Monetary

Highlights Global Yields: Flattening government yield curves in the developed world have raised concerns about a potential future growth slowdown. Yet real policy rates will need to move into positive territory before monetary policy becomes truly restrictive and curves invert. This means global bond yields have not yet peaked for this cycle. UST-Bund Spread: The U.S. Treasury-German Bund spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). UST Technicals: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains bearish. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Feature In most years, investment professionals can look forward to taking some well-deserved time off in July to hit the beach and read a good book. This year, those same investors are forced to keep an eye on their Bloombergs while responding to the public musings of Donald Trump. The president made comments late last week that threatened the independence of the Federal Reserve, while also accusing China and Europe of currency manipulation. While those headlines can briefly move markets on a sunny summer day, they represent more Trump-ian bluster than any potential change in the conduct of U.S. monetary or currency policy. Chart of the WeekCan Policy Be Truly "Tight"##BR##With Negative Real Rates? The underlying dynamic remains one of mixed global growth (strong in the U.S., slowing almost everywhere else) but with low unemployment and rising inflation in most major economies. That means that independent, inflation-fighting central bankers must focus on their inflation mandates. In the U.S., that means more Fed rate hikes and a firm U.S. dollar, regardless of the desires of President Trump - the author of the large fiscal stimulus, at full employment, which is forcing the Fed to continue hiking rates. In other countries, however, the economic backdrop is leading to varying degrees of central banker hawkishness. That ranges from actual rate hikes (Canada) to tapering of bond buying (Europe, Japan) to merely talking up the potential for rate increases (U.K., Sweden, Australia). The aggregate monetary policy stance of the major developed market central banks is now tilted more hawkishly. So it is no surprise that global government bond yield curves have been flattening and returns on risk assets have been underwhelming (Chart of the Week). Yet the reality is that all major global curves still have a positive slope, even in the U.S. and Canada where central banks have been most actively tightening, while real policy interest rates remain below zero. It would be highly unusual for yield curves to invert before real rates turned positive, especially if central bankers must move to an outright restrictive stance given tight labor markets and rising realized inflation. This implies that there is more scope for global bond yields to rise over the next 6-12 months. We continue to recommend that investors maintain a defensive overall duration stance ... and to focus more on that good book on the beach and less on Trump's Twitter feed. Where To Next For The Treasury-Bund Spread? Chart 2A Pause In The Rising Yield Trend,##BR##Not A Reversal The rise in bond yields in both the U.S. and euro area seen in the first quarter of 2018 has been partly reversed since then. One of the culprits has been a stalling of the rally in oil markets, which has prompted a pause in the rise of inflation expectations on both sides of the Atlantic (Chart 2). Yet another factor has been the larger decline in real bond yields, which have fallen around 20bps in the both the U.S. and euro area since the peak in mid-May (bottom two panels). A potential driver of those lower real yields is the growing concern over the potential hit to global growth from rising trade tensions between the U.S. and China (and Europe, Canada, Mexico, etc). This comes at a time when China's economic growth was already slowing and acting as a drag on global trade activity and commodity prices. There has been significant weakness in China's currency and equity market of late, which raises the specter of another broader global selloff as occurred during the Chinese turbulence of 2015/16. Yet the declines in industrial metals prices and emerging market corporate debt have been far more modest so far in 2018 (Chart 3). A big reason for that has been the more subdued performance of the U.S. dollar this year, unlike the massive surge in 2015/16 that crushed risk assets worldwide (Chart 4). A more likely driver of the recent drop in real yields in the U.S. and core Europe was the slump in euro area economic data earlier in 2018. That move not only drove yields lower, but also pushed out the market-implied timing of the first ECB rate hike (Chart 5) and drove the spread between U.S. Treasuries and German Bunds to new wides. In our last Weekly Report, we updated our list of indicators in the U.S. and euro area that we have been monitoring to assess if our below-benchmark duration stance was still appropriate.1 The conclusion was that the underlying trends in growth and inflation on both sides of the Atlantic still supported higher bond yields on a cyclical basis, although the pressures were greater in the U.S. Yet at the same time, the gap between U.S. and euro area government bond yields has remained historically wide, with the 10-year Treasury-German Bund spread now sitting at 255bps - the highest level since the late 1980s. Chart 3Slowing Growth##BR##In China... Chart 4...But Not Yet Enough To Threaten##BR##Global Financial Stability Monetary policy differences have historically been the biggest driver of that spread. Today, the Fed is well into an interest rate hiking cycle that began nearly three years ago, and is now in the process of unwinding its balance sheet. Meanwhile, the ECB has been keeping policy rates at or below 0% while engaging in large-scale bond buying (Chart 6). Chart 5A Turn In European Yields##BR##On The Horizon? Chart 6Wide UST-Bund Spread Reflects##BR##Monetary Policy Divergences When looking at more typical fundamental drivers of the Treasury-Bund spread, many of the cross-regional differences are already "in the price". The spread appears to have overshot relative to the three main factors that go into our Treasury-Bund spread valuation model (Chart 7): The gap between Fed and ECB policy rate The ratio of the U.S. unemployment rate to the euro area equivalent The gap between headline inflation in the U.S. and euro area The Fed's rate hikes have now widened the policy rate differential versus the ECB equivalent (the short-term repo rate) to 200bps. At the same time, the rapidly improving situation in the euro area labor market now means that the unemployment ratio has been constant over the past couple of years, while euro area inflation has also caught up a bit toward U.S. levels in recent months. Adding it all up together in our Treasury-Bund valuation model - which also includes the sizes of the Fed and ECB balance sheets to quantify the impact on yields of bond-buying programs - and the conclusion is that the current spread level of 255bps is 50bps above "fair value" (Chart 8). Chart 7UST-Bund Spread Overshooting Fundamentals Chart 8UST-Bund Spread Looks Wide On Our Model Importantly, fair value is still rising, primarily because of the widening policy rate differential. We have consistently argued that the true cyclical peak in the Treasury-Bund spread will occur when the Fed is done with its rate hike cycle. Yet there are opportunities to play that spread more tactically, based on shorter-term indicators. For example, the gap between the data surprise indices for the U.S. and euro area has been a correlated to the momentum of the Treasury-Bund spread, measured as the 13-week change of the level of the spread (Chart 9). Data surprises are now bottoming out in the euro area while they continue to drift lower in the U.S. As a result, the Treasury-Bund spread momentum has begun to fade, right in line with the narrowing of the data surprise differential. Also from a more technical perspective, the deviation of the Treasury-Bund spread from its 200-day moving average is at one of the more stretched levels of the past decade. Combined with the extended spread momentum, this suggests that the Treasury-Bund spread should expect to see a period of consolidation in the next few months (Chart 10). Chart 9Relative Data Surprises No Longer##BR##Support A Wider UST-Bund Spread Chart 10UST-Bund Spread Momentum##BR##Got To Stretched Extremes We have been recommending both a structural short U.S./long core Europe position in our model bond portfolio for over a year now. We also entered into a trade that directly played for a wider 10-year Treasury-Bund spread in our Tactical Trade portfolio. We initiated that recommendation on August 8th, 2017 when the spread was at 162bps. With the spread now at 255bps, we are now closing out that recommendation this week, taking a profit of 7% (inclusive of the gains from hedging the Bund exposure into U.S. dollars).2 At the same time, we feel that it is too early to position for a narrowing of the Treasury-Bund spread. The large U.S. fiscal stimulus will continue to put upward pressure on U.S. bond yields over the next year, both through higher U.S. inflation and the associated need for tighter Fed policy. Already, the Treasury-Bund spread reflects both the relatively larger dearth of spare capacity in the U.S. economy (Chart 11) and the expected widening of the U.S. federal budget deficit compared to reduced deficits in the euro area (Chart 12). Much like the rise in the fair value of the Treasury-Bund spread, this suggests that there is limited downside for the spread on a more medium-term basis. Chart 11UST-Bund Spread Narrowing Will Be##BR##Limited By Faster U.S. Growth... Chart 12...The Result Of Looser##BR##U.S. Fiscal Policy We are taking profits on our tactical spread based on our read of all of our relevant indicators. There is a good chance, however, that we could consider re-entering a spread widening trade on any meaningful narrowing of the spread or adjustment in our indicators. Bottom Line: The fundamental drivers of the 10-year U.S. Treasury-German Bund spread continue to point to the spread staying wide over the next 6-12 months. Yet the spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). A Quick Update On U.S. Treasury Market Technicals One of the overriding aspects of the U.S. Treasury market over the past few months has been the stretched technical backdrop. The combination of oversold price momentum, bearish sentiment and aggressive short positioning have helped keep yields in check, even as U.S. growth and inflation accelerate and the Fed continues to signal more future rate hikes. Back in March, we presented a study of previous episodes of an oversold U.S. Treasury market since the year 2000.3 Our goal was to determine how long it typically took for a resolution of oversold Treasury market conditions. Unsurprisingly, we concluded that the longest episodes of oversold Treasuries occurred when U.S. economic growth and core inflation were both accelerating, and vice versa. At the time of that report, all of the technical indicators that we looked at were signaling that Treasury bearishness was deeply entrenched (Chart 13). Now, four months later, there has been some change in those indicators: Chart 13UST Technical Indicators##BR##Are More Mixed Now The 10-year Treasury yield relative to its 200-day moving average: then, +43bps; now, +18bps The trailing 26-week total return of the Bloomberg Barclays U.S. Treasury index: then, -4.3%; now, -0.6% The J.P. Morgan client survey of bond managers and traders: then, very large underweight duration positioning; now, positioning is neutral The Market Vane index of bullish sentiment for Treasuries: then, near the bottom of the range since 2000; now, still near that same level The CFTC data on speculator positioning in 10-year U.S. Treasury futures: then, a large net short of -8% (scaled by open interest); now, still a large net short of -11%. Therefore, the message from the technical indicators is more mixed now than in March. Price momentum and duration positioning is now neutral, while sentiment and speculative positions remain stretched. The former suggests that there is scope for Treasury yields to begin climbing again, while the latter implies that there may still be room for some counter-trend short-covering Treasury rallies in the near term. In our March study, we defined the duration of each episode of an oversold Treasury market by the following conditions: The start date was when the 10-year Treasury yield was trading at least 30bps above its 200-day moving average and the Market Vane Treasury bullish sentiment index dipped below 50; The end-date was when the yield declined below its 200-day moving average. The details of each of those episodes can be found in Table 1. This is the same table that we presented back in March, but we have now added the current episode. At 150 days in length, this is already the fourth longest period of an oversold Treasury market since 2000. Yet perhaps most surprising is the fact that Treasury yields are essentially unchanged since the start date of the current episode (March 20th, 2018). There is no other period in our study that where yields did not decline while the oversold market resolved itself. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market Perhaps this can be interpreted as a sign that there is still scope for a final short-covering Treasury rally before this current oversold episode can truly end. Yet as we concluded in our March study, it took an average of 156 days for an oversold market to be fully corrected if U.S. growth was accelerating (i.e. the ISM manufacturing index was rising) and core PCE inflation were both rising at the same time - as is currently the case (Chart 14). Chart 14U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing The longest such episode in 2003/04 lasted for 203 days before the 10-year yield fell below its 200-day moving average. Yet the second longest episode (196 days) occurred in 2013/14, and Treasury yields ended up climbing to a new cyclical high before eventually peaking. Given the underlying positive momentum in both U.S. economic growth and inflation, but with a mixed message from the technical indicators, we suspect that this current oversold episode may have further to run. Yet as we concluded back in March, and still believe today, it will prove difficult to earn meaningful returns betting on a counter-trend decline in yields this time, as any such move will likely be modest in size and lengthy in duration. Bottom Line: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains very bearish and there are large speculative short positions. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Trendless, Friendless Bond Market", dated July 17th 2018, available at gfis.bcaresearch.com. 2 The return on this trade is calculated using the Bloomberg Barclays 7-10-year government bond indices for the U.S. and Germany, adjusted for duration differences between the indices. The German return is hedged into U.S. dollars, as this trade was done on a currency-hedged basis. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering From Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Many investors remain overweight equities; BCA recommends a neutral stance. Investors should position portfolios for rising rates. Fed Chair Powell weighed in last week on yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. More evidence of trade policy-related uncertainty, rising labor costs and deteriorating margins in the latest Beige Book. Feature The S&P 500 finished the week little changed, as investors braced for a wave of Q2 earnings reports this week and next. The S&P financials sector, which tends to lead the overall market, rose more than 1% last week, as the banks reported healthy Q2 results. The dollar sold off late last week after President Trump grumbled about the Fed's rate policy. BCA's view is that Fed Chair Powell will ignore Trump's comments on monetary policy and adhere to the central bank's mandate of low and stable inflation and full employment. Gold fell 1% on the week. BCA recommends monitoring the price of gold for clues about the neutral rate of interest. Fed Chair Powell's semiannual policy testimony to Congress dominated the headlines last week. Powell discussed trade policy, the yield curve, the neutral rate and financial stability. The week's economic data was robust, suggesting that Q2 GDP will be well above the Fed's view of potential GDP. Housing starts were soft in June, but the weakness was due to supply issues, not tepid demand. Widespread supply constraints were prevalent in the Fed's latest Beige Book. The strong economic data, along with a 23-year high in the number of inflation words in the Beige Book pushed the 10-year Treasury yield up 6 bps to 2.88%. BCA's U.S. Bond Strategy team notes that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%. In late June, BCA downgraded its 12-month recommendation on global equities and credit from overweight to neutral. We still expect that the U.S. stock-to-bond ratio will grind higher in the next year, as U.S. stocks move sideways and Treasury yields climb. We recommend that investors put proceeds from the sale of equity positions into cash. Not all investors are being risk averse. The National Association of Active Investment Managers (NAAIM) says that active managers have increased their equity risk tolerance since the start of the year (Chart 1). At 89%, the average exposure of institutional investors is close to the cycle high reached in March 2017, which was the greatest since the S&P 500 zenith in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated (Chart 2). Moreover, the asset allocation survey from AAII shows that investors' allocation to equites (at 69% in June) are in line with the 2007 market top (Chart 3). However, equity holdings based on this survey were higher before the peak in equity prices in 2000. Moreover, consumers' expectations for stock price returns in the next 12 months remain close to cycle highs (U of Michigan) and near 24-year extremes based on the Conference Board surveys (Chart 4). Despite the optimism, individual sentiment toward equities remains muted in some surveys (Chart 4, panel 3). Chart 1Active Managers Have Increased Equity Exposure This Year Chart 2Equity Speculation##BR##Is Elevated Chart 3Equity Allocations##BR##On The Rise... Chart 4Households Expect Higher Stock##BR##Prices In The Next 12 Months Individuals, banks and other financial institutions hold more equities today than at the height in 2007. However, insurance companies and pension funds' holdings of equites are not as elevated as they were in 2007 (Table 1). Somewhat surprisingly, households' cash positions are below the 2007 level and at a cycle low. However, the cash positions of financial institutions are four times as large as in 2007, partly due to the Fed's vigilance on financial stability. Pension funds and insurance companies have roughly the same allocation to cash today as earlier in the cycle (2012) and in 2007, just before the financial crisis. Table 1Asset Allocation: Comparison With Early 1990s Bottom Line: BCA's view is that the risk/reward balance for holding equities is much less attractive than it was at the start of the bull market in 2009. The economy is in the late stages of an expansion and is running beyond full employment. The Fed is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (not shown). The good news is already priced into the equity market. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early in 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily moving our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months. This shift would also be favored if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. 10-Year Treasuries: An Update BCA's U.S. Bond Strategy service recommends that investors remain below benchmark in duration. However, at 2.84%, the 10-year Treasury yield is 27 bps below its 2018 zenith of 3.11%, which was reached in mid-May. Chart 5 shows that the drop in yields since that time reflects both slower economic growth prospects and weaker inflation. Investors are concerned about the impact of Trump's trade policies on global growth and those fears have been stoked by the recent run of poor economic data in the U.S. Oil prices and inflation breakevens moved up in tandem earlier this year, and both are currently rolling over (not shown). U.S. inflation is back to the Fed's 2% target and the central bank remains on course to raise rates two more times in 2018 and another four times next year. The market is pricing in only three more hikes in the next 18 months. The economy is at full employment. Moreover, at 3.6%, the average of the New York Fed and Atlanta Fed's Nowcasts for Q2 GDP growth implies that the GDP expanded well above the Fed's projection of potential GDP (1.8%) in the first half of the year (Chart 6). Moreover, the lagged effect of easier financial conditions suggests that GDP growth in the second half of the year will also be far above potential (Chart 7). Chart 5Inflation Breakevens##BR##Rolling Over Again Chart 6U.S. Economy Poised For Above##BR##Potential Growth in 2018 Inflation breakevens (Chart 5) are falling again despite mounting inflation pressures. The New York Fed's Underlying Inflation Gauge (Chart 8, panel 4) climbed to 3.33% in June, its highest point since 2005. Moreover, wage inflation is trending up and the economy is beset with shortages and constraints.1 Chart 7Lagged Effect Of Easier Financial##BR##Conditions Will Boost Growth Chart 8Inflation Is##BR##Accelerating Bottom Line: Investors should position their portfolios for escalating rates. Global growth should bottom in the second half of the year and the U.S. economic activity reports will begin to outpace lower expectations. Moreover, with inflation at the Fed's target and mounting, inflation breakevens will adjust upward. BCA's position is that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current forward rates.2 Leading The Way S&P Financials provide a long lead time for market peaks. Table 2 shows that since the mid-1970s, a peak in the Financials sector relative to the S&P 500 occurs an average of 16 months before a peak in the overall index. The Bank (Industry Group) sector provides a similar warning (18 months), while the Investment Banking index's relative performance peaks 20 months before the S&P 500 tops out (Chart 9). Note that the leads times are slightly shorter in the last 15 years than in the 1976-2000 period (Table 2). Table 2Financial Stocks' Relative Performance Provides Early Warning Of Market Tops Chart 9Financials Lead The Broad Market In a recent report,3 BCA's U.S. Equity Strategy service noted that cyclicals and interest rate-sensitive sectors, including financials, perform well when U.S. fiscal policy is loose and monetary policy is tight. Furthermore, our equity strategists found that rising rates boost top-line growth for banks, while the impact of fiscal stimulus via lower taxes should support business and consumer demand for capital. Moreover, our U.S. Equity Strategy team examined sector performance in late cycles, defined as the period between the peak in the ISM Manufacturing Index and the next recession.4 Financials outperform the S&P 500 in late-cycle environments; in the early stages (peak in the ISM's index to peak in the S&P 500) financials underperform the broad market, but they outperform after the peak in the S&P 500 and the next recession. Bottom Line: Our equity strategists recommend that investors remain overweight financials relative to the S&P 500. The late-cycle environment, along with the favorable regulatory climate, suggest that financials still have some room to run. The implication is that the peak in the overall U.S. equity market is still over a year away. Until then, the Fed will continue to remain vigilant on the financial sector and financial stability. Staying The Course At his semiannual Congressional testimony last week, Fed Chair Powell reaffirmed that the Fed will maintain its gradual pace of rate hikes. Following his presentation, Powell met with legislators and discussed the yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. Powell repeated his June statement that the yield curve can be considered an indicator of monetary stance. Like Powell, BCA's position is that a steep curve signals that policy is stimulative and short-term rates will need to climb. The opposite holds if the yield curve inverts. A flat yield curve indicates that the policy stance is neutral. The 2/10-year curve has flattened to about 25 bps. Our view is that if the curve inverts with a few more Fed rate hikes, it would suggest that the neutral rate is lower than what the Fed believes and policy is becoming restrictive. Furthermore, BCA's U.S. Bond Strategy team anticipates that curve flattening will occur as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations at a higher level. On tariffs, Powell stated that "in general, countries that have remained open to trade, that haven't erected barriers including tariffs, have grown faster. They've had higher incomes, higher productivity." He added that more and broader tariffs are bad for the economy. Furthermore, Powell said that the FOMC has not yet seen evidence that the trade uncertainty has affected wages, but he noted that the central bank is concerned that capital spending plans may be at risk. The latest Beige Book (see next section of this report) finds that the business community is increasingly apprehensive about trade policy. BCA's Geopolitical Strategy service anticipates that trade-related uncertainty will remain in place at least until the U.S. mid-term elections in November.5 BCA views financial stability as a third mandate for the central bank,6 along with low and stable inflation, and full employment. Powell stated last week that financial stability vulnerabilities were "moderate right now," but he remarked that "we keep our eye on that very carefully after our recent experience." Chart 10 presents several indicators that the FOMC uses to assess financial vulnerabilities. Powell acknowledged the prominent status of financial stability when asked about the Fed's role. The central bank's Monetary Policy Report,7 released on July 13, has an entire section dedicated to financial stability. Powell spoke about the shape of the yield curve, saying it can relay a message about longer run neutral interest rates. BCA also recommends monitoring the price of gold for clues about the neutral rate of interest. Chart 11 shows that when the Fed funds rate is above its neutral or equilibrium rate, the 2/10 curve is flat (panel 3). Moreover, gold tends to appreciate when the stance of monetary policy is more accommodative and then the metal depreciates when the stance becomes more restrictive (panel 4). The steep decline in the gold price between 2013 and 2016 preceded downward revisions to the Fed's estimate of the neutral rate. An upside price breakout would signal that we should bump up our estimate of the neutral rate. Conversely, a large decline in gold prices would imply that monetary policy is turning restrictive. Gold prices recently headed lower. Chart 10FOMC Is Closely Monitoring##BR##Financial Stability Chart 11The 2/10 Curve,##BR##Gold And The Neutral Rate Bottom Line: The Fed will continue with gradual rate hikes until it believes policy has returned to near neutral. The yield curve and gold will help to indicate when that point is reached. Widespread Chart 12Inflation Words At A 23 Year High The Beige Book released last week ahead of the FOMC's Jul 31-August 1 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in June and July. The Fed's business and banking contacts mentioned either tariffs (31) or trade policy (20) a total of 51 times, an increase from 34 in May and 44 in April. In March, as President Trump announced the first round of proposed tariffs, there were only three mentions of trade or tariff-related uncertainty. Moreover, uncertainty arose nine times in July (Chart 12, panel 4); all were related to trade policy. A recent study by the Federal Reserve Bank of St. Louis8 found that GDP per capita, wages and the investment-to-GDP ratio, all decline after tariffs are implemented (Chart 13). The study covered tariffs in 14 countries from 1980 through 2016. Importantly, the researchers noted that while the data showed that past tariff increases are followed by persistent decreases in economic activity, this evidence does not necessarily mean that higher tariffs triggered these changes. It is possible that other economic events may have driven tariff increases and ensuing recessions. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book, despite the recent rise in the greenback. The report also finds widespread concern about profit margins. Chart 12, panel 2 shows that at 81% in July, BCA's Beige Book Monitor ticked up from May's 67% reading. The July reading was the highest since early 2016. The recent low in November 2017 at 53% was when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book hit an 18 -year low in July. On the other hand, the number of strong words climbed in July to a 30-month high. The 2017 Tax Cut and Jobs Act was noted 5 times in the latest Beige Book, up from 3 in May, but still far below 15 mentions in March and 12 in April. The legislation was cast in a positive light in three of the five mentions. The implication is that most of the good news related to the tax bill has already been discounted by businesses. BCA's stance is that the dollar will move up modestly in 2018. The trade-weighted dollar has climbed by 6% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the handful of references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be a meaningful issue for corporate profits in Q2 2018. We will provide an update on Q2 S&P 500 earnings in next week's report. The dearth of recent dollar references is in sharp contrast with a flood of comments during 2015 and early 2016 (Chart 12, panel 3). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The disagreement on inflation between the Beige Book and the Fed's preferred price metric widened in July as the number of inflation words surged (Chart 12, panel 1). Mentions of inflation in July's Beige Book were the greatest since at least 1995. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that core PCE may still rise. Chart 13The Economic Consequences Of Trade Wars Moreover, July's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. Furthermore, several districts stated that a lack of workers was impeding growth. In addition, "widespread", which is part of BCA's inflation word count, was used 14 times in July to describe both labor shortages and swelling input costs, up from 11 times in May. We discussed the impact of escalating labor and input costs on margins in last week's report.9 The Beige Books released this year suggest that concerns about deteriorating margins is more prevalent in 2018 versus 2017. Only 57% of comments about margins in the first five Beige Books of 2017 noted deteriorating margins. In the 2018 Beige Books, 85% of references to margins indicated concern about higher labor, interest and raw materials costs. Bottom Line: July's Beige Book supports our stance that rising inflation pressures will result in at least two more Fed rate hikes by year-end and four next year. Moreover, the Beige Book confirms that labor shortages are restraining output of goods and services in some economic sectors. Furthermore, rising input costs are pervasive and will continue to pressure corporate profit margins. BCA expects both corporate profit growth and margins to peak later this year. The nation's tax policy still gets high marks from the business community, but the impact is fading. Ongoing uncertainty over trade policy will restrain growth. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Aailable at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Bond Bear Still Intact", published June 5, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Special Report "Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening", published April 16, 2018. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Special Report "Portfolio Positioning For A Late Cycle Surge", published May 22, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," published July 24, 2017. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf 8 https://research.stlouisfed.org/publications/economic-synopses/2018/04/18/what-happens-when-countries-increase-tariffs 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Available at usis.bcaresearch.com.

Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Chart 11Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Chart 13Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The real culprit for the mushrooming U.S./euro area trade imbalance is the ECB, and specifically its post-2014 experiment with ultra-loose monetary policy. There could be a major sea-change in ECB policy after November 2019 when Draghi's Presidency ends - just as there was after the last two changes in the ECB Presidency in November 2003 and November 2011. The yield spread between 30-year U.S. T-bonds and German bunds has much more scope to tighten than to widen. The euro's undervaluation - as calculated by the ECB itself - will ultimately correct. European exporters and equity markets heavily exposed to exporters - such as Sweden's OMX - will find the going tough, one way or another. If a stronger currency doesn't hit them, then President Trump surely will. Feature Chart of the WeekThe U.S./Euro Area Trade Imbalance Is A Near-Perfect Function Of Relative Monetary Policy Here in London last week President Trump trumpeted one of his biggest gripes: "The European Union treats the United States horribly. And that's going to change. And if it doesn't change, they're going to have to pay a very big price... Last year, we lost $151 billion with the European Union. We can't have that. We're not going to have that any longer, okay?" 1 President Trump is absolutely right about the size of the U.S. trade imbalance with Europe. But he is wrong to place the blame entirely on "trade barriers that are beyond belief". At least half of the imbalance - including with Germany - has appeared since 2014 (Chart I-2). Therefore, by definition, this part of the bilateral deficit is neither a structural issue, nor about trade barriers. Chart I-2Half of Germany's Export Surplus Appeared After 2014 The Real Culprit For The Mushrooming U.S/Euro Area Trade Imbalance As we have identified on these pages many times, the real culprit for the mushrooming U.S./euro area trade imbalance is the ECB, and specifically its post-2014 experiment with ultra-loose monetary policy. This experiment has resulted in a significantly undervalued euro, which has made the euro area grossly over-competitive vis-à-vis the United States, as calculated by the ECB itself. The Chart of the Week provides the damning and incontrovertible evidence: the U.S./euro area bilateral deficit is a near-perfect function of relative monetary policy. Of course, the ECB is targeting neither the euro nor the trade imbalance; the ECB is targeting its definition of price stability. The trouble is that the ECB definition of price stability omits owner-occupied housing costs, and thereby understates true euro area inflation by 0.5 per cent. To the extent that the ECB thinks in terms of real interest rates based on its own (faulty) definition of inflation, this means that the ECB is setting real interest rates that are far too low for the euro area's true economic fundamentals, resulting in the significantly undervalued euro and the associated trade imbalance (Chart I-3 and Chart I-4). Chart I-3Relative Monetary Policy Has Driven The Euro's Undervaluation... Chart I-4...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance The bilateral deficit, by definition, is based on a true cross-border comparison, so it is tracking the 'apples for apples' real interest rate differential almost tick for tick, as our charts compellingly show. This true real interest rate differential is stretched relative to the fundamentals. In effect, while incorrectly measured inflation is deceiving the ECB, the mushrooming trade imbalance tells us that something is seriously awry. That something is not trade barriers that are too high; that something is ECB monetary policy that is too loose. The Target2 Imbalance Reaches €1.5 Trillion The ECB's ultra-loose policy has spawned another huge distortion: the euro area Target2 banking imbalance, which now amounts to an unprecedented €1.5 trillion (Chart I-5). What is the Target2 imbalance (Box 1), and why should we care about it anyway? Chart I-5ECB Policy Has Lifted The Target2 Banking Imbalance To Euro 1.5 Trillion BOX 1 What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability vis-à-vis the ECB. Target2 balances therefore show the cumulative net payment flows within the euro area. The ECB has delegated its QE sovereign bond purchases to the respective national central banks within the Eurosystem. In the case of Italian bonds, Italian investors have offloaded their BTPs to the Bank of Italy and deposited the received cash cross-border in countries with healthier banking systems - like Germany. Strictly speaking, this flow of Italian investor cash to German banks is not the same as the deposit flight during the depths of the euro debt crisis in 2012. Rather, we might call it precautionary cash management. Nevertheless, in Eurosystem accounting terms it still means that the Bundesbank has a new liability to German banks denominated in 'German' euros, while the Bank of Italy has a new asset - the BTP - denominated in 'Italian' euros (Chart I-6 and Chart I-7). The Target2 imbalance is the aggregate of such mismatches between Eurosystem liabilities denominated in 'German and other core' euros and assets denominated in 'Italian and other periphery' euros. Chart I-6The Target2 Imbalance Reflects The##br## Cross-Border Flow Of Italian Investor Cash... Chart I-7...To German Banks Does any of this Target2 accounting gymnastics really matter? No, so long as a 'German' euro equals an 'Italian' euro, the imbalance is just an accounting identity within the Eurosystem. But if Germany and Italy started using different currencies, then suddenly all hell would break loose. The Bundesbank liability to German banks would be redenominated into deutschemarks, while the Bank of Italy asset would be redenominated into lira. Thereby the ECB would end up with much greater liabilities than assets, and a solvency shortfall potentially equivalent to hundreds of billions of euros would end up on the shoulders of the ECB's shareholders - largely, German taxpayers. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in recent election and referendum outcomes, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do a detailed cost benefit analysis. A Sea-Change For The ECB In 2019? Although the ECB is unlikely to broadcast the undesired side-effects of its ultra-loose policy, it must by now be acutely aware that it is spawning huge imbalances. The costs are rising while the benefits are becoming questionable. The irony is that the one euro area economy that arguably does need stimulus - Italy - has a dysfunctional banking system which makes ultra-loose monetary policy largely ineffective anyway. Despite record low interest rates through the past four years, Italian bank credit growth has been virtually non-existent (Chart I-8). As we pointed out last week in Monetarists Vs Keynesians: The 21st Century Battle, the M5S/Lega coalition government is right to say: Italy would be better off with fiscal stimulus, not monetary stimulus.2 Chart I-8Italian Banks Have Not Been Lending The ECB will end its QE purchases at the end of this year, though the central bank has promised to maintain its current constellation of negative and zero interest rates "at least through the summer of 2019". However, it might be problematic to extend this forward guidance much beyond that. This is because Mario Draghi's eight year term as ECB President ends on October 31 2019, and it would be difficult both politically and operationally to tie the steering hands of his successor, especially if he/she comes from outside the current Governing Council. Interestingly, the last two changes in the ECB Presidency marked major sea-changes in policy direction: in 2003, Jean-Claude Trichet immediately stopped the rate cutting of his predecessor, Wim Duisenberg; and in 2011, Mario Draghi immediately reversed the rate hikes of his predecessor, Trichet. We would not bet against another major sea-change at the end of 2019 (Chart I-9). Chart I-9A Sea-Change For The ECB In 2019? If the end of 2019 does mark a turning point in relative monetary policy, investors should plan for three medium-term repercussions: The yield spread between 30-year U.S. T-bonds and German bunds has much more scope to tighten than to widen. The euro's undervaluation - as calculated by the ECB itself - will ultimately correct. European exporters and European equity markets heavily exposed to exporters - such as Sweden's OMX - will find the going tough, one way or another. If a stronger currency doesn't hit them, then President Trump's vow that "they're going to have to pay a very big price" surely will (Chart I-10). Chart I-10If A Stronger Currency Doesn't Hit European Exporters, Then President Trump Surely Will! 1 At the joint press conference with Theresa May. 2 Please see the European Investment Strategy Special Report 'Monetarists Vs Keynesians: The 21st Century Battle' July 12 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to go long gold, whose 65-day fractal dimension is close to the lower bound that has reliably signaled previous tradeable trend reversals. Set a profit target of 3% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 * 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Duration Checklist: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A below-benchmark overall portfolio duration stance is still warranted - even after our recent move to downgrade spread product exposure. Canada: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Feature Chart of the WeekStagflation Keeping Yields Afloat Developed market bond yields are lacking direction at the moment, pulled by competing forces. Overall global economic activity has lost some momentum and is now less synchronized. Yet the majority of major countries in the developed world are still growing at an above-potential pace that is keeping unemployment low and slowly boosting wages. This is helping underpin inflation, both realized and expected, while keeping government bond yields elevated despite increasing concerns about the future path of the global economy (Chart of the Week). The growing worries about a potential "U.S. versus the world" trade war are weighing on growth expectations, although not yet by enough to cause a meaningful pullback in global equity markets which remain supported by current solid earnings growth. Credit spreads have increased for both developed market corporate debt, but are still at historically narrow levels suggesting that investors are not overly concerned about default/downgrade risk. Emerging market (EM) debt has seen more significant spread widening in recent months, with a stronger U.S. dollar playing a large role there, but there has been little spillover from weaker EM markets into developed market credit valuations. We recently downgraded our recommended allocation to global corporate debt to neutral, while also upgrading our weighting on government bonds to neutral. Yet we maintained our below-benchmark overall duration stance, given our view that bond markets were still underpricing the potential for faster global inflation and tighter monetary policies given the persistent underlying strength of economic growth (especially in the U.S.). In light of that change in our view, an update of one of more reliable tools over the past eighteen months - our Duration Checklist - is timely. The Duration Checklist Is Still Bearish We have maintained our strategic below-benchmark stance on duration exposure for some time now, dating back to January 2017. Shortly afterward, we introduced a list of indicators to monitor going forward to determine if that defensive duration posture on U.S. Treasuries and German Bunds was still justified.1 We called that list our "Duration Checklist", and it contains elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The Checklist is meant to be a purely objective read on the data and how it relates to the likely future path of bond yields. We last updated the Checklist back on January 30th of this year.2 The conclusion was that the underlying economic and inflation backdrop was still indicating more upside for yields on a 6-12 month horizon in both the U.S. and Europe. There was a risk, however, that the bond selloff could pause given heightened bullishness on risk assets and extremely oversold conditions in government bond markets. Since that last update of the Checklist, the 10-year U.S. Treasury yield is higher (2.86% vs. 2.72%) while the 10-year German Bund yield is lower (0.36% vs. 0.70%). Although yields in both markets did climb to even higher levels - 3.12% and 0.78%, respectively - in February and March before pulling back to current levels. As we update the Checklist once again this week, we see that the backdrop is still conducive to rising bond yields in the U.S. and Europe, but with differing risks compared to six months ago (Table 1). Note that the Checklist was designed to assess if we should maintain our duration tilt, thus we apply a checkmark ("check") to any indicator that points to potentially higher bond yields, and an "x" to any element that could signal a bond market rally. Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds Global growth momentum is decelerating. The OECD's global leading economic indicator (LEI) is in a clear downtrend, having fallen for five consecutive months (Chart 2). That weakening is broad based, as shown by the depressed level of our LEI diffusion index. The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has been falling sharply since March of this year and now sits at the lowest level since January 2012. The Citigroup Global Data Surprise index peaked at the beginning of 2018 and has fallen steadily to below zero, although it may be in the process of bottoming out. Meanwhile, our global credit impulse - a reliable leading indicator of global growth - has noticeably slowed. We are giving an "x" to all these elements of our Duration Checklist, indicating that the current "soft patch" of global growth represents a risk to the performance of our below-benchmark duration stance. U.S. growth remains solid, but Europe is cooling a bit. The U.S. economy is firing on all cylinders at the moment (Chart 3). The ISM manufacturing index is near 60, while both consumer and business confidence are above the mid-2000s peak of the previous business cycle. Corporate profits are growing around 20% and our models suggest that this trend can continue over the rest of 2018. All these indicators earn a "check" on the U.S. side of our Duration Checklist. Chart 2Global Growth Indicators Are##BR##No Longer Bond Bearish Chart 3U.S. Growth##BR##Remains Strong The growth story is mixed in the euro area, however (Chart 4). The manufacturing PMI has been steadily falling since February of this year, but still remains well above the 50 line indicating an expanding economy. Consumer and business confidence are both at cyclical highs, but the upward momentum has stalled. Corporate profits are growing at a robust pace, but our models suggest that earnings should slow over the remainder of this year. In our Duration Checklist, the momentum of the growth indicators is the relevant measure and not the level. So we are now placing an "x" on the manufacturing PMI, which is giving a clear signal on slowing growth, while maintaining a "check" next to confidence and profit growth but with a question mark given that both may be in the process of rolling over. Inflation pressures are strengthening on both sides of the Atlantic. Back in January, the inflation elements of the Checklist were providing the most mixed signals. That is no longer the case (Charts 5 & 6). Oil prices are accelerating in both U.S. dollar and euro terms, which suggests upside risks on headline inflation in the U.S. and euro area. Unemployment rates are now below the OECD estimates of full employment, and wage inflation is accelerating, in both regions. Thus, all the inflation components of our Duration Checklist earn a "check". Chart 4Is Euro Area Growth Peaking? Or Just Cooling? Chart 5U.S. Inflation Backdrop Is Bond Bearish Chart 6Euro Area Inflation Backdrop Is Bond Bearish Both the Fed and European Central Bank (ECB) are biased to tighten monetary policy. The Fed continues to signal that additional rate hikes are coming given the underlying strength of the U.S. economy and rising trend in U.S. inflation. The ECB has announced that it will taper its net new bond purchases to zero by year-end in its asset purchase program, and has provided forward guidance on the timing of a first rate hike in 2019. Both policies are credible given falling unemployment and rising core inflation rates in both the U.S. and euro area. Thus, we are keeping the "check" on both sides of the policy portion of the Checklist. Investor risk appetite has grown more cautious. This element of our Checklist was a potential headwind to our below-benchmark duration stance back in January, but is much less of an impediment to higher yields now (Charts 7 & 8). Chart 7U.S. Investor Risk Appetite##BR##Has Cooled Off A Bit Chart 8European Investor Risk Appetite##BR##Has Also Cooled Off The cyclical advances of both the S&P 500 and EuroStoxx 600 have stalled, and both indices are now back close to their 200-day moving averages, suggesting that equity markets are not overstretched (and, therefore, ripe for a correction that could drive down bond yields in a risk-off move). The VIX and VStoxx volatility indices remain at low levels, even after the spike that occurred in early February and the more modest volatility shock in the aftermath of the Italian election in May. This implies that investors still prefer owning risky assets over risk-free government bonds. These elements warrant a "check" on both sides of our Duration Checklist. Corporate bond spreads, however, have widened over the past few months, suggesting that investors are pricing in some increased uncertainty over future creditworthiness. While the overall level of spreads is still historically low, the rising trend justifies an "x" in our Checklist as a possible headwind to rising Treasury and Bund yields from waning investor risk appetite. Treasuries and Bunds are not as oversold compared to January, but large short positions remain an issue. The 10-year U.S. Treasury yield is now trading just above its 200-day moving average, while the deeply oversold price momentum seen earlier in the year has eased up a bit but remains negative (Chart 9). The combined signal is a neutral one but, in our Checklist framework, neither of these measures is stretched enough to suggest that yields cannot move higher. Thus, we are giving a weak "check" to both momentum elements on the U.S. side. There is still a large short position in 10-year Treasury futures according to the CFTC data, however, and this remains an impediment to higher Treasury yields - we are keeping the "x" for this piece of the Checklist. For Bunds, yields are now trading just below the 200-day moving average while price momentum has turned slightly positive (Chart 10). While neither indicator is stretched from an historical perspective, they are not sending a message that Bunds are oversold. Thus, we are giving a weak "check" to both technical elements on the European side of our Checklist (note that due to a lack of available data, we exclude investor positioning when evaluating the technical backdrop for Bunds). Chart 9USTs Not Oversold,##BR##But Large Short Positions Remain Chart 10Bund Technicals##BR##Are Neutral The majority of indicators in our Duration Checklist continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, we conclude that a continued below-benchmark duration stance is warranted for both markets. Not all of the news is bond bearish, however. The cooling of global growth indicators, the euro area manufacturing PMI, the widening of corporate credit spreads and the persistent short position in the Treasury market remain potential headwinds to a renewed period of rising bond yields. Yet without evidence that U.S. or European capacity constraints are loosening up, triggering a dovish shift from the Fed and ECB, the upward trend in inflation will prevent any meaningful decline in yields from current levels. Bottom Line: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A continued below-benchmark overall portfolio duration stance is warranted - even after our recent move to downgrade spread product exposure. Canada Delivers Another Rate Hike, With More To Follow Chart 11The BoC & The Fed: Follow The Leader The Bank of Canada (BoC) hiked its policy rate last week by 25bps to 1.5%, once again delivering a tightening in lagged response to U.S. rate increases over the past year. The hike was not a surprise, as the Canadian economy is operating at full capacity and core inflation is at the midpoint of the BoC's 1-3% target band. Overnight Index Swap (OIS) markets are now pricing that both the BoC and the Fed will raise rates by another 75bps over the next twelve months, and we see the potential for even more increases than that - even with the Canadian economy cooling from the very rapid growth seen last year (Chart 11). The current spread between 2-year government bond yields in the U.S. and Canada is the widest since 2008, which is weighing on the level of the Canadian dollar versus the greenback (3rd panel). The latter is helping to ease financial conditions in Canada (bottom panel), especially at a time when the country is benefitting from the positive terms of trade impact of strong oil prices. The loonie is also being impacted by worries about future U.S. trade policy. The Trump administration has already imposed tariffs on Canadian steel and aluminum exports and is demanding serious concessions in the renegotiation of the North American Free Trade Agreement (NAFTA). In their latest Monetary Policy Review (MPR) that was released after the BoC policy meeting last week, the central bank provided an estimate of the impact of the steel and aluminum tariffs that went into effect on June 1st. The conclusion was that the 25% tariff on U.S. imports of Canadian steel, and 10% levy on U.S. aluminum imports, would have little net impact on the Canadian economy once the Canadian response was factored in. The BoC concluded that the level of total real Canadian exports would be reduced by -0.6% by year-end, but that Canadian real imports would also decline by a similar amount as the Canadian government slapped its own tariffs on U.S. exports of steel, aluminum and various consumer products. This neutral view on U.S.-Canada trade tensions appeared throughout the BoC's updated economic forecasts, as its projections on the growth of Canadian exports, imports and U.S. real GDP growth (the critical driver of Canadian trade) were all increased from the previous MPR published in April. That may be an overly optimistic assessment of the potential impact of a trade dispute with the U.S. Yet the BoC did admit that it can only estimate the impact of tariffs once the precise details are known, thus it cannot adjust its forecasts based on what might happen in the NAFTA negotiations. The BoC can only base its forecasts on what they can observe now, which is that Canada's overall economy remains in decent shape, even though the composition of growth is shifting. The BoC's latest Business Outlook Survey indicates that Canadian firms continue to see robust demand and are facing increasing capacity constraints. This is boosting hiring plans and keeping capital spending intentions reasonably firm even with the uncertainties over NAFTA that is causing some firms to delay investment (Chart 12). The BoC is projecting that overall Canadian real GDP will only grow by 2% in 2018, even with a smaller contribution to growth from consumer spending and housing. The year-over-year rate of change in retail sales volumes has already dipped into negative territory and is now at the lowest since the end of 2009 (Chart 13). The BoC has attributed this to some slowing in interest-sensitive spending in response to tighter BoC monetary policy. At the same time, household debt growth has been slowing and house price inflation has plunged over the past year (although most of this decline occurred in the overheated Toronto market). The BoC is not concerned about the impact of its rate hikes on the interest burden for households, despite the high level of household debt, given the accelerating pace of wages and income growth. The BoC is likely happy to see a shift away from overheating consumption fueled by speculative increases in house prices, but there is a risk that additional rate hikes could finally trigger the long-awaited bursting of the Canadian housing bubble. Chart 12Canadian Businesses Are Optimistic,##BR##Even With Trade Worries Chart 13Higher BoC Rates##BR##Do Have An Impact (On a related note - the topic of housing bubbles will be discussed at the upcoming BCA Investment Conference in Toronto on September 23-25 by Hilliard Macbeth of Richardson GMP, who has written several books on the topic of global asset bubbles and has some particularly strong views to share on Canadian housing.) Yet the BoC will have to take the risk that additional rate increases could cause a bigger shakeout in the Canadian housing market, given that Canadian inflation is trending higher. Headline CPI inflation is now above the midpoint of the BoC's 1-3% target band, while all the various measures of core inflation that the BoC monitors are hovering around 2% (Chart 14). The BoC estimates that the output gap in Canada is now closed, and that the tight labor market will continue to boost inflation. Chart 14Inflation On The Rise In Canada Chart 15Market Is Underpricing The BoC Already, the average hourly earnings measure of wage inflation is growing close to 4% on a year-over-year basis, although the BoC has noted in recent research that other measures of labor costs are not growing as fast.3 Nonetheless, with 10-year inflation expectations in the Canadian inflation-linked government bond market now trading just below the BoC's 2% target (bottom panel), and with a high number of Canadian businesses reporting increasing difficulties in sourcing quality labor, the inflationary message sent by the surging rate of average hourly earnings growth will likely prove to be correct. Even though the Canadian OIS curve is now discounting another 75bps of rate hikes over the next year, that would only take the BoC policy rate to 2.25% - still below the central bank's estimate of the neutral policy rate, which is between 2.5-3% (Chart 15). Given the likely need for the BoC to eventually move to a restrictive stance to cool off an overheating economy and keep inflation around the 2% target, we see more potential upside for Canadian bond yields, especially with very little increase currently priced in the forwards. Stay underweight Canada in hedged global bond portfolios. Bottom Line: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th, 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Some Thoughts On The Treasury-Bund Spread", dated January 30th, 2018, available at gfis.bcaresearch.com. 3 https://www.bankofcanada.ca/wp-content/uploads/2018/01/san2018-2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Weakening global growth is unlikely to derail the Fed, which must also contend with mounting domestic inflationary pressures. Maintain below-benchmark portfolio duration and only a neutral allocation to spread product versus Treasuries. MBS & CMBS: Non-Agency CMBS offer attractive return potential, but remain too risky for the current environment. Agency MBS are unattractively valued but should remain insulated from negative shocks. Agency CMBS offer an alluring combination of risk and potential reward. Monetary Policy: The effective fed funds rate has been creeping toward the upper-end of the Fed's target band, signaling that bank reserves are becoming scarce. If the situation persists the Fed will be forced to cease the shrinking of its balance sheet. Feature Crosscurrents Two opposing forces are acting on financial markets at the moment and U.S. Treasury yields are caught in the middle. One the one hand, rising U.S. inflation and the gradual tightening of monetary policy are pressuring yields higher. But on the other hand, cyclical indicators point to a slowdown in global economic growth at a time when protectionist trade policies already have investors on edge. The end result is that U.S. Treasury yields are aimless, awaiting a catalyst that will push the prevailing winds in one direction or the other. On the domestic front, inflationary pressures are clearly mounting. The year-over-year core consumer price index rose to 2.23% in June while the New York Fed's Underlying Inflation Gauge moved up to 3.33%, its highest level since 2005 (Chart 1). The Fed's preferred core PCE deflator grew 1.96% during the 12 months ending in May, only a hair below the 2% target. Meanwhile, our Boom/Bust Indicator - a composite of global metals equities, commodity prices and U.S. unemployment insurance claims - has rolled over and investor expectations as measured by the Global ZEW survey have collapsed. Both indicators correlate strongly with long-maturity bond yields (Chart 2). Chart 1Inflation Picking Up Steam Chart 2Global Growth Slowdown The plunge in Global ZEW investor expectations is particularly interesting because the same survey shows that investors continue to describe current economic conditions as incredibly strong (Chart 3). Clearly, investors view the current state of global demand as constructive but are worried about threats to the global economy from trade barriers and the persistent removal of monetary accommodation. Oftentimes, negative readings from the Global ZEW expectations survey precede similar drops in the current conditions survey, such as prior to the 2008 and 2001 recessions. But other times, such as in 1998, the drop in expectations sends a false signal that is quickly unwound. Chart 3ZEW Expectations Vs. Current Conditions Only time will tell which outcome will occur, but we think global growth will slow further before finding a floor.1 The implication for U.S. bond portfolios is that investors should maintain only a neutral allocation to spread product versus Treasuries. Weakening foreign growth and the resultant upward pressure on the U.S. dollar will negatively impact corporate bond spreads, as will persistent Fed tightening. Investors should also maintain below-benchmark overall portfolio duration, as rising inflation will make it difficult for the Fed to pause its rate hike cycle for any significant length of time. Picking Up Yield In MBS And CMBS? The combination of weakening global growth and rising domestic inflation makes finding attractive U.S. fixed income plays difficult. This week we consider the risk/reward proposition in residential mortgage-backed