Economy

Highlights Bond Strategy: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Japan Corporates: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Feature "I love it when a plan comes together." - Hannibal Smith, Leader of The A-Team Many investors likely came down with serious case of a sore neck last week, given the head-turning headlines that came out: Chart 1A Pause In The 'Inflation Scare' U.S. President Donald Trump announcing a blanket tariff on metals imports, then exempting some important countries (Canada, Mexico, Australia) only days later. Trump agreeing to an unprecedented meeting with North Korean leader Kim Jong Un on the nuclear issue, only to have the White House press secretary later announce that no meeting would take place without North Korean "concessions". The European Central Bank (ECB) hawkishly altering its forward guidance to markets at the March monetary policy meeting, but then having that immediately followed by dovish comments from ECB President Mario Draghi. The strong headline number on the February U.S. employment report blowing away expectations, but the soft readings on wages suggesting that the Fed will not have to move more aggressively on rate hikes. For bond markets in particular, the ECB announcement and the U.S. Payrolls report were most important. Investors had been growing worried about a more hawkish monetary policy shift in Europe or the U.S. This was especially true in the U.S. after the previous set of employment data was released in early February showing a pickup in wage inflation that could force the Fed to shift to a more hawkish stance. That created a spike in Treasury yields and the VIX and a full-blown equity market correction. Since then, inflation expectations have eased a bit and market pricing of future Fed and ECB moves has stabilized, helping to bring down volatility and supporting some recovery in global equity markets (Chart 1). With all of these "tape bombs" hitting the news wires, investors can be forgiven for re-thinking their medium-term investment strategy in light of the changing events. We think it is more productive to check if the initial expectations on which that strategy was based still make sense. On that note, the developments seen so far this year fit right in with the key themes we outlined in our 2018 Outlook, which we will review in this Weekly Report. The Critical Points From Our Outlook Still Hold Up In a pair of reports published last December, we translated BCA's overall 2018 Outlook into broad investment themes (and strategic implications) for global fixed income markets. We repeat those themes below, with our updated assessment on where we currently stand. Theme #1: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. ASSESSMENT: UNFOLDING AS PLANNED, BUT WATCH INFLATION EXPECTATIONS. Economic growth is still broadly expanding at a solid pace, as evidenced by the elevated levels of the OECD leading economic indicator and our global manufacturing PMI (Chart 2). The U.S. is clearly exhibiting the strongest growth momentum looking at the individual country PMIs (bottom panel), while there is a more mixed picture in the most recent readings in other countries and regions. Importantly, all of the manufacturing PMIs remain well above the 50 line indicating expanding economic activity. Last week's U.S. Payrolls report for February showed that great American job creation machine can still produce outsized employment gains with only moderate wage inflation pressures, even in an economy that appears to be at "full employment". The +313k increase in jobs, which included upward revisions to both of the previous two months of a combined +54k, generated no change in the U.S. unemployment rate which stayed unchanged at 4.1% with the labor force participation rate increasing modestly (Chart 3). Chart 2U.S. Growth Leading The Way Chart 3The Fed Can Still Hike Rates Only 'Gradually' The wage data was perhaps the most important part of the report, given that the spike in global market volatility seen last month came on the heels of an upside surprise in U.S. average hourly earnings (AHE) for January. There was no follow through of that acceleration in February, with the year-over-year growth rate of AHE slowing back to 2.6% from 2.9%, reversing the previous month's increase (middle panel). The immediate implication is that the Fed does not have to start raising rates faster or by more than planned. That pullback in U.S. wage growth, combined with the continued sluggishness of inflation in the other developed economies and the sideways price action seen in global oil markets, does suggest that inflation expectations may struggle to be the main driver of higher global bond yields in the near term. Overall nominal bond yields are unlikely to decline, however, as real yields are slowly rising in response to faster global growth and markets pricing in tighter monetary policy in response (Chart 4). Chart 4Real Yields Rising Now,##BR##Inflation Expectations Will Rise Again Later We have not seen enough evidence to cause us to change our view on inflation expectations moving higher over the course of 2018, particularly with BCA's commodity strategists now expecting oil prices to trade between $70-$80/bbl in the latter half of 2018.1 One final point: it is far too soon to determine if the protectionist trade leanings of President Trump will alter the current trajectory of global growth and interest rates. The implication is that investors should not change their overall planned investment strategy for this year at this juncture. Theme #2: Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. ASSESSMENT: UNFOLDING AS PLANNED. As shown in Chart 2, the big coordinated upward move in global growth seen in 2017 is already starting to become less synchronized in 2018. Recent readings on euro area growth have softened a bit while, more worryingly, a growing list of Japanese data is slowing. U.K. data remains mixed, while the Canadian economy is showing few signs of cooling off. China's growth remains critical for so many countries, including Australia, but so far the Chinese data is showing only some moderation off of last year's pace. Net-net, the data seen so far this year is playing out according to our 2018 Themes - better in the U.S. and Canada, softer in the U.K. and Australia. We are sticking to our view that the rate hikes currently discounted by markets in the U.S. and Canada will be delivered, but that there will be little-to-no monetary tightening in the U.K. and Australia (Chart 5). Theme #3: The most dovish central banks will be forced to turn less dovish: The ECB and Bank of Japan (BoJ) will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. ASSESSMENT: UNFOLDING AS PLANNED, ALTHOUGH WE NOW EXPECT NO BoJ MOVE TO TAKE PLACE THIS YEAR. Both central banks have already dialed back to pace of the asset purchases in recent months. This is in addition to the Fed beginning its own process of reducing its balance sheet by not rolling over maturing bonds in its portfolio. Growth of the combined balance sheet of the "G-4" central banks (the Fed, ECB, BoJ and Bank of England) has been slowing steadily as a result (Chart 6). The ECB continues to contribute the greatest share of that aggregate "G-4" liquidity expansion, although that is projected to slow over the balance of 2018 as the ECB moves towards a full tapering of its bond buying program by the end of the year (top panel). Chart 5Not Every Central Bank##BR##Will Deliver What's Priced Chart 6Risk Assets Are##BR##Exposed To ECB Tapering Barring a sudden sharp downturn in the euro area economy, the ECB is still on track for that taper. We have been expecting a signaling of the taper sometime in the summer, likely after the ECB gains even greater confidence that its inflation target can be reached within its typical two-year forecasting horizon. That story will not be repeated in Japan, however, where core inflation is still struggling to stay much above 0% and economic data is softening. We see very little chance that the BoJ will make any alterations of its current policy settings - with negative deposit rates and a target of 0% on the 10-year JGB yield - this year, as we discussed in a recent Special Report.2 We continue to expect a diminishing liquidity tailwind for global risk assets over the rest of 2018 (bottom two panels). Theme #4: The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. ASSESSMENT: UNFOLDING AS PLANNED. We saw a sneak preview of how this theme would play out during that volatility spike at the beginning of February, triggered by only a brief blip up higher in U.S. wage inflation. With a more sustained increase in realized global inflation likely to develop within the next 3-6 months, a return to that world of high volatility is still set to unfold in the latter half of 2018, in our view. After reviewing our four investment themes for 2018 in light of the latest news, we conclude that the themes are largely playing out. Therefore, we will continue to stick with the investment strategy conclusions for this year that were derived from those themes (Table 1):3 Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year 2018 Model Bond Portfolio Positioning: Target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Chart 7Tracking Our Recommendations 2018 Country Allocations: Maintain underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and add small overweights in the U.K. and Australia (where rate hikes are unlikely). The year-to-date performance of the main elements of our model bond portfolio are shown in Chart 7. All returns are shown on a currency-hedged basis in U.S. dollars. Our country underweights are shown in the top panel, our country overweights in the 2nd panel, our credit overweights in the 3rd panel and our credit underweights in the bottom panel. The broad conclusion is that our best performing underweight is the U.S. and best performing overweight is Japan. All other country allocations are essentially flat on the year (in currency-hedged terms). Our call to overweight corporate debt vs. government debt, focused on the U.S., has performed well, but mostly through our overweight stance on U.S. high-yield. Bottom Line: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Introducing The Japan Corporate Health Monitor Japan's relatively small corporate bond market has not provided much excitement for non-Japanese investors over the years. Japanese companies have always been highly cautious when managing leverage on their balance sheets, and have traditionally relied heavily on bank loans, rather than bond issuance, for debt financing. The result is a corporate bond market with far fewer defaults and downgrades compared to other developed economies, with much lower yields and spreads as well. Due to its small size, poor liquidity and low yields/spreads, we have not paid much attention to Japanese corporate debt in the past. Thus, we don't have the same kinds of indicators available to us for Japanese corporate bond analysis as we have in the U.S., euro area or U.K. One such indicator is the Corporate Health Monitor (CHM) to assess the financial health of corporate issuers.4 We are changing that this week by adding a Japan CHM to our global CHM suite of indicators. In other countries, we have both top-down and bottom-up versions of the CHM. The former uses GDP-level data on income statements and balance sheets to determine the individual ratios that go into the CHM (a description of the ratios is shown in Table 2), while the latter uses actual reported financial data at the individual firm level which is aggregated into the CHM. Table 2Definitions Of Ratios##BR##That Go Into The CHM Consistent and timely data availability is an issue for building a top-down CHM, as there is no one source of top-down data on the corporate sector. Some data is available from the BoJ or the Ministry of Finance, or even from international research groups like the OECD, but not all are presented using a consistent methodology. Some data is only available on an annual basis, which significantly diminishes the usefulness of a top-down CHM as a timely indicator for bond investment. Thus, we focused our efforts on only building a bottom-up version of a Japan CHM, using publically available financial information released with higher frequency (quarterly). We focused on non-financial companies (as we do in the CHMs for other countries) and exclude non-Japanese issuers of yen-denominated corporate bonds. In the end, we used data on 43 companies for our bottom-up CHM. By way of comparison, there are only 36 individual issuers in the Bloomberg Barclays Japan Corporate Bond Index that fit the same description of non-financial, non-foreign issuers, highlighting the relatively tiny size of the Japanese corporate bond market. Our new Japan bottom-up CHM is presented in Chart 8. The overall conclusions are the following: Japanese corporate health is in overall excellent shape, with the CHM being in the "improving health" zone for the full decade since the 2008 Financial Crisis. Corporate leverage has steadily declined since 2012, mirroring the rise in company profits and cash balances over the same period. Return on capital is currently back to the pre-2008 highs just below 6%, although operating margins remain two full percentage points below the pre-2008 highs. Interest coverage and the liquidity ratio are both at the highest levels since the mid-2000s, while debt coverage is steadily improving. The overall reading from the CHM is one of solid Japanese creditworthiness and low downgrade and default risks. It is no surprise, then, that corporate bond spreads have traded in a far narrower range than seen in other countries. In Chart 9, we present the yield, spread, return and duration data for the Bloomberg Barclays Japanese Corporate Bond Index. We also show similar data for the Japanese Government Bond Index for comparison. Japanese corporates have a much lower index duration than that of governments, which reflects the greater concentration of corporate issuance at shorter maturities. Chart 8The Japan Corporate Health Monitor Chart 9The Details Of Japan Corporate Bond Index Japanese corporates currently trade at a relatively modest spread of 36bps over Japanese government debt, although that spread only reached a high of just over 100bps during the 2008 Global Financial Crisis - a much lower spread compared to U.S. and European debt of similar credit quality. That is likely a combination of many factors, including the small size of the Japanese corporate market and the relatively smaller level of interest rate volatility in Japan versus other countries. Given the dearth of available bond alternatives with a positive yield in Japan, the "stretch for yield" dynamic has created a demand/supply balance that is very favorable for valuations - especially given the strong health of Japanese issuers. Chart 10Japan Corporates Do Not Like A Rising Yen It remains to be seen how the market will respond to a future economic slowdown in Japan, which may be starting to unfold given the recent string of sluggish data. On that note, the performance of the Japanese yen bears watching, as the currency has a positive correlation to Japanese corporate spreads (Chart 10). The linkage there could be a typical one of risk-aversion, where the yen goes up as risky assets selloff. Or it could be linked to growth expectations, where markets begin to price in the impact on Japanese growth and corporate profits from a stronger currency. Given our view that the BoJ is highly unlikely to make any changes to its monetary policy settings this year, the latest bout of yen strength may not last for much longer. For now, given the link between the yen and Japanese credit spreads, we would advise looking for signs that the yen is rolling over before considering any allocations to Japanese corporate debt. Bottom Line: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22nd 2018, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcareseach.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Portfolio In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 4 For a summary of all of our individual country CHMs, including a description of the methodology, please see the BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: No Improvement Despite A Strong Economy", dated November 21st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Fed Governor Lael Brainard stated last week that many of the headwinds that held back growth between 2014 and 2016 have faded. This acknowledgement from the most dovish Fed Governor opens the door for a more aggressive pace of Fed rate hikes, and gives the green light to the cyclical bond bear market. Labor Market: The economy continues to add jobs at a rapid pace, but there is some debate about whether the unemployment rate accurately reflects the amount of slack in the labor market. We find that even using the broadest measures of labor market slack, we should expect to see wages accelerate in the coming months. Credit Cycle: Corporate profit growth remains strong for now, but rising unit labor costs will cause profit growth to sustainably fall below debt growth later this year. This will lead to rising corporate leverage and wider bond spreads. We stand ready to reduce exposure to corporate bonds once our inflation targets are met. Feature Chart 1Fed's Current Projections Are Priced In The cyclical bond bear market is at a critical juncture. The yield curve has now largely priced-in the Fed's median fed funds rate projections (Chart 1), and this raises the possibility that the bear market could stall unless the Fed starts to signal a more aggressive path for hikes. With that in mind, last week's speech by Fed Governor Lael Brainard caught our attention.1 As the most dovish member of the Board of Governors, Governor Brainard's speeches are important bellwethers of inflection points in monetary policy. This is particularly true when the speeches convey a more hawkish tone, as was the case last week. Governor Brainard's shift in tone signals that the Fed is poised to adopt a somewhat more aggressive tightening bias. This will likely lead to upward revisions to its interest rate projections and give the green light for the cyclical bond bear market to continue. Brainard On Growth Comparatively weak economic growth outside of the U.S. has been a perennial concern for Governor Brainard, and indeed a key theme in this publication.2 But last week she acknowledged that this dynamic has shifted: Today many economies around the world are experiencing synchronized growth, in contrast to the 2015-16 period when important foreign economies experienced adverse shocks and anemic demand. [...] The upward revisions to the foreign economic outlook are also pulling forward expectations of monetary policy tightening abroad and contributing to an appreciation of foreign currencies and increases in U.S. import prices. By contrast, foreign currencies weakened in the earlier period, pushing the dollar higher and U.S. import prices lower. Chart 2 shows the dramatic shift that has occurred since mid-2016. The Global Manufacturing PMI has soared, and all but one of the 36 countries with available data now have PMIs above the 50 boom/bust line. As a consequence, the U.S. dollar has depreciated and import prices have surged. A more broadly-based global recovery is bearish for U.S. bonds. With