Consumer

Highlights Investors are worrying too much about the things that caused the global financial crisis, and not enough about those that could cause the next downturn. Despite the recent patch of soft data, the U.S. housing market is in good shape. Go long homebuilders relative to the S&P 500. Imbalances in the corporate debt market have increased, but are not severe enough to generate systemic economic distress. U.S. rates will need to rise quite a bit more than the market anticipates before the economy slows by enough to force the Fed to back off. The combination of a stronger dollar and inadequate Chinese stimulus will continue to pressure emerging markets. Even Brazil's pro-capitalist new president may not be able to reverse the country's bleak fiscal dynamics. Our MacroQuant model, which predicted the correction, points to further near-term downside risk for global equities. The cyclical (12-to-18 month) outlook looks much better, however. Feature The Market's Maginot Line One of the most reliable ways to make money as an investor is to figure out the market's collective biases and trade against them. Behavioral economists have long noted that people tend to assign too much weight to recent experience in taking decisions. As a result, in finance, as in military strategy, there is a constant temptation to fight the last war. The last war policymakers waged was against the scourge of deflation that followed the housing bust and financial crisis. For much of the past decade, investors have held a magnifying glass over anything that could possibly resemble the conditions that led up to the Global Financial Crisis. While such behavior is understandable, it is misplaced. History suggests that both lenders and borrowers tend to act prudently for years, if not decades, following major financial crises. Mistakes are still made, but they are different mistakes. People overcompensate. They obsess about the past rather than focusing on the future. U.S. Housing Is Okay There is no denying that the U.S. housing market has softened this year (Chart 1). Housing starts, building permits, and home sales have all fallen. Residential investment has subtracted from GDP growth over three consecutive quarters. Chart 1Housing Has Been A Drag On The U.S. Economy This Year There is little mystery as to why the housing market has been on the back foot. The Trump tax bill capped the deduction on state and local property taxes, while reducing the amount of mortgage debt on which homeowners can deduct interest payments from $1 million to $750,000. This had a negative effect on housing activity, especially in high-tax Democrat-leaning states with elevated real estate prices. More importantly, mortgage rates have risen by over 100 basis points since last August. Chart 2 shows that home sales and construction almost always decline after mortgage rates rise. In this respect, the weakness in housing activity is reminiscent of the period following the taper tantrum, when housing activity also slowed sharply. Chart 2No Mystery Why U.S. Housing Has Been Weak... We do not expect mortgage rates to fall from current levels. But they are not going to rise at the same pace as they have over the past year. Thus, while the headwinds from higher financing costs will not disappear, they will abate to some extent. Fundamentally, the housing market is on solid ground (Chart 3). Mortgage rates are still well below their historic average. Home prices have risen considerably, but do not appear excessively stretched compared to rents or incomes. Unlike in 2006, the home vacancy rate is near its historic lows. Residential investment stands at only 3.9% of GDP, compared with a peak of 6.7% of GDP in the second half of 2005. The average age of the residential capital stock has risen by nearly five years since 2006, the largest increase since the Great Depression. With household formation rebounding briskly from its post-recession lows, homebuilders are still arguably not churning out enough new homes. Chart 3A...But Fundamentals Are Still In Good Shape (I) Chart 3B...But Fundamentals Are Still In Good Shape (II) Mortgage lenders have learned from past mistakes (Chart 4). While lending standards have eased modestly over the past 4 years, underwriting standards have remained high. The average FICO score for new borrowers is more than 40 points above pre-recession levels. The Urban Institute Housing Credit Availability index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is at reassuringly low levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. Moreover, banks today hold much more high-quality capital than in the past, which gives them additional space to absorb losses (Chart 5). Chart 4Lending Standards Have Been Tight, But Are Starting To Loosen Chart 5U.S. Banks Are Well Capitalized With all this in mind, we are initiating a new strategic trade to go long U.S. homebuilders relative to the S&P 500.1 Corporate Debt: How Big Are The Risks? Unlike household debt, U.S. corporate debt has risen over the past decade and now stands at a record high level as a share of GDP. The quality of the lending has also been less than pristine, as evidenced by the proliferation of "covenant lite" loans. The interest coverage ratio for the economy as a whole - defined as the volume of profits corporations generate for every dollar of interest paid - is still above its historic average (Chart 6). However, this number is skewed by a few mega-cap tech companies that hold a lot of cash and have little debt. Chart 6Interest Coverage Looks Relatively High My colleague Mark McClellan, who writes our monthly Bank Credit Analyst publication, has shown that the interest coverage ratio for companies comprising the Bloomberg Barclays index would drop close to the lows of the Great Recession if interest rates were to rise by a mere 100 basis points across the corporate curve. The damage would be far worse if profits also fell by 25% in this scenario.2 While the corporate debt market has become increasingly frothy, it does not pose an imminent danger to the economy. There are several reasons for this. First, while U.S. corporate debt is high in relation to the past, it is still quite low in comparison with many other economies (Chart 7). The ratio of corporate debt-to-GDP, for example, is 30 percentage points higher in the euro area. This suggests that U.S. businesses still have the "carrying capacity" to take on additional debt. Chart 7U.S. Corporate Debt Is Not That High By Global Standards Second, the average maturity of U.S. corporate debt has risen over the past decade, with an increasing share of companies opting for fixed over floating-rate borrowings. This implies that it will take a while for the effect of higher rates to make their way through the system. Third, and perhaps most importantly, corporate bonds are generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. Bank loans account for only 18% of nonfinancial corporate-sector debt, down from 40% in 1980 (Chart 8). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Chart 8Banks Have Reduced Their Exposure To The Corporate Sector Tellingly, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal (Chart 9). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 9The 2015 Debt Scare Did Not Topple The Economy Government Debt: No Worries... Yet If the risks posed by both the housing market and corporate debt market are contained, what about the risks posed by soaring government debt? The long-term fiscal outlook is certainly bleak, but the near-term risks are low.3 President Trump's tweets aside, the U.S. has an independent central bank which has been able to keep inflation expectations well anchored. The U.S. private sector is also running a financial surplus at the moment, meaning that it earns more than it spends (Chart 10). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its fiscal deficit. Chart 10The U.S. Private Sector Is A Net Saver The private sector's financial balance will deteriorate over the next two years as household savings decline and corporate investment rises. This will put upward pressure on Treasury yields. However, if rising yields are reflective of stronger aggregate demand, this is unlikely to derail the economy. When Things Break Recessions are usually caused when the Fed raises rates by enough to undermine spending on interest rate-sensitive purchases such as housing, or when higher rates prick an asset bubble just waiting to burst. Given the lack of clear imbalances either in the real economy or financial markets, the Fed may have to raise rates significantly more than the market is currently anticipating. In fact, far from having to press the pause button midway through next year, our baseline expectation is that the Fed will expedite the pace of rate hikes in late 2019 as inflation finally starts to accelerate. Aggressive Fed rate hikes combined with an incrementally less expansionary fiscal policy will sow the seeds of a recession in late 2020 or 2021. Before the next U.S. downturn arrives, the dollar will have strengthened further. A resurgent greenback will cast a long shadow over emerging markets and commodity producers. As we discussed last week, China is unlikely to save the day by launching a massive stimulus program of the sort that it orchestrated in both 2009 and 2015.4 True, not all emerging markets are equal. Emerging Asia is more resilient now than it was two decades ago. Thailand, for example, was patient zero for the Asian crisis in 1997. Today, it sports a current account surplus of over 10% of GDP and low levels of external debt. This resilience will not prevent Asian economies from experiencing slower growth on the back of weaker Chinese demand, but it will prevent a full-blown balance of payments crisis from spiraling out of control. In contrast to Emerging Asia, Latin America looks more vulnerable (Table 1). BCA's chief emerging market strategist, Arthur Budaghyan, wisely upgraded Brazilian assets on a tactical basis on October 9th ahead of the presidential elections. Nevertheless, Arthur still worries that Brazil's daunting fiscal challenges - the budget deficit currently stands at 7.8% of GDP and the IMF expects government debt to rise to nearly 100% of GDP over the next five years (Chart 11) - are so grave that even South America's answer to Donald Trump may not be able to save the Brazilian economy. Table 1Vulnerability Heat Map For Key EM Markets Chart 11Brazil Is Fiscally Challenged A Correction, Not A Bear Market The current market environment bears some similarities to the late 1990s. The Fed is tightening monetary policy in order to keep the domestic economy from overheating. The U.S. economy is responding to higher rates to some extent, but the main effects are being felt overseas. The Asian Crisis did not end the bull market in U.S. stocks, but it did generate a few nasty selloffs, the most notable being the 22% peak-to-trough decline in the S&P 500 between July 20 and October 8, 1998. We witnessed such a selloff this October. The bad news is that our MacroQuant model is pointing to additional equity weakness over the coming weeks (Chart 12). The model tends to downgrade stocks whenever growth is slipping, financial conditions are tightening, and sentiment is deteriorating from bullish levels. All three of these things are currently occurring. Chart 12MacroQuant* Model Suggests Caution Is Warranted The good news is that none of our recession indicators are flashing red. Since recessions and bear markets typically overlap (Chart 13), the odds are high that the current stock market correction will be just that, a correction. Chart 13Recessions And Bear Markets Usually Overlap Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The corresponding ETFs are long ITB/short SPY. 2 Please see The Bank Credit Analyst Special Report, "The Long Shadow Of The Financial Crisis," dated October 25, 2018. 3 It is actually not even clear that a loss of confidence in America's fiscal management would cause a recession. The Fed largely determines borrowing costs at the short-to-medium end of the yield curve, which is where the government finances most of its debt. If people lose confidence in the dollar, they will either need to run down their cash balances by purchasing more goods and services or try to move their wealth abroad. The former will directly increase aggregate demand, while the latter will indirectly increase it through a weaker currency. To be clear, we are not suggesting that such an outcome would be beneficial to the economy; it would, among other things, greatly slow potential GDP growth by discouraging investment. But the near-term effect would likely be economic overheating and rising inflation rather than a recession. 4 Please see Global Investment Strategy Weekly Report, "Chinese Stimulus: Not So Stimulating," dated October 26, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights So What? Go long Brent / short S&P 500. The risk of a recession in 2019 is underappreciated. Why? The likelihood is increasing of a geopolitically-induced supply-side shock that pushes crude prices above $100 per barrel in the coming 6-12 months. Oil supply disruptions in Iran, Iraq, and Venezuela represent the primary source of risk. Historically, the combination of Fed rates hike and an oil price spike has preceded 8 out of the last 9 recessions. Also... A recession in 2019, ahead of the 2020 election, would set the stage for a confrontation between Trump and the Fed, adding fuel to market volatility. Feature Geopolitical tensions are brewing from the Strait of Hormuz to the Strait of Malacca. As we go to press, news is breaking that a Chinese naval vessel almost collided with the USS Decatur as the latter conducted "freedom of navigation" operations within 12 nautical miles of Gaven and Johnson reefs in the Spratly Islands. Given the trade tensions between China and the U.S., this alleged maneuver by the Chinese vessel suggests that Beijing is not backing off from a confrontation. Our view remains that Sino-American trade tensions can get a lot worse before they get better. The latest incident, which builds on a series of negative gestures recently in the South China Sea, suggests that both sides are combining longstanding geopolitical tensions with the trade war. This will likely encourage brinkmanship and further degrade U.S.-China relations. Yet China-U.S. tensions are not the only concern for investors in 2019. Another crisis is brewing in the Middle East, with the potential to significantly increase oil prices over the next 12 months. U.S. households may have to deal with a double-whammy next year: higher costs of imported goods as the U.S.-China trade war rages on and a significant increase in gasoline prices. In this report, we discuss this dire outlook. The Folly Of Recession Forecasting In mid-2017, BCA Research published two reports, one titled "Beware The 2019 Trump Recession" and another titled "The Timing Of The Next Recession."1 Both argued that if the Federal Reserve kept raising rates in line with the FOMC dots, then monetary policy would move into restrictive territory by early 2019 and increase the likelihood of recession thereafter. We subsequently adjusted the timing of our recession forecast to 2020 or beyond, based on a more positive assessment of the U.S. economy. In this report, we explore a risk to the BCA House View on the timing of the next recession. As BCA's long-time Chief Economist Martin Barnes has said, predicting recessions is a mug's game. There have been eight recessions in the past 60 years (excluding the brief 1980-81 downturn) and the Fed failed to forecast all of them (Table 1). Table 1Fed Economic Forecasts Versus Outcomes The Atlanta Fed produces a recession indicator index which is designed to highlight the odds of recession based on trends in recent GDP data. At the moment, the indicator is at a historically sanguine 2.4%. Unfortunately, low readings are not a reliable cause for optimism. The 1974-75, 1981-82, and 2007-09 recessions were all severe and the Atlanta Fed's recession indicator had a low reading of 10%, 1.6%, and 7.7%, respectively - just as the recession was about to begin (Chart 1). Chart 1The Market Is Not Expecting A Recession The 1974-75 recession is instructive, given the numerous parallels with the current environment: Energy Geopolitics: The 1973 oil crisis caused a massive spike in crude prices. This point is especially pertinent since the 1973 oil embargo is widely viewed as an important contributor to the 1974-75 recession. Real short rates had risen and the yield curve had inverted long before oil prices spiked, so recession was almost inevitable even without the oil price move. But the oil spike made the recession much deeper than otherwise. Protectionism: President Nixon imposed a 10% across-the-board tariff on all imports into the U.S. in 1971 to try to force trade partners to devalue the U.S. dollar. Dislocation: Competition from newly industrialized countries - Japan and the East Asian tigers in particular - laid waste to the steel industry in the developed world. Polarization: President Nixon polarized the nation with both his policies and behavior, leading to his resignation in 1974. Given the exogenous and geopolitical nature of oil supply shocks, today's recession indicators are missing a critical potential headwind to the economy. A geopolitically induced oil-price shock could create more pain than the economy is able to handle. Why An Oil Price Shock? America's renewed foray into the politics of the Middle East will unravel the tenuous equilibrium that was just recently established between Iran and its regional rivals. The U.S.-Iran détente that produced the signing of the 2015 Joint Comprehensive Plan of Action (JCPA) created conditions for a precarious balance of power between Israel and Saudi Arabia on one side, and Iran and its allies on the other side. This equilibrium led to a meaningful change in Tehran's behavior, particularly on the following fronts: The Strait of Hormuz: Tehran ceased to rhetorically threaten the Strait as soon as negotiations began with the U.S. (Chart 2). Since then, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities remain unchanged.2 Iraq: Iran directly participated in the anti-U.S. insurgency in Iraq. Tehran changed tack after 2013 and cooperated closely with the U.S. in the fight against the Islamic State. In 2014, Iran acquiesced to the removal of the deeply sectarian, and pro-Iranian, Prime Minister Nouri al-Maliki. Bahrain and the Saudi Eastern Province: Iran's material and rhetorical support was instrumental in the Shia uprisings in Bahrain and Saudi Arabia's Eastern Province in 2011 (Map 1). Saudi Arabia had to resort to military force to quell both. Since the détente with the U.S. in 2015, Iranian support for Shia uprisings in these critical areas of the Persian Gulf has stopped. Chart 2Geopolitical Crises And Global Peak Supply Losses Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Put simply, the 2015 nuclear deal traded American acquiescence toward Iranian nuclear development in exchange for Iran's cooperation on a number of strategically vital regional issues. By unraveling that détente, President Trump is upending the balance of power in the Middle East and increasing the probability that Iran retaliates. Since penning our latest net assessment of the U.S.