securities (Agency only) and commercial mortgage-backed securities (both Agency and non-Agency). We conclude that non-Agency CMBS offer attractive return potential, but remain too risky for the current environment. Agency MBS are unattractively valued but should remain insulated from negative shocks. Agency CMBS offer an alluring combination of risk and potential reward. Chart 4 shows our excess return Bond Map, a good place to start when considering the risk/reward trade-off between the different spread sectors of the U.S. fixed income universe. The horizontal axis shows the number of months of average spread widening required for each sector to lose 100 bps versus an equivalent-duration position in Treasury securities. The vertical axis shows the number of months of average spread tightening required to earn 100 bps. Sectors plotting closer to the bottom-left are less likely to lose 100 bps, but are also less likely to gain 100 bps. Sectors plotting closer to the top-right are more likely to gain 100 bps, but are also more likely to lose 100 bps. In Chart 4 we use an interval from 2000-present to estimate monthly spread volatility. Since the Agency CMBS index only begins in 2014, it is excluded from this chart. Chart 4Excess Return Bond Map (Spread Volatility Estimated From 2000 - Present) The Bond Map shows that neither Agency MBS nor non-Agency CMBS offer an attractive risk/reward proposition. Non-Agency CMBS carry a similar risk of losses as the riskiest corporate bonds while offering less return potential. Agency MBS offer only slightly greater return potential than Consumer ABS, but with considerably more risk. Chart 5 shows the same Bond Map but using a post-2014 time interval to estimate monthly spread volatility. This allows us to include Agency CMBS. Chart 5 shows that Agency CMBS clearly dominate Agency MBS, offering similar reward with less risk. It also makes non-Agency CMBS look much more attractive, since spread volatility in the CMBS sector has been much lower in the post-2014 period. Chart 5Excess Return Bond Map (Spread Volatility Estimated From May 2014 - Present) Macro Environment Favors Residential MBS Despite the poor valuation picture painted by the Bond Map, the macro environment casts Agency MBS in a more favorable light. The two main factors that influence MBS spreads are residential mortgage lending standards and mortgage refinancing activity. Neither factor is likely to send MBS spreads wider during the next 6-12 months. Extension risk can also influence MBS spreads from time to time, but we have shown in prior research that the required yield increase is massive and unlikely to occur.2 The shaded regions in Chart 6 correspond to periods when banks are tightening lending standards on residential mortgage loans. We can see that lending standards tightened sharply during the financial crisis and have generally been easing since then. More important, however, is that the post-crisis easing in lending standards has been extremely modest. The median FICO score for new mortgage borrowers has barely come down, and remains well above pre-crisis levels (Chart 6, panel 3). The Urban Institute's Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is also extremely low (Chart 6, panel 4). In addition, the household debt-service ratio remains incredibly healthy (Chart 6, bottom panel). With such high borrower quality, banks are much more likely to ease lending standards going forward. Mortgage refinancing activity has also been very low, and this should continue to be the case for some time. A good predictor of refinancing activity is the percentage of the MBS index (by par value) that carries a coupon above the current mortgage rate (Chart 7). At present, only 5% of the index carries a coupon above the current 30-year mortgage rate of 4.53%. We calculate that even if the mortgage rate fell to below 4% the percentage of the MBS index with the incentive to refinance would only rise to 38%, still consistent with muted refi activity. Only a drop in the mortgage rate to below 3.5% would cause the refinanceable percentage to spike significantly, reaching 73%. Chart 6MBS: The Macro Environment Chart 7Refi Risk Is Non-Existant Or course, mortgage rates are much more likely to rise during the next 6-12 months as the Fed continues to tighten monetary policy. In other words, the risk that an increase in refi activity will drive MBS spreads wider is very low. All in all, valuation is not attractive in the Agency MBS sector, but the macro environment is favorable and should ensure that spreads remain tight on a 6-12 month horizon. We recommend a neutral allocation to Agency MBS, and could upgrade the sector further at the expense of corporate bonds as we approach the turn in the credit/default cycle. Fading Headwinds In CMBS? Chart 8CMBS: The Macro Environment Non-Agency Aaa-rated CMBS appear relatively unattractive in Chart 4 and somewhat attractive in Chart 5. The latter chart uses a post-2014 time interval to estimate monthly spread volatility and this period flatters the CMBS sector. The macro picture for the sector is also decidedly mixed. A typical negative environment for CMBS spreads is characterized by tightening bank lending standards on commercial real estate (CRE) loans, falling demand for CRE loans and decelerating CRE prices (Chart 8). CRE lending standards were tightening throughout 2016 and 2017, while demand remained reasonably strong and CRE prices decelerated. But CMBS spreads performed quite well during this period, taking cues from the rally in corporate bonds rather than the slightly negative message from CRE fundamentals. More recently, we are receiving very mixed signals from our CRE indicators. Lending standards are no longer tightening, but CRE prices continue to decelerate and demand is close to unchanged. It is possible that a renewed easing in lending standards will cause CRE prices to accelerate, but that is far from certain. Our U.S. Equity Strategy service recently flagged numerous risks in the CRE space, including the fact that occupancy rates have already begun to contract.3 A possible signal that demand is waning. While the return of CRE lending standards to "net easing" territory is a positive development, it remains to be seen whether the easing will help spur a rebound in CRE prices in the face of weakening demand. The uncertain macro picture and the unattractive valuation shown in Chart 4 cause us to maintain an underweight allocation to non-Agency CMBS. In contrast, we remain overweight Agency-backed CMBS based on the attractive risk/reward profile presented in Chart 5. A Note On Monetary Policy Operations While we maintain that the expected pace of Fed rate hikes is by far the most important monetary policy question for investors, some technical issues related to the implementation of monetary policy have come to light during the past few months that merit a mention. These issues will likely gain even more attention later this summer when they are discussed at the Jackson Hole Monetary Policy Symposium where the chosen theme is "Changing Market Structure and Implications for Monetary Policy". The main problem that has emerged during the past few months is that the effective fed funds rate has begun to creep toward the upper-end of the Fed's target channel (Chart 9). While the Fed currently targets a range of 1.75% to 2% for the effective fed funds rate, the rate itself currently sits at 1.91%, dangerously close to the top. Chart 9Is The Fed Losing Control? IOER Is A Treatment, Not A Cure The Fed tried to push the effective fed funds rate back toward the middle of its target range following the June FOMC meeting when it lifted the interest rate on excess reserves (IOER) by only 20 bps instead of 25 bps. Previously, the IOER had been set at the upper-bound of the Fed's target range, now it is 5 bps below. At best, this manipulation of IOER is a stop-gap measure that will not permanently solve the Fed's problem. This is because the Fed's problem is that the effective fed funds rate is rising because bank reserves are once again becoming scarce. The Fed currently controls interest rates using a "floor system". In order for such a system to work the Fed must ensure that the banking system is supplied with more bank reserves than it wants. The excess supply of bank reserves then pressures the effective funds rate lower, toward a "floor" interest rate set by the Fed. The Fed currently uses two different interest rates to act as the "floor", the IOER and the overnight reverse repo rate (ON RRP).4 The problem is that if banks are not over-supplied with reserves then the floor is not binding and the fed funds rate could break above the Fed's target range. Several factors have conspired to drain reserves from the banking sector during the past few months. First and foremost is that the Fed is allowing the securities to run off its balance sheet. Table 1 shows a simplified version of the Fed's balance sheet as of July 5 and as of September 28 of last year, just before the Fed started to shrink its bond portfolio. The change in each balance sheet item between the two dates is also shown. Table 1A Simplified Federal Reserve Balance Sheet Changes in the Fed's securities holdings are the main driver of bank reserves, and Table 1 shows that the Fed has reduced its portfolio holdings by $156 billion since last September. This has drained $156 billion of reserves from the banking system. Reserves appear as a liability on the Fed's balance sheet, but as an asset on the banking sector's consolidated balance sheet. But Table 1 also shows that the U.S. Treasury's General Account at the Fed has increased by $170 billion since last September, draining bank reserves by the same amount. This occurred because the Treasury department has been rebuilding its cash holdings which had become very low due to repeated encounters with the debt ceiling. But this process is largely complete. The Treasury department was targeting a cash balance of $360 billion by the end of June and that target has essentially been met. Table 1 also shows that reverse repos declined significantly since September, offsetting some of the reserve drain from the run-off of the Fed's securities holdings and the increase in the Treasury's cash balance. As reserves become scarcer it becomes less necessary for banks to engage in reverse repos with the Fed, so reverse repo balances should continue to decline as long as the Fed is shrinking its securities holdings. There Is Only One Cure The key point is that if the Fed continues to shrink its balance sheet and drain reserves from the banking system, then at some point bank reserves will no longer be over-supplied and the Fed will lose control of interest rates if the situation is not rectified. What makes things particularly confusing is that nobody (including the Fed) is quite sure what level of bank reserves constitutes "scarcity" in the new post-crisis environment. Chart 10 shows that if the Fed's planned shrinking of its balance sheet continues un-interrupted then bank reserves will reach zero by March 2022. But under the stricter post-crisis regulatory regime, banks will desire reserve balances that far exceed what they demanded before the financial crisis. Unfortunately, the only way to find out at what point bank reserves become scarce is for the Fed to drain reserves from the system and wait for signs that interest rates are starting to rise above its target range. At that point, the Fed will be forced to stop shrinking its balance sheet in order to maintain control over interest rates. Based on the current behavior of the fed funds rate, we cannot rule out this situation arising within the next year. Some Notes On Treasury Operations Many have blamed sizeable T-bill issuance for the creep higher in the fed funds rate, and this is somewhat true. The Treasury department has been issuing T-bills in large amounts and parking the proceeds in its cash account at the Fed. As explained above, this has drained reserves from the banking system and put upward pressure on the effective fed funds rate. But the focus should be on the Treasury's cash balance and not T-bill issuance itself. This is important because going forward T-bill issuance will remain elevated. The Treasury must finance the increasing deficits mandated by Congress and has pledged to concentrate a large portion of this financing in bills. Specifically, the Treasury is targeting a range of 25% to 30% for the proportion of bills in the outstanding funding mix. At present, bills make up only 15% of the mix (Chart 11). But while bill issuance will stay strong, as long as the Treasury maintains its cash balance near current levels, then there will be no impact on bank reserves or the effective fed funds rate. Chart 10The Pace Of Balance Sheet Reduction Chart 11Gross T-Bill Issuance The Treasury department will also increase coupon issuance to finance the rising fiscal deficit (Chart 12), and has decided to do so by increasing issuance for every coupon but with a focus on the 2-year, 3-year and 5-year notes. Gross issuance in the 2-year and 3-year notes has already started to increase, and it will soon exceed 5-year and 7-year note issuance (Chart 13). Because so much of the Treasury's new issuance will be concentrated at the front-end of the curve (and in bills), it has dropped its prior stated goal of increasing the weighted-average maturity (WAM) of the funding mix. Its current policy states that "the WAM is just an outcome of an issuance strategy and not a goal in and of itself." Chart 12Gross Coupon Issuance Chart 13Gross Coupon Issuance By Maturity Bottom Line: The effective fed funds rate has been creeping toward the upper-end of the Fed's target band, signaling that bank reserves are becoming scarce. If the situation persists the Fed will be forced to cease the shrinking of its balance sheet. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "On The Move", dated February 13, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Equity Strategy Special Report, "UnReal Estate Opportunity", dated July 9, 2018, available at uses.bcaresearch.com 4 A detailed explanation of the floor system and its alternative "corridor system" can be found in U.S. Bond Strategy Special Report, "Cleaning Up After The 100-Year Flood", dated June 10, 2014, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Upside risks on base metals are being ignored. The U.S. labor market continues to tighten and businesses face escalating labor and input costs. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Feature Chart 1Core Inflation Creeping Higher Along With Wages Last week, U.S. equity prices reached their highest level since early February. The 1% drop in the trade-weighted U.S. dollar contributed to weakness in both oil and gold prices. 