less drag from a stronger U.S. dollar, interest rates must rise further to achieve the same amount of monetary tightening. Although we would still characterize the global economic recovery as highly synchronized, we recently flagged some preliminary signals that suggest the breadth of global growth might be deteriorating.3 Specifically, we observe that leading indicators of Chinese economic activity have rolled over, and the outperformance of emerging market currency carry trades has moderated (Chart 2, bottom panel). We will closely monitor both of these indicators during the next few months to see if the weakness persists, or if it starts to bleed into broader global growth aggregates. While the more optimistic assessment of global growth was the starkest change between last week's speech and Governor Brainard's earlier missives, she also noted reasons for optimism on the domestic front. Nonresidential investment is hooking up, and leading indicators point to further gains (Chart 3, panel 1). Financial conditions remain accommodative despite persistent Fed tightening. This differs from the mid-2014 to mid-2016 period when financial conditions tightened even though monetary policy was more accommodative (Chart 3, panel 2). Most importantly, the economy is poised to receive a huge dose of fiscal stimulus during the next two years in the form of a $1.5 trillion tax cut and a $300 billion increase in federal spending (Chart 3, bottom panel). Even our simple tracking estimate for U.S. GDP suggests that growth is shifting into a higher gear. Aggregate hours worked are growing at an annual pace of 2.2%. When coupled with a conservative estimate of 0.8% for productivity growth - the average since 2012 - that translates into real GDP growth of 3%, well above the average pace of 2.2% we've seen since 2010 (Chart 4). With growth that strong we will almost certainly see further tightening of the labor market in 2018. Chart 2Synchronized Growth Is Bond Bearish Chart 3Domestic Tailwinds Chart 4U.S. GDP Tracking At 3% Brainard On The Labor Market A key question for policymakers is how much slack remains in the labor market. If the Fed views the labor market as at full employment, then it necessarily expects inflation to accelerate and should be prepared to tighten policy. Conversely, an economy with significant labor market slack is not expected to generate inflation. Officially, the Fed's most recent Monetary Policy Report to Congress describes the labor market as "near or a little beyond full employment",4 and in last week's speech Governor Brainard gave an excellent summary of the risks surrounding that assessment. First, she noted that "if the unemployment rate were to continue to fall in the coming year at the same pace as in the past couple of years, it would reach levels not seen since the late 1960s" (Chart 5). With growth set to accelerate, we view this as a very likely outcome. In fact, we calculate that, assuming a flat labor force participation rate, the U.S. economy needs to add only 123k jobs each month to keep the unemployment rate under downward pressure. The economy has added an average of 190k jobs per month during the past year, and added a shocking 313k in February (Chart 6). We anticipate it will be some time before job growth falls below the 123k threshold. Chart 5How Much Slack? Chart 6Employment Growth However, it is possible that the unemployment rate is masking some hidden slack in the labor market. Governor Brainard noted that "the employment-to-population ratio for prime-age workers remains more than 1 percentage point below its pre-crisis level" (Chart 5, panel 2). "If substantially more workers could be drawn into the labor force, it would be possible for the labor market to firm notably further without generating imbalances." Chart 7Wage Growth Set To Accelerate In other words, if the labor force participation rate increases, then the unemployment rate could level-off even if job growth remains robust. This would keep a lid on inflation for longer than would be the case otherwise. In our view it will be very difficult for the participation rate to rise meaningfully on a cyclical horizon. As Governor Brainard noted in her speech: "declining labor force participation among prime-age workers predates the crisis" (Chart 5, bottom panel). Added to that, now nine years into the economic recovery, it is questionable whether workers that have been out of the labor force for so long are even able to be drawn back in. Our sense is that the unemployment rate will decline further in the coming months, and it will not be long before that translates into upward pressure on wages. It is important to note that whether we use the unemployment rate or the prime-age employment-to-population ratio as our preferred measure of labor market slack, we are very close to levels that have coincided with exponential wage gains in past cycles (Chart 7). Brainard On Inflation As discussed in our report from two weeks ago, our view is that the headwinds that had been working against inflation are set to fade this year.5 While Governor Brainard agrees that "transitory factors no doubt played a role in last year's step-down in core PCE inflation," she remains concerned that inflation's underlying trend may have softened. Brainard's concern relates to various measures of inflation expectations that are still below levels that prevailed prior to the financial crisis (Chart 8). Without expectations adjusting higher it is doubtful whether inflation can sustainably return to the Fed's 2% target. We share this concern, but note that the cost of inflation protection priced into bond yields has surged in recent months. Survey measures take longer to adjust than market prices, but we anticipate that these measures will also rise as inflation recovers in 2018. The further that measures of inflation expectations (both market-based and survey-based) recover, the more Brainard's concerns about a decline in inflation's underlying trend will fade into the background. Bottom Line: Governor Brainard correctly observed that many of the headwinds that held back growth between 2014 and 2016 have faded. This acknowledgement from the most dovish Fed Governor opens the door for a more aggressive pace of Fed rate hikes, and gives the green light to the cyclical bond bear market. How Sustainable Is Corporate Profit Growth? We've been growing more cautious on the outlook for credit spreads during the past few months, principally because the shift toward a less accommodative monetary policy removes an important support for the corporate bond trade. We view the Fed as getting even more hawkish once inflation expectations are re-anchored around pre-crisis levels, and as such we stand ready to reduce exposure to corporate bonds once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5% (Chart 8, panels 1 & 2). At the time of publication the 10-year TIPS breakeven inflation rate was 2.12% and the 5-year/5-year forward rate was 2.14%. But this is only one piece of the puzzle. For a true bear market in corporate bonds to set in we also need to see rising leverage and mounting defaults. At least for now that is not happening. Our measure of gross leverage for the nonfinancial corporate sector - calculated as total debt divided by EBITD - has flattened off during the past year, and the 12-month trailing default rate is in a steady decline (Chart 9). Chart 8The Re-Anchoring Of Inflation Expectations Chart 9Wider Spreads Need Rising Leverage Chart 9 shows that periods of sustained corporate spread widening almost always coincide with rising gross leverage. Or put differently, for corporate spreads to widen we need to see corporate debt growth consistently exceed profit growth (Chart 9, panel 2). At first blush it is not obvious that profit growth will weaken any time soon. Leading indicators such as total business sales less inventories and the ISM manufacturing index point to a favorable profit outlook (Chart 10). Profit growth should also continue to benefit from dollar weakness for at least the next few months (Chart 10, bottom panel). But there is one leading profit indicator that is starting to flash red. A simple profit margin proxy created by taking the difference between the nonfarm business sector's implicit price deflator and its unit labor costs turned negative in Q4. Chart 11 shows that, although this indicator can be volatile, sustained negative readings almost always foreshadow periods of falling profit growth and corporate bond underperformance. Chart 10Rising Leverage Needs Weaker Profit Growth Chart 11Watch Unit Labor Costs In 2018 The Q4 weakness was driven by a big jump in unit labor costs, and with labor markets as tight as they are this is certainly a trend we see continuing. Unless corporate selling prices can keep pace we will see profit growth sustainably fall below debt growth this year, and this will lead to corporate bond underperformance. Bottom Line: Corporate profit growth remains strong for now, but rising unit labor costs will cause profit growth to sustainably fall below debt growth later this year. This will lead to rising corporate leverage and wider bond spreads. We stand ready to reduce exposure to corporate bonds once our inflation targets are met. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20180306a.htm 2 Please see Theme 3 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017" dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/monetarypolicy/files/20180223_mprfullreport.pdf 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights BCA's view is that while a major trade war is unlikely, trade tensions will persist. The Fed, not protectionism, will end the cycle. There have been five episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policy were all aligned to boost the U.S. economy. The March Beige Book keeps the Fed on track to hike four times this year. Feature The Trump Administration's announcement last week to slap hefty tariffs on steel and aluminum runs the risk of provoking a "tit-for-tat" trade war. This proposed levy follows a similar move earlier this year to impose tariffs on washers and solar panels. The EU has retaliated with a threat to introduce tariffs on Harley Davidson motorcycles and Levi's jeans. Even if a trade war develops, our Global Investment Strategy team notes1 that the U.S. would suffer less in a trade war than other nations, and that higher tariffs may lead to more domestic demand, a more aggressive Fed and a stronger dollar. Certainly, the tariff issue does not signal the end of the U.S. economic expansion or equity bull market. BCA's view is that while a major trade war is unlikely, trade tensions will persist. Our Geopolitical Strategy service states2 that investors should closely monitor bellwether factors for trade policies, including Trump's position on NAFTA, exemptions granted on the steel and aluminum tariffs to countries (such as Mexico and Canada) and most importantly, the treatment of intellectual property trade with China. Bottom Line: The end of the equity bull market will probably be due to an overheated U.S. economy and rising financial imbalances, and not escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Policy Panacea The backdrop for U.S. economic growth remains solid. Consensus global GDP projections for 2018 and 2019 have perked up, in contrast with prior years when forecasters issued relentless lower GDP estimates (Chart 1). Moreover, global exports growth is in a persistent uptrend since the earlier part of 2016 (Chart 2). Chart 1U.S. & Global Growth Expectations Are Still Accelerating The surge in global growth occurs even as China's economy is poised to slow. Among the components of BCA's Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang), all six series are in a downtrend, and five fell in January (the growth in M2 was the exception).3 Although China's economy is decelerating, BCA's view is that a repeat of the late 2015/early 2016 shock is unlikely (Chart 3). Chart 2Global Exports##BR##Are Booming... Chart 3Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth In China The U.S. economy and financial markets will benefit from the uptick in global growth, a large dose of fiscal policy, still accommodative monetary policy, and a decline in regulation. Table 1 and Chart 4 show that there have been four other junctures in the past 35 years when these factors all pulled in the same direction to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. All four previous periods occurred closer to the start and not the end of a business cycle; BCA's stance is that the U.S. economy is in the late stages of an economic expansion that began in 2009. These phases lasted, on average, for just under two years. The current phase is entering its third year. The longest was in the early 2000s (2002-2004), while the shortest was a 14-month interval in the first year of the 1991-2001 economic expansion. Three of the prior four periods ended as fiscal policy turned restrictive. In the early 1980s' chapter, a reversal in global IP signaled the end of the growth sweet spot. Performance Of U.S. Financial Assets, Gold, Oil And Earnings When Global Growth Is Increasing Alongside Stimulative Monetary, Fiscal And Regulatory Policy .... Chart 4Global Growth, Fiscal, Monetary And Regulatory Policy##BR##All Pulling In The Same Direction Not surprisingly, risk assets perform well during these "tailwind" points (Table 1 again and Chart 5). The S&P 500 rose in the previous four periods and again in the current one. However, BCA's stock-to-bond ratio fell in the early 1990s and early 2000s. Credit tends to outperform Treasuries when monetary, fiscal and regulatory policy are synchronized, and small caps outperform large. This is the case in the current episode that began in January 2016. Gold and oil also perform well when global growth is surging, fiscal and monetary policy is stimulative and regulations are on the wane. However, on average, the dollar falls during these intervals as demonstrated in the early 2000s and early 2010s. S&P 500 earnings growth is solid and well above average during these phases. Chart 5U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push Table 2 shows that U.S. risk assets tend to struggle in the year after these legs end, but the economy keeps flourishing. Stocks underperformed bonds a year after the end of two of the four periods, but none of those periods coincided with a recession. Investment-grade and high-yield credit underperforms Treasuries in the ensuing 12 months, while small caps struggle to keep up with large. Gold performs well in three of the four periods, but oil posts a mixed performance. The dollar rises and S&P 500 earnings per share increase in the year after stretches of synchronous policy, but at a much slower pace than when the stimulative fiscal policy, deregulation and easy monetary policy are all in place. Table 2... What Happens In The 12 Months After These Episodes End... Tighter Fed policy will end the current era of pro-growth policies. BCA's stance is that the Fed will raise rates four times this year and another three or four times next year, pushing monetary policy into restrictive territory. U.S. fiscal policy will likely add to growth into the next year, thanks to tax cuts and the lifting of spending caps, and Trump will continue to look for deregulation opportunities. Bottom Line: Fed tightening will end the latest era of deregulation, easy monetary policy and stimulative fiscal policy, but not until early next year. Until then, a favorable backdrop will persist for stocks over bonds, credit, S&P 500 earnings and oil. Stay long stocks and credit, and underweight duration. This forecast assumes that the trade spat does not degenerate into a trade war. If that occurs, we would recommend reducing our overweight to risk assets sooner than early next year. Beige Book: More Tailwinds Fed Chair Powell's February 27 testimony to Congress noted that "some of the headwinds the U.S. economy faced in previous years have turned into tailwinds."4 The Beige Book released on March 7 highlights many of those tailwinds, keeps the Fed on track to boost rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach5 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market. Furthermore, the disconnect between the Beige Book's view of inflation and the market's stance has eased. Moreover, references to a stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and Trump's assault on regulation. The latest Beige Book ran from mid-January to February 26 and, therefore, did not capture the business community's reaction to the tariff announcement in early March. Chart 6, panel 1 shows that at 67% in March, BCA's Beige Book Monitor stayed near its cycle highs, which reconfirms that the underlying economy was upbeat in early 2018. The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 15 mentions of the tax bill in the March Beige Book, up from 12 in January and only 3 in November 2017 (not shown). The tax bill was cast in a positive light in 87% of the remarks in March versus 75% in January. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Chart 6Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation And Economy Based on the minimal references to a robust dollar in the past six Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018. This sharply contrasts with 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6, panel 4). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. Business uncertainty over government policy (fiscal, regulatory and health) multiplied in the past few Beige Books as Congress debated the tax bill. However, in general, these comments have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 6, panel 5). However, the controversy associated with the tariffs on steel and aluminum will add to business unease in the coming months unless Trump reverses his position. The disagreement between the Fed and the market on inflation narrowed in the March edition of the Beige Book (Chart 6, panel 3). The number of inflation words in the Beige Book rose to an 8 month high in March, reflecting the abrupt change in sentiment on inflation in early 2018 both in the business community and the market. In the past year, inflation words in the Beige Book climbed as the readings on CPI and PCE rolled over. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The March Beige Book supports BCA's view that the U.S. economy is poised to expand above its long-term potential in the first half of 2018. Moreover, the elevated soundings on inflation in the Beige Book in recent years have again proved prescience, as price measures are poised to turn higher. While the first few Beige Books in 2018 showed that the business and financial communities welcomed tax cut legislation, the next edition will likely reflect elevated concern over the nation's trade policies. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Trump's Tariffs: A Q&A", published March 9, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Client Note "Market Reprices Odds Of A Global Trade War", published March 6, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation", published March 7, 2018. Available at cis.bcaresearch.com. 4 https://www.federalreserve.gov/newsevents/testimony/powell20180226a.htm 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," published April 17, 2017. Available at usis.bcaresearch.com.