-Iran tensions in May, Iran has already retaliated.3 Our checklist for "kinetic" conflict has now risen from zero to at least 15%, if not higher (Table 2). We expect the probability to rise once the U.S. starts implementing the oil embargo in November. This will dovetail our Iran-U.S. decision tree, which sets the subjective probability of kinetic action by the U.S. against Iran at a baseline of 20% (Diagram 1). Table 2Will The U.S. Attack Iran? Diagram 1Iran-U.S. Tensions Decision Tree Bottom Line: The premier geopolitical risk to investors in 2019 is that President Trump's maximum pressure tactic on Iran spills over into Iraq, causing a loss of supply from the world's fifth-largest crude producer.4 We expect the U.S. oil embargo against Iran to remove between 1 million and 1.5 million barrels per day from the market. In addition, the loss of Iraqi production due to sabotage could be anywhere between 500,000 and 3.5 million barrels per day. Added to this total is the potential loss of Venezuelan exports due to the deteriorating situation there. When our commodity team combines all of these factors, they generate a worst-case scenario where the price of crude rises to $110 per barrel in 2019 or higher (Chart 3). And this scenario assumes that EMs do not reinstitute energy subsidies (and therefore their consumption falls faster than if they do reinstitute them). Chart 3Worst-Case Scenario Propels Oil Price Toward 0/Barrel The Ayatollah Recession We believe that the midterm election is a dud from an investment perspective, no matter the outcome. However, the election does matter as a hurdle that, once cleared, will allow President Trump to renew his "maximum pressure" tactic against China, Iran, and perhaps domestic tech corporations.5 Iran is a critical risk in this strategy. If President Trump applies maximum pressure on Iran, then a reduction in crude exports from Iran, Iranian retaliation in Iraq, and the simultaneous loss of Venezuelan supplies could combine to increase the likelihood of U.S. recession in 2019. Readers might recall that no sitting president has gotten re-elected during a recession. Why would Trump pursue a policy that risks his re-election chances in 2020? Surely he would deviate from his maximum pressure tactic if faced with the prospect of a recession. However, it is folly to assume that policymakers are perfectly rational, or fully informed. American presidents are some of the most unconstrained policymakers in the world, given both the hard power of the United States and the constitutional lack of constraints on the president when it comes to national security. Trump may believe, for instance, that the 660 million barrels of crude in America's Strategic Petroleum Reserve can offset the impact of sanctions against Iran.6 Or he may believe that he can force OPEC to supply enough oil to offset the Iranian losses. The problem for President Trump is that Iran is not led by idiots. Iranian policymakers understand that the best way to reduce American pressure is to induce an oil price spike in the summer of 2019 that hurts President Trump's re-election chances, forcing him to back off. As such, sabotaging Iraqi oil exports, which mainly transit through the port of Basra - a city highly vulnerable to Shia-on-Shia violence that is already a risk to the country's stability - would be an obvious target. An oil price spike would serve as a negotiating tool against the U.S., and the additional revenue would help replace what Iran loses due to the embargo. Tehran and Washington will therefore play a game of chicken throughout 2019, and there is a fair probability that neither side will swerve. President Trump may be making the same mistake as many predecessors have made, assuming that the Iranian regime is teetering at a precipice and that a mere nudge will force the leadership to negotiate. Oil price shocks and recessions have a historical connection. In a recent report, our commodity strategists highlighted that a spike in oil prices preceded 10 out of the past 11 recessions in the U.S. since 1945 (Table 3). Admittedly, not all spikes were followed by recession. The combination of an oil price spike and Fed rate hikes has produced a recession 8 out of 9 times.7 If oil prices rose to $100 per barrel in the coming 6-12 months, there will be several negative macro consequences. In particular, gasoline prices will rise back toward $4 per gallon (Chart 4). Retail gasoline prices have already increased by more than 50% since they bottomed in February 2016. So how much more upside can the U.S. private sector take? Table 3History Of Oil Supply Shocks Chart 4A Source Of Pressure For Consumers The Household Sector Consumer confidence is currently near all-time highs, which tends to signal that the path of least resistance is flat or down (Chart 5). Household gasoline consumption has already declined in response to higher oil prices since the middle of 2017. Given that gasoline demand is relatively inelastic, consumers may already be near their minimum consumption level. Chart 5Nearing All-Time Highs Instead, households will experience a decline in their disposable income. This will come on the back of both higher gasoline prices and an increase in the prices of other goods and services, as the oil spike spills across sectors. U.S. households - and most likely those in other markets - are stretched to the limit already. A recent Fed survey found that 40% of U.S. households do not have the funds needed to meet an unexpected $400 cost in any given month.8 Such an unexpected expense would require them to either sell possessions, borrow, or cut back on other purchases. Chart 6Most Americans Cannot Cut Saving To Spend Left with few other options, households would react to their lower disposable income by reducing demand for other goods and services. This dent in consumer spending would bring down aggregate demand, leading to slower employment growth and even less income and spending. Households could save less to maintain their current purchasing levels, given the recent rise in the savings rate (Chart 6). But this is unlikely. Although the household savings rate has increased in recent years, we have previously argued that a material part of the increase was driven by small business-owner profits. These owners have much higher levels of income than the median consumer. For Americans living paycheck-to-paycheck, it would be difficult to reduce a savings rate that is already close to, or below, zero. Higher oil prices will also hurt growth in Europe and Japan, economies that are already struggling to gain economic momentum after grappling with a weaker growth impulse from China. In addition, EM economies that took the opportunity to reform their oil subsidies amid lower oil prices post-2014 will have to grapple with a much larger shock to consumers than usual. The Corporate Sector In theory, what consumers lose from rising oil prices, producers of crude can gain in stronger revenue. This is especially important in the U.S. as domestic energy production has increased significantly over the past 10 years. Nonetheless, the oil and gas extraction sector accounts for just 1.1% of GDP and 0.1% of total employment. The marginal propensity to spend out of every dollar of income is lower for producers than consumers. Moreover, if consumer confidence fell and consumer spending weakened, non-energy capex would decline as businesses reassessed household demand and held off from making investment decisions. Small business confidence is at record highs, and as with consumer confidence, vulnerable to downward revisions (Chart 7). Chart 7Dizzying Heights Chart 8Only One Way To Go (Down) Profit margins remain at a highly elevated level and also have only one way to go (Chart 8). If high oil prices should combine with rising borrowing costs and upward pressure on wages (which could develop in this macro environment) the result would be a triple hit to margins (Chart 9). Of course, rising wages would give consumers some offset to higher oil prices, so the question will be the net effect of all variables. And if the dollar bull market continues, as our FX team believes it will, the combination of higher oil prices and a strong USD would hurt U.S. companies with international exposure. The debt load held by the U.S. corporate sector would turn this bad dream into a nightmare. Many American companies have spent the past 10 years increasing leverage to buy back equity (Chart 10). Companies with high debt would need to revise down their profit expectations, with potentially devastating consequences. Elevated debt levels also increase the likelihood of financial market stress if bond investors get worried and spreads begin to widen significantly. Chart 9Rising Pressures On Earnings? Chart 10Large Corporate Debts According to all measures, U.S. stocks are at or near their all-time valuation peaks. Investors have also priced in a significant amount of optimism for profit growth (Chart 11). These expectations would be subject to quick revision if our oil shock scenario plays out. In other words, investor expectations for profit margins are not sufficiently factoring the triple hit of higher oil prices, higher interest rates, and higher wages. Chart 11The Market Has High Hopes An additional geopolitical risk on the horizon for 2019 is the creeping "stroke of pen" risk from potential regulation of technology enterprises. This is unrelated to an oil price spike (other than that it would be an effect of U.S. policy) but could nonetheless combine with rising energy prices to sour investors' mood.9 Bottom Line: An oil price spike above $100 would produce negative consequences for the U.S. household and corporate sectors. Given the supply-side nature of the price shock, it would not be accompanied by the usual decline in USD, and could therefore hurt the foreign profits of U.S. corporations as well. If investors must also deal with mounting regulatory pressures on FAANG stocks, they could face a perfect storm. Given the high probability of such an oil price shock, why isn't a 2019 recession BCA's House View, rather than merely a risk to it? Because it is difficult to say how high oil prices need to rise to cause a recession. For example, 1973 both marked a permanent move up in oil prices and saw oil prices triple. In 2019 terms, that would mean an oil price above $200, a far less probable scenario than $100-$110. Nevertheless, the combination of elevated oil prices and the price impact on consumer goods of the U.S.-China trade war could combine to create a nightmare scenario for consumers. But it is impossible to gauge the level of both required to push the U.S. into a recession. Second, there are many ways in which today's macro environment is different from that in 1974. In the 1970s the inventory cycle was a key factor in the business cycle, with excesses building up ahead of recessions, forcing output cutbacks as demand weakened. That is no longer the case in today's world of just-in-time inventory management. Also, inflation was a much bigger problem back then, requiring tougher Fed action. On the other hand, debt burdens were much lower. Investment Implications To be clear, none of the usual recession indicators that BCA Research uses are flashing red at this time. The point of this analysis is to illustrate a credible, exogenous scenario that cannot be revealed through the usual data-driven recession forecasting methods. What happens if a recession does occur ahead of the 2020 election? How would President Trump react to a recession induced by his foreign policy adventurism in the Middle East? By doing what every other president would do: finding someone else to blame. In this case, we would put high odds on the Federal Reserve becoming the target of President Trump's fury. Ahead of 2020, the Fed and its independence may very well become an election issue.10 This could spell serious trouble for the Fed, which is at a massive disadvantage when it comes to explaining to voters why central bank independence is so important. The Fed had great difficulty managing public opinion regarding its extraordinary measures to combat the Great Recession - its attempts at public outreach largely failed. Compare the number of Trump's Twitter followers to that of the Fed's (Chart 12). Chart 12The Fed's PR Abilities Are Limited Though most of our clients and colleagues will probably disagree, we do not see central bank independence as a static quality. It was bestowed upon central banks by politicians following widespread inflation fears throughout the 1970s and 1980s, although in the U.S. the current tradition goes back to the 1951 Treasury Accord that restored the independence of the Fed. Our colleague Martin Barnes penned a report on the politicization of monetary policy in 2013.11 His conclusion is that political meddling in monetary affairs is less pernicious than economic performance. The Fed will incur Trump's ire, in other words, but it will be its failure to generate economic growth that causes a break in independence. We are not so sure. The next recession is likely to be a mild one for Main Street given the lack of real economic bubbles. But given the slow recovery in real wages over the past decade and the general angst of the populace towards governing elites, even a mild recession that merely reminds voters of 2008-2009 could produce deep anxiety and significant public reactions. Further, the idea of "independent," non-politically accountable institutions is going out of style. President Trump - and other policymakers in the developed world - have specifically targeted the "so-called experts" and "institutions." President Trump has attacked America's foreign policy architecture, NATO, the WTO, and a slew of supposedly outdated norms and practices for being "out of touch" with the electorate. This policy has served him well thus far. If our nightmare scenario of an oil price-induced recession plays out, the immediate implication for investors will be a sharp downturn in risk assets. As such, we are recommending that investors hedge their portfolios with a long Brent / short S&P 500 trade. Alternatively we would recommend going long U.S. energy / short technology stocks. A longer-term, and perhaps even more pernicious implication, would be the end of the era of central bank independence and a full politicization of the economy. Laissez-faire capitalist system would give way to dirigisme. In the process, the U.S. dollar and Treasuries would be doomed. Jim Mylonas, Global Strategist Daily Insights & BCA Academy jim@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 3 Please see BCA Research Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018 and "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "A Story Told Through Charts: The U.S. Midterm Election," dated September 19, 2018, available at gps.bcaresearch.com. 6 The Strategic Petroleum Reserve currently covers 100 days of net crude imports, or 200 days of net petroleum imports, and can be tapped for reasons of political timing as well as international emergencies. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge," dated September 13, 2018, available at bcaresearch.com. 8 Please see the U.S. Federal Reserve, "Report on the Economic Well-Being of U.S. Households in 2017," May 2018, available at federalreserve.gov. 9 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com. 10 Please see BCA Daily Insights, "Politics And Monetary Policy," dated August 22, 2018, and "The Battle Of The Press Conferences: Trump Versus Powell," dated September 27, 2018, available at dailyinsights.bcaresearch.com. 11 Please see BCA Special Report, "The Politicization Of Monetary Policy: Should We Care?" dated April 15, 2013, available at bca.bcaresearch.com. Geopolitical Calendar

Dear Client, I will be visiting clients next week. Instead of our Weekly Report, we will be sending you a Special Report written by my colleagues Matt Gertken and Ray Park. The report addresses the North Korean situation and argues that a positive, if not perfect, diplomatic solution will result from U.S.-North Korean negotiations. Best regards, Peter Berezin, Chief Global Strategist Highlights The U.S. can withstand further rate hikes. Neither economic nor financial imbalances are especially elevated, while fiscal stimulus will offset much of the sting from tighter monetary policy. Unfortunately, America's resilience to higher rates does not extend to the rest of the world. A stronger dollar is undermining emerging markets, which are already under pressure from slower Chinese growth and the looming prospect of trade wars. The crisis in Italy will further restrain the ECB from withdrawing monetary support. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors could consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield has reached 4%. EUR/USD came within a whisker of our 1.15 target this week. We will book profits on our long DXY trade recommendation if the dollar index reaches 96. A defensive posture is appropriate for now, but risk assets should recover later this year as the global economy finds its footing. This could set the scene for a blow-off rally in stocks. Feature Gauging The Pain Threshold From Higher Rates Chart 1Market Expectations Slightly Below Fed Dots After the recent turbulence, the market is pricing in 100 basis points of Fed rate hikes between now and the end of 2020 (Chart 1). Such a pace of rate hikes would be quite slow by historic standards. In past tightening cycles, the Fed would typically raise rates by about 50 basis points per quarter. Investors expect the real fed funds rate to peak at around 1%, well below the historic average of 3%-to-5%. Underlying these expectations is the presumption that the neutral rate of interest - the rate consistent with full employment and stable inflation - is quite low, and that the Fed will not have to raise rates much above neutral to cool the economy. According to the April FOMC minutes, "a few" participants thought that the fed funds rate was already close to its equilibrium level. There are many reasons to think that R-star has fallen over time, but in practice, the margin of error around estimates of the neutral rate is huge. Thus, rather than getting bogged down over technical issues, investors would be well served by taking a more practical approach and asking what they should be on the lookout for to determine whether interest rates have moved into restrictive territory. The State Of The U.S. Housing Market Housing has historically been the most important interest rate-sensitive sector, so much so that Ed Leamer entitled his 2007 Jackson Hole symposium paper "Housing Is The Business Cycle."1 Given the recent runup in mortgage yields, it is not too surprising that the latest data on U.S. housing has been on the weak side (Chart 2). Mortgage applications for purchase have come off their highs. Housing starts, building permits, and new and existing home sales all declined in April. Homebuilder sentiment improved a tad, but this was due to an increase in the current sales component; future sales expectations were flat on the month. The share of respondents who indicated that now was a good time to buy a home in the latest University of Michigan Consumer Sentiment survey declined to 69% in May, continuing its slide from a peak of 83% in December 2014. Still, we would not fret too much about the state of the U.S. housing market (Chart 3). Construction activity has been slow to increase this cycle, which has pushed vacancies to ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2006 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Chart 2U.S. Housing: Higher Mortgage##br## Rates Are A Headwind... Chart 3...But Don't##br## Fret Yet Household Debt Is Not Yet At Worrying Levels Lenders also remain circumspect (Chart 4). Mortgage debt has barely grown as a share of disposable income throughout the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. A dwindling share of loan originations since the financial crisis has involved adjustable rate mortgages (Chart 5). This has made the housing market more resilient to Fed rate hikes. Other parts of the household credit arena look more menacing, but not so much that they threaten to short-circuit the economy. Banks have been tightening lending standards on auto loans since Q2 of 2016 and credit card loans since the second quarter of last year. This should help moderate the increase in default rates that has been observed in those categories (Chart 6). Chart 4Mortgage Debt Is Not ##br##A Cause For Concern Chart 5Housing Market: More Resilient To ##br##Rate Hikes Than It Used To Be Chart 6Lenders Are More ##br##Circumspect These Days Student debt has continued to trend higher, but the vast majority of these loans is backstopped by the government. While the Treasury's own finances are on an unsustainable trajectory, this is more of a long-term concern than a short-term problem. If anything, fiscal stimulus over the next two years will allow the Fed to raise rates more than it could otherwise without endangering the economy. Corporate Borrowing: High But Not Extreme Like a river, market liquidity tends to flow along the path of least resistance, rather than towards those who happen to be the most thirsty. While the household sector was piling on debt during the 2001-2007 boom, the U.S. corporate sector was still recovering from the hangover produced by the capex boom in the late 1990s. A decade later, corporate balance sheets were in good shape. Spurred on by ultra-low interest rates, corporate debt levels began to rise. Today, the ratio of corporate debt-to-GDP is near a record high. Valuations for corporate assets have reached lofty levels. In inflation-adjusted terms, commercial real estate prices are 4% above their pre-recession peak (Chart 7). U.S. equities also trade at a historically elevated multiple to earnings, sales, and book value (Chart 8). There are bright spots, however (Chart 9). Thanks to lofty corporate profits, the ratio of corporate debt-to-EBITDA is in the middle of its post-1990 range based on national accounts data. Interest payments-to-EBIT are near historic lows. Corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. Although the picture is not as benign if one performs a bottom-up analysis of publicly-listed companies, the overall message is that the U.S. corporate sector can handle higher rates. Corporate stresses will eventually rise, but it will likely take a recession for this to happen, which we don't expect until 2020. Chart 7Commercial Real Estate Prices: ##br##Above Pre-Recession Levels Chart 8U.S. Equities##br## Are Overvalued Chart 9Corporate Debt Is High,##br## But So Are Profits Cyclical Spending Still Subdued The discussion above suggests that U.S. interest rate-sensitive sectors can withstand further rate hikes. This conclusion is buttressed by the observation that the cyclical sectors of the economy - the ones that tend to weaken the most during recessions - have yet to reach levels that make them vulnerable to a sharp retrenchment. Chart 10 shows that the sum of business capital spending, residential and commercial construction, and consumer discretionary goods purchases is still well below levels that have preceded past recessions. Along the same lines, the private sector financial balance - the difference between what the private sector earns and what it spends - is currently in surplus to the tune of 2.2% of GDP. This compares to deficits of 5.4% of GDP in 2000 and 3.8% of GDP in 2006 (Chart 11). Further monetary tightening, to the extent that it prevents any brewing imbalances in the real economy and financial markets from worsening, may be just what the doctor ordered. Chart 10Cyclical Spending Still Below Levels##br## Preceding Past Recessions Chart 11U.S. Private Sector Financial##br## Balance Is Healthy The Sneeze Felt Around The World The U.S. is not an island unto itself. Even if a bit outdated, the old adage which says that when the U.S. sneezes the rest of the world catches a cold, still rings true. As such, focusing on the neutral rate only as it pertains to the U.S. is a bit too parochial. There may be a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain in the U.S. itself. Emerging markets are particularly sensitive to changes in U.S. financial conditions. About 80% of EM foreign-currency debt is denominated in dollars. A stronger dollar and higher U.S. interest rates make it more difficult for EM borrowers to service their debts. While EM foreign-currency debt has declined as a share of total debt outstanding, this is only because the past decade has seen a boom in local debt issuance (Chart 12). As a share of GDP, exports, and international reserves, U.S. dollar debt is at levels not seen in over 15 years (Chart 13). Most emerging markets entered 2018 with strong growth momentum. Recent tracking estimates point to some deceleration in GDP growth, but nothing too alarming (Chart 14). That could begin to change. EM financial conditions have started to tighten, which is likely to weigh on activity. BCA's Emerging Market and Geopolitical Strategy teams have flagged the prospect of policy-inducing tightening in China. Trade tensions also seem to be escalating again following President Trump's decision this week to curb Chinese investment in the U.S., impose a 25% tariff on $50 billion of Chinese imports, and slap tariffs on foreign steel. All this could put an additional dent in global growth. While this publication does not expect a full-blown EM crisis, a period of EM underperformance over the next few months is likely. Chart 12EM Borrowers Like Local Credit, ##br##But Don't Dislike Foreign-Currency Debt Chart 13EM Dollar##br## Debt Is High Chart 14EM Growth Decelerating,##br## But Not Dramatically... Yet Italy: If You Are Gonna Do The Time, You Might As Well Do The Crime Even if emerging markets avoid another major crisis, one can always count on Europe to try to fill the void. The Italian 10-year bond yield is up over 100 basis points since the middle of April. Assuming a fiscal multiplier of one, a standard Taylor Rule equation says that Italy would need 2% of GDP in fiscal stimulus per year to offset the tightening in financial conditions brought upon by the recent increase in borrowing costs.2 That is 20% of GDP in stimulus over the next decade to pay for a fiscal package that has yet to be implemented by a government that does not yet (and may never) exist. At this point, investors are basically punishing Italy for a crime – defaulting and possibly jettisoning the euro – it has yet to commit. If you are going to get reprimanded for something you have not done, you have more incentive to do it. The market realizes this, which is why it is locked in a vicious circle where rising yields make default more likely, leading to even higher yields (Chart 15). The fact that GDP per capita in Italy is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 16). Chart 15When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Chart 16Italy: Neither Divine Nor A Comedy As we go to press, rumours are swirling that the Five Star Movement and Lega may be able to form a government after agreeing to appoint a less euroskeptic finance minister than the one the Italian President previously rejected. Regardless of whether this happens, investors are likely to remain on edge. Support for Lega has risen by seven percent since voters went to the polls in March. Populism is here to stay. All this suggests that the brewing crisis in Italy will not blow over easily. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors should consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield reaches 4%. At that point, the risk-reward trade-off from owning Italian debt would be too good to ignore. Until the Italian bond market reaches a capitulation point, the euro will remain under pressure. The Italian sovereign debt market is the biggest in Europe and the fourth largest in the world after the U.S., Japan, and China. If foreign investors continue to shun Italian debt, that will reduce capital inflows into the euro area. This means less demand for the common currency. Investment Conclusions The softening of global growth this year, along with tensions in emerging markets and Italy, have lit a fire under the dollar. Our long DXY trade is up 10.7% inclusive of carry. We continue to think that the path of least resistance for the dollar is up, but we will be looking to book gains on our trade recommendation once the dollar index reaches 96. That's roughly 2% above current levels. Slower global growth is bad news for cyclical equities. European and Japanese equities have a greater tilt towards cyclical sectors, so it is likely that their stock markets will underperform the U.S. over the next few months. This is particularly the case for Europe, where banks have come under pressure due to slower domestic growth, rising bond yields in Italy and Spain, and heightened exposure to emerging markets. For now, our MacroQuant model, which is designed to capture short-term movements in the stock market, is recommending a somewhat below-benchmark allocation to equities. Looking further out, our 12-month cyclical view on stocks remains modestly constructive, reflecting our expectation that the next major recession in developed markets is still two years away. Keep in mind that even the EM crisis in the 1990s did not plunge the U.S. into recession. On the contrary, the crisis restrained the Fed from raising rates too quickly. The resulting dose of liquidity led to a massive blow-off rally in equities, which took the S&P 500 up 68% between October 1998 and March 2000. European stocks did even better during that period, outperforming their U.S. peers by 40% in local-currency terms. We may be heading for a similar sequence of events. 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 The original Taylor Rule introduced by John Taylor in 1992 assigns a coefficient of 0.5 on the output gap. Thus, a one hundred basis-point rise in interest rates would be necessary to offset a 2% of GDP increase in output. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights China's industrial sector will continue decelerating, while consumer spending is so far booming. The world economy in general and EM in particular are exposed much more to China's industrial sector than to its consumer spending. The U.S. dollar will continue strengthening, regardless of the trend in U.S. bond yields. The reason is slowing global trade. The dollar rally and weakening global demand will ultimately lead to lower commodities prices. Stay put on / underweight EM financial markets. Turkey will need to hike interest rates more before a buying opportunity in its financial markets emerges. Feature The two key elements affecting the performance of EM financial markets are the U.S. dollar and commodities prices. The combination of a weak U.S. dollar and higher commodities prices is typically bullish for EM. The opposite also holds true: A strong dollar and lower commodities prices are bearish for EM. But what about the recent dynamics - the rally in the greenback and strong commodities prices? This combination is unlikely to be sustained. Historically, the divergence between the dollar's exchange rate and commodities prices has never lasted long (Chart I-1). The fundamental linkage between the U.S. dollar and commodities prices is global growth: improving global growth is positive for resource prices, and the U.S. currency has historically been negatively correlated with global trade - the trade-weighted dollar is shown inverted in this chart (Chart I-2). Chart I-1Commodities And The Dollar Chart I-2Global Growth And The Dollar Hence, if global growth stays strong, the U.S. dollar will pare its recent gains and commodities prices will stay well-bid. Conversely, if global trade decelerates commodities prices will inevitably have to change direction. We expect the dollar to stay well-bid because the current phase of dollar rally will at some point be followed by a second phase where the greenback's strength is driven by a slowdown in global trade. In this phase, commodities prices and U.S. bond yields will drop alongside a strengthening U.S. dollar. Weaker growth in China and in other EMs is the key reason we expect global trade volumes to slow. Is China Slowing? Making sense of growth conditions in China is never easy, but it is particularly confusing these days. We maintain that there is growing evidence that China's industrial segment is slowing and will continue doing so, yet consumer spending is still booming. The basis for the industrial slowdown is a deceleration in both money and credit growth, which has been taking place over the past 18 months or so. With respect to households, the borrowing binge continues. The unrelenting 20%+ annual growth in household credit continues to fuel the property bubble. In turn, a rising wealth effect from real estate as well as decent income growth are the underpinnings behind the booming consumer sector. The main and relevant point for investors from the perspective of China's impact on broader EM is as follows: the drop in the credit and fiscal impulse is heralding a deceleration in capital expenditures/construction. That, in turn, will lead to fewer imports of commodities and materials. Imports are the main transmission mechanism from China's economy to the rest of the world. Mainland imports in RMB terms have indeed decelerated meaningfully, yet import values in U.S. dollar terms have not (Chart I-3). So, what explains the recent gap between imports in yuan and dollar terms? The RMB's rally versus the U.S. dollar in the past 15 months has been responsible for this gap between import values. As one would expect, the spending power of mainland industrial companies has moderated because less credit and fiscal expenditures are being injected into the system (Chart I-4). Yet because the RMB now buys 10% more U.S. dollars than it did a year ago, mainland buyers' purchasing power of foreign goods that are priced in dollars has improved. As a result, the pace of growth of the value of U.S. dollar imports has remained buoyant. Chart I-3Chinese Imports In RMB & USD Terms Chart I-4Weaker Purchasing Power ##br##In China Will Hurt Imports If the RMB's exchange rate versus the dollar remains flat over the next 12 months, the growth rates of both imports in RMB and dollar terms will converge. In this case, a further slowdown in import spending in RMB terms will translate into considerable deceleration in mainland imports in U.S. dollar terms. In brief, the exchange rate is important because the U.S. dollar's depreciation versus the RMB since January 2017 has prevented the spillover from a slowdown in China's imports in local currency terms to the rest of the world in general and EM in particular. Chart I-5Goods And Services Imports: China And U.S. If and as the dollar continues to rally versus the majority of currencies, China could allow its currency to slip versus the greenback to assure a flat trade-weighted exchange rate and preserve its competitiveness. In such a scenario, China's purchasing power of goods and services from the rest of world will be impaired - which in turn means this economy will be remitting fewer dollars to the rest of the world. This will reduce the flow of U.S. dollars from China to EMs, adversely impacting the latter's financial markets and economies. Chart I-5 illustrates that China's imports of goods and services amount to $2.3 trillion compared with U.S. imports of goods and services of $3.1 trillion. Therefore, in terms of importance in global imports, China is not too far behind America. This holds true with respect to remitting dollars to the rest of the world. Provided that China imports more from EM - both from Asian manufacturing economies and commodities producers - than the U.S. does, then less mainland imports will entail fewer dollars flowing to EM. In short, the continued slowdown in China's purchasing power in U.S. dollar terms will negatively affect the rest of EM. This rests on our baseline view that mainland credit growth will continue slowing and the RMB will weaken against the dollar, albeit modestly for now. Mirroring the divergence between industrial sectors and consumers in the Middle Kingdom, there has been an equally clear divergence within imports: Imports of industrial supplies excluding machinery have slumped, while imports of household goods have continued to flourish. Chart I-6 demonstrates that imports have decelerated for base metals, chemicals, wood, mineral products and rubber. Even oil and petroleum products imports have slowed (Chart I-7). Yet imports of consumer goods are roaring (Chart I-8). Chart I-6China: Industrial Imports Are Slowing Chart I-7Chinese Fuel Imports Are Slowing Chart I-8Chinese Consumer Goods Imports Are Robust Which one is more important for EM: the industrial sector or consumer spending? Many developing economies in Latin America, Africa, the Middle East as well as countries such as Russia, Indonesia and Malaysia are very dependent on their commodities exports. These economies do not benefit much from booming Chinese consumers. For them, the critical variable is the mainland's industrial sector and its absorption of minerals and resources. In terms of size, Table I-1 illustrates that non-food commodities, industrial goods, machinery, equipment and transportation make up overwhelming majority of China's total imports. Meanwhile, consumer goods imports, excluding autos, comprise 15% of total imports. Hence, their impact on the rest of the world is small. Table I-1Structure Of Chinese Imports Further, most of consumer goods that households in China consume are produced locally rather than imported. That is why the world economy at large and EM in particular are more exposed to the mainland's industrial sector than its consumer one. Aside from imports, there are several other variables that validate our thesis of an ongoing slowdown in China's industrial sector. In particular: Total floor space sold (residential plus non-residential) has rolled over, heralding weakness in floor space started and, eventually, construction activity (Chart I-9). Growth rates of total freight traffic, diesel consumption, electricity and plate glass output have slumped (Chart I-10). Chart I-9Slowdown In Chinese Real Estate Chart