond term premia to rise, pushing yields even higher. Investors should use any bond rally as an opportunity to reduce duration risk. They should also look to scale back exposure to equities later this year in advance of a recession starting in late-2019 or 2020. Feature More Than A Technical Correction Global equities moved higher this week following last week's drubbing. We noted in our February 6th report that the correction was amplified by technical factors.1 Rising volatility led to a wave of forced selling in so-called risk parity funds. These funds automatically adjust their exposure to stocks based on how volatile they are. When volatility spiked, the funds started selling stocks. This pushed down equity prices, causing volatility to rise further, which led to even more forced selling. The good news is that the losses suffered by investors in these funds have had little effect on the underlying health of the financial system. This is a major difference from 2008, when delinquent mortgages led to huge losses for banks and other highly levered institutions. The equity selloff has also made stocks more attractive. Even after this week's rebound, the S&P 500 trades at a forward P/E of 18 - roughly where it stood in early 2017 and not much higher than it was in 2015 (Chart 1). Chart 1A Healthy Valuation Reset If that were all there was to the story, one could breathe a sigh of relief. Unfortunately, there is more to it than that. When a building collapses during an earthquake, does one blame mother nature or the company that built it? Sometimes the answer is both. The stock market had been ripe for a correction for a long time. Why did it happen last week? The answer, at least in part, is that the foundation on which the equity bull market was built - the presumption that monetary policy would stay easy for as far as the eye could see - began to crumble. The timing is too conspicuous to ignore. Stocks began to swoon just as the payrolls report revealed that average hourly earnings had surprised on the upside. Investors began to fret that the remaining runway for low inflation was not as long as they had supposed. Bond Yields Should Level Off In The Near Term... Are investors correct to be concerned? As we argue in detail below, over the long term, the answer is definitely yes. Over the next 12 months, however, the picture is much more nuanced. Actual inflation remains fairly tame. Even after this week's higher-than-expected CPI print, core CPI excluding shelter is up by only 0.8% year-over-year. Moreover, despite their recent climb, global bond yields are still quite low in absolute terms. The yield on the JP Morgan global bond index stands at 1.7%, close to half of what it was in 2011 (Chart 2). Chart 2AYields Are Still Low By Historic Standards (I) Chart 2BYields Are Still Low By Historic Standards (II) Chart 3Market Pricing Has Almost ##br##Caught Up To The Fed's Dots Market expectations now place the fed funds rate at the level implied by the dots for end-2018 and only slightly below the dots for end-2019 (Chart 3). Expectations for the first ECB rate hike in the second half of 2019 have also converged with what the central bank is targeting. The nearly two rate hikes for the Bank of England that are priced in this year may, if anything, be too aggressive. The latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in global bond yields will level off, and perhaps even temporarily reverse. This should give some support to stocks. ... But The Long-Term Direction For Yields Is Up While bond yields are due for a pause, the long-term trend remains firmly to the upside. BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016.2 As luck would have it, this was the same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. We argued at the time that both cyclical and structural forces would conspire to put in a bottom for yields. Since then, the global economy has continued to grow at an above-trend pace. This has caused output gaps to shrink in every major economy (Chart 4). The U.S. has now reached full employment. Wage growth tends to accelerate once the unemployment rate falls below NAIRU (Chart 5). Faster wage growth will give households the wherewithal to spend more. With little spare capacity left, this will fuel inflation. Chart 4Output Gaps Have##br## Shrunk In Advanced Economies Chart 5U.S. Wage Growth Set##br## To Accelerate Further The shift from fiscal austerity to largesse across much of the world is adding to the inflationary pressures. The Trump tax cuts are starting to look like chump change compared to the massive amount of spending coming down the pike. The Senate agreed last week to raise the caps on spending by $153 billion in FY2018 and an additional $143 billion in FY2019. This does not even include the $80 billion that has already been allocated to disaster relief, the still-to-be-negotiated sum for infrastructure spending, or up to $25 billion in additional annual spending that our Geopolitical Strategy team estimates would result if "earmarks" are reinstated (Chart 6).3 Chart 6Let The Good Times Roll Meanwhile, Japan is on track to ease fiscal policy this year.4 In Germany, the Grand Coalition deal was only concluded after Chancellor Angela Merkel conceded to demands for more spending on everything from education to public investment on technology and defense. Globalization, which historically has been a highly deflationary force, is on the back foot. Global trade nearly doubled as a share of GDP from the early 1980s to 2008, but has been stagnant ever since (Chart 7). Donald Trump pulled the U.S. out of the Trans-Pacific Partnership and he may very well pull it out of NAFTA. Opposition towards open-border immigration policies is rising. More Mexicans left the U.S. over the past eight years than entered it. On the demographic front, the three decade-long increase in the global ratio of workers-to-consumers has finally reversed (Chart 8). As baby boomers leave the labor force, the amount of GDP they produce will plummet. However, their spending on goods and services will continue to rise once health care expenditures are included in the tally. The combination of more consumption and less production is inflationary. Against a backdrop of slow potential GDP growth, policymakers will welcome rising inflation as the only viable tool left to deflate away high debt levels. Chart 7Global Trade Has Crested Chart 8Peak In The Ratio Of Workers-To-Consumers Productivity Stuck In The Slow Lane Faster productivity growth could help stave off this outcome. Unfortunately, so far, a sustained productivity revival is more of a dream than a reality. Chart 9 shows that G7 productivity has been rising at a disappointingly slow pace since the mid-2000s. Optimists like to tout the impact of robotics and the "Amazon effect". However, as my colleague Mark McClellan discussed in a series of reports, neither factor is quantitatively all that important.5 In the case of the Amazon effect, profit margins in the retail sector are close to record highs (Chart 10). This calls into doubt claims that online shopping has undermined businesses' pricing power. Recent productivity growth in the U.S. distribution sector has actually been slower than in the 1990s, a decade that produced large productivity gains from the displacement of "mom and pop" stores with "big box" retailers such as Walmart and Costco. Chart 9G7 Productivity: Not What It Used To Be Chart 10Retail Sector Profit Margins Near Record Highs Meanwhile, student test scores across the OECD have declined over the past decade (Chart 11). The accumulation of human capital has been the single most important driver of rising living standards over the past few centuries.6 This tailwind is now dissipating at an alarmingly fast pace. Chart 11AThe Contribution To Growth From ##br##Rising Human Capital Is Falling Chart 11BStudent Test Scores Are ##br##Declining In Many Countries Will The Stock-Bond Correlation Flip? As inflation becomes a greater concern over the coming years, the bond term premium will rise. Chart 12 shows that the term premium has often been negative in the recent past. This means that investors have been willing to accept a discount on holding long-term bonds relative to what they would get by rolling over short-term bills. Chart 12The Term Premium Has Been Negative Over The Past Three Years It is not surprising that this has been the case. Since the late 1990s, Treasury prices have tended to go up when the stock market sells off (Chart 13). This has made owning bonds a good hedge against bad economic news. Chart 13Bond Prices Have Tended To Rise When Equity Prices Fall Since The Late 1990s The last few weeks have seen a reversal of this pattern. Since January 26, the 10-year yield has risen by 25 basis points while the S&P 500 has fallen by 4.9%. When economies are operating at full capacity, anything that adds to aggregate demand will lead to higher inflation rather than faster growth. The latter is good for stocks because it means stronger earnings. The former is bad for stocks if it leads to a more rapid pace of rate hikes. As bond yields temporarily level off, the positive correlation between yields and equity prices should return. However, this may simply prove to be the last hurrah for this relationship. Over the long haul, bonds and equities will become more alike in the sense that they will prosper or suffer at the same time. The equity risk premium will shrink not because equities will be revalued upwards but because bonds will be revalued downwards. The runoff of the Fed's balance sheet and a slower pace of central bank bond purchases elsewhere will only compound the damage to bonds. Investment Conclusions Global bond yields are on a structural upward trajectory, however the progression will be a choppy one. The rapid rise in bond yields will flatten out, but the 10-year Treasury yield will nevertheless finish the year at about 3.25% - around 25 basis points above the forwards. Yields will continue to rise into next year. The resulting tightening in financial conditions will cause the U.S. economy to slow, ultimately setting the stage for a recession in late-2019 or 2020. The next downturn will see inflation and bond yields dip again. However, they will do so from higher levels than today. As in the 1970s, bond yields and inflation will trend higher over the coming years, reaching "higher highs" and "higher lows" with every passing business cycle (Chart 14). Investors should use any bond rally as an opportunity to reduce duration risk. They should also look to scale back exposure to equities later this year. A structurally high path for inflation is not good for the dollar. However, the coming stagflationary era will not be unique to the U.S. Many other countries actually have higher debt levels and weaker growth prospects than the U.S. More relevant to the current environment, the increasingly popular narrative that attributes the dollar's ongoing decline in 2018 to heightened fears of large budget deficits does not really mesh with what is happening to real rates. Real yields have actually surged since the start of the year (Chart 15). In this respect, today's landscape looks a bit like the early 1980s, a period when massive tax cuts and increased defense expenditures led to rising real yields and a stronger dollar. Chart 14A Template For The Next Decade? Chart 15Real Yields Have Surged Since The Start Of The Year Momentum is a powerful force in currency markets. This is particularly true for the dollar, which scores higher than all other currencies on our Foreign Exchange Strategy team's "momentum factor"7 (Chart 16). Today, the trend is definitely not the dollar's friend. Nevertheless, the fundamentals may be shifting in favor of the greenback. EUR/USD has decisively decoupled from the 30-year Treasury/bund spread (Chart 17). If the relationship had held, the cross would be trading at 1.12, rather than today's level of 1.25. The latest BofA Merrill Lynch survey reported "short USD" as one of the most crowded trades among fund managers. Going long the dollar could be a successful non-consensus trade for the next few months. Chart 16USD Is A ##br##Momentum Winner Chart 17EUR/USD Has Diverged From##br## Interest Rate Spreads This Year Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The Return Of Vol," dated February 6, 2018. 2 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 3 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018. 4 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018. 5 Please see BCA The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017; and Special Report, "The Impact Of Robots On Inflation," dated January 25, 2018. 6 Please see BCA Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; and BCA The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011. 7 Please see BCA Foreign Exchange Strategy Special Report, "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Dear Client, This Special Report is the full transcript and slides of a presentation I recently gave at the London School of Economics symposium: 'Will I Work For AI, Or Will AI Work For Me?' The presentation pulls together several years of research analyzing the impact of current technological advances on work, the economy and society. I hope you find the presentation insightful and provocative, especially the narrative surrounding Slide 12. Dhaval Joshi Slide 2 Feature Good afternoon Thank you very much for the invitation to speak here at the London School of Economics. The specific question you asked me was: will we be able to work in the future? (Slide 1). To which my answer is yes, an emphatic yes. I'm very optimistic that we will be able to work in the future. And one reason I'm saying this is, imagine that we had this symposium 100 years ago. I suspect we might have had exactly the same fears that we have right now (Slide 2). Slide 1 Slide 2 Specifically, at the start of the 20th century, about 35% of all jobs were on farms and another 6% were domestic servants. At the time, you could probably also have said, "Well, these jobs aren't going to exist." More or less half of the jobs that existed at that time were going to disappear - and disappear they did. So we'd have thought there would be mass unemployment. Of course, there wasn't mass unemployment, because just as jobs were destroyed, we had an equivalent job creation (Slide 3). For example, at the start of the 20th century, less than 5% of people worked in professional and technical jobs. But by the end of the century, these jobs employed a quarter of the workforce. I guess what I'm saying is that we're very conscious of job destruction because we can see existing jobs being destroyed. But we're not very conscious of job creation, because in real time, it's difficult to visualize or imagine where these new jobs will be. In essence, what we saw in the 20th century was one major segment of employment basically collapsed from very significant to insignificant. While another segment surged from insignificant to very significant (Slide 4). Slide 3 Slide 4 As you all know, there is an economic thesis that underlies this. It's called Say's Law, derived by French economist Jean-Baptiste Say in 1803. In simple terms, it says that new supply creates new demand. Think about it like this: why would you replace a human with a machine? You would only do that if it increases your productivity, right? Otherwise, it does not make sense to replace a human with any sort of machine, including AI. But because you have increased productivity, you then have extra income to spend on new goods and services. Now if those goods and services are being supplied by a machine, then you can redeploy humans to satiate new desires, desires that do not even exist at the time. In economic terms, the producer of X - as long as his products are demanded - is able to buy Y (Slide 5). The question is, what is Y? Y is the new product or service. Let me give you some examples (Slide 6). In the 19th century, we had the advent of railways. And then someone thought. "Hang on a minute. We have this way of moving things around much faster, and we've got all these people who live hundreds of miles from the coast who might want to eat fresh fish." So this was the birth of the frozen food industry. But you could not have the frozen food industry without railways. What I'm saying is that entrepreneurs will seize the new technology to satiate a desire. Or even create a new desire because maybe the people in the middle of the country never thought they could eat fresh sea fish. Until someone came along and said, "you can eat fresh fish now." Slide 5 Slide 6 Another example is, as technology improved the health and longevity of your teeth someone thought. "Well, hang on a minute. Maybe there's a desire to make teeth look beautiful." And we created this whole new industry called the dental cosmetics industry. We know this because prior to the 1960s, there was no job called dental technician or dental hygienist. A third example is, let's say that we have more advanced healthcare and pharmaceuticals, so humans are living longer and healthier lives. Well, then you can sort of ask. "Hang on a minute. Don't you want your dog to live the same long and healthy life that you're living?" And this is behind the explosion of the pet care industry that we're seeing at the moment. So while one segment of the economy will employ less, a new segment will come along to replace it. In the 20th century we saw farm work disappearing but professional work rising. Today, we are seeing manufacturing and driving jobs disappearing but healthcare work rising (Slide 7). Which does raise a pretty obvious question (Slide 8). Is there anything really different this time around? Slide 7 Slide 8 Well, the answer is yes, there is a subtle but crucial difference this time around. To see the difference, we have to look more closely at where jobs are being destroyed, and where they are being created. As you can see, the mega-sectors losing a lot of jobs are manufacturing, the auto industry, and finance (Slide 9). While on the other side of the ledger, we have job creation in health, social work and education. But now, let's look in a little more detail. Where, specifically, are the jobs being created? For this we have to look at the United States data which is much more granular than in Europe. Here are the top five subsectors of job creation this decade (Slide 10). At the top of the list is food services and drinking places, which is just a euphemistic way of describing bartenders, waitresses, and pizza delivery boys. We also have a lot of new administrative jobs and care workers. What is the common link in this job creation? Answer: these are predominantly low-income jobs. Slide 9 Slide 10 So it is true that we have an enormous amount of job creation in the last decade or so, and the policymakers keep boasting about it, they say, "Well look, the unemployment rate in the U.S. is at a record low, the unemployment rate in the UK is at a record low, the unemployment rate in Germany is at a record low. We're creating loads and loads of jobs." The trouble is that these are predominantly low-income jobs. Meanwhile the job destruction is in middle-income jobs in manufacturing and finance. This means what we're seeing in the labour market is called a 'negative composition effect' - a hollowing out of middle incomes. So while we're getting loads and loads of job creation, it is not translating into wage inflation at an aggregate level. I think one of the reasons is a concept called Moravec's paradox. Professor Hans Moravec is an expert in robotics and Artificial Intelligence, and he noticed this paradox (Slide 11). He said, "Look. For AI, the things that we think are difficult are actually easy." By easy, he means they're doable. Let me give you some specific examples. Say someone could speak five languages fluently and translate between them at ease. We would think that person is a genius, a real rare specimen, and the economy would value this person extremely highly, probably pay that person hundreds of thousands of pounds at a minimum. But actually, AI can translate across five languages quite easily, and even something like Google Translate, which we all use, does a reasonably good first stab at translating from one language to another. Slide 11 Or consider something like insurance underwriting. Pricing an insurance premium from lots of data on a risk. AI can do that extremely well, much better than a human can. Or medical diagnosis. Figuring out what's wrong with a patient from very detailed medical data. Again, AI beats humans hands down on that. What I'm saying is, these skills that we thought were difficult transpired not to be that difficult for AI, because they just amount to narrow-frame pattern recognition and repetition of algorithms. Whereas, the second part of Moravec's paradox is that AI finds the easy things very hard. Things that we think are really innate, we don't even give them a second thought like walking up some stairs, cleaning a table, moving objects around, and cleaning around them. Actually, AI finds these things incredibly difficult, almost impossible. We have a false sense of what is difficult and what is easy. The main reason is that the things that we find innate took millions and millions of years of human brain evolution for us to find them innate. And as AI is in essence trying to replicate the human brain, only now are we recognizing that things that we find innate are actually incredibly complex. If it took millions and millions of years to evolve the sensorimotor skills that allow us to walk up some stairs, recognize subtle emotional signals, and respond appropriately, then obviously AI is going to find it very, very difficult to replicate those innate human skills. Conversely, the brain's ability to do calculus, construct a grammatical structure for a language, or play chess only evolved relatively recently. So AI can do them very easily. Which brings me to quite a profound thought. If there's one thing that I want you to remember from this presentation it is this (Slide 12). Might we have completely misvalued the human brain? Might we have grossly overvalued things that are actually quite easy? And might we have undervalued things which are actually very, very difficult? And what AI is now doing is correcting this huge error. In which case, the next decade could be extremely disruptive as AI corrects this economic misvaluation of our skills. Slide 12 This might also explain the mystery as to why there is no wage inflation when the Phillips curve says there should be. The Phillips curve makes a simple relationship between the unemployment rate and wage pressures. And the folks at the Federal Reserve and Bank of England, they're sort of getting really perplexed. They're saying, "Look, unemployment is so low. Where is this wage inflation? It's going to kick in any time now." In fact, there's a bit of a paradox going on. For the people who are continuously employed in the same job, there has been pretty good wage inflation - at sort of three, four percent (Slide 13). But when you take the negative composition effect into account, then suddenly there's this big gap because what's happening is that the well-paid jobs are disappearing to be replaced by lower-paid jobs. So even if you give the bartender making thirty thousand a big pay rise to thirty-five thousand. Even if you hire two of them, but you're losing a finance job paying over a hundred thousand, then at the aggregate level, you won't see much wage inflation. And this problem, I think, continues for the next few years, minimum. It means that you will not get the wage pressures that a lot of economists think you're going to get from the low unemployment rate. Because you have to look at the quality of the jobs as well as the quantity. I think there is another disturbing impact from a societal perspective. Look again at where the jobs are being lost and where they're being created, and look at the percentage of male employees (Slide 14). Job destruction is occurring in sectors that are male-dominated, whereas job creation is occurring in sectors that are female-dominated. Slide 13 Slide 14 AI is good at narrow-frame pattern recognition and repetition of algorithms and functions - jobs like driving, which are typically male-dominated. Whereas jobs that require emotional input, emotional understanding, and empathy in the 'caring sectors' are typically female-dominated. So if you're a male, you're in trouble. You're in a lot of trouble. Obviously, there'll be re-training, so all the guys who were driving trucks will have to retrain as nurses, or as essential carers. But if you're a female, things are looking okay. You can see that in the data (Slide 15). Female labour force participation is in a very clear uptrend. Male participation is flat to down. This varies by country by country, and in the U.S., it's catastrophic for males, especially young males. Young male participation in the U.S. is really falling off a cliff at the moment. I think the other thing to say from a societal perspective is that the so-called 'Superstar Economy' is booming - both superstar individuals and superstar firms. One way of seeing this is in this index called 'the cost of living extremely well' calculated every year by Forbes (Slide 16). Whereas the ordinary CPI includes the cost of bread and milk, the CPI index for the extremely rich includes the cost of Petrossian caviar and Dom Perignon champagne. And a Learjet 70, a Sikorsky S-76D helicopter. I think there's a pedigree racehorse in there too. Anyway, we're seeing the CPI for the extremely rich rising at a dramatically faster pace than the CPI for society as a whole. So it would seem that superstar individuals and superstar firms are really thriving. Slide 15 Slide 16 Let's explain this dynamic in terms of a superstar we all recognise - Roger Federer. Roger Federer was unknown initially, but as he went up the tennis rankings and became a superstar, his income grew exponentially. The other aspect is, how long can he stay a superstar? Because all superstars are eventually displaced by a new superstar. So there's two aspects to the dynamics of superstar incomes (Slide 17). First, how exponential is your income growth? And second, how long do you stay a superstar? What I'm saying is that the rise of AI, by hollowing out the middle jobs, actually allows a few superstars to have this exponential rise in their income. Let's think about it in terms of the legal profession. The top lawyer will be in huge demand. Technology really boosts him. Not just AI, but things like the internet, the fact that social media will reinforce his position, whereby everyone will know who he is. Even if he can't service you directly, he will have a team with his brand on it. And he can stay there for longer before he is displaced. So this is the mechanism by which technology can increase income inequality by hollowing out the middle. In the legal profession, the assistant lawyer who just checks a document for simple legal principle, well the machine can do that. But the guy who knows all the oddities, who knows all the loopholes that can win you the case, the machine won't be able to do that. Essentially what I'm saying is that the technological revolution - it's not just AI, it's technology in aggregate, including the internet and social media, and so on - it increases the rate of income growth for a few superstar individuals and firms. And it increases their longevity (Slide 18). And these are the two drivers for the Pareto distribution of incomes. You can actually go through the mathematics of this to show that it does increase the polarization of incomes. Slide 17 Slide 18 Let's sum up (Slide 19). First of all, yes, we will be able to work in the future. I don't think there's any doubt about that because there will be new jobs created, the nature of which we can only guess because we're going to get new industries to satiate our new desires. However, in the coming years, middle-income work will suffer high disruption because of Moravec's Paradox. Some things that we thought were difficult are actually quite easy for AI. But things like gardening, plumbing, nursing, and childcare are very difficult for machines to replicate. Which means that low-income work will suffer much less disruption and, of course, low-income work will get paid better over time - though the gap is so large at the moment that it's preventing overall wage inflation from kicking in. And that, I think, will persist for the next few years at a minimum. Slide 19 Men are going to suffer much more disruption than women because of the nature of the job destruction versus the job creation. And the final point is that superstars will thrive. All of this has a lot of implications for how we respond as a society, and maybe we will need some support mechanisms in this period of disruption. I think the most intense disruption will be in the next decade. After that we will reach a new equilibrium once we have actually corrected this misvaluation of the brain, this misvaluation of what it is that makes us truly human. Thank you very much. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com

Highlights As the Fed proceeds with its policy tightening this year, higher real rates and a stronger USD will weigh on silver and platinum prices, and, to a lesser extent, palladium prices. Offsetting these downward pressures, silver, and to a lesser extent platinum, could take their lead from the gold market, and outperform on the back of increased equity volatility and understated geopolitical risks this year.1 Palladium, as always, will march to its own drummer, as this market's defining feature remains chronic physical deficits and depleted inventories, which will prevent prices from reacting too severely to tighter Fed policy this year. Energy: Overweight. Supply-demand fundamentals still are supportive of crude oil prices overall, and continued backwardation in forward curves. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, which gains as backwardation becomes more pronounced, is up 47.4% since inception on November 2, 2017. Base Metals: Neutral. Base metals remain well supported by still-strong global growth, estimates of which were revised higher by the IMF in its most recent World Economic Outlook. Precious Metals: Neutral. Fed tightening this year will weigh on silver and platinum, less so palladium (see below). Our long gold portfolio hedge is up 7.9%. Ags/Softs: Underweight. The USDA revised down its forecast of U.S. corn ending stocks in the latest WASDE on the back of an upwards revision to U.S. corn exports. Feature The term "precious metals" is something of a misnomer: Gold, silver, and platinum-group metals (PGMs) - chiefly platinum and palladium - do not constitute a single asset class, and should not be treated as such (Chart of the Week). Nevertheless, as with most commodity markets we cover, the evolution of these markets is highly sensitive to U.S. financial variables, particularly as regards monetary policy. Palladium is something of an outlier: It behaves more like an industrial metal, while silver, and to a lesser extent platinum, are more sensitive to the fundamental drivers of gold prices - i.e., the evolution of the USD's broad trade-weighted index (USD TWIB), and real U.S. interest rates. Palladium's demand is dominated by its use in catalytic converters in gasoline-powered cars, whereas industrial applications form a more limited source of demand for platinum and silver (Chart 2). Chart of the WeekA Schism In Precious Metals Chart 2Industrial Uses Dominate Palladium Gold, silver, and, to a more limited extent platinum are cointegrated in the long run, meaning their prices follow their own random walks, even though they share a long-term trend. Palladium, on the other hand, is more responsive to the physical realities of the automobile market - chiefly, demand for gasoline-powered cars. In our econometric analysis of the behavior of PGMs and silver, we use the CRB Metals Index as a proxy for industrial activity. We find that while all three are sensitive to changes in the CRB Metals Index, palladium prices are significantly more responsive (i.e., elastic) to industrial activity than platinum and silver (Table 1). Table 1Palladium Behaves Like An Industrial Metal Furthermore, while gold prices impact both silver, and, to a lesser extent platinum, they are not significant when it comes to the palladium market. Bullish Fundamentals Tightened Palladium Market Palladium registered a 60% gain in 2017. Its forward curve has been backwardated since June (Chart 3). This backwardation - i.e., spot prices trade higher than deferred prices - is a symptom of a tight market. In fact, according to Thomson Reuters GFMS data, the palladium market has been in a chronic deficit since 2007, with the 2017 deficit the largest since 2000. The culprit in this case has been strong demand and stagnant supply. While supply has been growing ~ 1% year-over-year (yoy) over the past 5 years, demand growth has averaged 1.7% yoy over the same period. Palladium demand over this period has been driven by its growing use in automobile catalytic converters, most notably in China, where sales of gasoline-powered cars exceed those of diesel-powered cars, which typically use platinum in their catalytic converters (Chart 4). Chart 3Tight Fundamentals In##BR##The Palladium Market Chart 4Growing Demand For##BR##Autocatalysts Dominated In The Past... Growth in global demand for palladium-based autocatalysts averaged 4.8% yoy in the past 5 years. The use of palladium for autocatalysts now makes up more than 75% of global palladium demand, up from 56% 10 years ago. Chinese demand for palladium used in autocatalysts grew from 10% of global demand in 2007 to more than a quarter of global demand last year. Given autocatalysts' oversized contribution to demand growth, the palladium market is highly dependent on car sales. Our modelling highlights global car production as a significant explanatory variable when it comes to palladium prices. Most significant are the U.S. and Chinese markets, which are the largest markets for gasoline-powered cars. While vehicle sales in China were strong in 2016, they have slowed considerably and recorded yoy declines in the most recent November and December data (Chart 5). Slowing demand growth for cars in China likely comes on the back of the phasing out of tax cuts on small vehicles. This will limit the upside for palladium prices from China's industrial demand. Growth in car sales in the U.S. has been even more muted, contracting in 2017 for the first time since 2009. However, a more concerted adoption of gasoline-powered cars in Europe - largely in response to efforts by cities to reduce emissions of particulate matter from diesel engines, and the highly publicized emissions-testing scandals involving European carmakers - will, at least partially, mitigate the negative impact of slowing demand from the top two gasoline-powered markets. On the supply side, global mine supply has been relatively stagnant over the past 5 years, expanding an average 1.2% yoy during this period. Russia, South Africa and Canada account for almost 90% of total palladium mine supply. And while Russian and South African supplies have been relatively flat over the years, Canadian palladium has grown to account for ~11% of global supply in 2017, up from 4% in 2010. Global palladium supply has been supported by metal recovered from autocatalyst scrap, which has been averaging 4.8% yoy growth in supply over the past 5 years. In fact, the share of palladium recovered from autocatalyst scrap has almost doubled in the past 10 years, and now makes up almost 20% of total supply. Growth in this source of supply has come down significantly (Chart 6). However, we expect palladium's exorbitant price and elevated steel prices to incentivize an increase in the metal's recovery from scrap. Indeed, GFMS expects recycled palladium to pave record highs this year and to surpass 2 million ounces next year. Chart 5...But Beware Of Slowing Gasoline Car Sales Chart 6Palladium Needs Restocking Strong demand, combined with limited supply growth, has weighed on palladium inventories. Furthermore, ETF holdings of palladium have come down sharply while net speculative long positions have skyrocketed. Given that stocks are so low, we do not expect a severe fall in prices. Bottom Line: Palladium behaves like an industrial metal and is especially sensitive to changes in demand for automobiles. While the stars were aligned for palladium last year - a weak USD, low real interest rates, and bullish fundamentals - car sales in the U.S. and China have been slow recently. Even so, a physical deficit will prevent a crash in the palladium market this year. Platinum Trading At A Discount To Palladium In contrast with palladium's remarkable performance last year, platinum was up a mere 3.4% in 2017. In fact palladium, which usually trades at a discount to platinum, has been more expensive since October (Chart 7). This can be attributed to differences in fundamentals. Palladium's market conditions have been significantly tighter than platinum. Greater demand for the physical metal than supply put the market in deficit last year, which supported platinum prices. As with palladium, catalytic converters are a major demand source for platinum; however, they account for ~ 40% of platinum demand - considerably less than the roughly 80% share of palladium demand accounted for by catalytic converter demand. Europe is the largest market for diesel cars, and, while total vehicle sales in Europe have remained healthy, diesel-powered cars have been losing market share since the Volkswagen emissions-rigging scandal came to light in 2015 (Chart 8). This hit platinum use in autocatalysts particularly hard. In addition, weaker demand from its second use - jewelry - is keeping a lid on platinum prices (Chart 9). In fact, Chinese demand for the white metal, which accounts for more than 50% of global platinum jewelry demand, has been falling. Despite weakening demand, global balances remained in deficit on the back of muted supply. Chart 7Platinum Now Cheaper Than Palladium Chart 8EU Diesel Car Market Losing Momentum Chart 9Platinum Jewelry Losing Its Appeal Platinum's market balance could be at risk if carmakers start using more of it in catalytic converters, now that it trades at a discount to palladium. Platinum is a superior material for autocatalysts, but palladium has been traditionally favored on a cost basis. Platinum's lower price incentivizes carmakers to switch to this metal. According to Johnson Matthey, it will be two years before the impact of such substitution begins to affect the palladium market. Bottom Line: Subdued demand for platinum jewelry combined with the loss of market share for diesel-powered cars in Europe will keep a lid on the platinum market this year. However, platinum follows gold, and this could support prices if equity investors hedge market volatility and future corrections by purchasing the metal. Silver Follows Gold Silver, and, to a lesser extent, platinum are not as exposed to the industrial business cycle as palladium. These metals' prices instead move in line with gold (Chart 10). Our modeling reveals that a 1% increase in gold prices is associated with a 0.76 pp increase in silver prices. Thus gold's spillovers to the silver market are significant. Even so, there are periods when this relationship disconnects. This is because, although industrial uses do not account for as large a share of silver demand as they do for palladium, such fundamentals do account for a significant source of demand. Thus, in addition to the financial factors which drive gold, silver's industrial applications give it some exposure to economic activity. In fact, a 1% increase in the CRB Metals Index is associated with a 0.17pp increase in silver prices. This explains why, in some instances, silver's cointegration with gold weakens. As a practical matter, gold is a superior hedge against equity downfalls than silver (Chart 11). While gold month-on-month (mom) returns outperform S&P 500 mom returns almost 80% of the time in periods of decreasing equity returns, the ratio for silver comes in at a lower 67%. On the other hand, gold mom returns outperform S&P 500 returns less than 30% of the time during periods when equities are increasing, while silver outperforms the stock market almost 40% of the time. Chart 10Silver And Gold##BR##Move In Tandem Chart 11Gold Outperforms Amid Equity Downfalls,##BR##Not During Rising Stocks In addition, although both gold's and silver's correlations with the S&P 500 become large and negative when the S&P 500 decreases in yoy terms, this negative correlation in the case of gold is significantly larger than for silver (Chart 12). In fact, along with silver's relatively weaker negative correlation with the S&P 500 during periods of negative equity returns, silver also exhibits a relatively stronger positive correlation with equities during periods of positive returns. While silver is an effective hedge against geopolitical and economic crises, gold's hedging ability remains superior (Chart 13). Silver and gold post similar returns during geopolitical crises; however, gold returns are significantly higher during economic crisis. Chart 12Negative Correlations More##BR##Pronounced During Equity Downfalls Chart 13Gold Is A##BR##Superior Protection This supports the finding that silver's hedging ability is hampered by its use in industrial applications, which make it more responsive to the business cycle than gold. Bottom Line: Gold and silver prices are cointegrated. However, given silver's industrial applications, it is more sensitive to business activity. This explains the periods of divergence in the two precious metals, and limits silver's ability to hedge against economic crises and falling equities. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 For a discussion of the gold market fundamentals, please see Commodity & Energy Strategy Weekly Report titled "Gold Still Shines Despite Threat Of Higher Rates," dated February 1, 2018. Available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds on a global scale. Hence, the risk is that financial market distortions will infect the economy, not the other way round. A global mini-downturn in the first half of 2018 is now all but guaranteed. High conviction equity sector recommendation: underweight the major cyclical equity sectors: specifically, Banks, Materials and Energy; but overweight Airlines. High conviction currency recommendation: yen first; euro second; pound third; dollar fourth. Feature Stock markets ascend by walking up the stairs, but they descend by jumping out of the window. Unfortunately, investors often misinterpret the low volatility of a market ascent as a sign that equity risk has diminished. In fact, the low volatility just tells us that walking up the stairs is a slow and dull process (Chart I-2). It tells us nothing about equity risk. Chart of the WeekA Global Mini-Downturn In H1 2018 Is Now All But Guaranteed Chart I-2Stock Markets Climb Up The Stairs, And Then Jump Out Of The Window The risk of equities, as we have just seen, is that they do periodically jump out of the window. Meaning that equities have the potential to suffer much more intense short-term losses than short-term gains. This ratio of potential losses to potential gains is technically known as negative skew. For a reminder why equity returns have this unattractive asymmetry, please revisit our Special Report 'Negative Skew': A Ticking Time-Bomb.1 That said, equity returns always possess negative skew, so there is nothing new about stock markets jumping out of the window, as they have this week. Persistent QE, ZIRP And NIRP Have Created A Severe Financial Distortion The much bigger story is that persistent QE, ZIRP and NIRP2 have imparted negative skew on bond returns too. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Approaching this lower bound for yields, bond prices have diminishing upside with increasing downside (Chart I-3). So at low bond yields, mathematics necessarily forces bond markets also to walk up the stairs and then jump out of the window (Chart I-4 and Chart I-5). Chart I-3Approaching The Lower Bound For Yields, Bond Prices ##br##Have Diminishing Upside With Increasing Downside Chart I-4In A Low Yield Era, Bond Markets ##br##Also Climb Up The Stairs... Chart I-5... And Then Jump Out ##br##Of The Window As the risk of owning 10-year bonds has increased to become 'equity-like', it has removed the requirement for an excess return, a risk premium, on equities. In other words, persistently ultra-accommodative monetary policy has diminished the prospective 10-year annual return on global equities to become 'bond-like', collapsing from 9% in 2012 to 1.5% today - exactly the same rate of return that is now offered by the global 10-year bond (Chart I-6). In effect, persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds. Chart I-6Equities' Prospective Returns##br## Have Become 'Bond-Like' However, as we explained last week in Beware The Great Moderation 2.0,3 the nose-bleed valuation of the world stock market is justified only as long as bond yields stays low. Above a 2% yield, the payoffs offered by bonds gradually lose their negative skew and thereby become less risky than those offered by equities. So equities must once again compensate by offering an excess prospective return, necessitating a derating of today's elevated valuations. Specifically, we wrote that the big threat to equity valuations "comes from the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1% or the U.S. 10-year T-bond yield rising to 3%." To which one client responded "markets do not respect round numbers... if the trigger-point is 3%, then you must act well before that." Wise words indeed. The U.S. 10-year T-bond yield got as far as 2.88% before triggering a reversal in equity valuations. Financial Distortions Threaten The Real Economy Chart I-7Financial Conditions 'Easiness' Is Just ##br##Tracking The Stock Market Many people naturally assume that the economy drives the financial markets. This may be true some of the time, or even most of the time. But in the last three downturns, the causality ran the other way round - financial market distortions dragged down the economy. The bursting of the dot com bubble triggered the downturn in 2001; the large-scale mispricing of U.S. mortgages caused the Great Recession in 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession in 2011. Which begs the question: is there a financial distortion or mispricing that could once again drag down the economy? The answer is an emphatic yes. To repeat, six years of persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds on a global scale, compressing the prospective 10-year annual return on world equities from 9% to 1.5%.4 Thereby, equity returns which would have accrued in the future have been brought forward to the here and now in the form of elevated capital values. But if higher bond yields correct the severely distorted valuation relationship between equities and bonds, the effect will be to move these returns from the present back to the future, depressing capital values today. Now note that while world GDP is worth around $80 trillion, the combination of equities and correlated risk-assets such as corporate and EM debt is worth double that, around $160 trillion, and real estate is worth $220 trillion. If returns from these richly valued asset-classes are redistributed from the present back to the future, through lower capital values today, there is a very real risk that current spending could take a hit. Supporting this broad thesis, central bank measures of 'financial conditions easiness' just track tick for tick the level of the stock market (Chart I-7). What To Do Now The upturn in bond yields which started last summer threatens to impact activity through two separate channels. As just discussed, the first is the financial market channel via a setback to global risk-asset capital values. The second is the bank credit channel. Changes in the bond yield very clearly and reliably lead changes in credit flows, the credit impulse, by 6 months. Therefore, the rise in bond yields is only now starting to pull down the credit impulse - and thereby the global activity mini-cycle, which is the all-important driver of mainstream European investments. It follows that a global mini-downturn in the first half of 2018 is now all but guaranteed (Chart of the Week). And that the higher that bond yields go from here, the more marked this mini-downturn will be. This reinforces two high conviction investment recommendations. First, it is now appropriate to underweight cyclical equity sectors: specifically, Banks, Materials and Energy. Against this, the one cyclical sector to upgrade to overweight is Airlines, given the sector's negative correlation with the oil price. Second, the payoff profile for exchange rates is just tracking expected long-term interest rate differentials (Chart I-8). This means that when the expected interest rate is close to the lower bound, the currency possesses a highly attractive payoff profile called positive skew. In essence, for any central bank already at the realistic limit of ultra-loose policy - such as the BoJ and ECB - the direction of policy rate expectations cannot go significantly lower. Conversely, tightening expectations for the Federal Reserve are approaching a magnitude that threatens either risk-asset prices and/or economic growth. So these expectations cannot go significantly higher (Chart I-9). Chart I-8Exchange Rates Are Tracking Long-Term ##br## Interest Rate Differentials Chart I-9Expected Interest Rates In The Euro Area And ##br##U.S. Will Converge One Way Or The Other On this basis, we reiterate our high conviction pecking order for currencies in 2018. Yen first; euro second; pound third; dollar fourth. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'Negative Skew: A Ticking Time-Bomb', July 27 2017 available at eis.bcaresearch.com. 2 Quantitative Easing, Zero Interest Rate Policy and Negative Interest Rate Policy. 3 Please see the European Investment Strategy Weekly Report, 'Beware The Great Moderation 2.0', February 1 2018 available at eis.bcaresearch.com. 4 This 1.5% forecast comes from regressing the world equity market to GDP multiple through 1998-2008 with subsequent 10-year returns, observing a very tight relationship, and then using the same relationship on current world equity market cap to GDP. Fractal Trading Model* This week's recommended trade is to go long utilities versus the market. The profit target is 3.5% outperformance with a symmetrical stop-loss. It was an excellent week for our other trades with short palladium hitting its 6% profit target, while underweight Japanese energy and long USD/ZAR are both in comfortable profit. 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