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

My colleagues Caroline Miller, Peter Berezin and I broadcasted a webcast this past Wednesday to discuss the outlook for the dollar along with recent market-relevant fiscal and trade policy pronouncements. If you haven't already, I hope you find time to listen in. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights On the one hand, because the Federal Reserve targets inflation and because tariffs are inflationary, when the economy is at full employment, tariffs could lift the USD. On the other hand, investors have been conditioned to the reality that tariffs are a tool used by previous U.S. administrations to weaken the dollar. Also, tariffs bring back memories of the 1970s stagflation, a very dollar-bearish period. Tariffs also raise the risk that the USD share of global reserves declines. Even if protectionist rhetoric raises the probability of a global trade war, we do not believe the set of tariffs proposed now are the beginning of such a catastrophe. However, we remain worried that Sino-American tensions will only escalate going forward. If a global trade war were to unfold, the USD would likely suffer down the road, and EUR/JPY could get hit. The short-term impact of Sino-U.S. trade tensions should be more limited; however, the AUD would suffer from this conflict. We are closing our short CAD/NOK trade at a 4.55% profit this week. Feature Last week, U.S. President Donald Trump announced that America would be slapping tariffs of 25% on steel imports and 10% on aluminum imports. True to himself, he then proceeded to tweet that "trade wars are good and easy to win." In response to this bravado, investors began to worry about the growing risk of a global trade war - a replay of the disastrous Smoot-Hawley tariffs of the 1930s - and the USD weakened anew. This obviously begs the following questions: Are tariffs and trade wars good or bad for the dollar? What is the real likelihood of a trade war engulfing the globe? What signposts should investors monitor to judge whether the world economy is regressing to a 1930s-like nationalist period? We think the current set of proposed tariffs will have a limited impact on the USD, especially as the Fed seems increasingly dead set on tightening policy. However, we need to monitor how NAFTA negotiations evolve. A breakdown in NAFTA negotiations would indicate a rising threat of a global trade war, which down the road would threaten the reserve currency status of the USD. Intellectual property trade disputes with China are another barometer to follow, as Sino-American tensions could intensify markedly. An escalation of these tensions would likely weigh on EM and commodity currencies. The SEK could suffer as well. How Could Tariffs Help The USD? There are two competing hypotheses out there, with diametrically opposed conclusions for investors. One school of thought argues that tariffs could help the dollar; another, that it would hurt the dollar. Chart I-1No Slack In The U.S. Let's begin by exploring how tariffs could help the dollar. Last July, the IMF published an in-depth study of the dynamics that may be associated with tariffs being implemented by any economy.1 Based on the assumption of the imposition of a 10% import tariff across the board, various interesting conclusions emerged. The imposition of imports tariffs should have an inflationary impact on the economy. The first stage is a one-off adjustment with a transitory impact, reflecting the sudden upward adjustment in the price of imports proportional but not equal to the size of the tariffs. If, however, the economy is at full employment, the higher price of foreign-sourced goods incentivizes repatriation of some production onshore. This repatriation brushes up against capacity constraints in the economy's production function, lifting prices over many quarters. The U.S. economy is at full employment, with aggregate capacity utilization at its tightest level since 2005. The U.S. could experience a second-round inflationary effect if broader tariffs are implemented (Chart I-1). The most important conclusion of the IMF study relates to interest rates. Tariffs put upward pressure on domestic nominal interest rates, especially if the economy is already at full employment (Chart I-2A). This is because the central bank presumably wants to counter the inflationary impact of the tariffs. On the other hand, because import tariffs hurt foreigners' exports, the tariffs hurt foreign economies. This makes the foreign output gap more negative than it would otherwise be. In this context, U.S. interest rate differentials rise relative to trading partners (Chart I-2B). Chart I-2A & BAt Full Employment, Import Tariffs Raise Rates The IMF also explores the impact of a global trade war, where tit-for-tat behavior proliferates globally. Unsurprisingly, the IMF's models show that global output declines by roughly 1% over five years after the implementation of the original tariffs (Chart I-3A), and global trade contracts by roughly 2% of GDP over the same time frame (Chart I-3B). Chart I-3A & BGlobal Trade Wars Hurt Trade And Growth The U.S. is a relatively closed economy, as exports constitute approximately 8% of GDP compared to 20% of GDP in major European economies and 16% of GDP in China and Japan (Chart I-4). Hence, the U.S. economy is likely to experience a smaller contraction of output in a global trade war than other major economies. Moreover, as the Global Financial Crisis illustrated, when global trade contracts, economies with deep current account deficits tend to experience an improvement in their trade balance. This means that for an economy like the U.S., which sports a current account deficit of 2.3% of GDP, contracting global trade will shrink the current account deficit, further mitigating some of the negative impact on GDP. Thus, the U.S. output gap would deteriorate less than in countries sporting large current account surpluses like Germany, Japan, or China. U.S. interest rates would rise relative to the rest of the world, causing the dollar to appreciate. Bottom Line: On the one hand, when an economy is at full employment, the imposition of tariffs can generate systemic inflationary pressures. The response of an inflation-targeting central bank would be to tighten policy. This describes the U.S. today, suggesting the USD could rise if tariffs are imposed. Moreover, if a full-fledged trade war ensues, the U.S. economy's lower sensitivity to global trade would limit the negative impact relative to its more globally exposed trading partners - another plus for the dollar. Chart I-4U.S. Growth Is Less Exposed To Global Growth Chart I-5History: Trade Spats Have Hurt The Dollar But The Dollar Is Falling, So What Gives? The analysis above is theoretical, and flies in the face of the real world, where the dollar has been weakening since President Trump announced his intention to impose tariffs. This analysis relies on two words: Ceteris Paribus, and the world is anything but Ceteris Paribus. Investors are having qualms about the dollar because of the history of tariffs. As Marko Papic highlighted in a recent special client note in BCA's Geopolitical Strategy service, tariffs and the threat of tariffs are often used by U.S. administrations to force an upward adjustment in the currencies of U.S. trading partners.2 This worked very well in 1971, when Nixon imposed a 10% surcharge on all imported goods. The 1985 Plaza Accord materialized amid threats of large tariffs by the U.S. on German and Japanese exports, which made those two nations much more willing to see their exchange rates appreciate sharply against the USD. Even more recent trade spats such as the U.S.-Japan tensions in the early 1990s or President George W. Bush's steel tariffs in 2002 were also associated with a weakening dollar (Chart I-5). History has another lesson in store: Investors fear a return of stagflation. The U.S. has a populist president, and fiscal policy is becoming expansionary despite the economy being at full employment - an environment very reminiscent of the late 1960s and early 1970s (Chart I-6). Tariffs too are inflationary and hurt output. Finally, while it remains to be seen if Fed Chairman Jerome Powell will be as malleable to the White House's demands as then Fed Chairman Arthur Burns was, Powell is still perceived as an untested Trump appointee. These apparent similarities with the 1970s are prompting investors to sell the USD. Stagflation was unkind to the dollar as the DXY fell 29% from the 1971 Smithsonian Agreement to December 1979. Chart I-6Like the Late 1960's: Full Employment And Fiscal Stimulus A theoretical concept is also frightening investors: Will Trump's policies prompt a decline of the dollar's share of global reserves? The U.S. dollar is the premier global reserve currency, accounting for 63% of allocated FX reserves. However, a paper from Harvard University highlighted that the dollar is in fact over-represented in global reserves based on trade flows.3 One of the key factors explaining the large role of the USD in global reserves is that many economies have dollarized financial systems, where the greenback represents a large share of their banks' liabilities. Since many of these economies have little access to direct financing from the Fed, as a matter of precaution these nations keep many more dollars in their FX reserve pools for rainy days. If the dollar increasingly becomes a weapon used by the White House, and the U.S. also wants to shrink its current account deficit through aggressively nationalist trade policy, the supply of dollars to the global financial system will decrease and become more volatile. This will make dollar-based financial systems around the world more unstable and dangerous. In the near-term, this uncertainty may support the dollar, but over the longer-run, growing trade restrictions by the U.S. could spur countries to abandon the USD as a source of financing. If they stop financing themselves in USD, they can diversify their FX reserves away from the dollar and mitigate geopolitical risk emanating from the U.S. Chart I-7Is The Exorbitant Privilege Ending? Why is this a problem? As Chart I-7 illustrates, the U.S. has a negative net international investment position of -40% of GDP - i.e. it owes much more money to foreigners than it is owed by foreigners. Yet, the U.S. still manages to eke out a positive primary international income balance of 1.1% of GDP. This is because foreigners are willing to hold dollar bonds at derisively low rates for such an indebted nation. Foreigners are willing to do so because they want to hold dollars as reserves. If the global demand for USD reserves declines, financing the U.S.'s current account deficit and negative net international investment position will become more expensive. The simplest and fastest way to make dollar assets more attractive for foreigners is to weaken the USD today, which lifts expected returns on U.S. assets down the road. Bottom Line: On the other hand, the dollar has responded negatively to the suggestion of new tariffs. The world is not a ceteris paribus environment, and investors are worried that tariffs could plunge the U.S. economy back into 1970's style stagflation. Moreover, the weaponization of the USD decreases its attractiveness as the premier reserve currency of the world, potentially endangering a crucial source of demand for the USD. So What? Both sides of the debate make some valid arguments. But as was the case with the twin deficit, the outlook for the dollar will hinge on the Fed's response to the impact of tariffs on inflation.4 If the Fed ignores the inflationary impact of the repatriation of production onshore, then, investors are correct to replay the stagflation story of the 1970s. However, the Fed doesn't seem to be so inclined. Chairman Powell has acknowledged accelerating U.S. economic momentum, and even perennial doves like Lael Brainard have highlighted the positive impact of stronger global growth, a weaker dollar, and fiscal stimulus on the U.S. growth outlook. The Fed seems ready to hike and does not want to fall behind the curve. There is another dimension to the question. What is the likelihood that Trump tariffs are the opening salvo of a protracted trade war? To be clear, tariffs on steel and aluminum only affect 1% of U.S. imports, or 0.15% of GDP. Tariffs will only have a macro impact if they are broadened or if widespread retaliation ensues. So far, these new tariffs barely affect the long-term trend of declining obstruction to trade, and they remain a far cry from the levels hit in the 1930s (Chart I-8). So, while the probability of a global trade war has risen, it is not a base-case scenario. Instead, it remains to be seen if Trump will become much more aggressive on the trade front. Canada - the top exporter of both steel and aluminum to the U.S. - would have been the country most negatively affected by these tariffs (Table I-1). However, key allies like Canada, Mexico, Australia, Korea and the EU will be exempted from the tariffs. This does not yet point to an all-out trade war between U.S. and the rest of the entire planet. Chart I-8Steel And Aluminum Tariffs: No Smoot-Hawley Table I-1Target Is Locked, Is It? While the probability of a generalized trade war with advanced economies is low, a continued toughening of relations with China is much more likely. President Trump wants greater access for U.S. firms to Chinese markets, and is likely to apply increasing pressure in that direction. For investors, it is important to evaluate if the U.S. is pursuing isolationist policies on a global level or if the impact will be limited to the Sino-American relationship. BCA's Geopolitical Strategy service recommend investors track the following signposts: NAFTA: Marko Papic and his team see a 50% probability that NAFTA will be abrogated as Trump is constitutionally unconstrained from abrogating the deal. If the White House continues negotiating with Mexico and Canada, it increases the likelihood that the tariffs are a shot across the bow directed at China. If NAFTA is not only abrogated but if the trade relationship reverts back to WTO rules, this would signal that the U.S. will remain highly belligerent, raising the risk of implementation of a broader spectrum of tariffs. China Intellectual Property Theft: China only imports US$8 billion in intellectual property from the U.S., suggesting that large-scale theft is happening. The Trump Administration is investigating Chinese technology transfers and Intellectual property theft under Section 301 of the Trade Act of 1974. This could lead to penalties imposed on China, including tariffs, an indemnity for past IP theft, and limitations to Chinese investments in the U.S. This would constitute a massive ratcheting up in Sino-U.S. tensions. This scenario has a much higher probability than a global trade war and it would have a meaningfully negative impact on the Chinese economy, as 19% of its exports are shipped to the U.S. The inflationary impact on the U.S. would be real as well. A global trade war would ultimately hurt the dollar as it would cause the dollar's share of global FX reserves to decline. However, commodity currencies, the Swedish krona and key EM currencies would suffer as global trade contracts (Chart I-9). The yen could perform especially well in this environment, rallying even against the euro (Chart I-10). But again, we see this scenario as a tail risk, not a base case. Chart I-9Key Losers From Falling Global Trade Chart I-10EUR/JPY Could Suffer If A Trade War Materializes Meantime, a bilateral conflict with China is likely to have a more limited impact on currency markets. However, the AUD would be the big loser in such a scenario as the Australian and Chinese economies are tightly linked (Chart I-11). This is an additional reason to underweight the AUD as the probability of growing Sino-American tensions is elevated. Finally, our short EUR/SEK trade is being very negatively affected by the current environment of trade tensions, as EUR/SEK rallies when global trade recedes (Chart I-12). Since we expect tensions to decrease over the coming months, EUR/SEK is likely to weaken, ultimately. Chart I-11China's Boost Is Dissipating Australia Is Tied To The Hip With China Chart I-12SEK At Odds With Trump Bottom Line: The current set of tariffs proposed by the White House is not the beginning of a global trade war. However, it shows that the probability of such an event has grown. Since we are anticipating that the Fed will fight inflationary forces created by further tariff impositions, we are fading the dollar's recent weakness. Yet, we worry that tariffs aimed more specifically at China could become more of a focus. So while we fade the impact of tariffs on the USD, risks are building up for EM currencies and the Australian dollar. Global trade tensions are also a major headwind to the Swedish krona. Housekeeping We are closing our short CAD/NOK trade at a 4.55% profit. Our target was hit, and the exemption of steel and aluminum tariffs for Canada is a positive outcome that could at least temporarily reduce the discount imputed on the CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Linde, Jesper and Andrea Pescatori (2017). "The Macroeconomic Effects of Trade Tariffs: Revisiting the Lerner Symmetry Result." IMF Working Paper No. 17/151, International Monetary Fund. 2 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War", dated March 6, 2018, available at gps.bcaresearch.com. 3 Shah, Nihar. "Foreign Dollar Reserves and Financial Stability"(2017) 4 Please see Foreign Exchange Strategy Weekly Report, "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card", dated March 6, 2018, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been positive for the dollar: PCE yearly inflation came in at 1.7%, outperforming expectations. ISM Manufacturing PMI and ISM prices paid both outperformed expectations, coming in at 60.8 and 74.2 respectively. Finally, unit labor costs yearly growth outperformed expectations, coming in at 2.5%. The only blip were initial jobless claims that surprised to the upside, coming in at 210 thousand. The dollar has depreciated by roughly 1.2% in the month of March so far. Overall, we continue to see upside for the dollar in the short term. However, this will be a countertrend rally within a cyclical bear market. Report Links: The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been mixed: Producer price inflation came in at 1.5%, underperforming expectations. It also declined from 2.2% the previous month. Moreover, Markit services PMI AND Markit Composite PMI both underperformed expectations Finally, both the gross domestic product yearly growth and the unemployment rate came in line with expectations, at 2.7% and 8.6% respectively. After falling below 1.22, the euro has rallied by 2% in the month of March. However, in contrast to last year, data in the euro area is starting to disappoint expectations, as the effects of the tightening in financial conditions resulting from the higher euro are starting to be felt in the real economy. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Consumer confidence came in at 44.3, surprising to the downside. Moreover Markit Services PMI also surprised negatively, coming in at 51.7. However, the unemployment rate came in at 2.4%, surprising positively. It also decreased from 2.8% the previous month. Q4 2017 GDP growth was also revised up to 2.2% from 0.5%, thanks to strong capex. The yen has appreciate further in March, at one point even trading below 106 as investors were still digeseting the impact of Trump's tariffs. Overall, while we expect further upside to the yen in the current volatile environment, the BoJ will be forced to combat this strength. At 102, USD/JPY will be a buy Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: PMI construction came in at 51.4, outperforming expectations. Moreover, Markit Services PMI came in at 54.4, also beating expectations. Finally, house price yearly growth also surprised positively, coming in at 1.8% After falling at the end of February, the pound has rallied by nearly 1%. Overall we expect the upside to the pound to be limited, given that Brexit negotiations are heating up and that any potential tightening by the Bank of England is already well priced in. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Gross domestic product yearly growth underperformed expectations, coming in at 2.4% Moreover, retail sales month-on-month growth underperformed expectations coming in at 0.1%. However, company gross operating profits quarterly growth outperformed expectations, coming in at 2.2%. AUD/USD has rallied roughly 1.3% since the beginning of the month. Overall, we continue to be bearish on the Australian dollar, as the economy is still not generating enough endogenous inflationary pressures to justify hiking rates. Moreover, a slowdown in economic activity in China would also weigh on this cross. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The trade balance came in at NZD -3.2 billion, underperforming expectations. However, thanks to robust dairy prices, the terms-of-trade index outperformed expectations, coming in at 0.8%. NZD/USD has rallied by nearly 1% in the month of March. Overall, upside to the kiwi will be limited, given that this currency will suffer amid the persistence in volatility. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Housing starts surprised to the upside, coming in at 229.7 thousand. Moreover, the Ivey Purchasing Managers Index also outperformed expectations, coming in at 59.6. However, gross domestic product quarter on quarter growth underperformed, coming in at 1.7%. The Bank Of Canada left rates unchanged on Wednesday. Overall, the Canadian interest rates curve prices the policy outlook appropriately, the CAD has now cheapened in response to the risk of a full abrogation of NAFTA. While we do agree that the risk of NAFTA being abrogated is elevated, a return to the previously standing Canada-U.S. Free Trade Agreement would have a limited impact on the Canadian economy. The downside risk to the CAD is now much more limited. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has generally been positive: The KOF leading indicator surprised to the upside, coming in at 108, and increasing from the previous month. Moreover, the unemployment rate also surprised positively, declining from 3% to 2.9%. However, retail sales growth underperformed expectations, coming in at -1.4% per annum. EUR/CHF has rallied by more than 1.5% since the beginning of the month. Overall, we expect this trend to continue, given that inflationary pressures in Switzerland are too weak for the SNB to back off from its ultra-loose monetary policy stance. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Registered unemployment came in line with expectations at 2.5%. However, it did go down from the previous month. Nevertheless, manufacturing output surprised negatively, coming in at -2%. USD/NOK has fallen by roughly 0.8% in the month of March. We are positive on the krone within the commodity currencies. This is because there are less hikes priced into the Norwegian curve than in other countries. Moreover, oil should outperform metals given than oil is less sensitive to a shock from China. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth underperformed expectations, coming in at 1.2%. Gross Domestic Product annual growth also underperformed expectations, coming in at 1.2%. However, the Manufacturing PMI surprised to the upside, coming in at 59.9. USD/SEK has been relatively flat this this month. Overall, we believe the Riksbank will be forced to lift rates in the face of rising prices. This will push EUR/SEK lower. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global trade data we track as indicators of current and expected commodity demand - particularly EM import volumes - will provide a lift to oil prices over the course of 1H18. We continue to expect global oil demand growth, led by EM growth, to rise by 1.7mm and 1.6mm b/d this year and next, respectively. Against this still-positive backdrop, heightened geopolitical tensions are ratcheting up volatility in our outlook. A global trade war - now a factor following the Trump administration's bellicose rhetoric - would reduce our oil demand forecasts. That said, our Geopolitical Strategy team notes past U.S. administrations have used the threat of trade wars to cheapen the USD, which would be bullish commodities.1 Energy: Overweight. Even though it is not a surprise, the anti-trade rhetoric coming out of Washington is a wake-up call for oil markets. Trade is deeply entwined with EM income growth, which drives commodity demand globally. A shock to global trade would be a shock to aggregate demand and oil demand, hence oil prices. Base Metals: Neutral. President Trump announced 25% and 10% tariffs on steel and aluminum last week. Markets are fretting over the possibility of a full-blown trade war if the U.S. zeroes in on China, as it apparently is doing, and Washington's allies impose retaliatory tariffs, should the Trump administration level tariffs on their exports.2 Precious Metals: Neutral. A global trade war would boost gold's appeal, and we continue to recommend it as a strategic portfolio hedge. Ags/Softs: Underweight. In a series of tweets earlier this week, President Trump suggested concessions on steel and aluminum tariffs to Canada and Mexico in exchange for concessions on NAFTA. Neither Mexico nor Canada supported this link. Feature Our short-term models of global trade volumes continue to indicate EM imports - a key variable in our analysis of industrial commodity demand - will continue to grow (Chart of The Week).3 This will be supportive of commodity prices generally, particularly oil, in 1H18. In 2H18 and beyond, the outlook is getting cloudier. And more volatile. A fundamental underpinning of our oil-demand expectation for this year and next is that a slowdown in China in 2H18 will be offset by a pickup in EM and DM aggregate demand - and trade volumes - ex-China, in line with the IMF's expectation for EM and DM growth this year and next (Chart 2).4 DM markets and India likely will take up the slack created by China's slight slowdown. In fact, India already is moving out ahead: Based on official data, India's economy grew at a 7.2% rate in December, topping China's 6.8% rate, according to a Reuters survey at the end of February.5 Chart 1EM Import Volumes Will Continue To Grow Chart 2EM Growth Ex-China Keeps Oil Demand Strong EM Import Volumes Are Important To Oil Prices EM demand drives global oil demand. Over the long haul, the relationship between oil prices and EM import volumes has been strong: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000 (Chart 3).6 These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes. All else equal (i.e., assuming supply is unchanged), this increases oil prices (via higher demand). The biggest weight in the EM import volume variable is China's imports, so the sustainability of the current Chinese growth is important, as is how smoothly policymakers there slow the economy in 2H18 as we expect. Chinese imports are sensitive to industrial output, which is captured by the Li Keqiang index, global PMIs, and FX markets (Chart 4). Provided policymakers can maintain income growth as the country pivots - once again - away from heavy industrial-export-led growth to consumer- and services-led growth, oil demand will not be materially affected, and should continue growing. At present, China's import volume growth has leveled off as Chart 4 shows, indicating income growth is holding up. China recently guided toward a GDP growth target of 6.5% for this year. Given they have a solid track record of achieving such targets, this indicates that they do not expect a severe slowdown. However, a hard economic landing - always a risk in transforming such a huge economy - would force us to reconsider our growth estimates. Chart 3EM Imports Supportive Of Prices Chart 4Growth In China's Import Volumes Levels Off In our analysis, we do not yet have enough information to determine whether the Trump administration will launch a trade war with China. The impact of President Trump's proposed steel and aluminum tariffs on China is de minimis: Chinese exports of these commodities to the U.S. amount to less than 0.2% of China's total exports, as our colleagues at BCA Research's China Investment Strategy note in this week's analysis.7 The big risk from these tariffs lies in what happens next. If they are the first step in additional tariffs directed at industries far more important to China, they could invite retaliation.8 If the recently announced tariffs expand to a global trade war - already the EU, Canada and Mexico have indicated they will not sit idly by while tariffs are imposed on exporters in their countries - the threat to world trade, and EM imports in particular, rises considerably. This would threaten crude oil prices. Trade Wars And Oil Flows Other than exports from the U.S., which could be targeted by states retaliating against tariffs, it is difficult to imagine the flow of oil being affected by a trade war in the short term: Oil is an internationally traded commodity, and traders adapt quickly to disruptions - e.g., re-routing crude flows in response to events affecting production, consumption, inventories or shipping.9 However, it does not require much of an intellectual leap to see EM trade volumes being significantly impacted by a trade war via the slowing in income growth globally. Such a turn of events would reduce aggregate demand in that part of the market - EM - that is responsible for the bulk of commodity demand growth. Falling EM trade volumes would be the natural result of falling incomes. This would be disinflationary, as well, which is not unexpected (Chart 5). We have found a long-term relationship with strong co-movement properties between EM import volumes and U.S. CPI and PCE inflation indexes. Our modelling indicates a 1% decrease (increase) in EM import volumes translates into a decrease (increase) in these U.S. inflation indexes of 15 to 20bp with a 6- to 12-month lag. These are non-trivial quantities: For instance, a decline in EM import volumes of 10% or more could shave as much as 2 points from U.S. inflation (Chart 6). Such a disinflation impulse once again coming from the real economy would, in all likelihood, force the Fed to throttle back on its interest-rate normalization policy or reverse course. Chart 5Lower EM Import Volumes##BR##Would Take U.S. Inflation Lower Chart 6EM Trade Volumes##BR##Over Time Volatility Likely To Pick Up As we noted above, our Geopolitical Strategy (GPS) colleagues point out the threat of tariffs and quotas has been used by U.S. administrations in the past to get systemically important central banks to support a weaker USD.10 The end game always is to spur exports to boost economic growth. The downside risk from trade wars discussed above is fairly obvious. Not so obvious is the upside commodity-price risk arising from a depreciation in the USD, which falls out of a strategy of using the threat of tariffs to ultimately weaken the USD. Our GPS colleagues quote Paul Volcker's summary of a similar gambit by Richard Nixon, who also ran a mercantilist presidential campaign in the late 1960s, to ultimately weaken the USD: The conclusion reached by some that the United States shrugged off responsibilities for the dollar and for leadership in preserving an open world order does seem to me a misinterpretation of the facts ... The devaluation itself was the strongest argument we had to repel protectionism. The operating premise throughout was that a necessary realignment of exchange rates and other measures consistent with more open trade and open capital markets could accomplish the necessary balance-of-payments adjustment. It is impossible to say whether such a depreciation is the Trump administration's end-game. However, if it is, this would be bullish commodities generally, gold and base metals in particular. For oil, a weaker USD would be bullish, but, as we have shown recently, fundamentals now drive oil price formation.11 Bottom Line: Current and expected EM import volumes indicate oil prices will continue to be supported by rising demand over the course of 1H18. We continue to expect global oil demand growth, led by EM growth, to rise by 1.7mm and 1.6mm b/d this year and next, respectively. Still, heightened geopolitical tensions brought on by bellicose trade signaling from the U.S. are ratcheting up volatility in our outlook. A global trade war would force us to lower our forecast for Brent and WTI crude oil from our current $74 and $70/bbl expectations for this year. However, as our Geopolitical Strategy team notes, past U.S. administrations have used the threat of trade wars to cheapen the USD. Should this turn out to be the Trump administration's strategy, the weaker USD would be bullish for commodity prices. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report "Market Reprices Odds Of A Global Trade War," published March 6, 2018. It is available at gps.bceresearch.com. Our colleagues note, "Import tariffs ought to be bullish for the greenback, given that they lead to higher domestic policy rates as inflationary pressures rise (and not just passing ones). However, as the previous two examples of U.S. protectionism teach us, the U.S. uses threats of tariffs so that it can get a cheaper USD. From Washington's perspective, both accomplish the same thing. Intriguingly, the U.S. dollar has sold off on the most recent news of protectionism." (Emphasis added.) 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Global Aluminum Deficit Set To Ease," published March 1, 2018, particularly the discussion beginning on p. 7. It is available at ces.bcaresearch.com. 3 Our 3-month ahead projections are based on two components: (1) the first principal component of a basket of currencies exposed to global growth; and (2) lagged U.S. monetary variables. Our modeling shows that exchange rates are forward-looking variables containing information of future fundamentals. Therefore, by selecting currencies exposed to global and EM growth, this allows us to run short-term forecasts of EM import volumes. The analysis is also confirmed using Granger-causality tests. 4 Please see "Brighter Prospects, Optimistic Markets, Challenges Ahead," in the IMF's January 22, 2018, World Economic Outlook Update, which notes its revised forecast calling for stronger global growth reflects improved DM growth expectations. 5 Please see "India regains status as fastest growing major economy," published by reuters.com on February 28, 2018. 6 These results fall out of co-integration regressions. 7 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation," published March 7, 2018. It is available at cis.bcaresearch.com. See also footnote 2 above. 8 President Trump reportedly is considering broadening the tariffs on a range of Chinese imports and limiting Chinese investment in the U.S., to punish the country for "its alleged theft of intellectual property," according to Bloomberg. Please see "U.S. Considers Broad Curbs on Chinese Imports, Takeovers," published by Bloomberg.com, March 6, 2018. 9 The U.S. is exporting a little over 1.5mm b/d of crude oil and 4.6mm b/d of refined products at present, according to EIA data. A drawn-out trade war resulting in U.S. oil exports being hit with retaliatory tariffs or quotas could derail the expansion of crude exports brought on by the growth in shale-oil output in America. The IEA expects the U.S. to account for the largest increase in crude exports in the world between now and 2040, "propelling the region above Russia, Africa and South America in the global rankings." This has the effect of reducing net U.S. crude imports to 3mm b/d by 2040 from 7mm b/d at present. An increase in product exports - from 2mm b/d to 4mm b/d - makes the U.S. a net exporter of crude and product, based on the IEA's analysis. The largest demand for crude imports comes from Asia over this period, which grows 9mm b/d to 30mm b/d in total. Please see "WEO Analysis: A sea change in the global oil trade," published by the IEA February 23, 2018, on its website at iea.org. 10 We urge our readers to pick up BCA Research's Geopolitical Strategy Weekly Report cited in footnote 1 above, which lays out our GPS team's analytical framework regarding trade wars. They note, "If constraints to trade protectionism were considerable, Trump would not have the ability to surprise the markets with bellicose rhetoric on a whim. BCA Research's Geopolitical Strategy cannot predict individual triggers for events. But our framework allows us to elucidate the constraint context in which policymakers operate. On protectionism, Trump operates in a poorly constrained context. This is why we have been alarmist on trade since day one." 11 We found that the more backwardated oil forward curves are the less impact the USD has on the evolution of prices. Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Getting Comfortable With Higher Prices," published on February 22, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Special Report