I-10China: Industrial Economy Is Weakening Nominal manufacturing production is decelerating in response to a weaker broad money impulse (Chart I-11). The Komatsu Komtrax index - which measures average hours of machine use per unit of construction equipment (excluding mining equipment) - has begun contracting (Chart I-12). Chart I-11China: Downside Risks In Manufacturing Chart I-12China: Sign Of Construction Slump Even though China's spending on tech products has been vibrant, the global semiconductor cycle - a harbinger of overall tech industry growth - is clearly downshifting as evidenced by declining semiconductor prices (Chart I-13). Finally, narrow money (M1) growth has historically correlated with Chinese H-share prices, and is currently pointing to considerable downside risk for Chinese equity prices (Chart I-14). Chart I-13Semiconductor Prices Are Falling Chart I-14Chinese Share Prices Are At Risk Bottom Line: China's industrial sector has been decelerating, a trend that will persist. Meanwhile, consumer spending is so far booming. The former is more important to the rest of the world in general and EM in particular than the latter. EM Selloff: Two Phases While it is impossible to forecast the timing and character of market dynamics and mini-cycles with precision, our assessment is that two phases of an EM selloff are likely. Phase 1: A relapse in EM financial markets occurs on the back of rising U.S. bond yields, a strong dollar, amid resilient commodities prices. This phase is currently underway. Phase 2: U.S. bond yields peter out and drift lower, yet the U.S. dollar continues to firm up, commodities prices relapse and the EM selloff progresses. This stage has not yet commenced. The driving force behind these dynamics would be slower global demand growth emanating from China and spreading to other developing countries. In between Phases 1 and 2, it is possible that EM will stage a temporary rebound. Yet the duration and magnitude of such a rebound are impossible to gauge. Because of its transient nature, barring precise timing, the rebound will be very difficult to play profitably. It is not impossible to envision that the escalating turmoil in EM financial markets could at some point lead the Federal Reserve to sound less hawkish. That could mark a top in U.S. bond yields. In such a scenario, will a peak in U.S. bond yields mark a bottom in EM currencies? It may do so temporarily, but the sustainability of a rally in EM currencies and risk assets would be contingent on global growth in general and commodities prices in particular. Chart I-15An Unsustainable Rebound ##br##In EM Stocks In 2014 As a matter of fact, a similar two-phase selloff with a rebound in between occurred in 2013-'15. Chart I-15 illustrates that EM currencies and stocks staged a short-lived rebound after U.S. bond yields peaked in late 2013. Yet this rally proved transient. The underlying impetus behind the resumption in the EM downtrend back in 2014-'15 was weakening growth in China, falling commodities prices and poor domestic fundamentals. Similar to the 2013-'15 episode, any rebound in EM risk assets resulting from lower U.S. bond yields will likely be fleeting if commodities prices drop, the dollar continues to firm up and global growth disappoints. To sum up, a potential rollover in U.S. bond yields in the coming months will not automatically entail an ultimate bottom in EM risk assets. Trends in global growth - particularly in China - and commodities prices will be critical to the outlook for EM. As per our themes and discussion above, we maintain that China's industrial growth and construction will surprise on the downside. Consequently, China's commodities imports will moderate, which will weigh on commodities prices. In the interim, weak global trade dynamics stemming from EM/China will benefit the dollar, which is a countercyclical currency. Bottom Line: The U.S. dollar will continue strengthening regardless of the trend in U.S. bond yields because of slowing global trade. The dollar rally and weakening global demand will ultimately lead to lower commodities prices. EM financial markets will remain under selling pressure as long as global growth continues slowing. EM Foreign Funding Vulnerability Ranking Which countries are most exposed to lower foreign funding? Chart I-16 presents ranking of EM countries based on foreign funding requirements. The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-16Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. Mostly, these stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen. The basis for this is depreciating currencies will make their foreign debt liabilities more expensive to service. Besides, as these debtors allocate more resources to service foreign debt, their spending will be negatively impacted and their domestic economies will weaken. Investment Conclusions Chart I-17Downside Risks In EM Share prices The dollar's strength will be lasting. Stay short a basket of select currencies such as the BRL, TRY, ZAR, CLP, IDR, KRW and MYR versus the U.S. dollar. For portfolios that need to overweight some EM currencies relative to the rest, our favorites are MXN, RUB, PLN, CZK, TWD, THB and SGD. CNY will for now modestly weaken versus the dollar but outperform many other EM peers. The biggest risk to the U.S. dollar in our opinion is the Trump administration's preference for a weaker greenback. Therefore, "open-mouth" operations by the U.S. administration to weaken the dollar are possible, and the dollar could experience temporary setbacks. Yet the path of least resistance for the dollar remains up, for now. There is considerable downside in EM share prices. Stay put and underweight EM versus DM in general and the S&P 500 in particular. Chart I-17 illustrates that rising EM sovereign bond yields and U.S. corporate bond yields (both shown inverted on the chart) herald a further selloff in EM stocks. Our equity overweights are Taiwan, Korea, Thailand, India, central Europe, Chile and Mexico, and our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. For fixed-income investors, defensive positioning is warranted. As EM currencies continue to depreciate, sovereign and corporate credit spreads will widen further. Credit portfolios should continue underweighting EM sovereign and corporate credit relative U.S./DM corporate credit. Foreign holdings of EM local currency bonds remain massive. EM currency depreciation versus DM currencies will erode returns for foreign investors and could spur some bond selling, exerting upward pressure on local yields as well.1 Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Is The Worst Over? After having dropped 30% in U.S. dollar terms since their peak in late January, Turkish equity prices are beginning to look depressed, begging the question whether a buying opportunity is in the cards. Our assessment is as follows: the nation's financial markets are not yet at the point to warrant an upgrade (Chart II-1). Judgment on Turkish markets is contingent on three questions: Has the lira become cheap? Are real interest rates sufficiently high to depress domestic demand and reduce inflationary pressures? Are equity valuations cheap enough to warrant buying despite the poor cyclical profit outlook? First, the lira needs to get cheaper. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of May 23 the lira is one standard deviations below its historical mean (Chart II-2). For it to reach one-and-half or two standard deviations below its fair value, it would roughly take another 10%-20% depreciation, versus an equal-weighted basket of the dollar and euro. Chart II-1Turkish Financial Markets ##br##Have More Downside Chart II-2The Turkish Lira Is Not That Cheap Second, in regard to monetary policy, our view is that it would take an increase of around 200-250bps in the policy rate in addition to yesterday's hike of 300bps to stabilize financial markets. Core inflation will likely rise to at least 14-15% from the current level of 12% in response to the ongoing currency depreciation. With the effective policy rate (the late liquidity window rate) now at 16.5%, another 200-250 basis points hike would push the nominal rates to 18.5-19% and real policy rate to 3.5-4%, a minimum level that is likely required to depress excessive domestic demand growth. Finally, equity valuations are reasonably appealing but not cheap enough to put a floor under share prices given the outlook for contracting corporate and bank profits. Chart II-3 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is now about 6, compared with the historical average of 8. Although this bourse is already one standard deviation cheap, the outlook for profit recession likely warrants even lower valuation to justify buying. Chart II-3Turkish Equities Could Get Cheaper An approximate 20% drop in share prices in local currency terms will bring the CAPE to 4.8, one-and-half standard deviation below the fair value. On the whole, an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms will likely create a buying opportunity in Turkish financial markets. That said, it is doubtful whether there is the political will - to tolerate another 15% drop in the currency from current levels or more tightening in monetary conditions in the very near run ahead of the upcoming June parliamentary elections. Given the authorities' tolerance for higher borrowing costs is low, investors should not rule out the potential for capital controls to be imposed. In fact, to protect assets against possible capital control, we would recommend investors who are short to consider booking profits if the exchange rate surpasses 5 USDTRY in a rapid manner. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD Non-dedicated long-only investors should for now stay clear of Turkish financial markets. As to dedicated EM equity and fixed income portfolios (both credit and local currency bonds), we continue recommending underweight positions in Turkey. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 We discussed EM currencies and bonds in details in May 10, 2018; the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. Residential investment will add to GDP growth this year and support housing-related investments. Q1 results for S&P 500 earnings and revenues are exceeding raised expectations amid increase in tariff talk. Feature Last Friday's employment report shows a strong U.S. labor market with moderate wage pressures. The Fed can continue with a leisurely pace of rate hikes, which do not disrupt risk assets. The U.S. economy added 164,000 of net new jobs in April. Taking into account the 30,000 upward revision to the prior months, the increase in payrolls was in line with the consensus forecast of 195,000. With the 3-month moving average at 208,000 the pace of jobs growth is running comfortably above the trend growth in the labor force. This is reflected in the unemployment rate dropping from 4.1% to a new cyclical low of 3.9%. The jobless rate is nearing the 3.8% low seen during the height of the tech bubble in 2000. Even though the pace of jobs growth is strong and the unemployment rate is probing new lows, wage gains remain moderate. Average hourly earnings increased by just 0.1% m/m in April. Moreover, last month's gain was revised down to 0.2% m/m from an initially reported 0.3% m/m. As a consequence, the annual rate of wage inflation has slowed slightly to 2.6% from a recent high of 2.8% in January. The underlying trend in wage inflation is higher, but it is fairly shallow (Chart 1). The April employment report is "Goldilocks" for U.S. equities. The labor market is strong and the economy is growing about 3%. With modest wage and inflation pressures, there is no need for the Fed to turn more aggressive to cool a rapidly overheating economy. The modest trajectory of Fed rate hikes alongside modest income gains and stout consumer balance sheets will insulate the largest segment of the economy from higher interest payments and rising gasoline costs. Residential construction will also benefit from a gradual central bank, and housing-related assets are poised to outperform. Corporate profits can also continue to grow while the Fed maintains a gradual pace of rate hikes. The Q1 earnings and revenue reports for S&P 500 firms are outstanding. BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. As we stated in our report on April 2,1 conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 2 shows that at 41.8%, household purchases of essentials as a percentage of disposable income are near all-time lows and have dropped by more than 1% since early 2013. In contrast, spending on necessities rose by a record 3% in the five years ending 2008. This matches levels reached at the end of the 1980s when interest rates, inflation and oil prices all soared. Wrenching consumer-driven economic downturns ensued after both episodes. Chart 1Another Goldilocks##BR##Jobs Report For U.S. Risk Assets Chart 2Consumer Is Not Stressed##BR##Despite Higher Energy Costs While investors remain concerned that rising rates and higher energy costs could derail the consumer and slow the economy, we take a different view. Energy represents 3.8% of consumers' spending on essentials while interest costs account for 15.9%. BCA expects that the Fed will continue to raise rates gradually in the next 12 months, in lockstep with the market's stance. However, we anticipate that the Fed will be more aggressive from mid-2019 through mid-2020 as inflation moves beyond the Fed's 2% target. BCA's U.S. Bond Strategy service notes that if we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will occur between 3.35% and 3.52%,2 roughly 35 to 50 bps higher than current levels. In previous research, we stated that a modest rise in rates would not be a burden on consumers.3 BCA's Commodity & Energy Strategy team forecasts that West Texas Intermediate oil prices will average $70/bbl. in 2018 and $64/bbl. in 2019. However, it also notes that tight balances in global oil make it likely those numbers will make excursions to $80/bbl.4 If production in Venezuela deteriorates more than expected or the supply in Iran or Libya is compromised, then oil could move beyond $80/bbl and, depending on the supply disruptions, to $90/bbl. Chart 3 shows that the consumer can easily withstand a rise in oil prices to $90/bbl. BCA's assumption is that natural gas and electricity prices will remain at current readings. Chart 3U.S. Consumer Is Well Insulated From Rising Energy Costs Bottom Line: Tighter labor markets and rising incomes will overcome rising interest rates and higher oil prices, and allow consumers to contribute to above-trend GDP growth. We see gradual upturns ahead for both oil prices and interest rates, but nothing so significant to trigger the collapse of consumer spending. Housing and housing-related assets will also flourish in the next year. Housing-Related Assets: An Update Residential investment will add to GDP growth this year and support housing-related investments. Chart 4 shows that housing in this cycle lagged previous slow-burn recoveries5 by a wide margin. Inventories of new and existing homes are near all-time lows, and the homeownership rate has turned higher alongside incomes and household formation (Chart 5). BCA's view is that escalating mortgage rates are not an impediment to housing construction. Nonetheless, housing did not contribute to economic growth in Q1 2018, but it did add 0.46% to real GDP in Q4 2017 as construction activity surged following last summer's hurricanes in Florida and Texas. Chart 4Residential Investment's Share##BR##Of GDP Has Lagged Prior Long Cycles Chart 5Solid Housing##BR##Fundamentals In Place Chart 6 estimates the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the gap implies an extra 1.35 million housing units. The equilibrium number of housing starts that cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' fully occurs in the next two years, which would add another 675,000 units per year, then total demand could be close to 2 million in each of the next two years. This compares with March's housing starts of 1.3 million. Clearly, this is an aggressive forecast, and we doubt starts will advance at this pace in the next few years, but it does suggest that housing construction is likely to perk up. Chart 6A Catch-Up Housing Construction##BR##Will Occur If This Gap Closes The above analysis suggests that residential investment will contribute to GDP growth this year and next. There are favorable implications for housing-related financial assets. We originally examined the implications of a rebound in residential construction activity in 2012.6 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables. We concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario in the following year (and beyond). Our original analysis is updated in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Secondly, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of houses for sale following the crisis period on housing-related asset returns. Table 1 presents the list of housing-related assets that we examined,7 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables contain useful information, with the exception of the two noted above, sales of new homes and inventories of unsold homes. The right-most column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset that varies from a low of 14% to a high of 22%. Table 1Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2017) Charts 7 and 8 present a set of relatively conservative assumptions for the key housing market variables shown in Table 1, based on a rise in housing starts only modestly above the scrappage rate referred to in the previous section. We assume that house price appreciation and housing affordability are moderate due to further rate hikes from the Fed and mounting inflation. We also suppose that the homebuilders' confidence index stays flat, refi applications remain low linked to the uptrend in mortgage rates, and purchase applications rise in conjunction with housing starts. Chart 7A Set Of Conservative Assumptions... Chart 8...For Key Housing Market Variables Finally, Table 2 illustrates the predicted excess returns of housing-related assets in the coming 12 months, along with the annualized excess returns in 2017 and, for reference, in the entire sample period. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 2Excess Returns Of Housing-Related Assets* (%) Investors can draw several important conclusions from our analysis: All but one of the housing-related assets are expected to outperform their respective benchmarks in the next year, even given our conservative assumptions about the pace of gains in the housing market. Our model predicts outperformance for the three corporate bond assets (shown in Tables 1 and 2) relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. Moreover, the model projects modest outperformance for agency MBS. With the exception of S&P 500 banks, the model's predicted excess returns are lower in the coming year than they have been on an annualized basis since the onset of the recovery. This highlights that housing-related assets have moved ahead at least some of the expected normalization in the housing market over the next few years. However, a full rise to our equilibrium estimate of 2 million starts during the next two years could potentially lead to an even larger outperformance than the model forecasts. Moreover, Charts 9A and 9B suggest that valuation will not be an impediment to the outperformance of housing-related assets. Chart 9AValuation Won't Be An Impediment... Chart 9B...