10-year Treasury yields were little changed, despite higher U.S. inflation readings. Base metal prices continued to decline, linked to escalating trade tensions between the U.S. and China and concerns over the health of China's economy. Comments from Fed Chair Powell late in the week on the benefits of fiscal policy for the U.S. economy were welcomed by markets. We discuss base metal prices, trade, inflation, the Fed and the implication of the U.S.'s precarious fiscal position in this week's report. We examine BCA's view on base metals in the context of disruptions to global trade and a slowdown in Chinese economic activity in the next section. The June CPI report suggests U.S. inflation is drifting towards the Fed's target. However, with no serious inflation outburst occurring at the moment, there is no need for the Fed to deviate from its path of gradual rate hikes in the near term. U.S. core CPI rose by 0.16% m/m in June, which is not quite consistent with a 2% annual inflation rate. Nonetheless, the underlying trend still shows a steady creep higher in inflation (Chart 1). The year-over-year core CPI rate ticked up to 2.3% from 2.2%. Core CPI inflation of about 2.5% is consistent with the Fed's 2% target for the core PCE deflator. The main source of upward pressure on U.S. inflation will come from core services (ex-shelter and medical care). We find that this subcomponent of core CPI is the most correlated with the tightness in the labor market and wage pressures. However, it accounts for only 25% of core CPI and, while improving, the acceleration in wages is mild (panel 4). Inflation, the labor market and trade were all discussed at the June FOMC meeting. Below, we assess the central bank's mid-June discussion on these topics as markets brace for the Fed's latest Beige Book (July 18) and the late July FOMC meeting. Fiscal policy was also discussed at the June FOMC meeting. The final section of this week's report examines the long term budget outlook and its implication for the economy and financial assets. Base Metals Update BCA's Commodity & Energy Strategy service notes1 that the London Metal Exchange Index (LMEX) will remain under significant downward pressure until fears of an escalating Sino - U.S. trade dispute are allayed. If this dispute evolves into a full-blown trade war, as our geopolitical strategists expect,2 emerging markets (EM) economies embedded in global supply chains could be hard hit. This would have ramifications for commodity prices in general and base metals in particular. Alternatively, if this trade dispute develops into a more open and free global trading system, EM income growth will significantly drive up commodity demand, especially for metals (Chart 2). However, a more open trading system would take time to develop and is beyond a 6-12 month investment horizon. BCA's view is that the dollar will continue to climb as the Fed boosts rates more than the market expects and as U.S. domestic economic growth outpaces global growth (Chart 3). Moreover, the ongoing trade row will put upward pressure on the dollar. We remain long on the dollar.3 Chart 2EM Macro Variables##BR##Drive LMEX Chart 3Divergent Paths For Growth And##BR##Rates To Drive U.S. Dollar Higher Bottom Line: Fears of a global trade war are punishing the EM economies and weighing on the prices of base metals. However, upside risks, for the most part, are being ignored, according to BCA's Commodity & Energy Strategy service. As a result, our commodity team sees some tactical long trading opportunities in copper, but the prospect of a worsening trade war is not kind for base metals. Oil is a different story.4 The Disappearing Act Data from the National Federation of Independent Business (NFIB) in June and the Job Openings and Labor Turnover Survey (JOLTS) in May support our stance that the slack in the U.S. labor market is disappearing and will ultimately lead to higher wage inflation and a peak in profit margins. Job openings and hiring plans at small businesses are at an all-time high (Chart 4, panel 1). Chart 4 also shows that small business owners' compensation plans (panel 2) remained near record levels in April and that concerns about "quality of labor" have never been higher (panel 3). Moreover, 7% of small firms say that the cost of labor is their most critical problem (panel 4). This concern has more than doubled since 2013. Job openings according to the JOLTS data also hit a new zenith in April, but ticked down a bit in May, which created an even wider gap between openings and hires (Chart 5, panel 1). Moreover, quits minus layoffs, another indicator of labor market slack, reached a record high (panel 2). The implication is that businesses of all sizes face a much tighter labor market. Chart 4Labor Market Slack Is Disappearing... Chart 5... Putting Pressure On Margins Moreover, the robust labor situation is widespread. Charts 6A and 6B show the ratio of job openings to the number of unemployed in 10 sectors of the economy. The ratio is at an all-time high in nine of the sectors. The exception is the information segment, which includes newspapers and magazines, broadcasting and telecommunications. Chart 7 shows that businesses are increasingly worried about the impact of escalating input costs on margins. Firms in the Atlanta Fed region expect a 2% bump in their input costs in the next 12 months; in early 2016, those same firms saw only a 1.3% rise (panel 1). Nearly 80% of managements expect their unit costs to climb by at least 1.1% in the next year. More than 20% of firms expect their input costs to jump at least 3.1% in the same period. Chart 6AStrength In The Labor Market... Chart 6B... Is Broad-Based Chart 7Businesses Worried About Input Costs Small businesses are increasingly able to pass on prices to consumers (Chart 5, panels 3 and 4). At 14%, having rolled over slightly, the percentage of small businesses reporting price changes remains near a 10-year high in June (panel 2). Moreover, 24% of small businesses planned price hikes in June, also a 7-year high. In late 2016, only about 4% of these entities expected to boost prices in the next 12 months (panel 3). Moreover, the New York Fed's Underlying Inflation Gauge5 hit a 13-year high in June (not shown). Bottom Line: The U.S. labor market continues to tighten and businesses face escalating labor and input costs. The implication is that margins may soon reach a top. In last week's report,6 we showed that the performance of a broad range of U.S. and global risk assets falters after margins peak late in the business cycle. Moreover, shortages of labor and some raw materials will push up inflation and keep the Fed on track to tighten two more times this year. BCA's view is that by mid-2019, the central bank will find itself behind the curve on inflation and begin to tighten more aggressively. Shortages and capacity constraints in the important trucking industry support our view. Keep On Trucking The trucking industry exemplifies the robust labor market, with strong demand for trucking services and shortages of drivers. Wage inflation remains muted in the trucking industry, despite strong demand for trucking services and shortages of drivers. Nonetheless, anecdotal data suggest that wages are understated in the trucking industry. Freight costs, which are key components in firms' input costs, affect the economy as a whole. Table 1 shows that trucking is one of many industries with labor shortages according to the 2018 Beige Books. However, the JOLTS data show that trucking has labor constraints, but very little wage inflation. The PPI for truck transportation services7 (a good proxy for what trucking firms charge customers) is up 7.7% year-over year (Chart 8). Some of that increase is linked to higher gasoline prices. However, it is difficult to split out the impact of wage costs from the gasoline costs in the PPI. Table 1Labor 'Shortages' Identified##BR##In The Beige Book Chart 8Margin Pressure In##BR##The Trucking Industry A Cass Freight Index that tracks full-truckload prices, but excludes fuel and fuel surcharges, rose 9% year-over-year in May (not shown).8 The broad Cass Freight Index climbed 17.3% year-over year in May, and suggests further gains are ahead for U.S. capital spending (Chart 9). Moreover, the latest survey by the FTR Transport Intelligence for June surged for orders of heavy trucks, with June being the highest on record at 140% year-over-year (not shown).9 Chart 9Supply Constraints In The Freight Business Will Erode U.S. Profit Margins The implication is that demand for trucking services remains vigorous and will ultimately push up wages. Higher wages in trucking mean higher shipping costs, and portends a peak in U.S. corporate margins later this year. A Divided FOMC The labor market, wages and inflation were key topics at the June 12-13 Federal Open Market Committee (FOMC) meeting. Trade and fiscal policy were also discussed. Policymakers noted that some firms have responded to a lack of qualified workers by offering training, introducing automation and boosting wages. This is typical late-cycle behavior. Fed economists recently updated their quantitative assessments of the FOMC's meeting minutes.10 The note provides a guide (Table 1 in the Fed paper and Table 2) to the number of quantitative descriptors (one, a couple, a few, etc.). We use this rubric to assess the FOMC's latest views. Table 3 evaluates the Fed's latest thinking on the labor market and wages, while Table 4 assesses the FOMC's discussion of inflation and inflation expectations. Table 2FOMC Minutes Rubric Table 3FOMC Assessment Of The Labor Market And Wages At June 2018 Meeting FOMC participants generally expected the unemployment rate to either remain below or decline further below their estimates of the longer run normal rate. Only several FOMC members thought that the unemployment rate overstated the labor market's strength. Furthermore, a number of members anticipated wage inflation to pick up (Table 3) given that the unemployment rate is expected to stay below the committee's view of NAIRU. Table 4 shows that FOMC members generally agreed that inflation was on track to meet the Fed's 2% target. However, many participants saw downside risks to inflation linked to political and economic turmoil in Europe and the emerging markets. A number noted that it was premature to conclude that the Fed had achieved its 2% inflation target. Nonetheless, some members worried that a prolonged stretch of economic activity above the economy's long-term potential could "give rise to inflationary pressures or financial imbalances." Only a few noted that inflation expectations were not consistent with the Fed's 2% objective. Only one member argued that the postponing rate hikes would help push up inflation expectations. Table 4FOMC Assessment Of Inflation And Inflation Expectations At June 2018 Meeting On trade, most FOMC participants noted that the uncertainty and risks associated with trade policy had intensified and expressed concern over the potential negative effects on business sentiment and investment spending. The committee continued to see fiscal policy as a plus for economic growth in the next few years. Nonetheless, a few participants worried that fiscal policy is not on a sustainable path (See next section, "An Unprecedented Macro Experiment"). Financial stability was not on the agenda at the latest FOMC meeting, although Fed Chair Powell discussed the topic at his mid-June news conference.11 Moreover, in a radio interview12 last week, Powell also mentioned financial stability. Our view is that the Fed will continue to focus on vulnerabilities in the U.S. and overseas financial markets in upcoming meetings.13 Bottom Line: So far, Fed policymakers have maintained their gradual approach to tightening policy (i.e. 25 basis points per quarter) as they try to balance the risk of a major inflation overshoot against the hazards of prematurely ending the economic expansion. Several policymakers reiterated that long-term inflation expectations are still not high enough to be consistent with meeting the 2% inflation target over the medium term. That is why we expect the Fed to become more aggressive in targeting an economic slowdown when the 10-year TIPS breakeven rate moves back into its 2.3-2.5% range.14 Stay tuned. An Unprecedented Macro Experiment15 Congress is conducting an extra-ordinary economic experiment: substantial fiscal stimulus when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind. However, the celebration could be followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely spill far more red ink than during any other economic expansion since the 1940s (Chart 10). Moreover, the debt ratio, which swelled to 106% in 1946 after WWII, could rocket past that level before 2030, even in the absence of a recession (Chart 11). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart 10U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Chart 11U.S. Debt In Historical Context Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Politicians are following the voters shift to the left. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as in the past. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.16 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle-class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block in the 2020s. President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning (i.e. jobs rather than cultural factors). Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to have high approval ratings among his supporters. Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Unlike the Reagan years, we do not expect that there will be a strong political force capable of leading a fight against budget deficits. The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake up voters and the political establishment into making tough decisions. Given demographic trends, it appears more likely that taxes will be on the rise than entitlements will be cut. We do not foresee a crisis in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas (Chart 12). U.S. government debt has already been downgraded by the S&P to AA+ in 2013, and the other two main rating agencies will probably follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium to entice them to continually raise their exposure to U.S. government bonds. Chart 12An Unsustainable Debt Accumulation Chart 13Structural Drivers Of The U.S. Dollar Taxes will eventually rise to service the government debt and some capital spending will be crowded out, both of which will undermine the economy's growth potential (Chart 13). Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because imports will be more expensive. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Escalating Trade Disputes Pressuring Base Metals", published July 12, 2018. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis", published July 11, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again", published July 6, 2018. Available at gis.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf", published July 5, 2018. Available at ces.bcaresearch.com. 5 https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Revisiting The Late Cycle View", published July 9, 2018. Available at usis.bcaresearch.com. 7 See Table 10 https://www.bls.gov/ppi/ppidr201806.pdf 8 https://www.cassinfo.com/transportation-expense-management/supply-chain-analysis/cass-freight-index.aspx 9 https://ftrintel.com/news/ftr-reports-north-american-class-8-orders-for-june-at-historic-highs 10 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 11 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 12 https://www.marketplace.org/2018/07/12/economy/powell-transcript 13 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 14 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "The Deflationary Mindset", published July 10, 2018. Available at usbs.bcaresearch.com. 15 Please see BCA Research's The Bank Credit Analyst Monthly Publication, "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 16 Please see BCA Research's Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016. Available at gps.bcaresearch.com.