Highlights Russian equities are among the cheapest emerging markets, and among the cheapest in the world - a re-rating could be epic; Weak growth potential and poor governance present tremendous challenges; Yet macro fundamentals are sound and economic policy is orthodox - Russia should behave as a low-beta EM market going forward; The government is highly likely to build on recent micro-level improvements with reforms to improve human capital and infrastructure; Vladimir Putin's military adventurism has stalled, reducing geopolitical risk from high levels; Continue to overweight Russian assets within EM portfolios; go long Russian / short Brazilian local currency government bonds. Feature Russia has one of the cheapest equity markets in EM and in the world. With conflict in Ukraine frozen, a stalemate in Syria, and domestic politics stable (if not inspiring), could the country be on the verge of an epic re-rating? To answer this question, investors have to first understand why Russia is cheap. Shockingly, geopolitical adventures and the 2014 collapse in oil prices have nothing to do with the bargain prices! Russian P/E plummeted in 2011 because investors realized that President Vladimir Putin was here to stay for potentially another two decades (Chart 1). And that signaled that weak governance and an atrocious record on attracting foreign investment would persist for the long term. And yet, Russian equity outperformance amidst the most recent global volatility rout serves as an indication that Russian equities have the capacity to outperform (Chart 2). Is this a fluke, or the start of something more long-term? Chart 1Russian Equities Are Cheap Chart 2Russia Outperformed In ##br##High Vol Environment This ... Is ... Sparta! Russia faces extreme challenges as a nation. It is an austere, isolated, and militaristic society - a modern-day Sparta compared to the West's Athens. Its few competitive wares are wheat, hydrocarbons, and guns. Its lack of openness toward immigration, foreign trade, services, technology, and human development tend to limit its productivity. To assess Russia's long-term economic potential, we should begin with the bad news. First, Russia has a disastrous population profile. Both labor force growth and the working age population are shrinking (Chart 3). The dependency ratio is high and rising at 45%. Though the fertility rate has notably perked up, it remains far below the replacement rate of 2.1 (Chart 4). Even given the current population, there is limited room to increase the labor participation rate, as it is already higher than in the U.S. and is not rising anymore. Chart 3Russia Loses Workers Chart 4Russian Fertility Beneath Replacement Rate Second, immigration is in decline. Most immigrants come from the Russian commonwealth, but in net terms, immigration has been drifting away since the global financial crisis, even more rapidly since the 2014 oil shock (Chart 5). Russia is rife with xenophobia and anti-immigrant politics. Even if policy were to become more inviting, the Russian-speaking sources of immigration are also seeing weak working-age population growth. And Russia is unlikely ever to become an all-weather migrant country (Chart 6).1 Chart 5Immigrants Not Welcome Chart 6Slow Growth In Immigration Sources Third, labor productivity growth has only just begun to recover and is weaker than in the past. Russia has fallen behind its emerging European neighbors (Chart 7). The same can be said for total factor productivity growth, which is a very important indicator for economies that want to modernize - it currently stands at zero. Fourth, Russia suffers from chronically weak institutions and poor governance: Inequality is high and rising (Chart 8). Chart 7Russian Productivity Has Fallen Chart 8Inequality Is On The Rise... Governance indicators are deeply negative - worse than China's (Chart 9). Corruption is rampant - Russia ranks 135 out of 180 countries on the Corruption Perceptions Index, only very slightly improving since 2014. Corruption reduces economic efficiency and the effectiveness of public investments.2 For instance, despite the rise in spending on the judicial system in Russia, "rule of law" has declined, according to the World Bank's Worldwide Governance Indicators (Chart 9, bottom panel). Nationalization remains the government's modus operandi. Not only have privatization schemes failed, but new nationalizations have continued to occur - namely the electricity sector and most recently the banks (see Chart 14 below). State ownership has risen from 30% of GDP in 2000 to 70% today.3 Fifth, Russia's self-inflicted standoff with the western world has resulted in a closed economy that misses out on the benefits of human capital, technology transfer, and trade. The country's international competitiveness is clearly suffering: Russian exports have lost market share in the world and in the EU. Even in Eastern Europe and Central Asia, two areas where Russia has the biggest advantages and lacks geopolitical constraints, Russian exports have been lackluster. Crucially, Russia is gaining market share in East Asia, though even here with difficulty (Chart 10). Leaving aside commodities, Russia has failed to develop a competitive manufacturing sector. Chart 9...And Governance Is Poor Char 10Lack Of Export Competitiveness Sixth, Russia's government spending priorities are heavily focused on national security and thus constrained from promoting economic productivity and improving governance. Total spending on national defense, state security, and diplomacy has risen to 6.4% of GDP and 31.7% of the government budget. This is twice as much as the U.S. and China at 3.2% and 2.8% of GDP, respectively. By contrast, total spending on social policy is 5.5% of GDP and 29% of the budget. Spending on education and healthcare, at 0.7% and 0.5% of GDP respectively, is well below European, American, and Chinese levels, and it has hardly increased as a share of government spending in recent years. Basic and applied research spending is tiny and falling. So far the most significant investments in social wellbeing have been limited to pensions. Yet it is a well-attested fact that increases to state pensions precede elections, as pensioners are a key political constituency for the ruling United Russia party. The spending tends to be fleeting and does not enhance productivity.4 Cutting military spending would give Russia more fiscal resources to address badly needed economic weaknesses. But it is not on the horizon, so economic reforms will face budgetary constraints. Bottom Line: Russia's long-term potential is stunted by population shrinkage, slow productivity growth, lack of openness and competitiveness, lack of diversification and complexity, weak institutions, and poor governance. Some Good News: Orthodox Macroeconomic Policy Now for the good news: Russia's economy has stabilized and its macroeconomic policy backdrop is sound and orthodox, especially relative to emerging markets. First and foremost, fiscal and monetary policies have become less pro-cyclical. This will reduce volatility in the real economy and ensure that the current cyclical recovery is sustainable (Chart 11). Fiscal policy has been tight and conservative. In fact, the government has only slightly let nominal expenditures grow since the oil crash, while spending has fallen considerably in real terms (Chart 12). Chart 11Russia Is Undergoing A Cyclical Recovery Chart 12Russia: Orthodox Fiscal Policy Consequently, the fiscal deficit has significantly narrowed. The conservative budget assumption of $40/bbl oil is still being upheld (Chart 12, bottom panel). Moreover, the new fiscal rule implemented by the Ministry of Finance last year has allowed Russia to rebuild its FX reserves (Chart 13). The rule stipulates that the Ministry of Finance will buy foreign currency when the price of oil rises above the set target level of 2,700 RUB per barrel (i.e. $40/bbl times 67 USD/RUB exchange rate), and sell foreign exchange when the oil price falls below that level. The objective is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Lastly, the public debt-to-GDP ratio is a mere 16% in Russia. On the monetary policy side, the Central Bank of Russia has been highly orthodox. Unlike many other EM central banks, it has refrained from injecting excess liquidity into the banking system and has maintained high real interest rates (Chart 13, bottom panels). All in all, Russia is much more advanced in its macroeconomic adjustment phase than other emerging markets: Commercial banks have been increasing provisions, even though the NPL ratio has begun to fall (Chart 14). Furthermore, the central bank has been reducing the number of dysfunctional banks by removing their licenses (Chart 14, bottom panel). Chart 13Russia: Orthodox Monetary Policy Chart 14Russian Banking Sector Underwent A Clean-Up Russia is further along in its deleveraging cycle than other EMs. Having gone through the pain of a massive currency devaluation followed by substantial increases in interest rates and bank restructuring, Russia can begin to re-leverage, which will be positive for consumption and investment. In fact, re-leveraging is already underway. Bank loans are expanding after a pronounced contraction. The credit impulse - i.e. the change in bank loan growth - continues to recover (Chart 15, top panel). Importantly, debt has room to grow, especially in the consumer sector where debt levels are low (Chart 15, bottom panel). Capital spending, which had collapsed both in absolute terms and relative to GDP, has started to recover. It is supported by a recovery in broad money supply (Chart 16). Starting from an extremely under-invested position, the recovery warrants major upside in investment outlays. Chart 15Russia: Re-leveraging ##br##Has Room To Continue Chart 16Russia: Capital Expenditures ##br##Will Rise From Low Level Exposure to external risks is limited: External debt across private and public sectors remains extremely low, limiting the impact of potential foreign currency sell-offs (Chart 17). Russia's foreign funding requirement - calculated by subtracting the current account balance from external debt servicing over the next 12 months - is the second-lowest in emerging markets after Thailand, making Russia's balance-of-payments position one of the least vulnerable in the EM universe. Furthermore, Russia is making clear improvements despite the dismal trends outlined above. On the margin these improvements could raise the country's long-term growth prospects: On the external side, the composition of exports is shifting away from commodity exports (Chart 18). Although commodity exports still account for the large majority of the export pool at 81%, a gradual shift towards other sectors will allow the economy to diversify its sources of revenue and employment. The allocation of government expenditures has marginally shifted towards addressing some of Russia's long-standing structural problems. Spending on infrastructure (transport and roads) has climbed steadily (Chart 19). This is critical as the road system in Russia is significantly underinvested and is a medium through which productivity can be efficiently increased. Chart 17Russia: External Debt Has Fallen And Is Low Chart 18Russia: Export Composition Is Improving In the private sector, employment for small and medium-sized enterprises (SMEs) has been rising (Chart 20). Importantly, this is happening in the peripheral districts as well as the economically more vibrant central federal district. Policy is becoming more supportive of SMEs, for instance via tax holidays. Allowing SMEs to gain a bigger share of the economy will hold the key to creating an environment where innovation and business confidence can start improving Russia's productivity prospects. Chart 19Russia: Road And Transport ##br##Expenditures Are Rising Chart 20Russia: SME Employment Is Rising Interestingly, the number of privately owned businesses being created is rising relative to the number of state-owned businesses. In addition, more state-owned businesses are being liquidated relative to privately owned ones (Chart 21), suggesting a willingness to accommodate "creative destruction." The "Ease of Doing Business" has improved markedly under administrative reforms, easier land registration, and improved contract enforcement (Chart 22). "Regulatory quality," "control of corruption," and "absence of violence" are key governance indicators that are directly relevant for the corporate outlook and investors, and these are improving, albeit from a negative level (Chart 23). Chart 21Russia: More Private, Less State-Owned Businesses Chart 22Easier To Do Business In Russia Chart 23Some Slight Governance Improvements In sum, while macro stability has been achieved, Russia needs to expand and sustain recent marginal developments on the micro level in order to improve its long-term economic and investment outlook. Bottom Line: The economy has stabilized and macroeconomic policy is orthodox. Marginal improvements in export composition, government spending allocations, and treatment of the private sector may not turn Russia into a high-productivity country overnight, but they do mark an inflection point that could arrest the downward trend of productivity. This is especially so if private and public initiatives are taken to further these initial developments. More Good News: Foreign Adventurism Has Stalled Russia's geopolitics are also unlikely to worsen from here, at least not in a way that is relevant to investors. President Putin's rhetoric reached peak bluster in his lengthy "State of the Nation" address to the Duma on March 1. Western media took the bait immediately, encapsulated best by The New Yorker headline, "Vladimir Putin Is Campaigning On The Threat Of Nuclear War."5 Should investors dismiss Putin's slick, computer-generated images of Florida getting nuked by multiple warheads? It depends. On one hand, our Russian geopolitical risk indicator suggests that investors have been demanding an ever smaller premium on Russian assets (Chart 24).6 There is, therefore, considerable room for the market to be surprised in the future. On the other hand, Chart 24 also shows that the premium is still at elevated levels, at least compared to the era prior to Russia's invasion of Crimea. Chart 24Geopolitical Risk Is Falling The main question for investors is whether a substantial increase in geopolitical risk could befall Russia over the short and medium term. We doubt it for three reasons: Stalemate in Syria: Russia got what it wanted in Syria. Embattled President Bashar el-Assad has survived, locking in Moscow's influence and allowing Putin to declare victory in late 2017.7 The Kremlin has already recalled most of its ground troops to Russia and has shied away from conflict with the U.S. since then.8 For example, when nine Russian mercenaries died in an attack against a U.S.