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance in 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform, even given conservative assumptions about the housing factors. Stunning Results More than 80% of S&P 500 companies have reported Q1 results, and EPS and sales growth are well ahead of consensus expectations at the start of April. Moreover, the counter-trend rally in margins remains in place. We previewed the Q1 2018 S&P 500 earnings season earlier this year.8 82% of companies have released results so far, with 79% beating consensus EPS projections, which is well above the long-term average of 69%. Moreover, 76% have posted Q1 revenues that topped expectations, exceeding the long-term average of 56%. The surprise factor for year-over-year numbers in Q1 stands at a robust 7% for EPS and 1.5% for sales. The earnings surprise reading is well above the long-term average of 5%, while the sales surprise figure is right at the long-term average. Both the earnings and sales surprise figures are even more impressive given that analysts' views of Q1 results increased between the start of Q1 2018 and the actual Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, in effect lowering the bar for results. Table 3S&P 500: Q1 2018 Results* We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Even so, the results to date suggest that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is a stunning 26% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain high on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 3). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly stout in energy (84%), technology (35%), financials (30%), materials (30%) and industrials (25%). The technology, materials, real estate and industrial sectors likewise all experienced substantial sales gains (16%, 13%, 14% and 11% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 24%. BCA's U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors in January.9 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 10). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. The assessment grew to 20% at the start of the earnings reporting season in early April. As of May 4, 2018, the figure climbed slightly to 22%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 10High Bar For 2018... But Focus Will Quickly Turn To 2019 While the ebullience is linked to the tax bill, other factors such as solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. However, U.S. trade policy is a concern in several industries. Chart 11 shows that through April 27, 45 companies cited tariffs in their Q1 earnings calls, a jump from 5 in the Q4 2017 reporting season. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition.10 Analysts expect EPS growth to slow significantly in 2019 (9%) from the anticipated 2018 clip, which matches BCA's stance (Chart 12). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Chart 11Plenty Of Tariff Talk##BR##In Q1 Earnings Calls Chart 12Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data) and subsequently decelerate because of a modest margin squeeze as U.S. wage growth picks up (Chart 11). A slowdown in global growth will also crimp profit growth later this year. Incorporating the fiscal stimulus lifted the EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. Stay overweight stocks versus bonds. 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, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "A Signal From Gold?", published May 1, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst Monthly Report from February 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely", published April 19, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's The Bank Credit Analyst Monthly Report from March 2017. Available at bca.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report," U-3 Or U-6?," published February 13, 2012. Available at usis.bcaresearch.com. 7 Note that we have excluded fixed- and floating-rate home equity loan ABS from our list of housing-related assets because of a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," published January 16, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com.

Special Report

Feature A Conversation With Ms. Mea I met with some of our European clients over the past few weeks, and used the opportunity to connect with Ms. Mea, a long-standing client of BCA who visited us last fall.1 As always, Ms. Mea was keen to scrutinize our viewpoints, delve into intricacies of our analysis and understand the differences between our interpretations of the global macro landscape and the prevailing market consensus. I hope clients find our latest dialogue insightful. Ms. Mea: It seems your negative call on emerging markets (EM) is finally beginning to work out: EM share prices in both absolute terms and relative to developed markets (DM) have dropped to their 200-day moving averages (Chart I-1). It seems we are at a critical juncture: If share prices bottom at these levels, a major upleg is likely and, conversely, if they break below this technical support, considerable downside may be in the cards. What makes you think this is not a buying opportunity? Indeed, EM stocks are testing a critical technical level. I doubt this is a buying opportunity. It looks like EM corporate profit and revenue growth have peaked (Chart I-2, top and middle panels). The question is not if but how much downside there is. I believe the downside will be substantial because the forces that drove this recovery are in the process of reversing. Chart I-1EM Equities Are At Critical Juncture Chart I-2EM Profits Have Topped Out First, the Chinese credit and fiscal stimulus of early 2016 has been reversed, and our China credit and fiscal spending impulse projects considerable downside in EM non-financial corporate earnings growth (Chart I-2, bottom panel). Second, Asia's manufacturing cycle is downshifting (Chart I-3). Korea's export growth is flirting with contraction (Chart I-3, bottom panel). Even if U.S. final demand remains robust, U.S. imports could slow, hurting the rest of the world. Chart I-4 illustrates that America's imports have been growing faster than its final demand, implying re-stocking of imported goods. Typically, periods of re-stocking are followed by waves of de-stocking. During the latter periods, import growth decelerates. Chart I-3Asia: Trade Is Decelerating Chart I-4U.S.: Final Demand And Imports Third, investor sentiment remains quite bullish on EM and EM equity valuations are not cheap in both absolute and relative terms (Chart I-5). Meanwhile, credit spreads as well as local bond yield spreads over U.S. Treasurys are very narrow. Chart I-5EM Equities Are Not Cheap Last but not least, U.S. wage growth and core inflation are rising. This warrants rising U.S. interest rate expectations and a rally in the dollar. As EM currencies depreciate against the greenback, EM stocks and bonds will sell off too. In a nutshell, it appears that the December and January spike in EM share prices was the final blow-off phase of this cyclical bull market. It is typical for a major market move to culminate with a bang. It seems this was the case with EM share prices, currencies and local bonds in December and January. Interestingly, the fact that EM share prices have failed to break above their previous highs is a bad omen (Chart I-1 on page 1). If our negative outlook on China's industrial cycle, commodities prices and the bullish view on the U.S. dollar play out, the current selloff in EM risk assets will progress into another bear market similar to the 2014-'15 episode. Ms. Mea: There is a widely held belief in the investment community that we are in the late expansion phase of the global business cycle. Late cyclical equity sectors, especially commodities and industrials, typically outperform at this stage. If so, this warrants overweighting EM as high commodities prices are going to help EM equities outperform DM ones. This is contrary to your recommended strategy of underweighting EM versus DM. Where and why do you differ from the consensus view? When discussing cycles, it is important to specify which economy we are referencing. With respect to the U.S. economy, I agree that we may be in a late-cycle expansion phase, when growth is strong, and wages and inflation are rising. In fact, in my opinion, U.S. wages and core CPI are likely to surprise to the upside (Chart I-6). Based on America's current economic dynamics, it makes sense to be overweighting late cyclicals. That said, just because the U.S. is in the late phase of its own expansion cycle doesn't mean China is at the same stage too. China's business cycle varies greatly from that of the U.S. and Europe. In my opinion, China's industrial sector in general, and capital spending in particular, are re-commencing the downtrend that took place between 2012-'16, but was interrupted by the injection of massive credit and fiscal stimulus in early 2016. Chart I-7 portrays China's manufacturing cycle along with the performance of EM stocks relative to their DM peers, as well as commodities prices. A few observations are in order: Chart I-6U.S. Wages And Inflation To Rise Further Chart I-7Where Are EMs & Commodities In The Cycle? China's capital spending and most of its industrial sectors were in their late cycle expansion phase in 2009-2011. The post-Lehman monetary and fiscal stimulus produced an unprecedented boom in investment spending. Yet, it was unsustainable because it created a misallocation of capital, enormous amounts of debt and asset bubbles. During this period, EM outperformed DM by a large margin, and global late cyclicals - such as materials, energy and industrials - outperformed the global equity benchmark. From 2012 to early 2016, there was a major downtrend in China's capital spending. Demand for capital goods/machinery and commodities downshifted and in some cases contracted (Chart I-8). After the new round of stimulus in early 2016, the Chinese economy recovered. However, the impact of this stimulus has now waned, and policymakers have been tightening policy since early 2017. Consequently, the downtrend in the mainland's industrial sector appears to be re-commencing and will likely deepen. In short, I view the rally in EM and commodities over the past two years as a mid-cycle hiatus in the bear market that began in 2011. Odds are that EM and commodities will sell off even if DM demand holds up. Chart I-9 denotes that global machinery and chemical stocks have already been underperforming the global equity benchmark. Energy stocks are still being supported by the rally in oil prices, but in my opinion it is a matter of time before oil prices roll over (we discuss our oil outlook below). However, given energy stocks have done so poorly relative to other sectors amid rising crude prices, they may not underperform, even if oil prices relapse. Chart I-8China: Construction Industry Profile Chart I-9Global Late Cyclicals Have Underperformed In 2010, I made the call that EM share prices, currencies and commodities had peaked for the decade. At the same time, I argued that technology, health care, and the equity markets with large weights in these sectors, namely the U.S., would deliver strong returns. This roadmap by and large remains pertinent. Chart I-10China Accounts For 50% Of ##br##Global Metals Demand Typically, winners of the previous decade perform poorly during the entire following decade. EM and commodities were the superstars of the last decade. There are still two more years to go in this decade. Consistent with this roadmap, we expect EM risk assets and commodities to relapse anew in the next 12-18 months. While the last two years were very painful not to chase the EM and commodities rallies, odds are that this has been a mid-cycle hiatus in a decade-long downtrend. Ms. Mea: Don't you think strong growth in DM will drive commodities prices higher, despite weakness in China? Are you bearish on oil because of China's demand too? I am optimistic about domestic demand in the U.S. and Europe. Yet, commodities prices, especially industrial commodities, are driven by China, not the U.S., EU or India. China consumes at least 50% of industrial and base metals (Chart I-10). Consistent with our view of a downtrend in China's capital spending in general, and construction in particular, we remain downbeat on industrial metals prices. Regarding oil prices, China's share in global oil demand is much smaller than it is for metals - the country consumes 14% of the world's petroleum products. Further, we are not negative on Chinese household demand for gasoline, but we are negative on mainland diesel demand. The latter fluctuates with industrial activity, as Chart I-11 illustrates. Importantly, oil prices will likely go down even if China's oil consumption growth remains robust. The basis is as follows: Investors' net long positions in oil are at record high levels (Chart I-12). Chart I-11China's Diesel Demand Chart I-12Investors Are Record Long Oil Traders have been buying oil because of rollover yield. Since the oil market is in backwardation, investors have been capturing rollover yield when they roll over contracts. Oil has been a carry trade over the past year as expectations of tight supply and a weaker U.S. dollar have spurred record numbers of investors to go long oil. As the U.S. dollar strengthens and China's growth slows, these traders will likely head for the exits with respect to their long oil positions. China has been importing more oil than it consumes since 2014. Our hunch is it has been accumulating strategic oil reserves. With oil prices spiking to $70, the pace of accumulation of strategic oil reserves may slow, and prices could retreat. China traditionally purchases commodities on dips. Finally, oil typically shoots up in the late stages of the business cycle. Chart I-13 illustrates that oil prices lag or at best are coincident with the global industrial cycle. In fact, often these spikes in oil prices - like the current one - occur due to supply constraints in the late stages of the business cycle. Nevertheless, they often mark the top. Chart I-13Oil Is Often Late To Peak In brief, while the case for oil is different than for industrial metals, risks to crude prices are tilted to the downside over the next six-to-nine months or so.2 Ms. Mea: One of the key drivers of your view on global markets has been a strong U.S. dollar. Why do you think the recent rebound in the dollar has staying power, and how far will it rally? Odds are that the U.S. dollar has made a major bottom and has entered a cyclical bull market. While we are not sure whether the greenback will surpass its early 2016 highs, it will at least re-test those levels on many crosses, especially versus EM and commodities currencies. The euro and other European currencies will likely not drop to their early 2016 lows, and as a result, EM currencies stand to depreciate considerably versus both the U.S. dollar and the euro. This will undermine the dollar- and euro-based investors' returns in EM equities and local currency bonds, and lead to an exodus of foreign funds. Contrary to market consensus thinking, the EM local interest rate differential over DM does not drive EM exchange rates. In fact, there is an inverse relationship between local interest rate spreads over U.S. rates and their currencies (Chart I-14). It is the exchange rate that drives local rates in EM. Currency depreciation pushes interest rates up, and exchange rate appreciation leads to lower interest rates. Many EM currencies correlate with commodities prices and global trade. The latter two will likely weigh on EM exchange rates in the next six to nine months. What's more, EM are much more leveraged to China than to DM. Both EM currencies as well as EM's relative equity performance versus DM mirror marginal shifts between Chinese and DM imports - the latter is a proxy for their domestic demand (Chart I-15). Chart I-14EM Currencies And Yields Differential Over U.S. Chart I-15EM Is Much More Sensitive To China Than DM As China's growth slumps, EM will likely catch pneumonia, while DM gets away with just a cold. This entails that EM currencies will come under downward pressure against both the U.S. dollar and the euro. Finally, provided EM ex-China has accumulated a lot of U.S. dollar debt, their currency depreciation will elevate debt stress. While we do not expect this to result in massive defaults, the ability of debtor companies with foreign currency liabilities to invest and expand will be curtailed. This is a negative for growth. EM debtors with dollar debt are much more vulnerable to an appreciating dollar than rising U.S. interest rates. From the perspective of their debt servicing costs alone, 10% dollar appreciation is much more painful than a 100 basis point rise in U.S. dollar rates. Hence, regardless of whether the greenback's rally occurs amid rising or falling U.S. bond yields, it will impose meaningful pain on EM debtors. In this context, EM sovereign and corporate spreads are too tight and will likely widen if and as EM currencies and commodities prices decline. Ms. Mea: In last week's statement, China's Politburo omitted the word "deleveraging" and the People's Bank of China cut the Reserve Requirement Ratio (RRR). Notably, onshore bond yields have dropped a lot. Does this not mean that stimulus is in the pipeline and the point of maximum stress for EM and commodities is now behind us? I doubt it. First, China's official media outlet, Caixin,3 explicitly stated that the Politburo statement does not mean either new stimulus or that the policy of battling financial excesses has been abandoned. Second, the RRR cut has led to only small net liquidity injections in the banking system. Its primary goal was to reduce interest rate costs for banks. Are falling bond yields in China a bullish or bearish signal for China-related risk assets? It is not clear. In 2017, interest rates rose considerably, yet China/EM risk assets completely ignored it. I was puzzled by this. Meanwhile, the recent drop in bond yields has coincided with falling EM share prices (Chart I-16). Third, the budget plan for 2018 does not entail major fiscal stimulus. Table I-1 denotes aggregate fiscal and quasi-fiscal spending will rise by 8% in 2018 compared to an actual rise of 8.6% in 2017 and 8.1% in 2016. All numbers are for nominal growth. Table I-1China: Fiscal And Quasi-Fiscal Spending (Annual Nominal Growth Rates) The government can always change its budgetary plans and boost fiscal spending beyond what is initially planned. This was the case in 2016. However, without material deterioration in growth, it is unlikely. The authorities undertook the 2015-2016 stimulus because of extremely weak growth and plunging global financial markets. Fourth, some commentators have noted that land sales have been strong, entailing more local government revenues