Special Report

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Dhaval Joshi, Senior Vice President Chief European Investment Strategist Feature We live in strange economic times. Financial markets applauded President Trump's Keynesian stimulus package, even though it will lift the U.S. structural deficit to a crisis-era level approaching 7% of GDP. Yet markets seem uncomfortable about the merest hint of fiscal stimulus in Italy, where the government finances are close to a structural balance! (Table I-1) Table I-1Italy's Structural Deficit Has Almost Disappeared Meanwhile the ECB must supposedly maintain negative interest rates to support a fragile Italy; and the Fed must supposedly hike rates many more times to prevent the U.S. overheating. In this Special Report, we ask: might the policy prescription of tight fiscal/loose monetary for Italy and loose fiscal/tight monetary for the U.S. be completely back to front? For Italy, Mainstream Economists Are Prescribing Wrong Remedies For many years, mainstream economists prescribed remedies for sluggish growth in southern Europe on the basis of three articles of blind faith. First, that the ailment in Italy (and previously in Spain and Portugal) arose from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that government borrowing is at best a necessary evil and at worst a recipe for disaster; As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, and aggressively shrinking government deficits. Of course, carefully chosen structural reforms are no bad thing for an economy. But can you name an economy in the world that would not benefit from carefully chosen structural reforms? The misguided obsession with structural reforms has caused mainstream economists to miss the real cause of Italy's ailment - its crippled banking system (Feature Chart). Feature ChartItaly's Problem In One Picture: A Crippled Banking System In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage to the national income stream generating a deflationary headwind for the economy. This headwind will persist until the banks are repaired to fulfil their intermediation task of recycling savings and debt repayments. Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart I-2). The upshot is that the real money supply has shrunk despite low private sector indebtedness (Chart I-3 and Chart I-4), record low interest rates and massive injections of liquidity into the banking system. Why? Chart I-2Italian Bank Lending Has Fallen In Real Terms Chart I-3Italy Is Less Indebted... Chart I-4...Than France The simple reason is that after the 2008 global financial crisis Italian banks' balance sheets were left unrepaired and undercapitalized (Chart I-5 and Chart I-6). For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition - namely, the government - must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Chart I-5After The 2008 Crisis Italian Banks ##br##Were Left Unrepaired... Chart I-6...And ##br##Undercapitalized When To Use Fiscal Stimulus, And When Not To Deficit spending is often associated with crowding out and misallocation of resources. But when the banking system is not recycling savings and debt repayments within the private sector, the opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the un-recycled private sector savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Unfortunately, this concept has met with great resistance. Most people are aware of the size of government debt and deficits, but few people are aware of the leakage to the national income stream that occurs when a dysfunctional banking system is unable to recycle savings and debt repayments within the private sector. By not making this crucial connection, people believe that government spending would be profligate. They do not realise that if the private sector as a whole is saving money, the public sector must borrow and spend the money to keep the economy afloat. This leads to important lessons on when Keynesian stimulus is highly effective and when it is ineffective. When the solvency of the private sector - including, crucially, the banking system - is healthy, bank lending responds well to changes in interest rates (Chart I-7 and Chart I-8). Hence, in such a world, monetary policy should be the main tool for regulating economic activity. This describes the recent situation in most developed economies, including the U.S. Fiscal stimulus is largely ineffective because it leads to crowding out, and a sub-optimal allocation of resources. Chart I-7Lower Interest Rates Have Stimulated ##br##Bank Lending In Germany... Chart I-8...And ##br##France... However, when the private sector and/or the banking system is insolvent and dysfunctional, it is monetary stimulus that becomes ineffective. No extent of depressing interest rates and/or central bank liquidity injections will stimulate bank lending (Chart I-9). This describes the recent situation in Italy. The broad money supply becomes very dependent on government spending, making fiscal stimulus highly effective. Chart I-9...But Not In Italy But can monetary stimulus still help via the exchange rate channel? A weaker euro boosts the competitiveness of firms selling euro priced products in international markets. Therefore, firms exporting discretionary goods and services which are price elastic could benefit. Against this, the weaker euro makes everyone in the euro area poorer in terms of the goods and services they can buy from outside the euro area. This is particularly significant for non-discretionary items - food and energy - of which Europe is a large importer. Given that the volumes of these purchases tend to be inelastic, their price increase in euro terms can weigh down the real spending power of euro area consumers. The upshot is that a weaker exchange rate's aggregate impact on an economy depends on how the winners and losers net out. Italy might become more competitive vis-à-vis its non-euro trading partners, but Italian consumers may suffer a loss of real spending power - which would partly or wholly cancel out the benefit to the exporters. What Is The Prescription Right Now? In summary, neither the monetarists nor the Keynesians are all-powerful. In a world where the private sector is dysfunctional, the effectiveness of both monetary and fiscal policies are opposite to those in a world in which the private sector is functional. Therefore, it is crucial to recognise which of these two phases the economy is in, and then implement the economic policies, monetary or fiscal, most effective in that phase. What are the key messages right now? In Italy, the banking system is still healing and not fully functional. This suggests that for Italy, the ECB's ultra-loose monetary policy is largely ineffective whereas fiscal stimulus - even modest - would be highly effective (Chart I-10). But in the other major economies, including the U.S., the private sector is fully functional. This means that monetary policy is effective, whereas fiscal stimulus will be largely ineffective (Chart I-11). Interestingly, in a just-released paper 'Fiscal Policy in Good Times and Bad' the Federal Reserve Bank of San Francisco reaches exactly the same conclusion, pointing out that:1 Chart I-10A Strong Recent Connection Between ##br##Fiscal Thrust And GDP Growth In Italy Chart I-11A Weak Connection Between Fiscal##br## Thrust And GDP Growth In The U.S. "A number of macroeconomic forecasters expect the Tax Cuts And Jobs Act to boost 2018 GDP growth by around a percentage point... (but) the true boost is more likely to be well below that, as small as zero..." Pulling all of this together, we end with two takeaways for investors: don't bet on the ultra-loose monetary policy in the euro area continuing indefinitely; and as the San Francisco Fed advises, don't bet on President Trump's Keynesian stimulus being a game changer for U.S. growth. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the FRBSF Economic Letter 'Fiscal Policy in Good Times and Bad', Tim Mahedy and Daniel J. Wilson, July 9, 2018 available at https://www.frbsf.org/economic-research/files/el2018-18.pdf

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Peter Berezin, Chief Global Strategist U.S. Housing Will Drive The Global Business Cycle... Again Highlights Housing is the main channel through which changes in U.S. monetary policy affect the real economy. The U.S. housing sector is in good shape, which means that the Fed will be able to raise rates more than the market anticipates. The Fed's tightening efforts are coming at a time when cyclical factors are raising the neutral rate of interest. Higher U.S. rates will push up the dollar, which will adversely affect emerging markets. Stay overweight developed market equities relative to their EM peers, while underweighting deep cyclical sectors relative to defensives. Feature U.S. Housing Back In The Spotlight The Global Financial Crisis began in the U.S. and quickly spread to the rest of the world. The U.S. housing market was at the epicenter of the last crisis and it could be the main source of global financial turbulence once again. Unlike ten years ago however, the problem is not that U.S. housing has become too vulnerable to a downturn. Rather, the problem, as we explain below, is that housing has become too resilient. Housing starts were slow to recover after the Great Recession. To this day, they are still 40% below their 2006 peak (Chart 1). As a result, the homeowner vacancy rate stands at only 1.5%, the lowest level since 2001. Mortgage lenders remain guarded. The ratio of mortgage debt-to-disposable income is 31 percentage points below where it stood in 2007. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. FICO scores among new borrowers are well above pre-crisis levels. The Urban Institute's Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, remains in extremely healthy territory (Chart 2). Chart 1No Oversupply Of U.S. Homes Chart 2Mortgage Lenders Are Being Prudent Housing And The Monetary Transmission Mechanism Chart 3Residential Investment Collapsed ##br##In Response To Higher Interest Rates##br## In The Early 80s... While Business Investment ##br##Was Barely Affected Housing is the main channel through which the Federal Reserve affects the real economy. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 3). "Housing is the business cycle," as Ed Leamer likes to say. To quote Leamer's timely 2007 Jackson Hole paper:1 Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy. Neutral Rate: Structural Versus Cyclical Chart 4Market Expectations Versus The Fed Dots The market is pricing in only 90 basis points in rate hikes between now and the end of 2020 (Chart 4). Yet, if U.S. housing is in as good shape as it appears, what is stopping the Fed from hiking rates much more than investors currently anticipate? The answer, one presumes, is that most investors share Larry Summers' view that the neutral rate of interest is very low. We have a great deal of sympathy for Summers' position. In fact, we ourselves have argued many times that a variety of secular factors are pushing down the neutral rate of interest. These include slower potential GDP growth, the shift to a capital-lite economy, and high levels of income inequality. That said, it is critical to distinguish between the secular and cyclical determinants of the neutral rate. While secular factors are pushing down the neutral rate, cyclical factors are pushing it up. Credit And Household Wealth On The Upswing Credit is one such cyclical factor. Private credit is now growing faster than GDP. The ratio of nonfinancial private debt-to-GDP has increased by an average of 1.2 percentage points during the past three years, which is close to its historic trend (Chart 5). Not all the new credit is used to finance domestic spending - some of it can flow into imports as well as the purchase of financial assets - but if one assumes that every additional dollar of credit boosts domestic demand by 50 cents, today's pace of credit growth is adding 0.6% of GDP to aggregate demand relative to a situation where the ratio of credit-to-GDP is stable.2 In addition, housing and equity wealth have been rising much more quickly than GDP. Household real estate wealth fell from a peak of 182% of GDP in 2006 to 115% of GDP in 2012. It has since clawed its way back to 142% of GDP, equivalent to where it stood in 2002. Equity wealth reached nearly 150% of GDP earlier this year, on par with the prior peak set in 2000. Historically, there has been a robust relationship between the ratio of household net worth-to-disposable income and the personal savings rate (Chart 6). At present, the former stands at an all-time high. This helps explain today's low savings rate. All things equal, a lower savings rate implies more desired spending which, in turn, implies a higher neutral rate of interest.3 Chart 5Rising Household Credit And Wealth Chart 6High Net Worth Explains Today's Low Savings Rate Loose Fiscal Policy Warrants A Higher Neutral Rate U.S. fiscal policy has also become extremely stimulative. The IMF estimates that the cyclically-adjusted primary budget deficit will reach 4.2% of GDP in 2019, a deterioration from a deficit of 1.7% of GDP in 2015. That is more accommodative than Japan, which is set to have a deficit of 2.7% of GDP next year; or the euro area, which is expected to record a surplus of 0.8% of GDP (Chart 7). Assuming a fiscal multiplier of one, fiscal policy will add a whopping 5% more to aggregate demand in the U.S. than in the euro area next year. If one combines this fact with all the other reasons we have listed for why the neutral rate is higher in the U.S. than the euro area, the market's expectation that the ECB will be hard-pressed to raise rates by very much over the next few years is probably not far from the mark.4 An Overheated Economy Will Lift The Neutral Rate The fact that the U.S. jobless rate has fallen below most estimates of full employment means that the Fed may have to bring rates above their neutral level for a while to cool the economy. An overheated economy may also push up the neutral rate itself, at least temporarily. Chart 8 shows that labor's share of income rose during the late 1990s, as businesses were forced to pay higher wages to attract workers. Workers tend to spend more of every dollar of income than companies. Thus, any shift in the distribution of income towards the former raises aggregate demand. Chart 7U.S. Fiscal Policy Is More Stimulative Than Abroad Chart 8Tight Labor Market And Rising Labor Share Of Income: ##br##A Replay Of The 1990s? Today, employers are complaining about a "shortage" of qualified workers. While the business press usually takes such comments at face value, the word "shortage" is highly misleading. Except in a few isolated cases, the number of workers a company employs is much smaller than the number of qualified workers it could theoretically hire. Even the internet giants compete for the same well-educated, tech-savvy workers. When companies say they cannot find good workers, what they usually mean is that they do not want to raise wages to entice good workers to move from competing firms. Fortunately for potential job-switchers, that is starting to change. The difference between wage growth among job switchers and job stayers in the Atlanta Fed's Wage Growth Tracker has risen to close to where it was in 2000 (Chart 9). Surveys suggest that companies are increasingly willing to raise wages (Chart 10). Higher wages and falling unemployment will boost spending, raise consumer confidence, and probably further supercharge the housing market. Chart 9Things Are Perking Up For Job Switchers Chart 10Surveys Show Employers More Willing To Raise Compensation Investment Considerations The 30-year U.S. prime mortgage rate has risen from a low of 3.78% last September to 4.55% at present, but still remains more than 2.5 percentage points below where it stood in 2006. In real terms, today's mortgage rate is significantly lower than the average rate since 1980 (Chart 11). For the first time in a decade, the Federal Reserve wants to slow GDP growth to prevent the economy from overheating. This means the Fed must tighten financial conditions. If housing does not buckle as the Fed raises rates, the tightening in financial conditions must come through a stronger dollar, higher corporate borrowing costs, and lower equity prices. We remain long the dollar and recently downgraded global equities from overweight to neutral. We also recommended that clients cut exposure to credit. Chart 12 shows that a rising dollar usually corresponds to wider high-yield corporate bond spreads. Chart 11U.S. Mortgage Rates Are Still Low Chart 12Rising Dollar Usually Corresponds ##br##To Wider High-Yield Spreads The rest of the world will feel the repercussions of Fed tightening, perhaps even more so than the U.S. itself. Emerging market equities almost always fall when U.S. financial conditions are tightening (Chart 13). One can believe that EM stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from boiling over. One cannot believe that both these things will happen at the same time. As a share of GDP, dollar-denominated debt in emerging markets is now back to late-1990s levels (Chart 14). Local-currency debt has also mushroomed (Chart 15). This puts emerging market policymakers in the unenviable position of having to decide whether to hurt domestic borrowers by hiking rates or keeping rates low and risking a steep devaluation of their currencies. Neither outcome would be good for EM assets. As such, equity investors should overweight developed market stocks over their EM peers. An underweight in global cyclical sectors relative to defensives is also appropriate at this juncture. Chart 13Tightening U.S. Financial Conditions ##br##Do Not Bode Well For EM Stocks Chart 14EM Dollar Debt Is High Chart 15EM Local Credit Is High Too Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). Thus, credit growth affects GDP and, by extension, the change in credit growth (the so-called credit impulse) affects GDP growth. 3 Conceptually, one can see the relationship between the savings rate and the neutral rate of interest in the Solow Growth Model. For example, the neutral real rate of interest, r*, in the Model is equal to (a/s) (n + g + d), where a is the capital share of income, s is the savings rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. An increase in the savings rate reduces the neutral rate. 4 Please see Global Investment Strategy Weekly Report, "The U.S. Needs A Stronger Dollar," dated May 4, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights If the EU27 pours cold water on Theresa May's much-hyped Brexit proposals, the immediate uncertainty around Brexit would increase. But a longer-term outcome that keeps the U.K. either in a protracted transition to exit, or attached to the EEA or EFTA would be benign for the U.K. economy. For U.K. gilts relative to other government bonds, it means bullish near-term, but bearish long-term. For the pound, it is the opposite: caution near-term, but scope for long-term appreciation, especially versus the dollar. Neutral FTSE100 in a European or global equity portfolio, given its large overweight to the technically extended oil and gas sector. The global 6-month credit impulse is still in a mini-downswing, which corroborates our successful underweight stance to the classical cyclical sectors. The dollar's recent rally is technically extended to a point which usually signals a tradeable reversal in the DXY. Feature Last week, we highlighted a surprising fact: wages in Europe and the U.S. are now growing at exactly the same pace, 2.7%. We also pointed out that wage growth in the euro area is running slightly lower than the EU28 average - which necessarily means that in a major European economy outside the euro area, wage growth is running considerably higher. That major European economy is the U.K. Chart of the WeekThe Pound Is A Function Of Relative Monetary Policy Absent Brexit, U.K. Interest Rates Would Be Much Higher U.K. wages are growing at 3.7% (Chart I-2). Total labour costs, which include other compensation such as employer pension contributions, are rising even faster, at 4.4%, a sharp acceleration from a year ago.1 Meanwhile, the unemployment rate is at a forty year low of 4.2% (Chart I-3). To put all of this into context, the U.K. metrics are broadly equal to, or more extreme than those in the U.S. where the Federal Reserve has already hiked the policy interest rate seven times! Chart I-2U.K. Wages Are Growing ##br##Faster Than In The U.S. Chart I-3The U.K. Unemployment Rate##br## Is As Low As In The U.S. You might think that the Bank of England would be emulating the Fed. Acknowledging "a tight labour market and gradually mounting pay pressure" Monetary Policy Committee member Andy Haldane did change his vote to a hike at the June 21 meeting. Yet the votes to remove ultra-accommodation remain in a minority of three to six. The BoE policy interest rate is still at 0.5%, only a fraction above its effective lower bound. And the tightening expected in the next couple of years remains very modest (Chart I-4). Why? Chart I-4Expectations For U.K. Rate ##br##Hikes Remain Subdued The BoE explains: "The main challenge continues to be to assess the economic implications of the United Kingdom withdrawing from the European Union and to identify the appropriate response to that changing outlook... ...those economic implications would be influenced significantly by the expectations of households, firms and financial markets about the United Kingdom's eventual relationships with the European Union and other countries, and the transition to them." The U.K./EU Relationship Has Only Three Possible Shapes Two years have passed since the U.K. voted to leave the EU, and the tomes that have been written on Brexit could have filled the British Library several times over. Yet on the crucial issue of what the U.K./EU relationship will look like, what we know today is little different to what we knew on the morning of June 24 2016. Just as then, we can say that the EU27 sees only three options for the long-term relationship between the U.K. and the EU. Stay in the EU. Plug into an off-the-shelf association, either the European Economic Area (EEA) or European Free Trade Association (EFTA), which already establishes the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland. Become a 'third country' to the EU like, for example, Ukraine and Turkey. The first option, to stay in the EU, is politically impossible for the U.K. unless and until a second referendum overturned the result of the first referendum - a not inconceivable, but distant possibility. The second option, to join the EEA or EFTA, is impossible until the U.K. government exorcises the hard Brexiters within its ranks who regard this endpoint as 'Brino' (Brexit in name only). Nevertheless, this - or something equivalent - is the most likely ultimate outcome once it becomes clear that what is on offer in the third option is a considerably worse deal for the U.K., both politically and economically. Becoming a third country necessarily involves a hard border. For the U.K. this creates an insoluble trilemma: the U.K./EU land border between Northern Ireland and the Irish Republic; the Good Friday peace agreement requiring the absence of any physical border within Ireland; and the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea (which would require a border between Northern Ireland and the rest of the U.K.). The U.K. government might suggest a solution: leave the EU single market for services and free movement of people, but commit to stay in the single market for goods by aligning U.K. tariffs and regulations with the EU. The U.K. government would argue that this would abrogate the need for customs checks and a hard border within Ireland. The problem with this is that the distinction between goods and services has become increasingly blurred. For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. It follows that the EU27 will almost instantaneously reject such a division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people. The rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy. Hence, the U.K. government's much hyped and lofty Brexit proposals risk getting a cold shower. The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland indefinitely remaining in the EU single market - an outcome that will be politically unpalatable. Meanwhile, the many U.K. firms which depend directly or indirectly on borderless EU supply chains for their livelihoods will fear a substantial disruption to their trade - an outcome that will be economically unpalatable. To mitigate these political and economic risks of becoming a third country to the EU, the U.K. would almost certainly need the safety net of a protracted transition period, which might become a never-ending 'rolling contract'. Throughout which, the U.K. would have to adhere almost fully to EU laws and regulations, an arrangement which a clear majority of the U.K. parliament supports (Figure I-1). Figure I-1Survey Of U.K. Members Of Parliament: ##br##Which Of These Would You Consider To Be Acceptable As Part Of A Transition Agreement? Then the reality might dawn: is it really worth going through a long transition to become a third country? Why not just attach to the EEA or EFTA instead? Although bereft of a seat at the EU top table, the carrot of EEA membership is that its Treaty Articles 112-114 enable a 'temporary brake' on the freedom of movement in particular economic sectors, satisfying a key demand of Brexit voters. The Investment Implications: Distinguish Near-Term From Long-Term If the EU27 pours cold water on Theresa May's much-hyped Brexit proposals, the immediate uncertainty around Brexit would increase. However, in the longer term any outcome that keeps the U.K. either in a protracted transition to exit or eventually attach to the EEA or EFTA would be benign for the U.K. economy and comfort the BoE. Hence, it is important to distinguish the near-term and long-term outlooks for U.K. investments. For U.K. gilts relative to other government bonds, it means bullish near-term, but bearish long-term (Chart I-5). Chart I-5Brexit Risks Have Constrained The BoE ##br##And Held Down U.K. Bond Yields For the pound, it is the opposite: caution near-term, but scope for long-term appreciation, especially versus the dollar (Chart of the Week). For the FTSE100 relative to other major equity indexes, there is another consideration: the FTSE100 is very overweight the oil and gas sector, whose outperformance appears technically extended. Hence, within a European or global equity portfolio, we recently downgraded the FTSE100 from overweight to neutral (Chart I-6). Chart I-6The FTSE100's Overweight To Oil And Gas##br## Drives Its Relative Performance We finish with two important charts outside the U.K.: The global 6-month credit impulse is still in a mini-downswing, which corroborates our successful on-going underweight stance to the classical cyclical sectors (Chart I-7). Chart I-7Underweight Cyclicals Whenever The Global 6-Month Credit Impulse Is In A Mini-Downswing Finally, the dollar's recent rally is technically extended to a point which usually signals a tradeable reversal in the DXY (Chart I-8). Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 As measured by Eurostat on a harmonized basis. Fractal Trading Model* As just discussed, this week's recommended trade is to position for a tradeable reversal in the trade-weighted dollar. Set a 2% profit target with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 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