-controlled base in Syria, the Russian government did not so much as protest.9 Stalemate in Ukraine: We controversially suggested in 2015 that the primary reason for Russia's intervention in Syria was to distract Putin's fired-up domestic constituency from the failures of Moscow's policy in Ukraine.10 The battle to carve out a substantive portion of Eastern Ukraine, where Russian speakers live, failed miserably. Out of the 13% of Ukrainian territory encompassing the Oblasts of Kharkiv, Luhansk, and Donetsk, Moscow-backed rebels stalled after conquering approximately 20% -- or in other words only 3% of Ukrainian territory as a whole (Map 1).11 Map 1Ukraine Is A Stalemate What Else Is Left? Russia has shied away from directly confronting NATO member states. As such, Putin is unlikely to do anything in the Baltics and Scandinavia, two regions where NATO and Russia have recently arrayed forces against one another. There is always potential for Moscow to reignite conflict in the Caucasus, but it is unlikely that the market would care (they did not in 2008!). We therefore take a different view of Putin's latest aggressive military rhetoric. By stating that Russia no longer fears the U.S. ballistic missile defense system in Europe due to technological advancement, Putin is giving himself the maneuvering room to stand-down from a constant aggressive military posture. Three other factors suggest that Russia-West tensions have peaked for the current cycle: Energy: The EU is gradually diversifying its natural gas imports away from Russia (Chart 25), but the drop in the Russian share of European gas imports in 2017 is not firmly established. Europe as a whole still depends on Russia for 33% of its natural gas consumption. The threat from U.S. LNG shale imports is a decade-long theme that will only accelerate when Europeans commit to building more import terminals (like the new one in Lithuania). Moscow is not sitting still but has begun to counter this threat by becoming a far more compliant partner to the Europeans. It has even adopted the EU Commission's regulatory framework, which it had roundly rejected seven years ago. As the U.S. threat grows over the next decade, Russia will have to compete with Americans on more than just price. It will have to show Europe that it is a reliable geopolitical partner as well. As much as Europe relies on Russian natural gas exports, Moscow relies twice as much on European natural gas imports (Chart 26). Chart 25The EU Is Diversifying... Chart 26...But Both Sides Still Need Each Other Putin's confidence: President Putin remains popular, with popular approval at 81%. His government has begun to lose support, however, with the spread between his approval and his government's approval widening to 39%, one of its highest levels. Given that Russia's president is largely in charge of foreign policy, the spread suggests that the population is largely content with the current geopolitical situation, but that the risks to Putin and his regime are domestic in nature. Given that Putin is a student of Russian history, he will remember that foreign adventures have collapsed almost every Russian regime over the past two centuries!12 Oil Prices: As we have repeatedly shown, low oil prices are a limiting factor to oil producers' ability to wage war (Chart 27). Political science research shows that the relationship is not spurious. Chart 28 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes when oil prices are higher.13 While oil prices have recovered from their doldrums from two years ago, they are still a far cry from where they stood just before the invasions of Georgia and Ukraine. Chart 27Low Oil Prices Discourage Oil States From Waging War Chart 28More Oil Revenue = More Aggression Bottom Line: Over the past decade, we have argued that Russia is aggressive not because it is playing offense but because it is playing defense. The military actions that Russia has taken since 2008 - Georgia, Ukraine, and Syria - have all focused on preserving its sphere of influence. With this sphere now largely secure - and with both Europe and the U.S. begrudgingly accepting Moscow's sphere - the probability of renewed conflict is likely overstated. Putin, Act IV Broadly, there are three different paths that Putin could take over the next six years, his fourth term in office. We review them below and give our subjective probabilities for them occurring: Détente with the West and liberalization - probability 5%. The only reason we consider this scenario an option is that the EU is gradually moving toward easing sanctions and increasing investment, while the U.S. Trump administration at least has the intention of improving ties with Putin, albeit mostly blocked by Congress. The risk remains that if Democrats take over the U.S. House of Representatives, meaningful new sanctions could be imposed on Russia. A new overseas military adventure - probability 20%. Moscow has proven to be unpredictable in the past. But while there is every reason to expect that Russia will maintain its standoff with the West, nevertheless relations are already at an extremely low level.14 Yes, Western governments will be on guard against Russian meddling in internal affairs. But the Kremlin has little interest in undermining the Trump administration, or Germany's Social Democratic Party, or Italy's Forza Italia.15 Some domestic reform while maintaining Far East strategy - probability 75%. This scenario consists of Putin attempting to augment the status quo with some substantive reforms and fiscal spending at home. At the same time, Moscow would continue to court East Asian trade and investment.16 Some normalization with the West may occur incidentally, but not as a condition of this scenario. Why do we assign such high probability to the domestic reform outlook? Credible opinion polling shows a clear majority demanding reform, with 83% of Russians wanting "change." The share of this group who want "decisive" change is slightly greater than those who want merely "incremental" change (Chart 29). This will motivate political leaders to push forward a reform agenda that increases popular support. The pressure for change is also clear in the aforementioned quality of life issues affecting the middle class, and the fact that the share of the population spending more than $20 per day has stopped growing in Russia (Chart 30). The middle class will increasingly have its ambitions frustrated if living standards are not improved. Recent elections already show worrisome trends for the regime, even within the rigged electoral system.17 Chart 29Russians Want Change Chart 30A Ceiling On Middle-Class Ambitions What kind of change do the Russian people want? Primarily, more social spending. When asked what kind of change voters would like to see, living standards and social protections come first, and "great power status" comes dead last (Chart 31).18 Specifically, Russians want improved medical services, lower inflation, and better education, agriculture, and housing and utilities - not better relations with the West, fairer elections, free markets, or democratic rights (Chart 32). Russians do not want painful cuts in entitlements, partial privatization of public services, or a higher retirement age (Chart 33). And there is no fiscal need for these. Chart 31Russians Want Social Spending... Chart 32...And Better Quality Of Life Chart 33Russians Oppose Any Cuts In Benefits The Kremlin is already responding to the demand for more spending. The most intriguing part of Putin's State of the Nation speech was his emphasis on the need to reduce poverty, improve social wellbeing, and speed up economic development (Table 1). Table 1Putin's State Of The Nation Address Putin also claimed in the State of Nation address that the upcoming reforms would require "hard decisions" to be made. It seems he is willing to impose painful economic changes.19 Bottom Line: If we are right that Putin's conquests are largely finished, then he must decide whether to focus narrowly on preserving his regime, or on broadening its support for the future. Since Putin can easily rule for longer than his upcoming six-year term,20 it is too soon to expect him to pursue a retirement strategy that sidesteps the need for significant social improvement. Instead he will try to improve regime support through economic reforms. Investment Implications First, a short word on OPEC 2.0 production cuts.21 Russia is less leveraged to oil than in the past (due to its aforementioned ability to devalue the ruble and its tight budget controls). Hence it is less committed to the cartel than Saudi Arabia, and more concerned that this year's buoyant oil price outlook could challenge the new fiscal rule (which mediates oil pass-through to the ruble) and encourage U.S. shale production. So Russia's OPEC 2.0 compliance in 2019 and beyond is murky. Lower oil prices incentivize Russia's economic rebalance and further constrain its military adventurism, but too low will reduce the fiscal resources for its reforms. What about the implications for Russian financial assets? On the tactical level, Russian stocks should see some volatility. Looking at recent Russian history, the events that caused the biggest sell-offs in the succeeding 90 days were presidential elections and the devaluation of the ruble in 1998. Yet the biggest rallies occurred when Putin consolidated power over political enemies and when events suggested substantial reforms were on the way. While we cannot rule out another post-election correction if oil and EM risk assets sell off, we would expect the market to rally eventually as Putin's new policy trajectory becomes clear. On the strategic level, Russian stocks are making a major bottom formation relative to the EM benchmark and will outperform the EM equity benchmark in the coming years (Chart 34). Both BCA's Geopolitical Strategy and Emerging Markets Strategy recommend an overweight position. Chart 34Russian And U.S. Energy ##br##Stocks Are Bottoming While the Russian bourse has historically tended to outperform the EM index during risk-on phases and underperformed in risk-off episodes, this has changed as a result of prudent macroeconomic policymaking. Namely, the decreased macroeconomic linkage between fluctuations in oil prices with the ruble and domestic interest rates. Consequently, we expect Russia to outperform in an EM risk-off phase. Another point that increases our level of conviction on overweighting Russia is that U.S. energy stocks relative to the S&P are currently at the bottom of a 60 year trend, perhaps marking an end to the structural underperformance of energy stocks (Chart 34, bottom panel). Emerging Markets Strategy recommends investors continue overweighting Russian sovereign and corporate credit within the EM credit universe, and maintain the following trades: Long Russian stocks and ruble / short Malaysian stocks an ringgit trades Long ruble / Short oil Within EM domestic bonds portfolios, Emerging Markets Strategy also recommends continuing to overweight Russian local currency bonds. Both Geopolitical Strategy and Emerging Markets Strategy recommend the following new trade: Long Russian / short Brazilian local currency government bonds. The public debt-to-GDP ratio in Brazil is 80% while it is only 16% in Russia. The fiscal deficit in Brazil stands at a large 8% of GDP, and interest payments on public debt are equal to 6 % of GDP. Meaning that without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. And public opinion is not favoring pro-market reformers. Adjusted for their respective cyclical, macro policies, currency and interest rate trends, Russian bonds offer better value than Brazilian ones and the best within the EM universe. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 See Sergey Aleksashenko, "The Russian Economy in 2050: Heading for Labor-Based Stagnation," Brookings, April 12, 2015, available at www.brookings.edu. 2 For instance, it is well known that corruption in the construction industry results in embezzlement and poor results in public infrastructure. If this is the case for roads, then it is all the more likely to be a problem with public administration and the judiciary, as more spending certainly does not mean more fairness and justice! 3 Federal Anti-Monopoly Service. Please see David Szakonyi, "Governing Business: The State and Business in Russia," Russian Political Economy Project, Foreign Policy Research Institute, January 2018, available at www.fpri.org. 4 Sarah Wilson Sokhey, "Buying Support? Putin's Popularity and the Russian Welfare State," Russian Political Economy Project, Foreign Policy Research Institute, February 2018, available at www.fpri.org. 5 Please see Geesen, Misha, The New Yorker, "Vladimir Putin Is Campaigning On The Threat Of Nuclear War," dated March 2, 2018, available at www.newyorker.com. 6 We rarely put much stock in quantitative measures of geopolitical risk. However, the parsimony and track record of our Russian geopolitical risk indicator makes it a valuable tool. The Geopolitical Risk Premium is calculated based on USD/NOK exchange rate, Russia's CPI relative to the U.S.'s CPI, and a time trend. We chose Norway because it is a "riskless" oil producer. The USD/RUB exchange rate was adjusted according to the relative inflation in the U.S. and Russia. The deviation from the fair value after taking into account these factors is the risk premium. 7 Please see Nathan Hodge, "Putin Declares Victory In Surprise Stopover In Syria," dated December 11, 2017, available at www.wsj.com. 8 The most recent deployment of Russia's stealth air superiority fighter - the Sukhoi Su-57 - appears designed to give the newly built jet some time in combat zone and is not an escalation. 9 Although Russian media is replete with rumors that several hundreds of Russians died in the attack, the Kremlin's official line is that only nine Russian nationals died in the attack. Please see, Christoph Reuter, "The Truth About The Russian Deaths In Syria," Der Spiegel, dated March 2, 2018, available at www.spiegel.de. 10 Please see, BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 11 A quick note on our map: we include Kharkiv in our definition of Donbass. Most international observers do not, as there was no pro-Russian revolt in the Oblast. However, this is a heuristic error given that the majority Russian speaking population of Kharkiv made it a prime region for revolt against Kiev. That it did not revolt illustrates the limits of Russian capabilities and the paucity of its strategic effort in East Ukraine. Our estimate of 3% of Ukrainian territory is consistent with other estimates, for instance the 2.5% cited in Carl Bildt, "Is Peace In Donbas Possible?" European Council On Foreign Relations, dated October 12, 2017, available at www.ecfr.eu. 12 The idea that the Russian populace gives its leaders a blank check to pursue aggressive foreign policy is not rooted in historical evidence. In fact, Russia has a very spotty history when it comes to the popular backing of failed military campaigns: the Crimean War in the mid-nineteenth century, the 1904-1905 Russo-Japanese War, the First World War in 1917, Afghanistan in the 1980s, and the First Chechen War in the early 1990s. Each of these military losses and dragged-out campaigns led to popular backlash and domestic political crises (in some cases outright revolutions!), especially when complemented with economic pain. Putin is an astute reader of history and therefore we doubt he will commit himself to another lengthy military campaign. 13 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 14 The United States has (for now) backed away from considering imposing sanctions on the purchase of Russian sovereign debt; U.S. Treasury Secretary Steve Mnuchin issued a report against this possibility. So far U.S. sanctions have focused on limiting U.S. financing for Russian state-owned enterprises and energy and financial sectors more broadly. 15 The German Foreign Minister Sigmar Gabriel, a top leader in the SDP, is leaning on the new Grand Coalition to discuss an easing of Russian sanctions contingent on a UN peacekeeping role in Ukraine. 16 China's economy is a key support, but Xi wants to change that economy in a way that is broadly negative for Russia. And the Belt and Road Initiative is not enough for Russia's needs. Russia will thus look not only to China but to all of East Asia for markets and investment. Thus China's reform intensity, and Russo-Japanese peace negotiations, are our bellwethers for Russia's Far East and broader export success. 17 The ruling United Russia performed poorly in the 2012 elections, and fell from 83% to 79% of seats in regional elections last September. That same month, the Moscow municipal elections shocked the ruling elite due to extremely low voter turnout of 15%. Last year, anti-corruption activist and opposition leader Alexei Navalny ignited a surprising countrywide political network during his failed bid to become a presidential contender. And even Communist Party candidate Pavel Grudinin's presidential campaign reflects a yearning for change. We would not be surprised to see striking personnel reshuffles, such as the replacement of Prime Minister Dmitri Medvedev with a new "fresh faced" reformer. 18 Given this sentiment at home, Russian policymakers are unlikely to have missed the significance of the recent events in Iran, in which such sentiments helped mobilize significant anti-regime protests. 19 Examples of difficult policies in Putin's speech include: improving tax enforcement and increasing income tax rate; cutting spending to afford investments in human capital, cutting law enforcement spending and the audit office (no cuts to defense spending were on the menu); reducing the size of the state sector; selling off assets and privatizing the banking sector; keeping inflation in check (this is popular, but requires persistently hawkish monetary policy). 20 Article 81.3 of the Russian constitution can be amended fairly easily to allow Putin additional terms in office beyond 2024. 21 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices," dated February 22, 2018, available at ces.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The direct impact of recently proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. In isolation, this development is not very relevant for investment strategy. However, the lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Feature The looming threat of U.S. protectionism came into full force over the past week, as President Trump stated that sweeping tariffs on all U.S. imports of steel and aluminum would soon be formalized. The tariff situation continues to evolve as we go to press, but the facts as they currently stand are the following: The proposed tariffs would be 25% on steel, and 10% on aluminum imports No exceptions are planned for any country, although statements from U.S. leadership on Monday suggested that Canada and Mexico may be exempt if NAFTA is renegotiated in the U.S.' favor Key European Union leaders threatened to retaliate against the U.S.' proposed tariffs, and the U.S. threatened to counter-retaliate China has taken a more cautious stance on the issue of retaliation, and is strongly seeking to negotiate with the Trump administration Minimal Direct Impact The developments over the past week raise two questions about China's economy that matter for investment strategy: What is the direct impact of the tariffs on China's exports likely to be? What is the implication for global growth? On the first question, the answer is fairly clear that the direct impact is likely to be small. The proposed tariffs do not disproportionately target China, and Chinese exports of steel and aluminum to the U.S. account for less than 0.2% of total exports (Chart 1). Exports of these products to all countries as a share of total exports is still quite small (panel 2). The second question is much more difficult to answer, and it has wide implications for both the Chinese economy and for investment strategy. When approaching the question, it is first important to note that the threat to the global economy from the imposition of the proposed tariffs comes from the potential for a series of retaliations from major trading partners, not the tariffs themselves. U.S. imports of steel and aluminum make up less than 1% of global goods exports, and Chart 2 presents a long-term history of average U.S. tariff rates along with our estimate of the impact of the U.S.' proposal. While the imposition of the announced tariffs would certainly change the trend that has been in place for some time, the rise is not very significant. Critically, even after the tariffs are imposed, U.S. tariffs rates will still be fractional when compared with those that prevailed during the early-1930s, when the Smoot-Hawley Tariff Act materially exacerbated the Great Depression. Chart 1Chinese Steel And Aluminum Exports##br## Are Not Significant Chart 2We're A Long, Long Way Away##br## From Smoot-Hawley China's cautious stance towards retaliation is, at first blush, an encouraging development, but it may not be as hopeful of a sign as it seems. First, despite a general feeling among investors that China was the intended target of the U.S.' proposed tariffs, a global tariff on steel and aluminum is likely to disproportionately affect developed countries rather than China. It is therefore not surprising that China has signaled a somewhat conciliatory stance. In our view, the likelihood of Chinese retaliation is considerably higher if further tariffs are announced on goods that make up a larger share of their exports. In addition, as we noted above, the European Union has already highlighted some U.S. goods that may be subject to higher retaliatory tariffs in response to the news (which already elicited a threat of counter-retaliation from the U.S.), and both Canada and Mexico have also threatened retaliation if they are not granted an exemption from the proposed tariffs. In our view, these threats should be treated seriously, especially after revisiting the lessons of one of the most famous experiments in game theory. Bottom Line: The direct impact of proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. Retaliation Risk And The Prisoner's Dilemma The dynamics of trade renegotiations can be examined, at least conceptually, through the lens of game theory. It is difficult to model these dynamics precisely because of the complexity of the relationship between trade and potential growth, but it is worth revisiting the lessons learned by the repeated playing of Prisoner's Dilemma, one of the most well-known examples of the application of game theory. To summarize, the Prisoner's Dilemma scenario describes two criminals who have been arrested, and whose statement to the authorities affects the manner in which punishment (if any) is distributed between the two of them. The standard payoff structure of the game is set up such that one prisoner is able to largely avoid punishment if (s)he accuses the other of the crime and the other prisoner remains silent, but that both prisoners receive a punishment if they both accuse each other that is greater than the punishment received if they both remain silent (Table 1). Given that tariffs and other forms of trade protectionism can only durably succeed at improving net domestic economic outcomes if they do not result in retaliation, from the perspective of trade renegotiation, accusing the other player in the game of Prisoner's Dilemma is tantamount to restricting trade, and remaining silent is equivalent to allowing existing trade relationships to persist. Table1In The Prisoner's Dilemma, It's Better To Return Defection With Defection The success of strategies employed in repeated games of Prisoner's Dilemma was studied most famously by Robert Axelrod in 1980.1 The winning strategy (in both of Axelrod's tournaments) was "Tit for Tat", which follows two very simple rules: cooperate initially, and thereafter copy the other player's decision in the previous round. This strategy has three attributes that Axelrod showed to be highly successful when playing repeated games of Prisoner's Dilemma: niceness (not being the first player to accuse/defect/renege), being provocable (responding to defections with in-kind retaliation), and forgiveness (not allowing one-time defections to impact future choices beyond a one-time retaliation). Chart 3 illustrates the performance of the "Tit for Tat" strategy in the first Axelrod tournament, along with the average scores of several other strategies. The most important lesson from both tournaments is summarized nicely in the chart: the average score of a series of "nice" strategies was considerably higher than those that were not nice. But Chart 4 also highlights that niceness is only a relatively successful strategy because of its ability to produce an optimal outcome with other nice strategies: all strategies, nice or not, tend to generate poor outcomes when played against strategies that are not nice. This is because the payoff structure of Prisoner's Dilemma is such that, compared with defection, co-operation makes a player worse off if their opponent defects. Chart 3In Repeated Games Of Prisoner's Dilemma,##br## "Nice" Strategies Pay Off... Chart 4...But Only Because They Do Well Against ##br##Other "Nice" Strategies In the context of global trade, this can be seen as the likelihood of outsized job losses (or the lack of job gains in a protected industry) from a failure to retaliate. The key point for investors is that the most basic lesson of the Prisoner's Dilemma suggests that market participants should be legitimately concerned about retaliation from the U.S.' trade partners (and subsequent counter-retaliation) if it continues to pursue a protectionist agenda, because it can be a rational response for an individual country even if it leads to poor outcomes for everyone involved. In addition, three assumptions of the Prisoner's Dilemma game are not valid in the real world (or the current environment), which in two of these cases further increases the risk of an iterative exchange of retaliation: Chart 5The U.S. Has A Trade Deficit ##br##With Many Trading Partners In terms of the payoffs associated with the game, Prisoner's Dilemma assumes an equal starting position (of zero "points") on both sides, which is not the case in the current environment. The U.S. has a sizeable trade deficit with the world (Chart 5), and several important trading partners with the U.S. (especially China) maintain significant non-tariffs barriers to trade. Regardless of whether this inequity has been caused by an unfair trading relationship, in the parlance of Axelrod's tournaments, this implies that the U.S. strategy is likely to be not nice due to the perception on the part of the Trump administration of an unequal starting position. The implication is that the odds of an escalation of the imposition of relatively small tariffs into a full-blown trade war are higher than would normally be the case. Prisoner's Dilemma has clear and symmetric payoffs, which is also not the case in the current environment. The Trump administration apparently feels that the payoff to the U.S. of certain trade restrictions is a net positive even assuming retaliation, which raises the possibility of a negative outcome for the global economy. Worryingly, in our view the chances are high that calculations of the net benefit of any trade restriction are being done on a political basis, rather than an economic one. Prisoner's Dilemma assumes that the participants are unable to communicate, which is a limitation that does not exist in a real-world trade negotiation scenario. This lowers the probability that the U.S. and its major trading partners will engage in a spiraling tit-for-tat trade war relative to what the game of Prisoner's Dilemma would imply, even if the recently announced tariffs on steel and aluminum stand and major partners do retaliate. Bottom Line: The lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. No Help From The Domestic Economy A protectionist agenda from the U.S. is also coming at an inconvenient time for Chinese policymakers, even if they were not blindsided by the move. Policymakers already have to contend with managing the impact of renewed reforms on economy's financial and industrial sectors, and the potential addition of the external sector to this list of problems needing attention is unwelcome. While a cooling of the economy was an inevitable result from the government's deleveraging campaign and shadow banking crackdown, Table 2 highlights how broadly leading economic indicators have decelerated. The table presents recent data points for several series that we identified in November Special Report as having leading properties for the Chinese business cycle,2 as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, how long this has been the case. Table 2No Convincing Signs Of An Impending Upturn In China's Economy Among the components of the BCA Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang index), all six series are in a downtrend and 5 out of these 6 fell in January (the growth in M2 was the exception). A similar story is borne out in the housing price data, with a variety of diffusion indexes having also fallen in January.3 The Caixin Manufacturing PMI remains the one bright spot, having recently risen above its 12-month moving average and having risen in January, in stark contrast to the official PMI (which fell a full point). But as Chart 6 highlights, following the last four episodes when the Caixin PMI exceeded the official PMI by this magnitude, the subsequent trend in the average of the two was down in every case. The implication is that the outlier nature of the current Caixin PMI shown in Table 2 is just that, and not a heralding a major upturn in China's economy. Chart 6The Caixin PMI Is Probably The Noise, Not The Signal Bottom Line: Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Conclusions For Investment Strategy Chart 7 illustrates the decision tree for Chinese stocks that we presented in our first report of the year. While there has been a modest further deterioration in the industrial sector, the pace of the decline is still consistent with the controlled slowdown scenario that we outlined in an October Weekly Report.4 As such, the recent softness in the data is not significant enough to cause us to change our recommended investment strategy. The key change over the past week has been the threat posed by U.S. protectionism to the global economy, which is the very first question to answer in our decision tree. The now high-beta nature of the Chinese stock market underscores that U.S. protectionism can significantly (negatively) impact the relative performance of Chinese equities if it destabilizes the global stock market, even if Chinese exports were to emerge from the exchange relatively unscathed. For now, we judge the likelihood of a full-blown tit-for-tat trade war to be a risk, and thus not a probable event. For now, market participants seem to agree: U.S. and global equities rebounded earlier this week in response to a feeling that the negative repercussions for global growth are likely to be minimal. Nonetheless, this is a risk that needs to be monitored closely, and to facilitate this our Geopolitical Strategy service has highlighted the following three bellwethers that they will be watching in order to judge the likelihood of a major escalation:5 Chart 7The Chinese Equity "Decision Tree" Tariff exceptions for allies: Given the national security basis for the steel and aluminum tariffs, it is likely that exceptions will be made for allies such as Canada and Europe. If yes, then the measure is unlikely to be part of a truly "America First" mercantilist strategy and is instead a veiled swipe at China to satisfy Trump's base ahead of the midterm elections NAFTA: Our geopolitical team has argued that the probability of NAFTA abrogation is around 50%.6 If the administration continues the negotiations in light of tariff announcements, however, it suggests that the revealed preference of the White House is less protectionist than it appears. Chinese intellectual property (IP) theft: The Trump administration is investigating Chinese technology transfer and IP theft under Section 301 of the Trade Act of 1974. If China is found to have acted unfairly, penalties would likely include a combination of tariffs and restrictions on Chinese investment in the U.S. This might include an indemnity for cumulative losses from past violations, which would be rare, if not unprecedented, and which China would reject outright. This could produce across-the-board tariffs of a sort that the U.S. has not imposed since the Nixon shock. Chart 8China Is Outperforming Global In Ex-Tech Terms In the meantime, Chart 8 highlights that investable Chinese ex-technology stocks (proxied by the MSCI China Index ex-technology) remain in an uptrend versus their global peers, which underscores that investors should have a high threshold for reducing exposure to China. This underscores that investors should have a high threshold for reducing exposure to China. While the ongoing slowdown in China's economy is likely to cause earnings growth to decelerate over the coming year, the continued likelihood of decently positive earnings growth coupled with a sizeable valuation discount relative to global signals that Chinese ex-tech stocks are remain attractive on a risk/reward basis. Investors should stay overweight. Bottom Line: Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "Effective Choice in the Prisoner's Dilemma" and "More Effective Choice in the Prisoner's Dilemma" by Robert Axelrod, The Journal of Conflict Resolution, Vol. 24 Nos.1 and 3, March and September 1980. 2 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of The Chinese Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 3 However, as discussed in our February 8 Weekly Report, we are keeping an eye on residential floor space sold given its history of leading China's housing market cycles. 4 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War", dated March 6, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto Populism", dated November 10, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Trump faces few constraints to further protectionism. His tariff announcement confirms our constraints-based methodology. Previous examples of U.S. protectionism show that the end game was not trade war, but USD depreciation. Key bellwethers for further protectionism are: waivers for allies, NAFTA, and China. The USD's global reserve currency status is at risk over the long run due to geopolitical multipolarity. Stay long defense stocks; short China-exposed S&P500 versus domestic-oriented companies; short EM assets. Feature "The import duty delights me..." - President Richard Nixon, August 2, 1971 (Oval Office Tapes) "Trade wars are good and easy to win." - President Donald Trump, March 2, 2018 The market has proven to be a terrible geopolitical analyst. It lost faith in Trump's overtly stated populism quickly into his presidency: What did the market do when Congress failed to pass repeal/replace of Obamacare? It immediately reduced the odds that the Republican-held Congress would get tax cuts or anything else done. What did the market do when Trump presented an austere "skinny budget," a budget that is normally ignored when any other president announces it? It immediately faded the odds of more deficit spending. What did the market do when Trump had a pleasant first meeting with Chinese President Xi Jinping at the Mar-a-Lago resort?1 It faded the odds of a trade war. It is becoming increasingly clear that the market has no framework for analyzing politics. It got the profligate tax cuts, extraordinary fiscal stimulus, and now Trump's protectionism wrong. In this Client Note, we explain how we got the odds of a trade war right, why market repricing is instructive, and how investors should position themselves for the coming volatility. Constraints Versus Preferences The mantra of BCA's Geopolitical Strategy is that preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. When making our forecasts, we focus on the constraints that bind policymakers and we ignore their preferences. President Trump did not announce that he would impose a 25% tariff on all imported steel and a 10% tariff on all imported aluminum because he was "unglued" or "angry" any more than World War One started because a Serb nationalist shot an Austrian archduke! He did so because he can. President Trump faces scant political, constitutional, and economic constraints when it comes to pursuing protectionist policies. Hence we have warned our clients to prepare for higher odds of trade wars and protectionism since the moment he was elected.2 There are three broad reasons why we have expected trade protectionism to re-emerge as a headline risk in 2018:3 Chart 1America Belongs To The Anti-Globalization Bloc Overstated political constraints: President Trump's base is anti-trade. We would argue that all Americans are far more protectionist than our clients wish to admit (Chart 1). Higher prices of Chinese made T-shirts and aluminum beer cans will not deter his supporters, nor will economic and market effects (short of a recession) change his voters' minds before the 2020 election. After all, President Trump was fully transparent during his presidential campaign when he promised a 45%-across-the-board tariff on Chinese imports and condemned NAFTA as a "disaster." It was this rhetoric that allowed him to outperform his opinion polls in the Midwest (Chart 2). Overstated constitutional constraints: The U.S. Congress has punted its responsibility for trade to the executive branch via several legislative acts over the decades. Most relevant at this juncture are: The Trade Expansion Act Of 1962: Allows the president to impose tariffs or quotas to offset any adverse impact of trade on national security;4 The Trade Act Of 1974: Allows the president to impose tariffs or quotas in order to deal with a serious U.S. balance of payments deficit or the unjust trade practices of another state; The International Emergency Economic Powers Act Of 1977: Allows the president to regulate all commerce and freeze all foreign assets in the case of a National Emergency.5 Overstated geopolitical constraints: Investors have continuously discounted the probability of Sino-American tensions, or even open conflict. Our clients know that we have been alarmists on this issue since 2012.6 In fact, it has been a key theme of BCA's Geopolitical Strategy that geopolitical risk is rotating to East Asia and that the constraints to U.S.-China conflict are falling as the symbiosis between the two economies fades (Chart 3). Chart 2Protectionism Boosted Trump In The Rust Belt Chart 3U.S.-China Symbiosis Has Died Bottom Line: If constraints to trade protectionism were considerable, Trump would not have the ability to surprise the markets with bellicose rhetoric on a whim. BCA's Geopolitical Strategy cannot predict individual triggers for events. But our framework allows us to elucidate the constraint context in which policymakers operate. On protectionism, Trump operates in a poorly constrained context. This is why we have been alarmist on trade since day one. Another Reason To Worry: Trump Is Not Unique The U.S. has a relatively recent tradition of bellicose protectionist rhetoric - under Presidents Richard Nixon, Ronald Reagan, and even at times George W. Bush and Barack Obama - perhaps due to the fact that it is the least globally exposed advanced economy (Chart 4). It is difficult to retaliate against the "consumer of last resort," which gives Washington D.C. considerable leeway in bullying global trade partners. Chart 4The U.S. Is Least Exposed To Trade President Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."7 Less understood, but very much part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. Also like Trump, he staffed his cabinet with trade hawks. Most notable amongst these was the Treasury Secretary John Connally, who wanted not only to close America's trade deficit but also to reduce U.S. military presence in Europe and Japan.8 Again, just like today, the economists in Nixon's cabinet opposed the surcharge, fearing retaliation from trade partners, while the politicians favored brinkmanship.9 We know from taped conversations of the Nixon White House that he and his advisors worried that the import surcharge could strengthen the dollar. But they decided to impose it anyway because of political expediency - Connally stressed that "it's more understandable to the American people to put on a border tax." They also saw it as a negotiating tactic. The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately forced other currencies to appreciate, mostly the deutschmark and yen. This is unsurprising given Germany's and Japan's total subservience to the U.S. in the early 1970s. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt transatlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, which included increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. Summing up the episode, then Undersecretary of the Treasury, Paul Volcker, remarked that: The conclusion reached by some that the United States shrugged off responsibilities for the dollar and for leadership in preserving an open world order does seem to me a misinterpretation of the facts ... The devaluation itself was the strongest argument we had to repel protectionism. The operating premise throughout was that a necessary realignment of exchange rates and other measures consistent with more open trade and open capital markets could accomplish the necessary balance-of-payments adjustment.10 Volcker's point was that the devaluation of the USD ultimately staved off protectionism. But he also reveals that the U.S. was close to abandoning its role as global defender and consumer of last resort due to domestic economic pressures. What does the 1971 "Nixon shock" teach us? FX depreciation obviates the need for protectionism: In both the case of the "Nixon shocks" and Reagan's 1985 "Plaza Accords," the rest of the world accommodated the U.S. and avoided a global trade war by allowing the USD to depreciate; Politics trumps economics: President Nixon ignored the advice about the economic effects of protectionism and used the import surcharge as a negotiating strategy - a successful negotiating strategy, we should add; Americans are not globalists: Not only is the U.S. economy largely insulated from the rest of the world, but Americans are not unequivocally pro-trade. Nixon was never hurt politically by the surcharge, and it even proved widely popular with the public. President Trump has come under withering criticism for using tariffs in 2018. However, his predecessors did so successfully as part of wider negotiations without ending global trade, all the while remaining popular with the public. The only question the history leaves unanswered is why Trump hasn't used tariffs sooner! What if the rest of the world does not play ball this time around? Two keystone themes of BCA's Geopolitical Strategy suggest that this time may be different: Apex of Globalization: The U.S. could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization and deeper access to U.S. markets. In 2018, however, this promise has been muted, with global trade as percent of GDP having peaked (Chart 5) and trade growth continuing to trail global GDP growth (Chart 6). America's trade partners may be far less willing to give in to U.S. protectionist threats in a world where the global trade pie is growing at a much slower pace. Multipolarity: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. still guarantees European defense, and thus could see some concessions from its ally, its geopolitical relationship with China is practically hostile. And, at the end of the day, it is Chinese trade policies that have had an adverse effect on U.S. manufacturing, not European. Chart 5Globalization Has Reached Its Apex Chart 6Trade Growth Trails Output Growth If this time is different, American policymakers will be left with only one lever: FX devaluation. Our current view that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation picks up. But what if Jay Powell, untested and facing political pressure from the White House, decides to respond to higher nominal GDP growth by hiking rates more slowly? Bottom Line: History teaches us that Trump's bellicose rhetoric is not unique to recent American presidents, let alone to world leaders. Previous times that the U.S. has threatened serious protectionism against trade partners the effect was USD depreciation, not trade wars. In addition, global trade boomed after each U.S. threat of protectionism, it was not derailed. What Matters (And What Does Not)? According to our calculation, Trump's suggested steel and aluminum tariffs would, in the most liberal estimate, impact just 0.3%-0.8% of global trade.11 As such, the proposed tariffs are insignificant from a macro perspective. They would also ostensibly have a much greater impact on U.S. allies, with China and Russia impacted only on aluminum (Chart 7). That said, the market is looking beyond the announced measures as it quickly reprices the greater risk of a global trade war that it ignored for the past 18 months. This, however, does not mean that the probability of a global trade war is high, just that the market was caught unaware due to complacency. We suggest three bellwethers for investors. If all three of these lean towards mercantilism, then the probability of global trade war is indeed high. Exceptions for allies: Given the national security basis for the steel and aluminum tariffs, it is likely that exceptions will be made for U.S. allies Canada and Europe. If yes, then the measure is unlikely to be part of a truly "America First" mercantilist strategy and is instead a veiled swipe at China and a political one-off to satisfy Trump's base ahead of the midterm elections; NAFTA: We have argued that the probability of NAFTA abrogation is around 50%, much higher than what the market is currently pricing in, for similar reasons as those outlined in this report.12 In short, we do not see any constraints - neither legal-constitutional nor political nor economic - preventing President Trump from ending the deal. If the administration continues the negotiations in light of tariff announcements, however, it suggests that the revealed preference of the White House is far less protectionist. It would also suggest that any Trump tariffs are really about China (Chart 8). China intellectual property (IP) theft: The Trump administration is investigating Chinese technology transfer and IP theft under Section 301 of the Trade Act of 1974. If China is found to have acted unfairly, penalties would likely include a combination of tariffs and restrictions on Chinese investment in the U.S.13 This might include an indemnity for cumulative losses from past violations, which would be rare, if not unprecedented, and which China would reject outright. Trump's rhetoric - and China's verifiably severe violations on IP - could produce across-the-board tariffs of a sort that the U.S. has not imposed since the Nixon shock. That would be a game changer in Sino-American tensions. Such a tariff could come to be remembered as the moment the Second Cold War began. Chart 7U.S. Allies Are Most Exposed Chart 8China, Not NAFTA, In Trump's Crosshairs Bottom Line: We would largely discount individual cases of tariffs that target specific goods, depending on the magnitude. These are largely within the realm of the expected and accepted. Trump's proposal would at most affect 0.8% of total global trade and that is assuming that no exemptions are made for allies. The real game changers would be if the U.S. began to think of "national security" in a narrow sense, no longer exempting geopolitical allies from an aggressive trade policy. A combination of both mercantilism and isolationism would imperil the transatlantic alliance and thus the American anchor in Eurasia. The loss of that alliance and that anchor, if pursued to its logical conclusion, would usher in the collapse of America's global hegemony.14 We would watch carefully whether the U.S. goes after China with broad, across-the-board tariffs. An all-out trade assault on China by the U.S. would avoid a global trade war, but would likely usher in a new Cold War, as China's internal stability would be threatened. Investment Implications Our forecast that Trump's protectionism would become investment-relevant in 2018 has come true. Now comes the hard part of forecasting how it plays out. It is tempting to simply replay the 1971 and 1985 episodes. After all, the U.S. is as closed of an economy today as it was then, largely immune to protectionist retaliation from the rest of the world. However, the U.S. economy is a third smaller as a percentage of global GDP than in both those episodes (Chart 9). And its geopolitical relevance to Europe is waning, whereas China remains a potent rival that may not "play ball." In fact, Chinese policymakers may be forced to accept a trade war in order to blame the painful effects of structural reforms on the Trump administration.15 Chart 9The U.S. Is Not As Dominant As It Was Before we assign high probability to any particular investment recommendation based on a higher probability of trade wars, we want to see how the NAFTA negotiations play out, whether the U.S. hits geopolitical allies with tariffs, and how the China IP case plays out. Nonetheless, the following three trades appear cogent even without such evidence: Long defense stocks: Our highest conviction investment call on the theme of "Apex of Globalization" is to go long defense stocks.16 We have recommended a vanilla trade to articulate this view, long S&P 500 aerospace and defense / short MSCI ACW, up 14.56% since initiation in December 2016. For a higher risk, higher reward strategy, we would suggest investors go long a basket of U.K., German, French, Italian, and Japanese major defense companies. In a world where the U.S. ceases to be a defender of last resort, countries will look to diversify their security portfolio away from America, and that will mean demand for non-U.S. military exports. Short U.S.-China plays: Investors should go long the most domestically-focused U.S. sectors - financials and telecoms17 - and go short our index of China-exposed S&P 500 companies. We were stopped out of this trade in March 2017 and again in September 2017, as we bet too early that the market would reprice the probability of a trade war. Short EM: Emerging markets have the most to lose in a potential trade war, especially amid higher U.S. bond yields. However, not all emerging markets are equally exposed. For example, India is largely insulated. A long India / short Brazil equity market position should reap returns in a de-globalized world (and BCA's Emerging Markets Strategy would endorse this trade based on macroeconomic factors). What about the U.S. dollar? Import tariffs ought to be bullish for the greenback, given that they lead to higher domestic policy rates as inflationary pressures rise (and not just passing ones). However, as the previous two examples of U.S. protectionism teach us, the U.S. uses threats of tariffs so that it can get a cheaper USD. From Washington's perspective, both accomplish the same thing. Intriguingly, the U.S. dollar has sold off on the most recent news of protectionism. Or are they already pricing in the likely conclusion of the current impasse (dollar falls) based on historical precedent? Or could it be a more ominous sign that the greenback's days as the global reserve currency are numbered? If the U.S. abandons its twin roles as the world's defender and consumer of last resort, then foreigners may decide that they should no longer reflexively store their wealth in U.S. assets. Think this is all merely geopolitical hogwash? Think again. Chart 10, courtesy of our colleague Mathieu Savary (BCA's chief FX strategist), is probably the best geopolitical chart we have ever published. It illustrates how the U.S. can manage to have a positive net international income despite a deeply negative net international investment position (NIIP). How is this possible? Because foreigners are willing to hold onto U.S. assets (U.S. Treasuries) for largely geopolitical reasons. It is too early to tell if this paradigm shift in global finance is underway. In the short term, Trump's rhetoric is likely to face the same constraints as Nixon's surcharge: geopolitical alliances will force him to carve out exemptions and focus on China. And if a trade war envelopes U.S. and China - rather than the world - we would bet that the U.S. dollar would rally, given that it would remain the safe-haven currency. Remain long DXY for now. Chart 10Exorbitant Privilege Chart 11Multipolarity Undermined The Pound Sterling But our view is that - over the long term - a multipolar world entails a multipolar currency regime. Such a development may come faster than most of us think. For example, the U.K. pound lost nearly a quarter of demand as the global reserve currency between just 1899 and 1913 (Chart 11).18 Financial markets move faster today. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 And served him chocolate cake that was this big. 2 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Reports, "Political Risks Are Understated In 2018," dated April 12, 2017, and "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017. 4 The Supreme Court is unlikely to counter U.S. executive action undertaken on the grounds of national security. 5 Such as perhaps the ongoing "American carnage"? 6 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Sino-American Conflict: More Likely Thank You Think," dated October 4, 2013, available at gps.bcaresearch.com. 7 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Berry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 8 Treasury Secretary John Connally makes Commerce Secretary Wilbur Ross look like a "globalist." Connally was famous for quipping that "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 9 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." In fact, the decision to impose the surcharge was made at a secret Camp David meeting on August 13, 1971 at a meeting to which officials from the State Department and the National Security Council were not even invited. 10 Paul A. Volcker, "The Political Economy of the Dollar," Federal Reserve Bank of New York Quarterly Review 1-12 (1978-79), quoted in Irwin (2013) (see footnote 7). 11 The sum of U.S. nominal imports by end-use category with steel and aluminum as part of the description was about US$56 billion in 2017, or roughly 0.32% of global goods exports according to the IMF's Direction of Trade statistics. An alternative and more liberal estimate using UNCTAD data and including a broader range of U.S. metals imports ("iron and steel," all "nonferrous metals," and all "manufactures of metal") yields 0.77%, or about $127 billion out of $16.5 trillion worth of total global imports. The former is more likely than the latter. The executive order raising the tariffs has not yet been issued so details are not known. 12 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto Populism," dated November 17, 2017, available at gps.bcaresearch.com. 13 President Trump, when commenting on the potential U.S. action, has described the coming punishment as "We're talking about big damages. We're talking about numbers that you haven't even thought about." 14 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "How To Profit From De-Globalization," dated December 9, 2016, and "Trump, Day One: Let The Trade War Begin," available at gps.bcaresearch.com. 17 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks," dated March 5, 2018, available at uses.bcaresearch.com. 18 Please see Barry Eichengreen, et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org.