and hence more infrastructure investment. Yet Chart I-17 portrays that the broad money impulse leads land sales. If their past relationship holds, land sales will decrease in the next 12 months. Chart I-16China's Bond Yields And EM Stocks Chart I-17China: Land Sales Are To Slump Finally, the regulatory clampdown on banks and shadow banking is ongoing. This along with the anti-corruption campaign in the financial industry could have a larger impact on credit origination than a marginal drop in interest rates or marginal liquidity provision. On the whole, if the authorities, again, open the credit and fiscal spigots wide, they will relinquish their pledge of structural reforms, a reduction of financial excesses and containing rising leverage. This would entail policymakers opting for a short-term gain in sacrifice of the country's long-term economic outlook. Growth financed by banks originating money out of thin air will ultimately (in the years ahead) lead to lower productivity and higher inflation - i.e., stagflation. I believe Beijing understands this and will not open the credit and fiscal taps too fast or too wide. In brief, China-related risk assets will likely sell off a lot before the next round of stimulus arrives. Ms. Mea: What about Chinese consumer spending and the outlook for technology companies that have become dominant in the EM equity index? Does your negative outlook for investment spending entail a downtrend in household spending? I have been bearish on China's industrial cycle and capex, but not on consumer spending. In fact, household expenditure growth is booming and is unlikely to slow a lot, even amid a downtrend in the construction sector. However, there are a number of reasons to expect a moderation of the current torrid pace of household spending: Capital spending accounts for 42% of GDP, and as it slumps, job creation and income gains will slow. If banks originate less credit, there will be less investment, and income growth will likely be affected. Contrary to widely held beliefs, Chinese households have become a bit leveraged - the ratio of household debt to disposable income is slightly higher in China than in the U.S. (Chart I-18). Further, borrowing costs in China are above those in the U.S. This entails that debt servicing costs as a share of disposable income are higher for households in China than in the U.S. Chart I-18Household Leverage: China And U.S. Not surprisingly, the authorities are clamping down on banks and shadow banking lending to households. It seems that policymakers in China worry much more about credit and leverage excesses than global investors. We published an in-depth Special Report on China's real estate market on April 6 where we argued that excesses remain large and a period of property price deflation cannot be ruled out.4 This means that property wealth effects could turn from a tailwind to a headwind for households for a period of time. All that said, I am not bearish on household spending, apart from real estate purchases. What does this entail for mega-cap companies' share prices, like Tencent and Alibaba? For sure, technology will continue to gain importance in China, like elsewhere. However, given these stocks have seen significant share price inflation and trade at high multiples, buying these stocks at current levels may not be a good investment. Valuations and business models as well as regulatory risks are key in the current circumstances. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. From a big-picture perspective, Chart I-19 demonstrates that Tencent's and Amazon's share prices have gone up 12- and10-fold, respectively, in real U.S. dollar terms since January 2010, as much as the run-up that occurred during previous bubbles. Chart I-19Each Decade Had A Mania With respect to performance of other heavyweights like TSMC and Samsung, the electronics cycle - like overall trade in Asia - has topped out, as evidenced by relapsing semiconductor prices (Chart I-20). Chart I-20Semiconductor Prices Have Rolled Over This is a very cyclical sector, and a further slowdown is to be expected following the growth outburst of the past 18 months. This may be enough to cause a meaningful correction in technology hardware and semi stocks. Ms. Mea: Finally, translating these themes into market strategy, what are your strongest conviction recommendations? Investment and asset allocation strategy should favor DM over EM in equity, currency and credit spaces. This strategy will likely pay off in both risk-on and risk-off environments. Our overweights within the EM equity universe are Mexico, Taiwan, Korea, India, Thailand and central Europe. In the meantime, Brazil, Turkey, South Africa and Malaysia are our strong-conviction underweights. In terms of sector trades, I would emphasize our long-standing short EM banks / long U.S. banks position. Finally, it seems EM currencies are breaking down versus the U.S. dollar. There is much more downside, and traders and investors should capitalize on this trend by being short a basket of EM currencies like the BRL, the ZAR, the CLP, the MYR and the IDR versus the dollar. For fixed-income investors, depreciating EM currencies are a major headwind for both local currency and U.S. dollar bonds, and we recommend defensive positioning. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Special Report "Ms. Mea Challenges The EMS View," dated October 19, 2017, available on emsbcaresearch.com 2 This differs from BCA's house view which is bullish on oil prices. 3 "Caixin View: Politburo Comments on Expanding Domestic Demand Don't Signal Stimulus," Caixin Global, April 2017. 4 Please see Emerging Markets Special Report "China Real Estate: A New-Bursting Bubble?," dated April 6, 2018, the link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Slower nominal GDP growth explains virtually all of the increase in China's debt-to-GDP ratio over the past ten years. The authorities were unwilling to restrain debt growth as it became obvious that nominal income was decelerating because this would have only exacerbated the economic downturn. Excess private-sector savings forced the Chinese government to rely on debt-financed investment by state-owned companies (SOE) and local governments in order to keep aggregate demand elevated. Financial deregulation also encouraged debt accumulation. Debt growth linked to speculative activity can be curbed without endangering the economy, but a lasting solution to the surplus savings problem will require consumers to spend more. This will take a while. At some point over the next few years, the central government will transfer a large fraction of SOE and local government debt onto its own balance sheet. The risk to investors is that this "debt nationalization" happens reactively rather than proactively. Feature If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment. - Zhou Xiaochuan, Former Governor of the People's Bank of China, October 19, 2017 The Calm Before The Storm? Stability begets instability. That is the nature of business cycles, Hyman Minsky famously argued. Rising confidence leads to excessive risk-taking, higher asset prices, and mounting economic imbalances. Eventually the mood sours. Like Wile E. Coyote running off a cliff, investors look down and see that there is nothing but thin air between them and the ground below. Panic ensues. Is China on the verge of its own Minsky Moment? A glance at the evolution of its debt-to-GDP ratio would certainly say so. But before running towards the exit door, consider the following: People have been fretting about spiraling Japanese government debt levels for over twenty years now. And yet, interest rates remain at rock-bottom levels in Japan. China's Savings Glut In many respects, China finds itself facing similar problems to those that have haunted Japan. The simultaneous bust in equity and real estate prices in 1990 sent Japan's private sector into a prolonged deleveraging cycle (Chart 1). In order to prop up demand, the Japanese government was forced to run large budget deficits. In effect, the government had to absorb the excess savings of the private sector with its own dissavings. The abundance of domestic private-sector savings forestalled a financial crisis, but it also led to today's gross government debt-to-GDP ratio of 240%. Like Japan, China suffers from a dearth of spending, or equivalently, an abundance of savings. The IMF estimates that Chinese gross national savings reached 46% of GDP in 2017. While this is down from a peak of 52% of GDP in 2008, it is still abnormally high for any major economy, even by emerging market standards (Chart 2). Chart 1 Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 2China's Savings Rate Stands Out Even By EM Standards By definition, whatever a country saves must either be invested domestically or channeled abroad via a current account surplus. China's savings rate has edged lower over the past ten years, but its current account surplus has dropped even more, falling from nearly 10% of GDP in 2007 to 1.4% of GDP at present. As a result, investment as a share of GDP has actually risen to 44%, a three-point increase since 2007 (Chart 3). The decline in China's current account surplus was inevitable (Chart 4). In 2007, China accounted for 6% of global GDP in dollar terms. Today it accounts for 15%. Having a massively undervalued currency, as China had in 2007, is just not politically tenable anymore, especially with Donald Trump in the White House. Simply put, China has become too big to continue exporting its way out of its problems. Chart 3Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Chart 4Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Debt As The Conduit Between Savings And Investment How does a country transform savings into investment? In an economy like China where the stock market at times appears to be little more than a casino, the answer is that credit markets must play the dominant role. Households or firms with surplus savings park their funds in banks or other financial institutions. These institutions channel the savings to willing borrowers. Debt ends up being the natural byproduct of surplus savings. China is still a relatively poor country with a lot of catch-up potential. Capital-per-worker is a fraction of what it is among advanced economies (Chart 5). Even with its bleak demographics, China would need to grow by around 6% per year over the next few years just to converge with South Korea in output-per-worker by 2050 (Chart 6). All this means that China needs to invest more than most other economies, which is only possible if it saves more than other economies. Chart 5China Has More Catching Up To Do (1) Chart 6China Has More Catching Up To Do (2) Unfortunately, one can have too much of a good thing. The fact that China's capital stock-to-output ratio has risen dramatically in recent years means that the economy is already investing too much. And the optimal amount of investment will only fall over time as potential GDP growth continues to decelerate. Unless savings come down, China will find itself increasingly awash in excess capacity. Chart 7If Only GDP Growth Did Not ##br## Decelerate Over The Past Ten Years Slower trend growth will also make deleveraging more difficult to achieve. The overall stock of nonfinancial debt grew at an annualized rate of 18.8% between 2008 and 2017. Notably, this growth rate was not much higher than the one of 16.5% between 2003 and 2007 - a period when the debt-to-GDP ratio was broadly stable. The main difference between the two periods lies in the denominator of the debt-to-GDP ratio, not in the numerator: Nominal GDP expanded at an annualized rate of 11.2% between 2008 and 2017, a sizable retreat from the pace of 18.4% between 2003 and 2007. Chart 7 shows that the debt-to-GDP ratio today would be virtually identical to its end-2007 level had nominal GDP continued to grow at its 2003-2007 pace over the past ten years. Financial Deregulation Has Exacerbated The Debt Problem The Chinese government's reluctance to crack down on credit growth was motivated by the desire to support aggregate demand. However, in turning a blind eye to what was happening in credit markets, a lot of debt was generated that was not directly tied to the intermediation of savings into investment. Chart 8Debt And Capital Accumulation Went Hand In Hand Debt can be created when someone borrows money to finance the purchase of goods or services. Debt can also be created when someone borrows money to finance the purchase of pre-existing assets. Crucially, while the former typically requires additional "savings" (i.e., someone needs to reduce their spending relative to their income), the latter does not.1 Granted, savings can still play an indirect role in facilitating debt-financed asset purchases. Financial assets are typically backed by something of value. A mortgage is backed by a piece of property. A corporate bond is backed by both the tangible and intangible capital that a firm possesses. The more a country has been able to save over time, the larger its capital stock will be. China, of course, has been saving like crazy for years. It is thus no surprise that its debt-to-GDP ratio has soared as its capital stock has expanded (Chart 8). Financial deregulation in China has allowed a large share of its capital stock to repeatedly shift hands. Debt has often been created in the process. The problem is that debt-financed asset purchases drive up asset prices, sometimes to unsustainable levels. And the higher the price of the asset, the greater the risk that it will not yield enough income to cover the borrowing costs. When asset prices are rising, borrowers and lenders are apt to disregard this risk, figuring that they can always sell the asset at a high enough price to pay back the loan. But once prices start falling, reality sets in very quickly. Stability begets instability. Consumers Need To Step Up The authorities are keenly aware of the risks discussed above. This is the key reason why they are clamping down on the shadow banking system, which has increasingly become the main source of speculative lending in China. We expect the pressure on shadow banks to persist in 2018. This will continue to weigh on credit growth. The more vexing challenge is how to reduce excessive household savings. The government's current strategy of cramming down the capital stock by taking out excess capacity from sectors such as steel, coal, and solar may be better than nothing, but it still pales in comparison to a strategy of encouraging consumer spending. Higher consumer spending would obviate the need for state-owned companies and local governments to keep people employed in make-work projects. The good news is that there are plenty of ways that China can boost household consumption. Government spending on education, health care, and pensions as a share of GDP is close to half of the OECD average (Chart 9). Increasing social transfer payments would give households the wherewithal to spend more. Unlike in most countries, the poor in China are net savers (Chart 10). Expanding the social safety net would discourage precautionary savings. Chart 9Chinese Social Welfare Spending ##br##Is Lagging The OECD Average Chart 10Low Income Households Are Net ##br##Savers In China The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 11).2 A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply over the past few decades (Chart 12). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 11High Tax Burden For ##br##Low Income Households In China Chart 12Shifting Income To Poorer Households Would Reduce ##br##China's Household Savings Rate Debt Nationalization Is Inevitable Chart 13Ratio Of Workers-To-Consumers Is Peaking,##br## And China Is No Exception Realistically, reforms aimed at encouraging consumption will take a while to implement. In the meantime, debt levels are likely to keep rising. Much of China's debt burden remains on the books of state-owned companies and local governments. At some point over the next few years, the central government will transfer a large fraction of this debt onto its own balance sheet. This would ease concerns about a mass wave of defaults. The key question for investors is whether this de facto "debt nationalization" is done proactively or reactively in response to a crisis. If the latter occurs, investors should steer clear of Chinese assets, as well as China-related plays such as commodities and commodity currencies. If the former pans out, global risk assets could rally. While the truth will fall somewhere between those two extremes, our bet is that the proactive view will prove closer to the mark, at least relative to market expectations (keep in mind that Chinese banks are trading below book value, so a lot of bad news has already been priced in). The Chinese authorities talk a lot about the importance of reducing moral hazard, but in practice, they have shown very little tolerance for defaults. Just as they did in the early 2000s, government leaders could commission state-owned asset management companies to purchase distressed debt from banks and other lenders at inflated prices. Chinese financials, which are nearly 70% of the H-share index, will benefit. Will investors balk at the prospect of the Chinese government blowing out the budget deficit in order to rescue insolvent borrowers? There might be some short-term panic, but as has been the case with Japan, as long as there are plenty of excess domestic savings to go around, the risk of a debt crisis will remain minimal. Indeed, the issuance of more government debt would help alleviate what has become a critical problem for Chinese savers: The lack of safe, liquid domestic assets available for purchase. What is true, from a longer-term perspective, is that the combination of higher debt and slower growth will eventually create a strong incentive for the Chinese government to inflate away debt. As in many other countries, China's "support ratio" -- broadly defined as the ratio of workers-to-consumers -- has peaked (Chart 13). As the growth of output and income falls behind consumption growth, China's savings glut will become a thing of the past. Rather than raising rates, the PBOC will just let the economy overheat. Such a day of reckoning is probably still at least five years away, but eventually inflation will return to China. Concluding Thoughts On The Current Market Environment A true "Minsky moment" in China - one where the financial sector seizes up due to spiraling fears of bankruptcies and defaults - is not in the cards. Nevertheless, China's economy is slowing, and growth is likely to decelerate further over the next few quarters as the authorities restrain credit growth and the property market continues to cool. The slowdown in Chinese growth is occurring at the same time as the economic data has been deteriorating around the world. The equity component of our MacroQuant model - which is highly sensitive to changes in the direction of growth - has been in bearish territory for two straight months (Chart 14). Our base case remains that global growth will stabilize over the next few months at an above-trend pace. Global bond yields are still near record-low levels and fiscal policy is moving in a more stimulative direction (Chart 15). It would be odd for the global economy to deteriorate sharply in such an environment. Chart 14MacroQuant Model Suggests Caution Is Warranted Trade protectionism is an obvious risk to this sanguine cyclical view. BCA has long argued that globalization is under threat from the combination of rising populism and the end of America's role as the world's sole superpower. However, the retreat from globalization will occur in fits and starts. Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now. Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff (Chart 16). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune. Chart 15Global Economy Buttressed By ##br##Accommodative Fiscal And Monetary Policy Chart 16Trump's Approval Rating Has ##br##Actually Risen During Equity Selloff For its part, the Chinese government is also looking to strike a deal. The U.S. exported only $131 billion in goods to China last year. This is already less than the $150 billion in Chinese goods that Trump has targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Bottom Line: The near-term picture for global equities and other risk assets is murky, but the 12-month cyclical outlook is still reasonably upbeat. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For instance, if someone buys stock on margin or takes out a second mortgage on their house, new debt is created without anyone having to cut back on spending. In the context of China, imagine a financial institution which funds the purchase of a building by issuing a certificate of deposit or by selling a "wealth management" product. Both the asset and liability side of the financial institution's balance sheet go up (i.e., new debt is created). Suppose further that the company that sold the building puts the proceeds into a certificate of deposit or wealth management product. The entire transaction is self-financing. The example above illustrates that debt can go up in some situations even if everyone's spending habits remain the same. The need to intermediate savings is one source of debt growth, but it does not have to be the only one. 2 Please see "People's Republic Of China: Selected Issues," IMF Country Report, dated August 15, 2017.

Highlights BCA expects consumer spending to remain supportive of above-trend economic growth in the U.S. in the next few quarters. Our view is that the 2018 outlook for both the U.S. economy and corporate profits remains constructive, but evidence is gathering that worldwide growth is peaking. Today's elevated levels of corporate leverage could intensify the pullback in business spending in the next recession. Housing is a reliable leading indicator of economic activity. Spending on new construction will enhance growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Feature U.S. equity prices rallied last week, although the NASDAQ lagged the broader indices. Despite the gain in the final week of the month, the S&P 500 finished lower in March. The back to back monthly declines in February and March were the first since September and October 2016. The 10-year Treasury yield fell last week, and credit underperformed. Oil and gold prices sold-off, but the dollar rose. Worries about global growth and a widening trade war were the key drivers, as investors looked ahead to Q1 earnings reporting season, which will kick into high gear next week. BCA expects global growth to be solid this year, although there are signs that growth is peaking outside the U.S. Moreover, the U.S. economy appears to be generating positive momentum, aided by housing and capex. This is why we expect 2018 to record strong EPS growth in the U.S., which will provide the equity market with a strong tailwind. That said, elevated levels of corporate leverage and low interest coverage ratios are a concern. Stay long stocks over bonds. We expect consumer spending to remain supportive of above-trend economic growth in the U.S. in the next few quarters. Household balance sheets are the best that they have been since 2007. Net worth is soaring and the aggregate debt-to-income ratio is close to record lows last seen at the turn of this century. Moreover, conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 1 shows that at 41.4%, household purchases of essentials as a percentage of disposable income are near an all-time low and have dropped by almost 2 percentage points since 2012. In contrast, spending on necessities rose by a record 3% in the five years ending 2008, matching levels reached at the end of the 1980s that reflected rising interest rates, surging inflation and soaring oil prices. Wrenching consumer-driven economic downturns ensued after both episodes. We see gradual increases ahead for both oil prices and interest rates, but nothing that would trigger the collapse of consumer spending. Furthermore, BCA forecasts only a modest rise in inflation and an acceleration in wage growth; both will boost disposable income. Meanwhile, U.S. inflation is heading higher. The core PCE deflator accelerated to 1.6% y/y in February, up from a low of 1.3% y/y in mid-2017. The coming months should see a further acceleration in inflation, in part due to the very soft base effects from last year (Chart 2). That said, one worrying point is that our diffusion index for the PCE deflator remains well below zero. This means that the inflation pick-up is not broad-based, but due to outsized gains in a few components. Core PCE inflation is usually decelerating when our diffusion index is below zero. Chart 1Consumer Is Not Stressed##BR##Despite Higher Energy Costs Chart 2BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End Bottom Line: The Q1 weakness in consumer spending and GDP growth is unlikely to persist. A return to above-trend growth and inflation inching to the 2% target will keep the Fed on a path of gradual interest rates hikes. Animal Spirits Still Intact Our view is that the 2018 outlook for both the U.S. economy and corporate profits remain constructive, but evidence is gathering that worldwide growth is peaking. Investors may begin to question recent upward revisions to the growth outlook for this year and next. Globally, industrial production has softened and the manufacturing PMI has shifted lower in most of the advanced economies (Chart 3). Bad weather in North America and Europe in early 2018 may be partly to blame, but Korean exports - a leading indicator for the global business cycle - have also weakened. It is also disconcerting that some of BCA's measures of global activity related to capital spending are lower in recent months, including capital goods imports and industrial production of capital goods (Chart 4). Nonetheless, the G3 aggregate for capital goods orders remains in an uptrend, which suggests that it is too soon to call an end in the mini capital spending boom. Furthermore, our global leading indicators are not heralding any major economic slowdown (Chart 5). BCA's Global LEI continues to trend up and its diffusion index is above the 50 line. Chart 3A Downshift In##BR##Global Growth? Chart 4Some Measures Of##BR##Global Capex Have Softened Chart 5Global Leading Indicators Are Not##BR##Heralding A Major Economic Slowdown Turning to the U.S., the environment for continued robust capital spending is still in place. The Tax Cut and Jobs Act of 2017 will boost capex, although we note that business spending tends to climb faster in the 12 months before a corporate tax cut than in the year afterward.1 The caveat is that there have been only three corporate tax cuts in the past 50 years. Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM data, roaring global exports and robust sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters (Chart 6). CEO confidence reached an all-time high in 2018Q1. According to the latest Duke Fuqua School of Business/CFO Magazine Global Business Outlook (Chart 7, panel 1),"sixty-six percent of U.S. CFOs say corporate tax reform is helping their companies, with 36 percent saying the overall benefit is medium or large."2 Chart 6U.S. Capex Poised For Liftoff Chart 7CEO Confidence And Capex Plans Surging Surveys by the Conference Board and Business Roundtable show similar patterns (Chart 7, panel 1). Notably, the soundings on all three surveys climbed since Trump's election, but subsequently retreated as his pro-business agenda stalled during the summer. The dip in sentiment reflected the lack of legislative progress in Washington in the first 10 months of the Trump administration. The upbeat numbers in the regional Federal Reserve Banks' surveys of capital spending intentions further support escalating capex in the next few quarters. The average reading from the New York, Philadelphia and Richmond Feds' capex survey plans are at an all-time high in early 2018 (Chart 7, panel 2). Furthermore, the regional FRBs' capex spending plans diffusion indices are close to a cycle high, despite a modest pullback since last summer (Chart 7, panel 3). In addition, ABC's Construction Backlog indicator (CBI),3 a leading indicator that measures in months the amount of construction underway but not yet completed, hit a peak early this year, which suggests that 2018 is poised to be a strong year for nonresidential building activity (Chart 8). Moreover, architectural billings hit a new cycle high in Q4 2017(not shown). This signifies that investment in office, industrial and commercial space will accelerate in the coming year. However, there are some warning signs in the nonresidential construction portion of capital spending. Commercial real estate (CRE) prices have galloped to new heights (Chart 9, panel 1). Rent growth in all but the industrial buildings sub component of the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 9, panel 2) and that a slowdown in construction may ensue. Chart 8Nonresidential Construction##BR##Backlog At Eight Year High Chart 9Commercial Real Estate Prices Have##BR##Surpassed Pre-Recession Levels Corporate Health Fundamentals Last week's National Accounts (NIPA) corporate profit report allows us to update BCA's Corporate Health Monitor (CHM) (Chart 10). The level of the CHM improved slightly between Q3 and Q4, but the overall reading remains in 'deteriorating health' territory. However, the CHM moved slowly back toward "improving health" in 2017. The improvement in Q4 was broad-based, as five of the six components improved. Liquidity decreased slightly between Q3 and Q4. Leverage declined and interest coverage improved. Our CHM has a tendency to improve during phases of increased fiscal thrust.4 In contrast, corporate leverage increases substantially in the 12 months following a corporate tax cut. As an economic expansion enters the late stages, investors focus on where leverage pressure points may lurk. The Bank Credit Analyst's March 2018 Special Report5 on U.S. corporate vulnerability to higher interest rates and a recession raised some eyebrows. In a sample of 770 companies, we estimated how much interest coverage for an average company would decline under two scenarios: (1) interest rates rise by 100 basis points across the curve; and (2) interest rates rise by 100 basis points and there is a recession in which corporate profits tumble by 25% peak to trough. Given the number of client inquiries, we re-examined our results. We questioned whether our sample of high-yield companies distorted the overall results because it included many small firms and outliers. We are more comfortable with the results using only investment-grade firms, shown in Chart 11. The 'x' marks the interest rate shock and the 'o' marks the combined shock. Chart 10Corporate Health Improved In 2017 Chart 11Interest Coverage Is Deteriorating Nonetheless, the main qualitative message is unchanged. The starting point for interest coverage is low, considering that interest rates are near the lowest levels on record and profits are extremely high relative to GDP. This is the result of an extended period of corporate releveraging on the back of low borrowing rates. Chart 12 shows that the interest coverage ratio has declined even as profit margins remained elevated. Normally the two move together through the cycle. The implication is that the next recession will see the interest coverage ratio fare worse than in previous recessions. Rating agencies use many other financial ratios and statistics, but our results suggest that downgrades will proliferate when the agencies realize that the economy begins to turn south. Moreover, banks may tighten their C&I lending standards earlier and more aggressively because they also will be attuned to the first hint of economic trouble given the degree of corporate leverage in their portfolios. Recovery rates may be particularly low in the next recession because the equity cushion has been squeezed via buybacks, which will intensify widening pressures in corporate spreads. Tighter lending standards would generate more corporate defaults, even wider spreads and a more pronounced tightening in financial conditions. Therefore, corporate leverage could intensify the pullback in business spending in the next recession. The good news is that we do not see any other major macroeconomic imbalances, such as areas of overspending that could turn a mild recession into a nasty one. The market and rating agencies will ignore the leverage issue as long as growth remains solid. Indeed, ratings migration has improved markedly following energy-related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 13). For now, we remain overweight U.S. investment-grade and high-yield bonds within fixed-income portfolios. Chart 12Margins And Interest Coverage##BR##For Investment Grade Firms Chart 13Improving Ratings Migration##BR##Supports Our Credit Overweight Bottom Line: We are keeping an eye on our Corporate Health Monitor, bank lending standards, the yield curve and our profit margin proxy to time our exit from both corporate bonds and equities.6 We are also watching for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will get more aggressive in leaning against above-trend growth and a falling unemployment rate. The tightening labor market will continue to support the housing market, despite higher mortgage rates. Risks To Housing Are Limited Residential investment will add to growth in 2018. Inventories of new and existing homes are close to all-time lows (Chart 14). Housing affordability remains well above average and will remain supportive of housing investment even if rates climb by 100 bps (Chart 15). Recent soundings from the Fed's Senior Loan Officers survey shows that mortgage demand has ebbed in recent quarters (Chart 16). The housing sector has also benefited from a recovery in household formation in the past few years alongside the labor market and disposable income. Chart 14Housing Fundamentals##BR##Are Stout Chart 15Housing Affordability Under##BR##Various Rate Assumptions Chart 16Supply And Demand##BR##For Mortgages On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 14, panel 3). Furthermore, U.S. real residential home prices are still below their 2006 peak. In addition, at under 3.9%, residential investment as a share of GDP remains well below the 12-year high of 6.6% achieved in 2005 (Chart 17, panel 1). It is difficult to see how residential investment can decline meaningfully when household formation is on the rise and home inventories are already low. Homebuilders appear to agree with this sentiment and report confidence levels near all-time peaks (Chart 17, panel 2). Employment in construction and related fields also suggests that the housing market remains on solid footing. (Chart 18, panel 1 and 2). Panel 3 shows that nearly 80% of states have escalating construction employment. This metric tends to lead construction jobs by a few months. Moreover, construction jobs tend to be at least coincident with housing construction. Segments of construction (residential and specialty employment) lead residential investment in some cases. Chart 17Real Home Prices Not Yet##BR##Back To Prior Peak Chart 18Housing Related##BR##Employment Trends Furthermore, the disconnect between the NAHB Housing Market Index and housing's contribution to economic growth (Chart 18, panel 4) also suggests housing is poised to lift off. Housing investment is the best leading indicator for real GDP growth among all sectors (Chart 14, panel 4). Construction of new homes and apartments, along with additions and alterations to existing stock, peaks as a share of GDP an average of seven quarters before the end of an expansion. Consumer spending on durable, nondurable and services reach a high, five quarters before GDP hits a zenith, while business capital spending tops out six quarters ahead of the economy. There are risks for housing despite the upbeat fundamentals. Banks have been tightening their lending standards in recent quarters, although they are still loose relative to previous cycles, and an overtightening may impede the real estate market (Chart 16). It is possible that the GOP's tax plan to significantly change the treatment of state and local real estate taxes and mortgage interest could also negatively affect housing demand, particularly in the luxury market. Additionally, rising foreign demand in certain U.S. markets may lead to mini-bubbles in coastal areas. The latest reading on the Case-Shiller home price index showed nominal housing prices climbing at the fastest rate in three years, although as noted above, inflation-adjusted house prices remain below prior peaks. A prolonged period of house price increases above income gains would challenge our sanguine view of housing affordability. However, the Fed and the banking system are hyper-vigilant about excesses in the housing market, therefore, it is unlikely that another housing bubble will be tolerated. Bottom Line: Housing is a reliable leading indicator of economic activity. Spending on new construction will enhance growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Faster GDP growth will be accompanied by higher inflation and a more active Fed, especially relative to current market expectations. BCA expects global growth to be solid this year although there are signs that growth is peaking outside the U.S. Moreover, the U.S. economy appears to be generating positive momentum even before the effects of tax cuts fully kick in. This is why we expect 2018 to record strong EPS growth in the U.S., which will provide the equity market with a strong tailwind. Stay long stocks over bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report "Opportunity," dated December 11, 2017, available at usis.bca.research.com. 2 http://www.cfosurvey.org/2018q1/press-release.html 3 https://www.abc.org/News-Media/Construction-Economics/Construction-Backlog-Indicator/entryid/13680/abc-s-construction-backlog-indicator-hits-a-new-high-2018-poised-to-be-a-very-strong-year-for-construction-spending 4 Please see BCA U.S. Investment Strategy Weekly Report "Opportunity," dated December 11, 2017, available at usis.bca.research.com. 5 Please see The Bank Credit Analyst Monthly Report, dated February 22, 2018, available at bca.bcaresearch.com. 6 Please see The Bank Credit Analyst Monthly Report, dated February 22, 2018, available at bca.bcaresearch.com.

Highlights Consumer spending is well supported despite weak readings on household purchases in early 2018. The recent rollover in M&A activity does not signal a top in equity markets nor warns that a recession looms. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. Feature Investors began to worry last week about a slowing U.S. economy sending prices of risk assets and Treasury yields lower. The threat of a wider trade spat with China was also a concern, along with the latest round of political intrigue at the White House. Oil fell more than 1% on supply concerns. While the U.S. economic surprise index moved lower since the start of the year, BCA's view is that the U.S. economy is poised to grow well above potential in the first half of the year. Consumer spending is well supported despite weak readings on household purchases in early 2018. The FOMC will provide a new set of economic forecasts and dot plots at this week's meeting. BCA expects the Fed to raise rates this week and three additional times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. According to our U.S. Equity Strategy service's "buy the dip" cycle-on-cycle analysis, a retest of the recent equity lows typically occurs in the first month following the initial shock, suggesting that the S&P 500 is already out of the woods.1 The return of vol may keep a lid on the SPX for a while longer, but our strategy since February 8 is to buy the dips as we do not foresee an end to the business cycle in 2018. Moreover, the recent weakness in M&A activity is not a sign that the bull market is finished. Despite the dip below 2.90% last week, BCA's U.S. Bond Strategy services pegs fair value for the 10-year Treasury yield at 2.96%.2 Assuming a 3% terminal fed funds rate, our U.S. Bond Strategy team expects the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%.3 Too Cold? Chart 1Weak February Retail Sales At Odds##BR##With Strong Consumers Fundamentals The Tax Cut and Jobs Act put extra cash into consumers' pockets and helped to lift consumer confidence to a cycle high. Household net worth is at a record level, the labor market is strong and wage growth is accelerating, albeit modestly at this point in the cycle. Despite the favorable backdrop, consumers are on the sidelines in early 2018 (Chart 1). Moreover, early March's unusually harsh winter weather in the Northeastern U.S. may prolong consumers' malaise for another month. The retail sales control group, which feeds into GDP calculations, rose a scant 0.1% m/m in February. The reading was well below the consensus of a 0.5% m/m gain. Headline retail sales dipped by 0.1%, well short of expectations (+0.4%). Auto sales (-0.9%) declined for the fourth month in a row in February. It is clear that the surge in auto sales in the wake of last fall's hurricanes pulled up demand. The weakness in February's spending was broadly based, with 7 of 13 major retail sales categories showing month-over-month declines. However, the recent weakness in consumer outlay masks the robust activity in the past 12 months. Overall retail sales are up a solid 4.1% from a year ago, while sales in the retail control group rose by 4.3%. In addition, sales are higher in 12 of the 13 main categories in the past year, led by non-store retailers (+10.1%), miscellaneous store retailers (+7.5%), clothing (+4.9%) and building materials (+4.6%). As a result of the tepid consumer spending readings in early 2018, the Atlanta Fed's GDPNow model has projected Q1 real GDP growth of just 1.8%, adjusted downward from 2.5% on March 9 (Chart 2). At the start of this month, the Atlanta Fed pegged Q1 GDP at 3.5%. Accordingly, some investors are concerned that household spending is nearing a peak and a recession may be imminent. We see it differently. BCA's stance is that consumer spending should continue to grow by at least 2% in 2018. U.S. consumer health has improved markedly in the past year, driving BCA's Consumer Health Indicator into positive territory (Chart 3). Higher equity prices, a stout labor market and an acceleration in real incomes are behind the improvement. Consumer spending growth tends to accelerate when the Health Indicator is rising. The improvement supports BCA's view of a stronger U.S. economy alongside a global synchronized recovery, at least in the next 12 months. Chart 2Q1 GDP Estimates Have Moved Sharply Lower Chart 3The Consumer Is In Good Shape Household net worth in 2017Q4 was at a record high, the result of stable house prices and frothy equity markets, according to the latest Flow of Funds data for 2017Q4 (Chart 4). Moreover, the composition of households' balance sheet is less alarming today than at prior peaks, because equities and real estate relative to household income or total assets are more reasonable. Furthermore, debt levels are tamer today than in 2006. Households may be less vulnerable to unexpected shocks (Chart 4 again) in light of their more resilient balance sheets. BCA's view is that financial vulnerabilities from the household sector are well contained. Household borrowing is increasing modestly at an annual pace of 4%, in sharp contrast with a 12% rate in the middle of the first decade of the 2000s. A broad measure of household solvency, such as the household debt-to-income ratio, is within the range of the past few years and back to pre-recessionary readings. Furthermore, liquidity buffers (liquid assets-to-liabilities) are almost as high as the levels that preceded the equity market boom/bust in 1999-2000 (Chart 5). Chart 4Household Sector Balance Sheet Composition Chart 5Household Sector Buffers Are Solid Nevertheless, risks may dampen the pace of consumer spending. Debt-to-income ratios have bottomed for the cycle (Chart 5 again) and banks are tightening their lending standards. The result is that consumer delinquency rates are on the upswing, notably in credit cards and autos (Chart 6). Moreover, the personal savings rate cannot sustainably remain around its recovery low of 3.2% (Chart 7, last panel). Chart 6Consumer Loan Metrics Chart 7Key Supports For Consumer##BR##Spending Remain In Place At 2.8%, annual wage compensation growth remains sluggish and far from the 3-4% rate per year that the Fed stated would be consistent with an economy closer to 2% inflation (Chart 7, panel 4). Moreover, households are still unlikely to binge on more debt to smooth out their expenditures as they did in the middle years of the first decade of the 2000s. A further acceleration in consumer spending would occur only alongside steady improvement in the labor market and improving household confidence on future employment and income gains. Bottom Line: Consumers' good mood and healthy balance sheets have not translated into firmer spending growth so far in 2018. Nonetheless, even with below-average consumer spending, the U.S. economy is expanding above the Fed's estimate of potential GDP, the labor market is tightening and inflation is grinding higher. The Fed remains on track to hike rates four times this year. The outlook for the U.S. consumer remains bright because of solid fundamental tailwinds such as strong employment growth, stable disposable incomes, frothy household net worth and buoyant confidence. Consumer headwinds to monitor are households' historically low saving rates, still tepid wage inflation and escalating delinquency rates. Too Hot? U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and in 2007. Some investors are concerned that the recent rollover in deal volume is a signal that a recession or an equity market top is nigh. Deal volume in dollars and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016. Since then, merger activity has moved lower. The decline in corporate combinations accompanied a sizeable rally in equity markets and robust U.S. and global economies. Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. The recent peak in corporate takeovers (July 2017) relative to GDP matched those prior highs, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, last summer's zenith in global or cross-border M&A, a better indicator of market zest than U.S.-only activity, did not eclipse the peaks in 2007. Even at last summer's high, measured against both global GDP and market cap, worldwide corporate combinations remained below their 2015 top and well below their 2007 peak. At just 6.5% in early 2017, the GDP-based metric was significantly under the 2007Q3 pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were boom years for M&A. Moreover, Phase I of the Fed funds rate cycle4 (the Fed is tightening, but policy is still accommodative) supports accelerating M&A activity (Chart 8A). Corporate combinations also climb during Phase II (Fed tightening, but policy is restrictive). However, M&A activity peaked at the end of Phase II in 2000 and 2007 (Chart 8B). BCA's view is that we will remain in Phase I until at least the end of 2018 and that Phase II may not be over until the end of 2019 or later. Chart 8AM&A Activity In Phase I Of The Fed Cycle... Chart 8BM&A Activity In Phase II Of The Fed Cycle... Bottom Line: The recent rollover in M&A activity does not signal a top in equity markets nor warn that a recession looms. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks and M&A) is not out of line with previous economic expansions (Chart 9). Stay overweight stocks versus bonds as the U.S. economic expansions becomes a decade-long phenomenon. Chart 9Comparison Of Corporate Outlays Across Four Economic Expansion Phases Just Right Wage inflation remains in a gradual upward trend, accelerating just enough to nudge up price inflation and prompt the Fed to hike rates four times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. However, the January reading (+2.8 yoy) on average hourly earnings (AHE) stoked fears of the former, while the February reading (+2.6%) raised concerns of the latter. Chart 10 confirms that most measures of labor market slack have returned to normal. Moreover, the latest soundings on the job market from the National Federation of Independent Business suggest that small business owners have the most job openings in at least 18 years (Chart 11, panel 1). In addition, key concerns have shifted to the quality of the job applicants (panel 2) and the cost of labor (panel 3), away from taxes and over-regulation. Chart 10Labor Market Slack##BR##Is Disappearing Chart 11Hiring And Labor Costs A##BR##Key Concern For Small Businesses Those concerns were underscored in the Federal Reserve's January and February Beige books. Table 1 shows industries with labor shortages; in the year ended February, the gain in average hourly earnings in all but 3 of the industries was faster than average. Moreover, in all but 1 of these categories, labor market conditions are now the tightest since before the onset of the 2007-2009 recession. A recent Fed study5 examines the labor shortages in the manufacturing sector in more detail. The Beige Books noted that many businesses are having trouble finding low-skilled (and to a lesser extent, middle-skilled) workers, with a few mentions of the challenges of finding/retaining highly skilled employees, especially in STEM job functions. Chart 12 shows the wage gains for supervisory staff, a proxy for skilled (panel 1) and non-supervisory employees, and an imperfect proxy for low-skilled workers (panel 2). Both metrics are rising, but the skilled worker proxy accelerated more than the low-skilled metric. Moreover, at 3.1%, the latest reading on supervisory employees is nearly double the pace of non-supervisory personnel. The Atlanta Fed's Wage Tracker provides another lens on wage gains by skill level. Chart 13 shows that wage inflation among skilled positions is running well above average. Raises among mid- and low-skilled labor lag far behind. Notably, wages in all three have rolled over since late 2016. Table 1Labor "Shortages" Identified##BR##In The Beige Book Chart 12Supervisory Vs. Production##BR##Wage Inflation Chart 13Wage Inflation##BR##By Skill-Level Chart 14 argues that slightly faster compensation growth is imminent. The top panel shows that more than 80% of U.S. states register unemployment below the Fed's estimate of full employment. In the past, rates over 60% have been associated with wage pressures. The percentage climbed above 60% in January. The bottom panel of Chart 14 demonstrates the relationship between state unemployment rates and wage gains in each state. Chart 1480%+ Of States Have Unemployment Rates Below NAIRU Bottom Line: The labor market is back to normal, but is not overly tight, as shown in Chart 10. Wages and employment costs are in an uptrend, yet firms are still reluctant to give large pay increases to their labor force. That said, against the backdrop of fiscal stimulus, real GDP growth will remain well above potential, which means that the unemployment rate is headed to 3½% or even below. At some point, the labor market will overheat. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Reflective Or Restrictive", published March 12, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "From Headwinds To Tailwinds", published March 6, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "The Two-Stage Bear Market In Bonds", published February 20, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Lingering In The Policy Sweet Spot," September 26, 2016 and "Stocks And The Fed Funds Rate Cycle," December 23, 2013. Both available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm