UK

Highlights 'Super Thursday' June 8 brings three potentially high-impact events for financial markets: a U.K. General Election; a ECB monetary policy meeting; and former FBI Director James Comey's testimony to the U.S. Senate intelligence committee. Each of these events has the potential to move markets - especially currencies - abruptly in either direction. Medium-term investors should use Super Thursday and its aftermath as follows: If the pound sells off, use it to buy pound/dollar. If the euro sells off, use it to buy both euro/pound and euro/dollar. Use any associated underperformance of FTSE100/Eurostoxx50 to buy this relative equity position. Feature Traders will be salivating at the prospect of three potentially high-impact events for financial markets in the space of a day: a U.K. General Election; a ECB monetary policy meeting; and former FBI Director James Comey's testimony to the U.S. Senate intelligence committee about possible collusion between the campaign of President Donald Trump and Russian officials. This report will focus on the first two of these 'Super Thursday' events. Chart of the WeekRelative Interest Expectations Must Follow Relative Economic Performance 300-340 Conservative Seats = Short-Term Pain For The Pound Chart I-2The Pound Is Where It Was When##br## The Election Was Called The U.K. General Election result has the potential to move the pound abruptly in either direction. Therefore, it also has the potential to drive FTSE100/Eurostoxx50 relative performance which is just an inverse currency play. But treat the U.K. election result as a trading opportunity rather than as a game changer for any investment position. Theresa May admits that she called the snap election to strengthen her narrow parliamentary majority ahead of Brexit negotiations. When she called the election, the Conservatives were riding high in the polls, and markets expected May easily to achieve her aim. Reasoning that a much strengthened majority would reduce the influence of the hard Brexiters in her party, the pound rallied (Chart I-2). But as the polls have tightened, it has given back this gain. If the number of Conservative seats does not meaningfully move up from the current 330, or worse, if the result increases uncertainty, the pound is vulnerable to a further snap sell-off. A parliamentary majority requires 326 MPs, but around 320 is enough for an effective majority because Sinn Fein MPs,1 the speaker and deputy speakers do not vote. 315 might just scrape a Conservative minority government supported by its Northern Ireland Unionist allies. Hence, if the Conservatives win 300-340 seats, a knee-jerk sell-off in the pound is likely. Chart I-3The Brexit Vote Depressed The Pound Because##br## It Depressed U.K. Interest Rate Expectations If the Conservatives win well above 340 seats, the pound should knee-jerk rally - as May's effective majority would strengthen enough to marginalize the hard Brexiters. If the Conservatives win well below 300 seats, the pound might also settle higher - as this is the territory of a Labour minority government supported by the Scottish National Party and Liberal Democrats, and thereby a softer Brexit. But any major moves in the pound after the election will prove to be transient, because the over-arching driver of currencies is the interplay of interest rate expectations. Chart I-3 illustrates that last year's Brexit vote depressed the pound because the shock outcome precipitated a base rate cut and depressed expectations for Bank of England interest rate policy. In contrast to the Brexit vote, the General Election result per se will not have a lasting impact on the pound because it is unlikely to change the interest rate setting calculus for the BoE relative to other central banks. The BoE has been one of the most inert central banks when it comes to changing interest rates in either direction. Last year's emergency rate cut, forced by the shock vote for Brexit, has been the BoE's only policy rate move in 8 years! We expect the BoE to continue with its policy rate inertia because U.K. real consumption is highly correlated (inversely) to inflation. When inflation is too high, real consumption is undermined, making it difficult to hike rates; when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-4). This mirror image performance of inflation and real consumption has tied the hands of the BoE for 8 years, and will continue to do so. Chart I-4Why The Bank Of England's Hands Are Tied With the BoE's hands tied, relative interest rate expectations - and therefore the medium-term direction of the pound - will depend on the other central bank in the respective cross rate. Which brings us neatly to the ECB. The ECB Must Follow The Hard Data Years of extreme and experimental central bank intervention have left markets hyper-sensitive to the slightest change of nuance in central bank communication. We have now come to a ridiculous state of affairs where reducing two instances of the sentence "the balance of risks remain tilted to the downside" in the March 9 ECB press conference introductory statement to just one instance in the April 27 statement is regarded as de facto monetary tightening! The slightest change of nuance in central bank communication can powerfully drive markets over a timeframe of a few weeks or months. As Peter Praet, the ECB Chief Economist, warns: "After a prolonged period of exceptional monetary policy accommodation, financial markets are particularly sensitive to any perceived change in the future course of monetary policy. (Therefore) any substantial change in communication needs to be motivated by some more evidence in the hard data." On this basis, we expect the ECB to acknowledge the hard data showing euro area growth is solid and broad, and downside risks are diminishing; but that the required upward adjustment in inflation remains sluggish. For euro/dollar, a mixed message such as this might create a near-term setback of around 2%, given that it has rallied strongly in the past 65 days and is now technically overbought (see page 8). We would regard a 2% setback for the euro as a medium-term buying opportunity. As Peter Praet points out, central banks' data-dependency means that policy must follow the hard data over a timeframe of six months or longer. The Chart of the Week, Chart I-5 and Chart I-6 should make this crystal clear. Relative interest rate expectations and bond yield spreads ultimately follow relative economic performance. Chart I-5Bond Yield Spreads Must Follow The Hard Data On Economic Growth Differentials... Chart I-6...And Inflation Differentials If, as we expect, euro area growth2 continues to perform in line with or better than the U.S. and U.K. - and inflation differentials continue to narrow - then relative interest rate expectations will also continue to converge. Even the ECB admits that its main growth worry comes not from the euro area economy itself but rather from "the considerable uncertainty surrounding the new U.S. Administration's policies." In this regard, observe that the post-Trump spike in U.S. interest rate expectations has barely unwound (Chart I-7). We think it should unwind more. And who knows, perhaps James Comey will be the immediate catalyst. Chart I-7The Trump Spike In U.S. Interest Rate Expectations Hasn't Unwound What To Do After Super Thursday Chart I-8Pound/Euro (Inversely) Drives ##br##FTSE100/Eurostoxx50 In summary, policy rate expectations - in relative terms - will structurally continue to: Get less dovish in the euro area. Remain broadly unchanged in the U.K. Get more dovish in the U.S. Hence, our structural preference for currencies is euro first, pound second, dollar third. Which brings us finally to what medium-term investors should do after Super Thursday. If the pound sells off, use it to buy pound/dollar. If the euro sells off, use it to buy both euro/pound and euro/dollar. And use any associated underperformance of FTSE100/Eurostoxx50 to buy this relative equity position (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Sinn Fein MPs are not eligible to vote because they refuse to pledge allegiance to the Queen. 2 Growth must be adjusted for different demographics. Our preference is to use real GDP per head based on working age (15-64) population. Fractal Trading Model* Euro/dollar is technically overbought, so traders can play a countertrend move. Target a 2% retracement. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Merkel is not revolutionizing but reaffirming Germany's Europhile policy; An earlier date for the Italian election would bring market jitters forward from Q1 2018; Yet a new German-style electoral law would decrease the risks of a populist win; The Tories will retain their majority in U.K. elections. Fiscal policy will ease regardless of the outcome; Close long Chinese equities versus Hong Kong/Taiwan; remain overweight Euro Area equities. Feature Possible early elections in Italy and a narrowing lead for Theresa May in the June 8 U.K. election has unsettled investors over the past week. The former threatens to rekindle the flames of the Euro Area conflagration and has weighed on Euro Area equities (Chart 1). The latter threatens Prime Minister May's mandate and political capital, suggesting that the U.K.-EU Brexit negotiations could be acrimonious later this year. This report deals with both issues. Yes, Italy is a major risk to the Euro Area, and despite general awareness of the election, it is not clear to us that investors realize the depth of the risk. As such, Euro Area equities may outperform developed market peers right until the election. As for the U.K. election, we think its impact on global risk assets is non-existent and its impact on U.K. assets is likely to be fleeting. The bigger threat to global markets remains China. In a March report, we suggested that Chinese policymakers may be testing the waters for broad-based financial and industrial sector reform akin to their late 1990s efforts.1 These reforms could be deflationary in cyclical terms and thus a risk for global growth. We argued that the timeline for these efforts would have to wait for the conclusion of the nineteenth National Party Congress this fall and thus Beijing's policy represented a potential problem for 2018.2 Chart 1Italy Weighs On European Risk Assets Chart 2China: Monetary Tightening Takes A Toll Then again, President Xi Jinping may flout the rule of thumb in Chinese politics that aggressive policy actions should wait until after the five-year party congresses. Monetary tightening - which could be the first salvo of broader financial-sector reform - has already had negative effects on the real economy (Chart 2). The economic surprise index has corrected, as have China's PMI and LEI. Further Chinese tightening would invariably hurt Chinese demand for imports (Chart 3), which would have negative knock-on effects for EM economies, whose growth momentum appears to have already rolled over (Chart 4). Investors should carefully monitor China over the summer. Any signaling from policymakers that they are willing to move away from the "Socialist Put" and towards genuine deleveraging (not to mention their promised free-market reforms) would have negative global implications. Our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, has pointed out that Europe's economic outperformance relative to the U.S. is highly leveraged to Chinese liquidity (Chart 5).3 As such, decisions made by policymakers in Beijing will likely be more important for European asset performance than who sits in Rome's Palazzo Chigi. Chart 3Tighter Credit Impulse##br## Will Drag Down Imports Chart 4A Chinese Import ##br##Drag Will Hurt EM Chart 5Euro/U.S. Growth Differentials ##br##And Chinese Liquidity We are closing our long Chinese equities / short Taiwanese and Hong Kong equities trade for a gain of 3.45%. While policymakers are already backpedaling a bit, financial tightening inherently raises risks in an excessively leveraged economy. Europe Über Alles? Many clients are asking about German Chancellor Angela Merkel's recent comments on European unity. On the heels of the G7 summit, during which Merkel locked horns with U.S. President Donald Trump, Merkel delivered the most Europhile speech of her career: The era in which we could fully rely on others is over ... That's what I experienced over the past several days ... We Europeans truly have to take our fate into our own hands ... But we have to know that we Europeans must fight for our own future and destiny. To many in the media and financial industry the speech seemed like a massive departure from Merkel's cautious and reticent approach to European policymaking. We could not disagree more. European integration imperatives are intrinsically geopolitical, as we have argued since 2011.4 Members of the Euro Area are integrating not because of liberal idealism or misguided dogmatism on monetary union. Rather, they are engaged in a cold, calculated, and deeply realist political project to remain relevant in the twenty-first century. This net assessment has guided our analysis of various Euro Area crises. We supported our top-down theoretical view with bottom-up data showing that European voters were not revolting against integration. Integration may be elite-driven, but it has broad popular support. Support for the common currency has never dipped below 50% (Chart 6), despite a once-in-a-generation economic crisis, and most European states are pessimistic about their separate futures outside the EU (Chart 7). Chart 6Voters Approve Of The Euro Chart 7EU Exits: Not On Horizon German policymakers have operated within these geopolitical confines since the Euro Area sovereign debt crisis began in the waning days of 2009. At every turn of the crisis, whenever one or another German policymaker issued a "red line" regarding what "Berlin cannot accept," the correct view was to bet against that policymaker, i.e. against any Euroskeptic outcome. Since 2010, we have seen: Numerous direct bailouts of member states; A dove appointed to lead the ECB, with Berlin's blessing; Direct ECB purchases of government bonds; Deeper fiscal and banking integration of the Euro Area, albeit at a slow pace; Expansion - not contraction - of Euro Area membership; The reversal of fiscal austerity. We were able to forecast these turns because our constraint-based methodology gave us a high-conviction view that German policymakers would ultimately be forced down the integrationist, Europhile road. The German population did not revolt against these constraints. Germans are not Euroskeptic. We have no idea why many investors think they are: there is no evidence of it in data or history. German history is replete with failed efforts to unify (and lead) the European continent by hook or by crook. The country is cursed with just enough economic prowess to be threatening to its peers and yet not enough to dominate them by force. As such, it is a German national security imperative to ensure that it does not see the rest of Europe coalesce into an economic or military alliance against it. The EU and its institutions, which allow Germany to be prosperous without the threat of an enemy coalition, are therefore worth preserving, even at a steep cost. True, the costs of bailing out Greece, Ireland, Portugal, and Spain tested German enthusiasm for European integration. However, German support for the common currency never dipped below 60% amidst the sovereign debt crisis and has since rebounded to a record high of 81% (Chart 8). Only 20% of Germans are confident of a future outside the EU (Chart 9). Chart 8Rise Of The Europhile Germany Chart 9Germany: No Life After EU Death As such, Merkel's statement following the G7 summit is only surprising because it is explicit. Indeed, the reason Merkel made this statement now is not because she suddenly had a grand geopolitical realization, nor because Trump suddenly disabused her of a naïve belief in the benevolence of the United States. Merkel has understood Europe's imperatives for at least a decade. The real reason for her statement is domestic politics. Martin Schulz, Merkel's opponent in general elections to be held on September 24, has tapped into the rising Europhile sentiment among Germans. The Social Democratic Party (SPD) sprang back to life this year following Schulz's appointment as SPD chancellor-candidate. Despite a recent relapse for the SPD in the polls, Merkel wants to ensure that she is not vulnerable on her left flank to the more Europhile Social Democrats. In the face of this renewed threat from the SPD, the venue of Merkel's speech was highly symbolic: a summit of the Christian Social Union (CSU), the Bavarian sister party to Merkel's Christian Democratic Union (CDU), held in a beer hall no less! Bavaria is the most conservative and Euroskeptic part of Germany. Over the past two years, the CSU has flirted with abandoning its post-war electoral alliance with the CDU due to Berlin's various Europhile turns. This development threatened to undermine Merkel and her base of power from within. Merkel's speech, to the most Euroskeptic part of Germany, was designed to prepare her conservative base for a further deepening of European integration. It was not a policy shift but rather a statement that brought her rhetoric more in line with her policy actions. It was also a reminder to her core allies that they must continue on the current policy path unless they would rather have Schulz's SPD force them into even deeper European integration, and faster. What does this mean going forward? We think that the dirty word of European politics - "Eurobonds" - will come into play again. As if on cue, the European Commission has published a report that proposes bundling the debt of Euro Area sovereigns.5 The proposal is not exactly calling for Eurobonds, but rather for securitizing existing bonds into new instruments. As usual, a German finance ministry spokesperson opposed the plan. However, the path of least resistance will be towards more integration that may include such securitization. In fact, Eurobonds already exist. Europe's fiscal backstop mechanisms - formerly the European Financial Stability Facility (EFSF) and now the European Stability Mechanism (ESM) - have both issued bonds to finance sovereign bailout efforts. So has the European Investment Bank (EIB). Their bonds trade largely in line with French sovereign debt, with a 37 basis point premium over German 10-year Bunds (Chart 10). Most importantly, the European Commission - the executive arm of the EU - already has authority to issue bonds and even tap member states for funds in case it needs to fill a gap. As the European Commission cites in its pitch-book to bond investors (yes, you read that correctly), "should the funds available from the EU budget be insufficient, the Commission may directly draw on the Member States, without any extra decision making being required."6 Currently, EU treaties forbid bond issuance that would directly finance the budget of a member state. However, Article 143 lays down the possibility of granting mutual assistance to an EU country facing a balance-of-payments crisis, which the EU Commission handles via its €50 billion balance-of-payments assistance program. In the future, the Commission could issue bonds to finance joint, EU-wide projects for areas like defense or infrastructure. It does not appear that such a decision would require a change to EU treaties. Over the long term, the integration imperative will remain strong in Europe. Ironically, Donald Trump is probably the best thing that has happened to European unity, at least since President Vladimir Putin. However, we think media commentators may be overstating President Trump's impact. The U.S. was already growing aloof toward Europe under President Obama, who overtly tilted his foreign policy towards Asia, and President Bush, whose administration clashed with "old Europe" and merely flirted with "new Europe." With the prospect of the U.S. withdrawing its security blanket, Europeans are being forced to integrate. Otherwise they would have to deal with the full range of global crises - from debt to terrorism to migration to war - as separate, and weak, individual states. And the U.S. is unlikely to return to its post-World War II level of concern regarding European affairs anytime soon. We doubt that even a recession would greatly impede the integrationist impulse on the continent. The Great Financial Crisis was a once-in-a-generation economic crisis and yet it has deepened, not decreased, support for integration. That said, risks remain. While the median voter in Europe appears to support the elite-driven integrationist effort, the median voter in Italy is on the fence. Bottom Line: Merkel's Europhile speech in Bavaria was meant to reinforce the ongoing integrationist path to her domestic audience in an election year. We suspect that Germany under Merkel, along with France under recently elected President Emmanuel Macron, will continue down the same path. At some point in the not-so-distant future, this may include the issuance of Eurobonds for specific projects. Our long-held geopolitical view supports overweighting Euro Area risk assets, given economic momentum and valuations. However, near-term political risks in Italy are substantial and pose the main risk to our strategic view. Italy's Divine Comedy - Coming Soon To A Theater Near You? Early Italian elections - in September 2017, instead of February-May 2018 - have become a real possibility. Matteo Renzi, leader of the ruling Democratic Party (PD) and former prime minister, recently signaled that he would be willing to compromise on a new electoral law, and that it could pass as early as July, given a tentative agreement with the Forza Italia party of former prime minister Silvio Berlusconi. This would satisfy the condition of President Sergio Mattarella that a new electoral law be passed before elections can proceed. What does this development mean for markets? Italian political elites share the same integrationist goals of their European peers. There is no logic in Italian independence from the EU. Rome's ability to patrol its coastline for smugglers bringing in migrants would not improve with independence, nor would its ability to negotiate a low price for Russian natural gas. Italy is, as much as any European country, in terminal decline as a geopolitical power. Membership in the EU is therefore a natural, and realist, response to its weakness. In addition, exiting the monetary union would be fraught with risks that would overwhelm any benefits that Italian exports may gain from devaluation. It is highly unlikely that Germany, France, Spain, and the Netherlands would allow Italy - the Euro Area's third largest economy - to set a precedent of using massive currency devaluation while maintaining access to the Common Market. Rome would in fact break its Maastricht Treaty obligations. These stipulate that every member state, save for Denmark and the U.K., must become a member of the EMU. It would likely be evicted from both the EU and the Common Market. Furthermore, as we discussed in our September net assessment of Italy, the country's 19th nineteenth century unification has never made much sense.7 We would go so far as to argue that Euro Area amalgamation makes more sense than the unification of Italy. Northern Italy remains as much part of "core Europe" as London, the Rhineland, or the Netherlands, whereas the south - the Mezzogiorno - might as well be in the Balkans. We do not see how Rome would afford the Mezzogiorno on its own without access to both the EU's markets and ECB-induced low financing costs. All that said, the median Italian voter is not buying the Euro Area at the moment. Unlike their European peers, Italians seem to be flirting with overt Euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 50% (Chart 11). Similarly, a plurality of Italians appears to be confident in the country's future outside the EU (Chart 12). Chart 11Italy A Clear Outlier On The Euro Chart 12Italians Willing To Go Solo? Of course, only about a third of Italians identify themselves as only "Italians," largely in line with the Euro Area average and nowhere near the trend in Britain, where the share of the public that feels exclusively British has generally ranged from half to two-thirds (Chart 13). Nevertheless, the Euroskeptic trend in Italy is real and jeopardizes European integration. Our high-conviction view that European politics would be a "red herring" in 2017 was originally based on data that showed that voters in the Netherlands, France, and Germany increasingly supported European integration. This allowed us to dismiss polls that suggested that Euroskeptic politicians - such as Geert Wilders or Marine Le Pen - would do well in this year's elections. Even if they did perform well, the median voter's stance on European integration would force such policymakers to modify their Euroskepticism. This process has already happened in Spain (Podemos), Finland (The Finns, formerly known as the True Finns), and Greece (SYRIZA). In Italy, however, the median voter's Euroskepticism has not abated. As such, parties such as the Five Star Movement (M5S) and Lega Norde (LN) have no political incentive to modify their Euroskepticism. In fact, LN has done the opposite, evolving from a liberal and pro-EU regional sovereignty movement into a far-right, anti-immigrant, Euroskeptic, and nationalist Italian party -- a full brand overhaul. The timing of the upcoming election is difficult to forecast. Nonetheless, Renzi's compromise on changing electoral rules has now increased the probability that the election be held in Q4 2017, instead of Q1 2018. Renzi reportedly favors the same date as the German election, September 24. To accomplish this timetable, the new electoral law would have to be rushed through Italy's bicameral Parliament. The Chamber of Deputies - the lower house - is expected to vote on the compromise law in the first week of June, with the Senate passing the law by July 7. Given that the top four parties all seem to agree with adopting a German-style electoral system - proportional representation, with parties required to gain at least 5% of the vote to gain any seats - this ambitious timeline is possible. However, there are still some minor outstanding issues, which could drag out the process until the fall. In addition, local elections scheduled for June 11 (with a second-round run-off on June 25) could change the calculus of the ruling PD. If Renzi's party underperforms, he may back away from early elections, although the message would be that a strong populist performance in early 2018 is more likely. Polls have not budged much for the past 18 months, although Renzi's PD lost support around the time of its failed December 2016 constitutional referendum (Chart 14). The market may find solace in the fact that the revised electoral law would grant no "majority-bonus" to the winner, virtually ensuring that the Euroskeptic M5S cannot govern on its own. Chart 13Majority Of Italians Are Also Europeans Chart 14Ruling Party And Populist M5S Neck-In-Neck The risk to the market, however, is that M5S outperforms and then creates a limited coalition with right-wing Euroskeptics. Such a coalition could have the singular goal of calling a "non-binding, consultative" referendum on Italy's Euro Area membership. The official M5S line is that it would call such a referendum "if fiscal policies of the Euro Area did not change." Either way, the Italian constitution forbids referendums on international treaties, but a consultative referendum would give impetus to Euroskeptic parties to start negotiating a Euro Area exit for the country. There are two reasons why such an outcome is possible, if not our base scenario. First, a German-style 5% threshold will eliminate the votes cast for a number of minor parties from the overall calculation. These currently combine to make up about 18% of the total vote. This means that the parties that meet the 5% minimum will gain a larger share of seats in the parliament than they gained of the overall popular vote (82% of the vote will hold 100% of the seats), as is the case in Germany. There is a chance that both the PD and M5S get a considerable seat boost in the final tally that puts them close an overall majority. Second, much will hinge on whether the right wing - and Euroskeptic - Fratelli d'Italia (FdI) enter parliament. They are currently polling at about 5% of the vote. If they gain seats, it would significantly increase the percentage of total seats held by Euroskeptic parties. There is no evidence at the moment that M5S, which is on the left of the policy spectrum, would contemplate such an electoral alliance with LN and FdI. The party remains opposed to any coalitions and we suspect that it would not break its pledge to pursue the highly risky strategy of calling a referendum on the Euro Area. The M5S stands for a lot of different things: anti-corruption, anti-establishment, youth empowerment, etc. Euroskepticism is one of its pillars, not a singular objective. In fact, party leader Beppe Grillo recently attempted to abandon the Euroskeptic alliance with UKIP at the European Parliament to join the ultra-liberal, and Europhile, Alliance of Liberals and Democrats for Europe. Various factions vying for control of the movement oscillate between overt Euroskepticism, aloofness toward Europe, and open support for European integration. In addition, Italian voters may adjust ahead of the election by switching their support away from the various minor parties currently polling below 5% and toward the four major parties. This will likely benefit the ruling PD more than any other party. Out of the four parties highly unlikely to cross the 5% threshold - Campo Progressista (CP), Movimento Democratica e Progressista (MDP), Alternativa Popolare (MP), and Sinistra Italiana (SI) - three are centrist or aligned with the PD. One (Sinistra Italiana) would likely see its voters split between the PD and M5S (Chart 15). Such vote migration would clearly benefit the center-left PD, which Renzi is likely counting on in accepting the German-style proportional electoral system.8 Chart 15Most Minor Party Votes ##br##Would Help Ruling Democrats Bottom Line: Investors trying to make sense of the Italian election will find relief in the new electoral law. A purely German-style system - given the current level of factionalism in Italian politics - is unlikely to produce a populist government in Italy. In fact, the center-left PD could see a boost in support as voters switch away from minor parties. The tentative compromise on the electoral law has both increased risks by making an earlier election more likely and decreased risks by reducing the probability of an anti-market result. That said, there is still a possibility that M5S crosses the ideological aisle to form an alliance with right-wing Euroskeptics to try to take Italy out of the Euro Area. We doubt that they will do so. Nonetheless, it will be appropriate to hedge such a risk in currency markets closer to the date of the election, once the date is known. We therefore closed our long EUR/USD recommendation last week for a gain of 3.48%. Whatever the outcome of the election, Italian political risks will remain the main threat to European integration (and assets) going forward. We therefore expect the ECB to keep one eye on Italy, forcing it to be less hawkish than it otherwise would be. We will explore Italian politics and economy further in an upcoming report with our colleagues at BCA's Foreign Exchange Strategy. U.K.: The Election Is About G The latest polling averages show that Prime Minister Theresa May's Conservative Party maintains a 5% lead over Jeremy Corbyn's Labour Party, despite Labour's remarkable rally since early elections were called on April 18 (Chart 16). One projection of actual parliamentary seats that takes into account the crucial factor of voter turnout suggest that the Tories could add from 15 to 34 seats to their 2015 take of 330 seats - and this roughly matches our back-of-the-envelope calculation that the Tories could pick up 11 seats on account of the Brexit referendum (Table 1).9 Chart 16Labour Revives On Snap Election Table 1Referendum Results Offer Some Simple Gains For Tories There have been only two other cases in recent memory in which Britain's incumbent party led by double digits two months ahead of an election: 1983 and 2001. In the first case, Margaret Thatcher followed up the hugely successful Falklands campaign by expanding her popular support in the final two weeks to win a huge 144-seat majority. In the second case, Tony Blair lost some of his lead but still won the election handily.10 There has not been a case in recent memory where a double-digit lead dropped into single digits as quickly as it did this past month. Moreover, looking at the latest individual polls, it is too soon to say that Labour's rally has ended. Indeed, YouGov's model even shows the Conservatives losing their majority.11 Snap elections are always a gamble, as we have stressed throughout this campaign.12 There is no question that Labour has the momentum and May is feeling the heat. Yet the Tories have a fairly solid foundation of support at the moment. First, they are still polling above 40% support, almost 10% higher than before the referendum, reflecting the rally-around-the-flag effect after voters' surprising decision to leave the EU. They even poll above 40% among working-class voters, the original base of Labour, and the country's aging demographic profile also heavily favors them. (Youth turnout would have to surprise upward to upset the Tories.) Second, the Tory strategy of gobbling up supporters of the U.K. Independence Party (UKIP) has succeeded (Chart 17). UKIP has no raison d'être after achieving its foundational goal of Brexit. The Conservative Party's decision to hold a referendum on the EU was, in fact, driven by this rivalry from the right flank. UKIP posed the chief threat to the Tories through its ability to dilute their vote share in Britain's first-past-the-post electoral system. Now, almost all conservative voters will vote for the Conservative Party, while Labour must still compete with the Liberal Democrats, Greens, Scottish National Party, and Welsh Plaid Cymru in various constituencies (Chart 18). Chart 17Tories Keep Devouring UKIP Chart 18Labour Has Rivals, Tories Do Not Third, while May's popularity is merely converging with her party's still-buoyant level, Corbyn is less popular than both May and his own party (Chart 19). Corbyn still has a net negative favorability and is seen as less "decisive" and less "in touch" with voters than May. Fourth, voters still see Brexit as the most important issue of the election (Chart 20) and May as the best candidate to manage the tricky exit negotiations ahead. Because Brexit is the driver, the benefit of the doubt goes to the Tories. The 2015 elections, the EU referendum, the polls since the referendum, and the parliamentary votes (driven by popular pressure) enshrining the referendum result all suggest a great deal of public momentum on this key issue. The only truly historic development that could have broken this momentum, given that the economy is holding up, is the Tory decision to seek a "hard Brexit," i.e. exit from the EU's Common Market. Yet opinion polls show that Brexit still has the support of a majority of likely voters; moreover, 55% of voters would rather have "no exit deal" than "a bad exit deal."13 If voters still see this as the defining issue, then the Tories still have a key advantage. On the other hand, perceptions of Jeremy Corbyn and Labour have improved rapidly and May's simultaneous popularity slump is especially important in this election. She is a "takeover prime minister" (having initially gained the office when Cameron resigned rather than leading her party into an election as the presumed prime minister) and thus highly vulnerable. This election is largely about her need for a "personal mandate."14 Her political missteps (both real and perceived) are very much at issue in this particular election. Chart 19May Lifts Tories, Corbyn Drags Labour If polls continue to narrow, the election could produce a "hung parliament," in which no single party holds the 326 seats necessary for a majority in the House of Commons. What should investors expect in that scenario? First, May would have the chance to rule a minority government or form a coalition. A minority government would be weak, vulnerable to collapse under pressure, and would have a harder time controlling the Brexit negotiations. As for a coalition, there is very little chance that the other major parties would cooperate with her - the Liberal Democrats would not reprise their role as coalition partner from 2010-15. But there is a slim chance that the Democratic Unionist Party (DUP) of Northern Ireland could unite with the Tories to obtain a majority. The DUP has not exercised real power in a century, literally, and several of its members do not normally even take their seats in Westminster. However, the party is Euroskeptic and could provide just enough support to accomplish the single goal of a Tory-led Brexit. Suffice it to say that this outcome is not impossible - the Tories have been courting the DUP for months and the existence of a historic "common cause" changes the usual parliamentary dynamic. Still, this arrangement would be highly unusual, causing a massive uproar, and would lead to all kinds of uncertainties about parliament's ability to pass a final Brexit deal in 2019. Second, assuming May fails, the Labour Party would have to rule in the minority or form a coalition (if informal) with the Scottish National Party, LibDems, Plaid Cymru, Greens, and others. Here are the most likely outcomes of such an arrangement, in broad brush strokes: Brexit will in all likelihood proceed, given that all parties have professed respect for the referendum outcome. Since the new government would likely not seek to curtail immigration as strictly, it could seek to retain membership in the Common Market. However, a la carte membership in the Common Market remains the greatest difficulty with the EU member states, and therefore it is possible that even Labour would have to accept the logic of exiting the Common Market. In fact, we could see Labour's insistence on access to the Common Market producing more acrimony with the EU than the Tory clean-break strategy. Nevertheless, the odds of a "Brexit cliff" in which the U.K. exits without a trade deal would fall from their already low level, given Labour's unwillingness to let that happen. Despite moving ahead with Brexit, a Labour-led government would increase the relatively low probability of an eventual reversal of the decision, given that it would be more inclined to accept or encourage such an outcome in the face of a bad exit deal, a recession, or other challenges that cause public opinion to shift. The Scottish National Party would probably sideline its demands for a second Scottish independence referendum - especially given that polls supporting a second referendum have floundered for the time being - though not permanently.15 Fiscal spending would increase as a result of Labour's and the SNP's campaign promises and greater focus on domestic social issues. Even if May avoids squandering her party's majority (our baseline case), there are several important takeaways from her drop in the polls: Chart 21Dementia Tax' Gaffe Added To Tory Woes The median voter wants government support: The Labour Party's rally began as soon as elections were called, with left-leaning voters switching away from the LibDems once they saw a chance to challenge the ruling party. But the Tories took a hit from May's unprecedented (and publicly awkward) reversal on a party manifesto pledge only days after publishing it (Chart 21). The pledge, now infamous as the "dementia tax," was an attempt at fiscal tightening by which the government would include the value of an elderly person's home in the assessment of their financial means when it came to government support for social care. By contrast, Labour has rallied on the back of a party manifesto that promises fiscal expansion in various categories, including £7.7 billion additional funds for health care, social care, and nursing. More broadly, National Health Service funding, rent caps, and a higher "living wage" are the top four campaign pledges that gain above 60% popular support. As we elucidated last year, the two economies that most enthusiastically embraced a laissez-faire model - the U.S. and the U.K. - are now experiencing the most effective swing to the left.16 The U.K. campaign confirms that, with the Tories minimizing cuts and Labour offering greater spending. Brexit means Brexit: 69% of the public claims that government should follow the referendum outcome, and 52% favor Theresa May's proposed Brexit strategy. The opposition parties are not openly opposing the referendum outcome, as mentioned. Moreover, Labour's pledge to prevent the U.K. leaving the bloc without a trade deal is one of the least popular campaign pledges (only 31% approve), while the Liberal Democrats' pledge to hold a second nationwide referendum on the outcome of the exit talks is also unpopular (34% approve) (Chart 22). Labour is recovering support by focusing on its bread-and-butter, left-wing, social platform. Terrorism is not driving voters: The tragic terrorist attacks at parliament, Manchester, and London Bridge have hardly given May and the Tories any additional support despite being the party viewed as stronger on security. Amid a bull market in terrorism, British voters, like European peers, are becoming somewhat inured to periodic attacks against "soft" targets.17 Health is a bigger concern than immigration: A large majority of Britons think immigration has been too high in recent years, but only about 25% think it is a major issue facing the country, compared with 43% who cite health care as a major issue (see Chart 20 above). These are not completely independent issues because many people believe that immigrants are putting pressure on scarce health care resources. Immigration is closely tied to Brexit and will remain a burning issue if the government does not convince voters that it is more vigilant. But the Labour Party's greater support on health care (as well as education and other social issues) is a growing liability to the Tories as Brexit becomes more settled. If Brexit was a revolt against the elites, it is not necessarily the only manifestation of that revolt. The elitist Tories should be careful that they do not rest on their laurels having been on the right side of that particular issue. The key takeaway is that, aside from Brexit, fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then.18 That is also why the ruling party has already eased fiscal policy. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline to beyond 2022 (Chart 23). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 24). The Tories are also claiming that they will reboot the country's industrial strategy to improve productivity, which will become all the more imperative if they even partially follow through on their pledge to cut immigration numbers from the current annual ~250,000 to under 100,000, which will necessarily reduce labor force growth and thus also potential GDP growth.19 The National Productivity Investment Fund will need a projected £23 billion just to get on its feet. Given that Labour is proposing even more ambitious spending increases (£49 billion additional spending through 2022), the direction of U.K. politics - away from austerity - is clear regardless of the election outcome. Finally, our colleagues at BCA's Global Fixed Income Strategy expect the Bank of England to maintain loose monetary policy for the foreseeable future, being unable to turn more hawkish against inflation in the context of continued risks and uncertainties related to Brexit.20 Thus monetary and fiscal conditions are both accommodative for the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports,21 the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, could weigh on the pound regardless of the election outcome. As such, we closed our short USD/GBP last week for a gain of 3.34%. Bottom Line: We do not expect a hung parliament; most signs suggest that the Tories will retain at least a weak majority. However, a hung parliament that produces a Labour-SNP alliance would not likely reverse Brexit (though it would make a reversal more conceivable). Such an alliance could eventually result in an exit deal that is both less politically logical than the Tory deal (because London would pay to stay in the Common Market yet have less say in how it is managed) and more favorable to the British economy in the long run (because retaining the benefits of Common Market access). But this is not a foregone conclusion. We maintain our view that Brexit itself has largely ceased to have concrete market-relevant impacts other than a decline in Britain's long-term potential GDP growth. There are two reasons for this. First, May has ruled out membership in the Common Market and thus has removed a potential source of acrimony with Brussels over any "special treatment." Second, the EU does not want to precipitate a crisis in the U.K. that could reverberate back onto the continental economy. Investment Implications We remain strategically overweight European equities relative to their U.S. peers, a trade that has returned 7.39% thus far. We would remind clients that we closed our long GBP/USD and long EUR/USD tactical trades last week for 3.34% and 3.48% gains, respectively. We are also booking a 3.45% profit on our "One China Policy" strategic trade (long Chinese equities as against their Taiwanese and Hong Kong peers). We still think policymakers will do everything they can to keep China's economic growth stable ahead of the party congress this fall, but, as we discussed in our May 24 missive,22 the decision to tighten financial regulation is risky and threatens to cause unintended consequences. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, “China Down, India Up?” dated March 15, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, “Political Risks Are Understated In 2018,” dated April 12, 2017, available at gps.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, “ECB: All About China?” dated April 7, 2017, available at fes.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, “Europe’s Geopolitical Gambit: Relevance Through Integration,” dated November 3, 2011; and “Europe: The Euro And (Geo)politics,” dated February 11, 2015, available at gps.bcaresearch.com. 5 Please see European Commission, “Reflection paper on the deepening of the economic and monetary union,” May 31, 2017, available at ec.europa.eu. 6 Please see European Commission, “EU Investor Presentation,” April 7, 2017, available at ec.europa.eu. 7 Please see BCA Geopolitical Strategy Special Report, “Europe’s Divine Comedy: Italian Inferno,” dated September 14, 2016, available at gps.bcaresearch.com. 8 The only minor party that is Euroskeptic, FdI, is just close enough to the 5% threshold that its voters are unlikely to abandon it. They will not likely give the Euroskeptic Lega Norde and M5S much of a boost. 9 Please see Lord Ashcroft Polls, “2017 Seat Estimates: Overall,” May 2017, available at lordashcroftpolls.com. 10 In the 1997 election, Tony Blair and Labour led by double digits, but they were in the opposition. Their lead in the polls shrank slightly before Blair won a 178-seat majority, even larger than Thatcher’s 144 seats in 1983 and Clement Attlee’s 147 seats in 1945. 11 Please see YouGov, “2017 UK General Election Model,” accessed June 6, 2017, available at yougov.co.uk. 12 Please see BCA Geopolitical Strategy Weekly Report, “Buy In May And Enjoy Your Day!” dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see Anthony Wells, “Attitudes to Brexit: Everything We Know So Far,” March 29, 2017, available at yougov.co.uk. 14 Please see footnote 12 above. 15 Please see The Bank Credit Analyst and Geopolitical Strategy Special Report, “Will Scotland Scotch Brexit?” dated March 30, 2017, available at bca.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, “The End Of The Anglo-Saxon Economy?” dated April 13, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, “Brexit Update: Does Brexit Really Mean Brexit?” dated July 15, 2016, and “Brexit Update: Red Dawn Over Britain” in Geopolitical Strategy Monthly Report, “King Dollar: The Agent Of Righteous Redistribution,” dated October 12, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, “With Or Without You: The U.K. And The EU,” dated March 17, 2016, available at gps.bcaresearch.com. 20 Please see BCA Global Fixed Income Strategy Weekly Report, “Adventures In Fence-Sitting,” dated May 16, 2017, available at gfis.bcaresearch.com. 21 Please see “Brexit: A Brave New World” in BCA Geopolitical Strategy Weekly Report, “The ‘What Can You Do For Me’ World?” dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, “Northeast Asia: Moonshine, Militarism, And Markets,” dated May 24, 2017, available at gps.bcaresearch.com.

Special Report

Highlights Overall Investment Grade (IG) Corporates: An update of our regional sector relative value models shows that it has become increasingly difficult to find industries where debt looks cheap. Maintain overweight allocations to U.S. & U.K. IG, and stay underweight Euro Area IG, but keep overall spread risk close to neutral levels. U.S. IG: Within U.S. Investment Grade corporate debt allocations, upgrade Energy names (Oil Field Services, Integrated) and Cable & Satellite to overweight, while downgrading Consumer Cyclical sectors (Retailers) and Other Industrials to Underweight. Euro IG: Stay underweight and keep spread risk (i.e. DTS) close to index levels. Reduce exposure to Cable & Satellite, Electric Utilities and Natural Gas Utilities. U.K. IG: Stay overweight U.K. IG but keep overall spread risk near index levels. Feature Chart of the WeekCandidates For Additional Spread Convergence Back on January 24th, we published a Special Report that introduced specific Investment Grade (IG) corporate bond sector allocations for the U.S., Euro Area and U.K. to our model portfolio framework.1 The recommended weightings were based on the output from our sector relative value models for each region. We had presented those models on a semi-regular basis in the past, but without any specific numerical allocation among the sectors. By attaching actual weightings to each sector, within a "fully invested" model portfolio, we are now able to more accurately measure the aggregate success of our recommendations. In this follow-up report, we discuss the performance of our sector tilts since January, refresh our relative value models and present changes to our allocations. The broad conclusion is that, while our calls have done well over the past few months and our IG portfolios have outperformed the broad IG bond indices, it remains difficult to find compellingly cheap sectors (particularly in non-financial industries) given the overall tight level of corporate bond spreads. This is especially true in the Euro Area, where we see the poorest risk/reward tradeoff for IG exposure relative to the U.S. and U.K. We are more comfortable recommending an overweight stance on U.S. and U.K. IG corporates versus Euro Area equivalents, in line with our overall allocation in our main model portfolio. Given the tight overall level of spreads in all three regions, however, we are focusing our recommendations on sectors that have cheaper valuations but with riskiness closer to the overall IG indices - like Energy in the U.S. and Wireless in both the Euro Area and U.K. (Chart 1). Good Performance From Our Sector Tilts The performance of our sector recommendations has been reasonably solid since January (Chart 2). Our U.S. sector tilts added +5bps of excess return versus duration-matched U.S. Treasuries, coming mostly from our overweights in Energy and Financials. Within the Euro Area, we were able to generate +9bps of excess return versus government debt, also mainly from above-benchmark allocations to Energy and Financial names. In the U.K., our call to overweight Bank debt provided essentially all of our +23bps of outperformance versus Gilts. These strong excess returns came on top of a very strong performance for corporate debt since January 24th. Excess returns for IG in the U.S., Euro Area and U.K. were 0.9%, 1.3% and 1.3%, respectively. The detailed breakdown of the returns by sector are shown in Appendix Tables at the back of this report. To determine the success rate of our sector tilts, we can define "winners" as sectors where we had an active view (i.e. not neutral) and where the relative performance of the sector versus the overall IG corporate index was in the direction of that active view. For example, our decision to go underweight Diversified Manufacturing in the Euro Area was a good one, as that sector had an excess return of 0.7%, well below that of the overall Euro Area IG index (a 1.3% excess return). We can define "losers" in the same way, where the relative sector performance went against our active allocation. In Chart 3, we show the "winners" and "losers" for our U.S., Euro Area and U.K. sector allocations since late January. Our success rate was quite good, as we had far more winners than losers in all three regions. The Big Picture For Corporate Credit: Favorable Business Cycle, But Valuations Are Not Cheap We have been maintaining an overall overweight allocation to IG corporates since late January. This was based on a view that global economic activity was accelerating, which would support faster profit growth. This would provide cyclical relief for stressed corporate balance sheets in the U.S. Euro Area & U.K. corporates would also benefit from a better profit backdrop, with the added bonus of central bank asset purchases helping to improve the supply/demand balance for IG debt. Yet spreads have already tightened substantially throughout the IG universe. This reflects declining macro volatility and the ongoing investor stretch for yield after the rise in global government bond yields earlier this year faded significantly. The result is that there is now far less dispersion among corporate sectors, by industry or by credit quality, then we've seen in recent years (Charts 4, 5 & 6). Coming at a time of high corporate leverage, and with central bank liquidity growth starting to roll over as we discussed in last week's Weekly Report, we are recommending an "up in quality" bias to sector allocations and credit exposure, while favoring U.S. and U.K. corporates over Euro Area equivalents.2 Chart 4Tight Spreads, Flat Credit Curve##BR##In The U.S. Chart 5Tight Spreads, Flat Credit Curve##BR##In The Euro Area Chart 6Tight Spreads, Flat Credit Curve##BR##In The U.K. Bottom Line: An update of our regional sector relative value models shows that it has become increasingly difficult to find industries where debt looks cheap. Maintain overweight allocations to U.S. & U.K. IG, and stay underweight Euro Area IG, while keep overall spread risk close to neutral levels. U.S. Investment Grade: Stay Overweight, But Be Selective In Tables 1A and 1B, we present the results of our U.S. IG sector valuation model as of May 31st.3 We are maintaining an overweight recommendation on U.S. IG in our overall model portfolio, as we continue to see the backdrop for U.S. economic growth being much friendlier for corporate debt versus Treasuries. Credit spreads are very tight, however, so we are maintaining some degree of caution in our sector recommendations. Specifically, we are aiming to favor industries with option-adjusted spread (OAS) at or above that of the overall U.S. IG index, but with a positive valuation from our U.S. IG relative value model. We also wish to keep the aggregate level of spread risk, using our preferred "duration times spread" (DTS) metric, in line with that of the overall U.S. IG index. As can be seen in the scatter diagram in Chart 7, which plots the model valuations versus the DTS score for each sector, there are precious few non-financial sectors that offer attractive spreads that are not riskier than the overall index. Our model has shown some improvement in value within the sub-sectors of the Energy space, which is a consequence of the softness in oil prices over the past few months. With our commodity strategists calling for a recovery in oil prices back up towards to $55-60 range by year-end, we see this an opportunity to raise our allocations to Energy by upgrading the Independent and Integrated sub-sectors to overweight from neutral. At the same time, we are reducing the size of our prior overweights in Refining and Midstream to keep the overall Energy sector allocation to no more than two times that of the U.S. IG Energy index - a pure risk management move on our part. We are also upgrading some of our prior underweights in the Communications sectors to neutral (Media & Entertainment, Wirelines & Wireless) and to overweight (Cable & Satellite), given relatively attractive valuations in those areas. By the same token, we are cutting Other Industrials to underweight from neutral with valuations now looking unattractive. All of our U.S. sector changes result in an upgrade of our weighting to the broad Industrials grouping by 5 percentage points to 58.6%. We are reducing our large overweight to U.S. Banks by an equivalent amount to "fund" this new allocation within our 100% invested model IG portfolio. The net result of all these changes is that our U.S. IG portfolio has an overall DTS score of around 9, in line with that of the U.S. IG benchmark index. Thus, we are not making any changes to our aggregate recommended spread risk, in line with our top-down views on the overall level of credit spreads and curves, as described earlier. Bottom Line: Within U.S. Investment Grade corporate debt allocations, upgrade Energy names (Oil Field Services, Integrated) and Cable & Satellite to overweight, while downgrading Consumer Cyclical sectors (Retailers) and Other Industrials to Underweight. Euro Area Investment Grade: Not Much Value Left, Remain Underweight In Tables 2A and 2B, we show the output from our Euro Area IG sector valuation model. The scatter diagram showing the model residuals versus the individual sector DTS scores is shown in Chart 8. Finding value has become a problem in Europe, with only a few sectors (most notably, Metals & Mining, Oil Field Services, Life Insurance and P&C Insurance) showing a double-digit spread residual from our model. All those sectors also offer wider spreads than the overall Euro Area IG index, but the Insurers stand out as being much riskier from a DTS perspective. That is a function of the wide spread for the overall Insurance sector, which is nearly double that of the overall Euro Area IG index. We see no reason to change our existing allocations to those sectors in our model portfolio, keeping Metals & Mining and Oil Field Services at overweight and the Insurers at neutral (a prudent tradeoff between wide spreads and high risk). It would likely take a meaningful rise in European interest rates before any serious compression in Insurance spreads could unfold, given the struggles that industry faces from low yields on its fixed income investment assets. A rise in European bond yields could unfold later this year if the European Central Bank (ECB) signals that a tapering of its asset purchase program will begin next year. We see that scenario as increasingly likely, given the overall strength of the Euro Area recovery. The ECB will only shift its stance gradually, due to the lack of immediate inflation concerns. Any signal that that fewer bond purchases are in the offing, however, will pose a major risk for European corporates given the large ECB buying of that debt over the past year. We see very few necessary changes to our Euro Area allocations at the moment, as our overall portfolio DTS is in line with the IG benchmark index (around 6). We do recommend cutting Cable & Satellite and Utilities (Electric & Natural Gas) to underweight. Bottom Line: With corporate spreads at tight levels, and with few sectors showing compelling value, we are comfortable in remaining underweight Euro Area corporates, while keeping spread risk (i.e. DTS) close to index levels. Reduce Cable & Satellite, Electric Utilities and Natural Gas Utilities to underweight. U.K. Investment Grade: Stay Overweight, Focusing On Financials In Tables 3A and 3B, we present our update U.K. IG sector model, with the scatterplot of model residuals versus DTS scores shown in Chart 9. Not much has changed in terms of which sectors appear cheap in our model versus the late January levels. Financials, in general, have the cheapest spreads on an absolute basis, especially the Insurers. Although the cheap valuation on the Insurance debt mirrors the same problem highlighted above for the Euro Area insurers - interest rates that are too low to generate acceptable investment returns on the insurers' portfolios. We are maintaining our overall modest overweight allocation to U.K. IG, while keeping overall spread risk close to index levels. While the political and security risks within the U.K. are significant at the moment, there is no threat of the Bank of England moving to a less accommodative monetary policy anytime soon. A backdrop of churning economic growth, an undervalued British Pound and a central bank maintaining hyper-easy monetary policy is still a decent one for U.K. corporate debt. In terms of sector allocation changes based on our U.K. IG sector valuation model, we recommend upgrading Health Care and REITs to overweight, downgrading Other Industrials to neutral and cutting Tobacco to underweight. Bottom Line: Stay overweight U.K. IG but keep overall spread risk near index levels. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 Our valuation framework assesses the attractiveness of each IG sector within a cross-sectional analysis. The OAS for each sector is regressed against common risk factors (interest rate duration, credit quality) with the residual spread determining the valuation of each sector. Appendix

Highlights Geopolitical risks remain overstated in 2017, but China and Italy could scuttle the party; June elections in France and the U.K. are not market-movers; But early Italian election is a risk that could prompt the ECB to stay easy, close long EUR/USD for a gain; U.S. budget reconciliation process may be arcane, but is vital to understand upcoming tax reform process; Investors should expect details of tax reform by Q4 2017, but legislation may only pass in Q1 2018. Feature We turned the traditional adage of "sell in May and go away" on its head last month in a report titled "Buy In May And Enjoy Your Day!"1 So far so good (Chart 1). The fundamental reasons behind the breakout is the narrowing of the global equity risk premium on the back of easy monetary policy and a recovering global economy (Chart 2) two trends that our colleagues at the Global Alpha Sector Strategy highlighted last September.2 Since then, geopolitical risks cited as likely to end the party have been largely overstated.3 We continue to worry about Chinese financial sector reforms, U.S. politics, Sino-American tensions, signs of growing U.S. mercantilism, prospects of early Italian elections, and especially the developments in North Korea. But these remain risks for 2018, rather than 2017.4 Chart 1Blow-Off Phase Has Resumed Chart 2Global ERP Has Room To Fall There are still some "loose ends" to tie up from the first quarter, including the upcoming French legislative and U.K. general elections. On the former, there is nothing to say other than that investors should indeed prepare for a "French Revolution," by which we mean a supply-side revolution.5 Current seat projections based on the latest polling have pro-market, centrist, Europhile parties controlling between 85-92% of the National Assembly following the two-round elections in mid-June (Diagram 1).6 Diagram 1French National Assembly Seat Projection Yes. In France. Skeptical commentary will surely rain on the centrist parade by pointing out that anti-establishment presidential candidates won nearly 50% of the vote in the first round of the presidential election (true), that Marine Le Pen will be back even stronger in 2020 (false), or that the electoral system is designed to suppress the populist vote (yes, so what?). We are not as perceptive nor profound as the witty op-ed writers. Our far simpler conclusion is that the French National Assembly will elucidate the revealed preference of the French electorate, given the electoral rules that are quite familiar to all French voters. And that preference appears to be for pro-market, and quite possibly painful, structural reforms. We remain long French industrials relative to German ones, but our clients may find alternative ways to play the upcoming free-market revolution in France. On the British front, Tory PM Theresa May is facing her first genuine crisis. The impact of the Manchester terrorist attack on the election is difficult to forecast. However, May's "dementia tax" gaffe has clearly given Labour new life in the polls (Chart 3). What most commentators saw as a clear shoo-in for the Conservative Party has now become a competitive, if not exactly tight, race. Chart 3Labour Gains... Chart 4...But Tories Keep Devouring UKIP We would note that despite Labour's rise in the polls, May's strategy of suppressing the UKIP vote by campaigning from the nationalist right is paying off. As Chart 4 illustrates, UKIP voters appear to be switching to the Tories en masse: UKIP has gone from support of 20% in April 2016 to under 5% today. Given Britain's first-past-the-post electoral system, May's strategy of swallowing the UKIP whole is a savvy move. It will eliminate the probability that UKIP siphons votes away from the Tories in competitive constituencies. Our own, highly conservative, estimate gives the Tories a minimum of 11 gained seats (Table 1). This is based on constituencies that voted for Brexit but where Labour and the Liberal Democrats won by less than 5% in the last election. Table 1Minimal Scenario Gives Tories 11 New Seats For Their Majority We do not think that the election will have much impact on the Brexit process. Political risks peaked in January when May announced that she planned to take the U.K. out of the EU Common Market. We pointed out at the time that this decision made it highly unlikely that the U.K. and EU negotiations would take an acrimonious turn.7 The market agreed with us, with the pound bottoming in mid-January. We continue to believe that the Brexit process will have no investment relevance for global assets. As for U.K. equities and the pound, a larger-than-expected seat grab by the Tories (375+) at the upcoming election would likely strengthen the pound further, which in turn could weigh on the FTSE 100 (with the FTSE 250 being less affected). A disappointing result, one where the Conservative Party fails to reach 350 seats, could create temporary headwinds for the pound. The one risk that remains on our horizon is faster-than-expected deleveraging in China. As we mentioned in our report last week, China's financial crackdown raises near-term risks (Chart 5).8 We do not think that policymakers are looking to enact wide scale financial sector reform, which would entail a surge in realized non-performing loans, bankruptcies, and defaults ahead of the Fall Party Congress. However, Chinese investors and businesses may already be looking ahead to 2018. Chart 5Policymakers Are Inducing Financial Risk... Chart 6...At A Time When Vulnerability Is Growing China's reserves-to-M2 ratio - an IMF-proposed measure that captures Chinese reserves of liquid assets against those that its residents could potentially liquefy as part of wide scale capital flight - has continued to decline (Chart 6). Measures of quarterly net portfolio flows and capital flight show that the Q4 2016 outflows accelerated sharply after a slowdown in outflows in the previous two quarters (Chart 7), although we have no information for Q1 2017. More recently, there has been a stunning surge in Bitcoin prices. The crypto-currency is up 65% since the start of May, which cannot be attributed to Euro Area fears given the victory of Europhile Emmanuel Macron in the French election. Could it be related to policy uncertainty in China? We think yes (Chart 8). China remains our pick for the risk that is most likely to scuttle our sanguine view on global risk assets in 2017. Chart 7Chinese Outflows Restarted In Q4 2016 Chart 8Chinese Uncertainty Is Bitcoin's Gain The final risk to investors that we have been tracking this year is inaction by U.S. Congress on the tax reform front. We have received many client questions regarding when investors should expect to see tax reform legislation and when (and how) it is expected to pass. We turn to this question in the rest of this report. Market Relevance Of The Budget Reconciliation Process The U.S. legislative process is complicated, arcane, and highly mutable. We have tried to spare our clients as much of the headache of U.S. congressional procedure as possible.9 However, the budget reconciliation process underpins current efforts to reform both the 2010 Affordable Care Act (Obamacare) and enact tax reform. To understand how, when, and whether the GOP-controlled Congress will pass these pieces of legislation, it is necessary for investors to learn the basics of the reconciliation process in particular, and the budget process more broadly. Budget reconciliation - or simply, reconciliation - simplifies the process of passing a budget and was introduced by the Congressional Budget Act of 1974.10 To understand why reconciliation matters, we first have to explain how the U.S. Congress sets the budget. The U.S. Budget Process The U.S. budget process (Diagram 2) begins with the U.S. president submitting the White House budget request to Congress. This is a largely ceremonial act as Congress has the power over the appropriations process. Diagram 2U.S. Budget Process: A Tentative Timeline Congress takes into account the president's request as it formulates a budget resolution, which both houses of Congress pass but which is not presented to the president and does not actually constitute law. The resolution sets out the guidelines for the budget process, which is supposed to ultimately produce an appropriations bill. It is this bill, also referred to as a budget bill, which appropriates funding for the various federal government departments, agencies, and programs. Under a revised timetable in effect since 1987, the annual budget resolution is supposed to be adopted by both chambers of Congress by April 15, giving legislators sufficient time to then pass a budget bill by the start of the fiscal year on October 1. However, there is no obligation to do so. In fact, Congress failed to pass a budget resolution for most of President Obama's two terms in office due to a high degree of polarization between the Democrats and Republicans. As such, the government was funded via "continuing resolutions," which merely extended pre-existing appropriations at the same levels as the previous fiscal year. Reconciliation Process Where does the reconciliation process fit? It was originally introduced to simplify the process of changing the law on the books in order to bring revenue and spending levels into line with the budget resolution. The crucial feature of the process, and the reason we are focusing so much on it, is that it limits the debate in the Senate to 20 hours, thus automatically preventing any Senator from filibustering the ultimate legislation that emerges from the reconciliation process. No filibuster, no need to reach 60 Senate votes to invoke cloture, an act that ends the debate in the chamber. In the current context, where the Republican Party controls 52 seats, this means that the Republicans can use the reconciliation process to pass legislation that would otherwise be "filibustered" in the Senate. The reconciliation procedure is a very powerful legislative tool by which Congress can pass controversial legislation, as long as such legislation has an impact on government revenues or spending levels. Tax legislation, obviously, would impact government revenues. George W. Bush used the reconciliation procedure to lower taxes in 2001 and 2003. His father, George H. W. Bush used reconciliation to raise taxes in 1990 (and thus roll back some of the Ronald Reagan 1986 tax reform). The 1996 welfare reform - the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 - was also passed via the reconciliation process. Obamacare was not passed via the reconciliation procedure. The main portion of the bill - including almost all of its key provisions - was passed at the beginning of the 111th Congress in 2009 when the Democrats held 58 seats in the Senate following the momentous 2008 election.11 It was the subsequent amendments to the original bill that required the reconciliation process due to the death of Massachusetts Senator Ted Kennedy, particularly several crucial funding provisions. The one unifying feature of all reconciliation bills is that they must have an impact on the budget, essentially by changing the revenue or spending levels of the federal government. If the bill introduces extraneous provisions that deviate from the budgetary requirement, then these can be struck out by invoking the so-called "Byrd rule." Waiving the Byrd rule requires an affirmative vote of three-fifths of the Senate, which is 60 votes. As such, it essentially requires the 60-seat majority needed to also invoke cloture, making the entire reconciliation process redundant. Bottom Line: The budget reconciliation process allows U.S. Congress to pass legislation without the a 60-seat Senate majority. However, procedural rules require the provisions of a reconciliation bill to deal exclusively with legislation that impact government revenue or spending levels. Timing Since the introduction of the procedure in 1974, there have been 24 reconciliation bills, three of which were vetoed by the president. The reconciliation process begins with the passing of the budget resolution, which sets out the "reconciliation instructions." However, since the procedure was introduced, it has rarely progressed along the intended timeline. The very first reconciliation act in 1980 was introduced in a budget resolution that passed well after the April 15 deadline, in mid-June. And the ultimate appropriations bill, the Omnibus Reconciliation Act of 1980, was only signed into law in early December 1980, so essentially two months after the start of FY1981 on October 1. Investors should therefore understand that the U.S. budget process has no real firm deadlines. The schedule is highly malleable. A reconciliation bill also does not have to be passed with the actual budget. Despite being initiated by the budget resolution, reconciliation runs parallel to the budget process. For example, Congress has already set appropriations for FY2017, but the reconciliation bill on Obamacare - set by the FY2017 budget resolution - is still in negotiations. Diagram 3 illustrates that half of all reconciliation bills were passed after the start of the fiscal year for which they were introduced in a budget resolution. And five reconciliation bills were passed in the calendar year of the fiscal year for which they were supposed to reconcile the budget, basically mid way through the fiscal year. Diagram 3Timing Of Reconciliation Procedures This is important in the current context because investors are waiting for tax reform legislation which is supposed to be passed via the budget reconciliation process for FY2018. However, the GOP-controlled Congress has not even finished the budget process for FY2017. In fact, the budget resolution for FY2017 only passed the House on January 13, 2017. As we learned above, U.S. budget process guidelines call for the budget resolution to have been passed by April 15, 2016. As such, the Obamacare repeal and replace bill, if it were to ultimately pass the Senate, would certainly be the most delayed reconciliation bill ever. In fact, we could see the current Congress passing the FY2017 reconciliation bill in the waning days of FY2017! Congressional rules only allow one budget resolution to be active at any one time. In fact, as soon as a new budget resolution is passed, the old reconciliation instructions are made void. As such, investors have to wait for the Republicans to decide what they plan to do with the Obamacare reconciliation bill before they begin contemplating tax reform. Bottom Line: Republicans in Congress decided to issue reconciliation instructions as part of the FY2017 budget resolution, which passed in January. As such, investors have to wait until that process ends - with either Obamacare repeal or failure of the bill - before Congress can produce a FY2018 budget resolution with reconciliation instructions for tax reform. We suspect that the FY2018 budget resolution will be passed sometime between the end of the August Congressional recess, on September 5, and December. But that is just a guess (Diagram 4). It could happen earlier, in July, if Obamacare is dealt with over the next month. Diagram 4Tentative U.S. Political Timeline Reconciliation Rules And Tax Reform Changing America's complex tax laws is precisely the sort of legislative action that reconciliation was designed to facilitate. That said, investors are still not sure whether the Trump administration and Congress will be able to agree on comprehensive tax reform that includes lowering top rates for corporations, or whether they will merely agree to cut household taxes on households. Some clarity will emerge once the Republican-controlled Congress passes the FY2018 budget resolution, which will contain reconciliation instructions for either comprehensive tax reform (most likely) or merely household tax reform (unlikely). At that point, the length of the reconciliation process will depend on how much agreement there is surrounding tax reform. Diagram 3 shows that tax cuts - such as those in 2001 and 2003 - take relatively little time to pass. Tax reform, on the other hand, could take a while longer given multiple competing interests. If comprehensive, we would expect tax reform to be passed by the end of Q1 2018. Would that mean that tax cuts would only be effective from January 1, 2018? Or, even less bullish, from the start of FY2019? No. The GOP would have the option of making tax cuts retroactive and thus can avoid a huge market disappointment if tax cuts come later in the next year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.12 Can reconciliation be used to pass budget-busting tax reform, as we have argued investors should expect? You bet! From 1980 to the 1990s the reconciliation procedure was primarily used - and in fact designed - to reduce the deficit through reductions in mandatory spending, revenue increases, or both. It has since become a tool to expand deficits. This was most famously done by the Bush era reconciliation bills in 2001 and 2003, which introduced large tax cuts. The aforementioned Byrd rule forces any provision of a bill that increases the deficit beyond the years covered by the reconciliation bill to "sunset." In the case of the 2001 and 2003 bills, this meant that Bush-era tax cuts expired in 2011 (estate tax) and 2013 (which investors will remember as the "fiscal cliff"). The sunset period does not have to be ten years, it could conceivably be a lot longer, in effect making tax reform permanent, as far as most investors' time horizons are concerned. Following the Democratic Party sweep in the 2006 midterm elections, the Democrat-controlled Senate changed reconciliation rules to prohibit any deficit-increasing measures, regardless of the sunset clause loophole. However, the Republicans changed the rules back in 2015, after they re-took the Senate in the 2014 midterm election. This is crucial for two reasons: first, it means that the current procedural rules on the books allow deficits to be blown out via the reconciliation procedure and second, it establishes that the current cohort of Republicans in Congress is fiscally profligate, despite media punditry to the contrary. Bottom Line: The reconciliation process was designed to facilitate precisely the type of legislation that Republicans will try to pass via tax reform. According to the current procedural rules, such legislation can increase the budget deficit, as long as it sunsets at the conclusion of the budgetary period set out by the legislation (normally 10-years, but it could be longer). We suspect that tax reform will take until Q1 2018 to pass, but Republicans will be able to make its effects retroactive to January 1, 2017. The Big Picture - What Does It All Mean For Fiscal Policy? We expect the Republican-held Congress to attempt to pass comprehensive tax reform over the next four quarters. If the GOP fail to agree on "revenue offsets" for corporate tax cuts, we could see the Republican Congress electing to pass simple tax cuts for households, as the Bush-era tax cuts of 2001 and 2003 did. To facilitate such legislation politically, the Republicans will rely on "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue lost through tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, factors that actually add to revenues. In other words, "tax cuts pay for themselves." It is true that the Congressional Budget Office (CBO) will balk at dynamic scoring. But we doubt that "egghead, socialist economists" will stand in the way of tax reforms. As we discussed above, the CBO's score will ultimately only force the Republicans to "sunset" tax reform legislation, not scuttle it. The market disagrees with us. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 9). Chart 9Market Has Voted: No Fiscal Stimulus We think the market is making a serious mistake by taking the Republican mantra of "revenue neutral" - meaning that any tax cuts would need to be offset by other revenue-raising measures - tax reform seriously. This is easier said than done. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - will all face resistance from vested interests. We suspect that the GOP will produce some revenue offsets, but not enough to have a revenue-neutral tax reform. The path of least resistance, therefore, will be to bust the budget and then force the measures to expire over the life of the budget-setting window. White House budget director Mick Mulvaney has already floated the idea of extending the 10-year budget scoring window to 20 years. This would allow tax reform measures, even if they are characterized by the CBO as profligate, to expire in two decades. That's practically a lifetime away, as far as any investor is concerned. What is the investment significance of a stimulative tax reform package? Our colleague Peter Berezin has recently pointed out that it is ironic that fiscal stimulus is coming to America only when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year, as the Fed responds to greater fiscal thrust with tighter monetary policy.13 We encourage our clients to read BCA Special Report "Beware The 2019 Trump Recession," penned by Martin Barnes in March, which details the likely path that assets and the economy will take over the next two years.14 In the short term, the market will continue to fret that tax reform is doomed and that Republicans are committed to austerity. However, budget-busting tax reform could begin to be priced in by the market well before the reconciliation bill is ultimately passed. We suspect that the outlines of tax reform will emerge this summer. The market may realize that stimulus is coming as soon as the FY2018 budget resolution, containing tax reform instructions, is passed in Q3 or Q4 2017. Such a realization later this year could augur a violent snap-back in the USD. Currently, the two-year real interest rate differentials between the euro area and the U.S. have widened by 58 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 10). We have been long EUR/USD since March 22,15 in expectations that investors would be busy covering their euro hedges that they put on in the lead up to the French elections, the outcome of which we have had a high conviction on since November.16 However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will ultimately subside (Chart 11). Chart 10Widening Real Rate ##br##Differentials Support The Dollar Chart 11Speculators Are Long The Euro##br## For The First Time In Three Years We are therefore closing our USD short versus both the euro and the pound, for gains of 3.48% and 3.34% respectively. As we expected, the ECB is going to look to guide investors towards a "dovish" tapering of its QE program. Speaking before the European Parliament's committee on economic affairs, ECB President Mario Draghi confirmed that "very accommodative financing conditions" reliant on "a fairly substantial amount of monetary accommodation" would continue. The ECB will have to make a decision whether to extend its sovereign bond purchase program into the next year or start winding it down as planned. Given news flow out of Italy that an election may be planned as early as September, the ECB may be forced to stand pat until after the end of the year. Given our view that tax reform in the U.S. would ultimately happen, and that it would eventually be marginally stimulative, any resurfacing of political risks in Europe - which we are expecting - should be negative for the EUR/USD. What should investors do about European equities? We are cautious. As we have been pointing out to our clients since September of last year, Italy is the political risk in Europe.17 However, we think that most investors are willing to bet that European equities can survive Italian political turbulence. This could be a mistake in the short term, as we think that Euroskeptic (albeit evolving) Five Star Movement could win a plurality in the next election. In the long term, Italy will become ECB's proverbial boulder, that Draghi must push up a hill like Sisyphus, only to see it roll down to the bottom with each bout of Italian political instability. As such, Italy's instability will force ECB to set its monetary policy for the weakest link in the Euro Area (Italy), rather than the aggregate. This should be positive for Euro Area risk assets, but negative for the euro, all other things being equal. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Strike While The Iron Is Hot," dated September 2, 2016, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com. 6 The dates for the two rounds of the legislative elections are June 11 and 18. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 We draw on several overviews of the budget reconciliation process in this report. Please see David Reich and Richard Kogan, Center on Budget and Policy Priorities, "Introduction To Budget 'Reconciliation'," dated November 9, 2016, available at cbpp.org; Megan S. Lynch, Congressional Research Service, "The Budget Reconciliation Process: Timing Of Legislative Action," dated February 23, 2016, available at fas.org; and Megan S. Lynch, Congressional Research Service, "Budget Reconciliation Measures Enacted Into Law: 1980-2010," dated January 4, 2017, available at fas.org. 11 To reach the required 60 seat filibuster-proof majority the Democrats relied on some luck and cunning. Democrat Al Franken unseated Republican Incumbent Norm Coleman in a recount in Minnesota and Arlen Specter, a Republican from Pennsylvania, switched his party affiliation to Democrat. 12 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and the courts upheld the legislation. Hence, there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar tax years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 13 Please see BCA Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight," dated May 26, 2017, available at gis.bcaresearch.com. 14 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Fiscal policy is likely to be eased modestly in most advanced economies over the next two years. The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has proposed. Ironically, fiscal stimulus is coming to America just when the economy has reached full employment. The market is pricing in too little Fed tightening over the remainder of the year. The dollar's swoon is ending. Go short EUR/USD with a target of parity by the end of the year. Feature Fiscal Thrust Around The World In its latest Fiscal Monitor, the IMF estimated that advanced economies eased fiscal policy by 0.2% of GDP in 2016, reversing a five-year streak of fiscal tightening (Chart 1). The Fund expects a further 0.1% of GDP of easing in 2017, followed by a neutral stance in 2018. In the EM universe, the IMF foresees a fiscal thrust1 of -0.2% of GDP in 2017 and -0.4% of GDP in 2018. Chart 1IMF Expects Modest Fiscal Easing In Advanced Economies, Further Tightening In EM Averages can disguise a lot of variation across countries (Charts 2). Comparing 2018 with 2016, the IMF expects Canada and the U.S. to experience a positive fiscal thrust of 0.7% of GDP and 0.4% of GDP, respectively. The fiscal thrust is projected to be -0.2% of GDP in the euro area, -1% of GDP in the U.K., and -0.5% of GDP in Japan. Among the larger advanced economies, Australia is expected to experience the largest degree of fiscal tightening, with a fiscal thrust of -1.2% of GDP. Across the EM universe, most of the fiscal tightening is projected to occur among oil producers. The IMF expects oil-exporting economies to collectively reduce their fiscal deficits by US$150 billion between 2016 and 2018. Political considerations require that the IMF give considerable weight to the stated objectives of governments when formulating fiscal projections. In reality, governments often struggle to meet their budget targets. Consequently, the Fund has typically overestimated the degree of fiscal consolidation that ends up happening (Chart 3). As such, our own projections foresee somewhat less fiscal tightening - and in some countries, a fair bit of fiscal easing - than the IMF projects. In particular: Chart 2Countries Will Follow Different Fiscal Paths Chart 3IMF Forecasts Tend To Overestimate Extent Of Fiscal Consolidation We do not expect much more incremental fiscal tightening out of the euro area. Thanks to a slew of austerity measures, the euro area's structural primary budget balance went from a deficit of 2.6% of GDP in 2010 to a surplus of 1.0% of GDP in 2014. It has remained close to those levels ever since. Now that a primary surplus has already been achieved and interest rates and bond spreads have fallen to exceptionally low levels, the need for further belt tightening has abated. That's the good news. The bad news is that high government debt levels in many European economies rule out any major new stimulus programs (Chart 4). The U.K. will slow the pace of fiscal consolidation. The U.K.'s structural primary budget deficit fell from a peak of 7.1% of GDP in 2009 to 1.3% of GDP in 2016. The IMF expects the primary balance to move into a surplus of 0.6% of GDP in 2019. We think that's unlikely. The Conservatives are under intense pressure to keep the economy afloat during Brexit negotiations. Prime Minister Theresa May has indicated she will delay eradicating the budget deficit until the middle of the next decade, having previously promised a 2020 target date. Japan has limited scope to further tighten fiscal policy. Japan's structural primary budget deficit reached 6.9% of GDP in 2010. The IMF expects it to reach 3.7% this year and fall further to 2% in 2020, provided the government goes forward with raising the VAT from 8% to 10%. We are skeptical that Japan's economy will be strong enough to allow the government to raise taxes. However, even if it is, this will only be because the Bank of Japan gooses growth by keeping long-term yields pinned to zero, thereby allowing the yen to depreciate further. China is making a structural transition to large budget deficits. The IMF estimates that China's structural primary budget balance deteriorated from a surplus of 0.1% of GDP in 2014 to a deficit of 2.8% of GDP in 2016. The increase in the fiscal deficit cannot be explained by the reclassification of off-budget spending as on-budget, since the IMF's "augmented" fiscal balance - which attempts to control for such statistical issues - deteriorated by roughly the same amount (Chart 5). Part of the erosion in China's fiscal balance stemmed from the global manufacturing slowdown in 2015-2016, which hit tax receipts and necessitated a healthy dose of fiscal stimulus. However, there is more to the story than that. As we controversially argued in "China Needs More Debt," now that China is no longer in a position to run gargantuan current account surpluses, large fiscal deficits will be necessary to absorb excess private-sector savings.2 The government's desire to rein in credit growth will only add to the impetus to find new sources of aggregate demand. The era of red ink has begun. Chart 4Government Debt Levels Outside Of Germany Are Still High Chart 5China's Fiscal Deficit Has Been Increasing The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has ambitiously proposed. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 6). We think this pessimism is overdone. Donald Trump desperately needs a "win," and cutting taxes is one key area where the President and Congress both see eye to eye. Trump's falling poll numbers have heightened the risk that the Republicans will lose control of the House of Representatives next November (Chart 7). This makes passing a tax bill before the midterm elections all the more urgent. The main questions surround the scale and scope of any tax cuts, and just as critically, how they are paid for. We discuss these issues next. Chart 6Markets Have Priced Out Meaningful Fiscal Stimulus Chart 7Challenging Outlook For Republicans In 2018 Trump's Budget Proposal: Fake Math Chart 8Trump In Wonderland? If the definition of a good leader is one who underpromises and overdelivers, then President Trump's budget proposal left much to be desired. Trump's plan assumes that U.S. growth will reach 3% over the next ten years. Even in the unlikely event that the economy manages to avert a recession over this period, such a growth rate would be a remarkable feat. After all, growth has averaged only 2.1% since 2009. And keep in mind that the unemployment rate has fallen from 10% to 4.4% over this interval, consistent with potential GDP growth of only 1.4%. The slow pace of capital accumulation following the Great Recession undoubtedly hurt the supply side of the economy, but it would take a phenomenal - and rather implausible - acceleration in potential GDP growth to justify Trump's 3% target. Many of the other assumptions in Trump's blueprint are no less dubious (Chart 8). Despite projecting much slower growth, the Federal Reserve expects short-term rates to rise to 3% in 2019. In contrast, the Trump administration sees rates increasing to only 2.4%, an assumption that perhaps not coincidentally helps reduce projected debt-servicing costs. Most flagrantly, the plan assumes no decline in the revenue-to-GDP ratio, even though the basis for faster growth largely rests on the assumption of steep tax cuts. When pressed on the issue, officials from the Office of Management and Budget sheepishly noted that there would be offsetting limits on tax deductions, which would have the effect of broadening the tax base. However, no specific information was given on what these would entail. Many theories have been offered as to why Trump offered such an outlandish budget plan. Was he trying to appease conservatives in Congress? Perhaps this was just a sly attempt to gain leverage in future budget negotiations? Our theory is simpler: Trump promised an economic boom during the election campaign, while assuring voters that his tax cuts would more than pay for themselves. Hell would need to freeze over before he released a plan that did not share these assumptions. Congress Will Decide So where do we go from here? The specifics of Trump's plan are irrelevant. Congress will rewrite the budget from scratch. Major spending cuts will be scrapped. So will the onerous cuts to insurance subsidies and Medicaid in the House version of the health care bill. The Senate will ditch those. In contrast, Trump's tax cuts will be preserved, albeit on a smaller scale than envisioned in his budget proposal. Granted, congressional leaders have said they want tax reform to be revenue neutral, meaning that any tax cuts would need to be offset by other revenue-raising measures. That is easier said than done, however. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - all face severe resistance from vested interests. In Washington, where there is a will there is usually a dishonest way. Budget forecasts are typically made over a 10-year window. Thus, it is possible to lower taxes upfront and promise spending cuts and ill-defined revenue raising measures in the tail end of the budget window. Such a strategy would generate a positive fiscal thrust early on, while leaving the door open for Congress to dump any future spending reduction or revenue measures before they are actually implemented. Add to that the tax revenue that is projected to pour in from supply-side reforms, and the stage is set for a dollop of fiscal easing starting in early 2018. How likely is it that Republicans will pursue such a strategy? Very likely. As evidence, look no further than the fact that White House budget director Mick Mulvaney floated the idea on Wednesday of extending the 10-year budget scoring window to 20 years. Investment Conclusions Chart 9Phillips Curve Is Alive And Well An obsessive focus on fiscal austerity hamstrung the recovery in many countries following the Great Recession. The irony is that fiscal stimulus is coming to America just when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year. Despite all the obituaries that have been written for the death of the Phillips curve, the data show that it is alive and well (Chart 9). Higher inflation will allow the Fed to raise rates once per quarter. The market is not prepared for this. Investors currently expect only 45 basis points in rate hikes over the coming 12 months. That is far too low. On the other side of the Atlantic, the ECB's months-to-hike measure has plummeted from 65 months in July 2016 to only 24 months today (Chart 10). Real rates are projected to be a mere 14 basis points higher in the U.S. than in the euro area in five years' time (Chart 11). Chart 10The Big Shift In Market Sentiment Towards ECB Policy Chart 11The Vanishing Transatlantic Bond Spread Poor demographics and high private-sector debt levels imply that the neutral rate of interest is lower in the euro area than in the U.S. And while the euro area may not be tightening fiscal policy any longer, the fact that its structural primary budget balance is 2.6% of GDP larger than America's means that the euro area's overall fiscal stance will contribute less to aggregate demand than in the U.S. This will force the ECB to keep rates lower for longer, causing the euro to weaken. Chart 12Widening Real Rate Differentials ##br##Support The Dollar Chart 13Speculators Are Long The Euro For ##br##The First Time In Three Years Incredibly, two-year real interest rate differentials between the euro area and the U.S. have widened by 41 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 12). We think this divergence has occurred because investors have been busy covering the euro hedges that they put on in the lead up to the French elections. However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will subside (Chart 13). With all this in mind, we are going short EUR/USD today with a year-end target of parity and a stop-loss of 1.14. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The fiscal thrust is defined as the change in the structural primary budget balance from one year to the next. As a convention, we define a positive thrust as loosening in fiscal policy (i.e., a lower fiscal balance). 2 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, and "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights This week, we are reprising and updating "The Other Guys In The Oil Market" from our sister service Energy Sector Strategy (NRG), because it so well captures the state of oil production outside the U.S. shales, Middle East OPEC and Russia. "The Other Guys" account for ~ half of global supply. Next week, we'll publish a joint report with NRG analyzing today's OPEC meeting. The aptly named "Other Guys" account for ~ 42mm b/d of production, which they are struggling to maintain at current levels, let alone increase. These producers supply nearly half of global production, and have been stuck in a pattern of slow decline for years despite high oil prices. Beginning in 2019, we expect production declines to accelerate. This will put enormous pressure on the three primary growth regions, which markets likely will start pricing in toward the end of next year. Energy: Overweight. OPEC 2.0 is expected to extend its 1.8mm b/d of production cuts to the end of 1Q18 at its meeting in Vienna today. Going into the meeting, markets were being guided to expect even deeper cuts. Our long Dec/17 Brent $65/bbl calls vs. short $45/bbl puts, and our long Dec/17 vs. Dec/18 Brent positions are up 75.0% and 509.5% respectively, following their initiation on May 11, 2017. Base Metals: Neutral. Steel and iron-ore prices are getting a boost from China's anti-pollution campaign, which is expected to run through the end of this month. This was launched ahead of the anti-pollution campaign we expected after the Communist Party Congress in the fall. Iron ore delivered to Qingdao is up 3.1% since May 9, when Reuters reported the campaign began.1 Precious Metals: Neutral. Gold was well bid earlier in the week on the back of a weaker USD. Our long gold position is up 1.9%, while our long volatility trade, which we will unwind at tonight's close, is down 98.5%. Ags/Softs: Underweight. The weaker USD takes some pressure off wheat and beans over the short term, and might prompt a short-covering rally. We remain bearish, however, as the USD likely will bottom in the near future.2 Feature U.S. Onshore, Middle East OPEC (ME OPEC), and Russia combine to produce ~43 MMb/d of oil plus another ~11 MMb/d of other liquids (NGLs, biofuels, refinery gains, etc.). Combined, these producers increased crude production by 5 MMb/d plus another 1 MMb/d of other liquids production over the past three years (2014-2016), creating the oversupply that crashed prices. We expect these producers to add another 1.60 MMb/d of oil plus 1.14 MMb/d of other liquids by 2018 (over 2016 levels), dominated by nearly 2.0 MMb/d of oil and NGLs from the U.S. shales. Oil production from the other 100+ global oil producers also represents about ~42 MMb/d, but on balance has been slowly eroding since 2010, failing to grow even when oil prices were $100+/bbl. Despite some 2017 recovery from Libya, we expect total production to continue to fall in both 2017 and 2018. The few recently expanding producers among the Other Guys are running out of growth. Canada, Brazil, North Sea and GOM account for ~13 MMb/d of oil production in 2016, adding ~1.5 MMb/d over the past three years (2014-2016). North Sea production is projected to resume declines starting in 2017; GOM will reach it peak production sometime in 2017 or 2018, then start to ebb; large new Canadian oil sands projects will add ~310k b/d in 2017-2018, but scarce additions are scheduled beyond that; and Brazil's once-lofty growth plans have slowed to a crawl in 2016-2018. Global deepwater drilling activity and exploration spending have collapsed, lowering the reserve base, and undermining the stability of current production levels. Outside Of Just Three Regions, Oil Supply Picture Looks Worrisome Often overlooked in our discussions about world oil markets are the supply contributions of over 100 geographic regions. This collection of suppliers (which we will call the "Other Guys") is defined as all producing regions in the world other than: 1) U.S. Onshore (shales, specifically), 2) OPEC's six Middle East members, and 3) Russia. The Other Guys deliver nearly half of global production, try to maximize production every day (even OPEC nations among the Other Guys have not had production constrained by quotas), and still have endured consistent, albeit modest, production declines over the past six years. Chart 1Outside Of A Very Few Regions,##BR##Oil Production Has Struggled At the end of 1Q17, oilfield-services leader Schlumberger voiced sharp concerns regarding stability of supplies from these ignored producers, warning that aggregate capital expenditures within these regions will sustain an unprecedented third straight year of decline in 2017, with total spending only about half of 2014 levels. Chart 1 shows the divergent production histories of the three growing regions versus the rest of the world. Chart 1 also shows production of the Other Guys excluding the especially dramatic declines/volatility of Libyan production. Even though these producers benefitted from the same incentives and profitability from high oil prices as the three growing regions, as a group, they have been unable to expand production. As oil prices have plunged, drilling activity in these nations has also plummeted, raising concerns that production declines could start accelerating in the near future. Chart 2 shows that oil-directed drilling activity among the international components of the Other Guys (Chart 2 excludes GOM and highly-seasonal Alaska and Canada) has crashed by ~40%, from an average of over 800 rigs during the five-year period of 2010-2014 to under 500 rigs for the past year. Offshore drilling has collapsed even a little more sharply for these producers than overall oil-directed drilling, falling ~43% from an average of over 280 rigs to only 160 today (Chart 3, excludes GOM). Chart 2Other Guys' Drilling##BR##Has Collapsed 40% Chart 3International Offshore Drilling Is Down Over 40%,##BR##Boding Poorly For The Stability Of Future Production Offshore Production Declines To Accelerate Chart 4Other Guys' Offshore Drilling Has Collapsed As a particularly worrisome trend for the Other Guys' production stability, offshore drilling activity has collapsed in some of the most important offshore oil producing regions in the world, including the GOM, North Sea, West Africa, and Brazil (Chart 4). Considering the multi-year lag between drilling activity and the start of oil production, and the large well size and quick declines associated with offshore wells, the oil production impacts of this drilling collapse that started two years ago have not really been felt yet. When these regions get past the wave of new production from 2015-2017 project additions (projects started during 2011-2014), they will face a dearth of new projects maturing in 2018-2022 due to this collapse in drilling, with new production likely to be inadequate to offset the declines of legacy production. Brazil, the North Sea, West Africa, and GOM together account for about 12 MMb/d of oil production (Chart 5). These four offshore regions have benefitted from intense investment from 2010-2015 as shown by the surging rig counts during that period in Chart 4. This investment/drilling drove 1.1 MMb/d of oil production growth in Brazil, the GOM, and the North Sea from 2013 to 2016, without which total production from the Other Guys would have declined by 1.4 MMb/d rather than just 0.3 MMb/d. Despite strong investment, production in West Africa merely held flat outside of Nigeria during 2013-2016 while falling by 0.4 MMb/d within Nigeria (mostly in 2016 due to pipeline disruptions from saboteurs). Chart 5Offshore Production Will Stop Expanding, Then Decline Brazil offshore drilling activity over the past year is less than half of levels during 2010-2013. As a result, production growth will moderate significantly over the next few years, expanding far less (250k b/d in 2018 vs. 2016, based on our balances data) than the rapid 470,000 b/d step-up in production during 2013-2014. While Brazil still has a rich endowment of pre-salt reserves, marshalling capital and the International Oil Companies' (IOCs) focus to resurrect development activity will take years. We expect no growth during 2019-2020. The North Sea has seen production cut in half from the time of peak production in 1999 until 2013. Production declines were briefly halted and re-expanded by ~300,000 b/d during 2014-2016 due to a concerted drilling effort and brownfield maintenance program incentivized and financed by $100/bbl oil prices. Drilling has since declined 35% from average 2010-2014 levels, and production is expected to resume its downward trend in 2017-2018. Overall oil-directed offshore drilling in the GOM has been cut by over 50% from 2013-2014 levels. Based on our field-by-field analysis published in January, we estimate GOM oil production will hit a peak in a year and a half or less and then will succumb to declines due to lack of new drilling. West Africa has suffered production declines for the past several years due to both geologic challenges as well as more recent (2016-2017) political/sabotage related disruptions in Nigeria. With offshore drilling activity plummeting 70%-80%, we expect production declines will accelerate and it will take years of increased drilling to yield new production that can stem the declines. The collapse in Nigerian drilling, from 10 rigs in 2010-2013 to only 2-3 rigs over the past year, likely means that Nigerian production is incapable of returning to 2015 levels even if its recent sabotage issues are resolved. In aggregate, as shown in Chart 5, we expect production from these four offshore regions to stagnate during 2017-2018 (North Sea and West Africa decline while Brazil and GOM expand) before declining by ~0.5 MMb/d in each 2019-2020 due to the dramatic curtailment of investment during 2015-2017. SLB Talks Its Book, But Makes A Strong Point At an industry conference at the end of March, Schlumberger (again) railed against the inadequacy of the cash flow-negative U.S. shale industry to single-handedly supply enough production growth to satisfy continuing global demand growth, especially once the Other Guys start seeing more pronounced negative production effects from the sharply reduced investments over 2015-2017. "The 2017 E&P spend for this part of the global production base...is expected to be down 50% compared to 2014. At no other time in the past 50 years has our industry experienced cuts of this magnitude and this duration." - Paal Kibsgaard, CEO of SLB. SLB highlighted an analysis of depletion rates constructed with data from Energy Aspects. (The March 27 presentation can be found at www.slb.com). Annual depletion rates (annual production/proved developed reserves) in the GOM had spiked to over 20% in 2016 from a long-term level of only ~10% during 2000-2013. Similarly, depletion rates in the U.K. and Norwegian sectors of the North Sea also surged from ~10% to ~15% over the past three years. In both the GOM and the North Sea, oil production had recently been expanded, but proved developed reserves declined. Due to such low drilling investments during 2015-2016, producers have replaced only about half of the oil reserves that they've produced in the GOM and North Sea over the past three years (2014-2016). Eventually, this lack of investment in cultivating tomorrow's resources will catch up to the industry, and production will decline. Investors must take SLB's commentary with a grain of salt, as they could be construed as sour grapes. The immense pull of new capital spending to the U.S. shales has substantially benefitted SLB's primary competitors more than it has benefitted SLB (SLB is much more focused on international and offshore projects). Still, investors are too complacent about the stability of non-U.S. production. SLB's analysis and warnings of accelerating production declines should not be ignored. Bottom Line: Outside of the three regions of sharply growing production (U.S. onshore, ME OPEC and Russia) that investors are focused on, the other half of global production has been stagnant to declining despite high oil prices and high levels of drilling during 2010-2015. Now that drilling and capex in these regions has declined by 40%-50%, production declines should accelerate in coming years. Offshore production, especially, has not seen enough drilling to replace reserves, and is poised to decline within the next 2-3 years. The accelerating declines of the "Other Guys" will allow more room for growth from U.S. shales, ME OPEC and Russia. Matt Conlan, Senior Vice President, Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see "China steel hits nine-week peak amid crackdown, lifts iron ore," published by reuters.com May 22, 2017. 2 Please see the feature article in last week's edition of BCA Research's Foreign Exchange Strategy entitled "Bloody Potomac," in which our colleague Mathieu Savary lays out the case for an imminent USD rebound. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights Duration: The opposing forces currently pulling on global bonds - softer growth and core inflation readings vs. tightening labor markets - are keeping yields locked into narrow trading ranges. We expect the strength of the global upturn to reassert itself, leading to higher government bond yields and corporate credit outperformance over the balance of 2017. U.K./Canada/Australia: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a relatively flatter curve in Canada and a relatively steeper curve in the U.K. Portugal Trade Update: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Feature Chart of the WeekMarket Volatility Is Low For A Good Reason What was once a fairly straightforward narrative for global bond markets earlier this year is now being challenged. Growth data has cooled a bit in the U.S. and China, while commodity prices have fallen, suggesting that the global economy may be losing steam even with leading indicators still rising and the European economy looking robust. At the same time, core inflation measures have ticked lower despite the signs of tighter labor markets throughout the developed world. These moves on the margin have stalled the upturn in global bond yields, resulting in lower fixed income market volatility that is likely playing a role in keeping realized equity market volatility at depressed levels (Chart of the Week). We continue to see the recent pullback in U.S. data as being temporary in nature. The economy should improve in the coming months given the still-solid trends in U.S. corporate profits and household income and the still-low level of interest rates. The signs of a building China slowdown are potentially more worrisome, especially on the inflation front given how much Chinese demand has boosted commodities and overall traded goods prices over the past year. Although we are not expecting a major Chinese downturn that could spill over more broadly to the world economy, it is likely that the next leg up in inflation in the developed economies will come from diminished spare capacity and rising core inflation, rather than a commodity-driven reacceleration of headline inflation. We continue to recommend a strategic underweight overall portfolio duration stance, as we expect the Fed to deliver on its planned rate hikes before year-end and the European Central Bank (ECB) to soon begin signaling a tapering of its asset purchases next year. We continue to favor corporate credit over sovereign debt, particularly in the U.S., given the strength of the current global upturn, but staying up in credit quality (i.e. focusing on Investment Grade and higher-rated credit tiers in High-Yield). Stuck On Neutral: Considering Trades Between Canada, Australia & The U.K. Over the past few months, we have upgraded our stance on government bond exposure in the U.K., Canada and Australia - all to neutral and all for essentially the same reason. There was not a compelling enough case to expect any of the central banks in those countries to move interest rates before year-end, in either direction, given the lack of sustainable inflation pressures and mixed messages on growth. With policymakers stuck on hold for the foreseeable future, keeping our recommended bond weightings at benchmark was the logical (albeit unexciting) choice. Even the mixed messages sent by our own bond indicators highlight the difficulty in making a decisive market call at the moment. Our Central Bank Monitors for Canada and Australia have recently flipped into the "tighter policy required" zone, joining the U.K. Monitor which has been there for some time (Chart 2).1 This would suggest moving to an underweight stance in anticipation of tighter monetary policy in those countries that is currently not priced into money market curves (bottom panel). Yet the best performing bond market of the three over the past two years has been the U.K. - a trend that started before last year's Brexit vote when the U.K. economy was in relatively good shape and the Bank of England (BoE) was starting to send hawkish messages. Gilts now look the most overvalued judging by the current negative real yields on offer (Chart 3), yet our U.K. Central Bank Monitor is showing signs of topping out, further adding to the confusion. Chart 2Markets Don't Expect Anything From BoE/BoC/RBA Chart 3Gilts Look Most Expensive Having mixed directional signals, however, does not imply that there are not trade opportunities within these markets. Even if the BoE, the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are not in a hurry to begin hiking interest rates, domestic growth and inflation pressures are building at a different pace within these economies, creating potential cross-market trade opportunities. Economic Growth: Canada has the strongest leading economic indicator, manufacturing PMI and consumer sentiment, but the softest business confidence (Chart 4) - perhaps because of concerns over the future protectionist trade policies of U.S. President Donald Trump. In the U.K., a combination of falling real wage growth and persistently high levels of political uncertainty after Brexit are weighing on consumer sentiment, yet business confidence is the strongest of the three countries. Meanwhile, overall confidence in Australia is the weakest, even with manufacturing in a strong upturn. Most worryingly, real consumer spending is slowing rapidly in all three countries, although it is holding up relatively better in Canada. Inflation: The differences in price pressures are less pronounced (Chart 5). Inflation rates are similar among the three economies as Australian core CPI inflation appears to have finally bottomed out in the first quarter of this year after falling steadily since 2014. All three countries are witnessing decelerating wage growth, however, even with solid job growth in Canada over the past year. Spare capacity measures like the output gap and unemployment gap show the U.K. economy being closest to full employment (Chart 6). Spare capacity is steadily being absorbed in Canada, although the BoC attributes this to a slower pace of potential GDP growth, according to last month's BoC Monetary Policy Report (MPR).2 Chart 4Canadian Economic Data Looks Strongest Chart 5No Major Inflation Differences Home Prices & Debt: The housing markets remain an issue in Canada and Australia, where home prices look severely overvalued with household debt at elevated levels (Chart 7). The governments in both countries are trying to use regulatory and macro-prudential solutions to cool red-hot housing demand, but rapid growth in housing wealth remains a source of stimulus for consumers at the moment. The situation is different in the U.K., where home valuations and debt levels are nowhere near as elevated as in the other two countries (although London homeowners may disagree). Chart 6No Spare Capacity In The U.K. Chart 7Household Debt A Concern In Canada & Australia Exports: Each country is also exposed to a different major economy via the export channel. The OECD leading economic indicators for the U.S., Euro Area and China (the largest export markets for Canada, the U.K. and Australia, respectively) are all ticking higher, suggesting that export demand should pick up for Canada, the U.K. and Australia in the near term (Chart 8). However, Australian exports to China have already expanded at a 60% annual rate and our Emerging Market and China strategists are expecting some cooling of Chinese growth in the latter half of this year; slower export growth should be expected. Chart 8An Unsustainable Surge In Aussie##BR##Export Demand From China After adding up all the pieces, it is still difficult to select one government bond market over the others in absolute terms. The U.K. would appear to have the least bond-friendly backdrop, with higher inflation and very low real interest rates. Yet the BoE is worried about many factors - Brexit uncertainties on trade and business confidence, declining real household income growth - that should prevent them from shifting to a less accommodative monetary stance before year-end that would involve reduced Gilt purchases and/or outright interest rate hikes. Conversely, Australia seems to have the most bond-bullish climate - a still-negative output gap, plunging consumer confidence, very low inflation and the heaviest exposure to a Chinese economy that is set to cool off. Yet while core inflation remains low at 1.5%, it appears to be bottoming out and the RBA is currently forecasting that its preferred measure of underlying inflation will move up to 2% - the low end of its 2-3% target range - by early 2018, according to their just-released Statement on Monetary Policy.3 In Canada, the BoC continues to take a very cautious view on Canadian growth, despite the robust 4% real GDP growth seen in the first quarter of this year. Sluggish growth in exports and capital spending is expected to be a drag on growth this year, according to the April BoC MPR. Yet the central bank is now "decidedly neutral" and is no longer considering a rate cut as it was earlier this year according to BoC Governor (and BCA alumnus) Stephen Poloz.4 Given all the various factors pushing and pulling on these three economies and central banks, it is perhaps no surprise that yield moves have been highly correlated across these bond markets over the past several months (Chart 9). The most attractive near-term risk/reward opportunities now appear to be in relative yield curve trades rather than directional allocations or cross-country spread trades. Specifically, we see an opportunity to play for a steeper Gilt curve, and a relatively flatter Canadian government bond curve, via a 2-year/30-year box trade. Given the strong readings on current and leading economic indicators in Canada, combined with our view that the recent patch of slower U.S. growth will prove to be temporary, we see the greatest potential for upside growth surprises in Canada. The BoC is likely to wait before delivering rate hikes until there is decisive evidence of accelerating inflation, especially given the potential economic risks deriving from the Canadian housing bubble. However, better-than-expected growth will exert more flattening pressure on the Canadian yield curve than the U.K. or Australian curves, where downside growth risks are greater. Already, the very front end of the Canadian curve is starting to disengage from the U.K. and Australian curves, with the 2-year/5-year flattening modestly in Canada and the other markets showing steepening curves at similar maturities (Chart 10, top panel). We expect that relative flattening pressure to exert itself further out the yield curve for Canadian government debt over the latter half of 2017. Chart 9Yields Are Highly Correlated... Chart 10...Curve Slopes, Slightly Less Correlated In the U.K., the long end of the Gilt curve has rallied to very rich levels, with the 10-year/30-year slope now trading near the bottom of the range that has prevailed since 2014 (bottom panel). Much of that has been driven by a decline in longer-term inflation expectations that has accompanied the more stable British Pound. While the uncertainty surrounding the upcoming Brexit negotiations with the European Union will likely weigh on business confidence and investment spending in the U.K., the immediate impact of the robust Euro Area economy on U.K. exports should provide a boost to U.K. economic growth. Coming at a time when the U.K. is at, or even beyond, full employment, this should put some mild upward pressure on inflation expectations further out the curve, leading to steepening pressures on a relative basis to Canada. This can already be seen in looking at the 2-year/30-year yield curve box between the Canada and the U.K. in Chart 11. In all three panels, we show the steepness of the Canadian bond curve minus that of the Gilt curve, alongside the differentials in actual inflation, and market-based inflation expectations from the index-linked markets, between Canada and the U.K. As can be seen in the top two panels, the Canadian curve looks too steep relative to the U.K. curve given the higher rates of headline and core inflation in the U.K. The bottom panel shows that the 2-year/30-year box is in line with the relative inflation expectations within the two countries. We see this as a sign that U.K. inflation expectations are too low relative to actual U.K. inflation, leaving the Gilt curve too flat relative to the Canadian curve. While this would appear to argue for a relative trade between inflation-linked bonds in Canada and the U.K., the poor liquidity of the small Canadian linker market makes this a difficult trade for most investors to put on. We prefer to express the view via yield curves, particularly with the 2-year/30-year Canada-U.K. box currently priced in the bond forwards to move sideways over the rest of the year (Chart 12). This means that betting on a steeper Gilt curve relative to Canada does not incur negative carry - important for a trade with a more medium-term horizon like this. Chart 11Gilt 2/30 Curve Too Flat Relative To Canada Chart 12Enter A 2/30 Canada-U.K. Box Trade This week, we are adding this 2-year/30-year Canada-U.K. position to our strategic model portfolio at -7bps. The initial target is for the box to return to -50bps - the bottom of the range that has prevailed since 2015. A deeper decline would occur if the BoC begins to signal a rate hike in Canada at some point that puts even more flattening pressure on the Canadian curve, although that is not our base case expectation over the rest of 2017. The risk to the trade would come from a deceleration of U.K. inflation that eliminates the current divergence between realized and expected inflation. What about Australia? We anticipate that there will be an opportunity to move to an eventual overweight position in Australian bonds in the coming months to position for the slowing of Chinese growth, and the related demand for Australian exports, that we expect. We are choosing to stay neutral for now, however, given the current uptick in Australian inflation that muddies the water on any call on RBA monetary policy. Bottom Line: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a flatter curve in Canada and a steeper curve in the U.K. Tactical Overlay Housekeeping: Cutting Losses On Portugal Shorts One of our long-held positions in our Tactical Overlay trade portfolio has been a short position in Portugal 10-year government bonds versus a long position in 10-year German Bunds. We put the trade on last summer as part of a broader allocation at the time out of Peripheral European sovereign debt into core European debt. The logic was straightforward - the combined stress of decelerating economic growth and struggling banking systems in the Periphery (made worse by the ECB's negative interest rate policies) would result in some spread widening in Italy, Spain and Portugal. While that story remains true in Italy, both leading economic indicators and measures of financial sector risk like credit default swap (CDS) spreads for senior banks have a decline in Spain and Portugal. While we have already upgraded our recommended allocation to Spanish debt in our model portfolio, we had been reluctant to consider a similar move in Portugal given our concerns about its economy and, more importantly, its banking system. But with leading economic indicators starting to perk up and bank CDS spreads in Portugal falling sharply, and with German Bund yields rising alongside growing market nervousness of a potential ECB taper, Portugal-Germany spreads have tightened sharply. We are belatedly cutting our losses on this position this week and closing out the position at a loss of -1.6%. We plan on publishing a deeper dive on Portugal in the coming weeks to update our views on the country and its bond markets. Bottom Line: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28 2017, available at gfis.bcaresearch.com. 2 http://www.bankofcanada.ca/wp-content/uploads/2017/04/mpr-2017-04-12.pdf 3 http://www.rba.gov.au/publications/smp/2017/may/pdf/statement-on-monetary-policy-2017-05.pdf 4 https://www.bloomberg.com/news/articles/2017-04-12/poloz-sees-faster-canada-return-to-full-capacity-key-takeaways The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by the global risk appetite, as approximated by corporate spreads, and commodity prices. Based on our timing model­s, the countertrend correction in the dollar is toward its tailend. Any additional weakness should be used to buy the greenback. The euro is now expensive based on our timing model. However, it could become slightly more expensive as markets continue to price in the euro area-friendly outcome of the first round of the French election. Feature In July 2016, in a Special Report titled "In Search Of A Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline, a sanity check if you will, to our regular analysis. In this report, we review the logic underpinning these intermediate-term models and provide a commentary on their most recent readings for the G10 currencies vis-à-vis the USD. UIP, Revisited The uncovered interest rate parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is the one that will make an investor indifferent between holding the bonds of country A or country B. This means that as interest rates rise in country A relative to country B, the currency of country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of country B (Chart 1). Chart 1Interest Rate Differentials Remain Useful ##br##Gauges For XR Determination There has long been a debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. Research by the Fed and the IMF suggest that incorporating longer-term rates to UIP models increases their accuracy.2 This informational advantage works whether policy rates are or aren't close to their lower bound.3 Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements do not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of investor indifference between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.4 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from each other. It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan comes to the front of the mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 2Over The Long Run, Real Rate ##br##Differentials Work Best Chart 3Real And Nominal Rates ##br##Can Be Different Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real, not nominal long-term rate differentials. Global Risk Aversion And Commodity Prices Chart 4The Dollar Benefits From Global Woes Global risk appetite is also a key factor to consider when trying to model exchange rates. Risk aversion shocks tend to lead to an appreciation in the dollar, which benefits from its status as the global reserve currency.5 Much literature has often focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power for the option-adjusted spreads on junk bonds (Chart 4). Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.6 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resource prices constitute a terms-of-trade-shock for them. However, this relationship holds up for the euro as well, something already documented by the ECB.7 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe: Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite: Proxied by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. Real rates differentials, junk spreads, and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a 3-9 month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). The U.S. Dollar Chart 5Dollar Fundamentals Strengthening... Chart 6...But Timing Could Be Better To Buy DXY To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss, and Swedish real rates weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. The FITM for the DXY has stabilized and is now slowly moving upward (Chart 5). The ITTM itself is even pointing upward, arguing that the dollar is at a neutral level and that its previous overshoot has now been corrected. However, historically, the DXY rarely stabilizes at its fair value, overshooting the mark instead. Based on historical behavior, the DXY is likely to undershoot its ITTM by another two percent or so before an ideal entry point to buy the USD emerges (Chart 6). Longer term, we continue to expect the dollar to stay on an upward trend. The U.S. neutral rate remains above that of Europe and Japan. Moreover, U.S. economic slack is dissipating much faster than in Europe, and the U.S. may already be in the process of hitting its own capacity constraints. This suggests that the Fed has much greater scope to normalize policy than the ECB. With the OIS curve pricing in a 25 basis point hike in the U.S. over the next 12 months, this will support the USD versus the euro. Japan, too, exhibits increasing signs of limited slack in its economy. However, with the BoJ committed to an inflation overshoot in order to upwardly shock moribund Japanese inflation expectations, we think that Japanese real rates will lag U.S. ones, putting significant upside on USD/JPY. The Euro Chart 7Euro Fundamentals Are Deteriorating Chart 8The Euro Is No Longer Cheap The FITM for EUR/USD has rolled over and is now pointing south, suggesting that fundamentals are moving against the euro (Chart 7). This reflects large rate differentials between the U.S. and the euro area, but also, the recent softness in some corners of the commodity complex. Last spring, the FITM did a good job forecasting the rebound in the euro, and the fact that it is flagging impeding euro weakness deserves to be highlighted. In terms of entering a short EUR/USD tactical bet, at the current juncture, the ITTM suggests an entry point is soon to emerge (Chart 8). Now that the dueling pair of the second round of the French election has been determined - Macron vs Le Pen - the euro was able to price out nightmare scenarios involving two Eurosceptic candidates. In fact, with the realization that Macron holds a 20% lead over Le Pen in second round polling, the market has begun to completely price out any euro-endangering outcome for the French election. This means that the euro is likely to move toward its historical premium to the ITTM before reverting toward its cyclical downtrend. Practically, this means that EUR/USD could run toward 1.11-1.12 before rolling over, something that may happen by May 8th. On a 12- to 18-months basis, we are comfortable with the current message from the FITM. The European economy may be growing above trend, but there remains enough slack in Europe that wage and core inflation dynamics are still very muted. This contrasts with the U.S. economy, where most indicators we track argue that wages and core inflation should gain some upward momentum this year. This means that rate differentials between the euro area and the U.S. are likely to underperform even what is priced into the relative interest rate curves. This should weigh on EUR/USD as the euro is not cheap enough to compensate for these economic dynamics. The Yen Chart 9A Dovish BoJ Will Weigh ##br##On Yen Fundamentals Chart 10The Yen Is No Longer ##br##Tactically Cheap The FITM model shows that the post-election rally in USD/JPY was overdone as the yen's fundamentals have stopped deteriorating after October 2016 (Chart 9). As we see the growing likelihood of a decreasing deflationary impulse in Japan, the strong dovish commitment of the Bank of Japan should pull Japanese real rates lower vis-à-vis their U.S. counterparts. This underpins why we remain cyclical bears on the yen. Tactically, based on the ITTM, it will soon be time to close our short USD/JPY trade. While the yen had massively undershot any rational anchor in the wake of the Trump electoral victory, this undervaluation appears to have vanished after the yen's sharp rebound (Chart 10). A small overshoot in the yen is likely, but unless one is already short USD/JPY, this move should not be chased. In fact, USD/JPY below 108 should be used as an opportunity to reverse yen longs and play what may prove to be a powerful USD/JPY rally. The British Pound Chart 11GBP: A Long-Term Bargain... Chart 12...But Upside Against USD Is Limited According to the FITM, the pound's fair value has been stable post-Brexit, but it is now beginning to point lower. However, despite this turn of events, GBP/USD is currently trading at such an exceptional discount to the FITM - courtesy of a heightened geopolitical risk premium - that this deterioration in fair value is unlikely to matter much (Chart 11). Nonetheless, the fact that fundamentals have a negative directional bias for cable is prompting us to express our tempered optimism toward the pound by shorting EUR/GBP instead of buying GBP/USD. At a tactical level, the ITTM suggests that GBP/USD could have a bit more upside. GBP/USD is at equilibrium based on our timing model, but undershoots tend to be compensated by subsequent overshoots (Chart 12). That being said, with the ITTM still pointing south - in line with the FITM - any further rebound in GBP/USD is likely to prove to be limited. GBP/USD beyond 1.33 should be used as an opportunity to sell cable. On a multi-year basis, GBP is quite cheap, not only on a PPP basis, but also when incorporating relative productivity dynamics. This means that while we have a positive dollar-bias over the next 12-18 months, our favorite non-USD currency is currently the GBP. The June 8th general election is likely to give Theresa May the parliamentary majority she needs to have a more comfortable negotiating position with the EU, helping her obtain more advantageous terms for the U.K., re-enforcing our positive long-term bias on the GBP. The Canadian Dollar Chart 13Oil And Spreads Are Working##br##Against The Loonie... Chart 14...And So Is##br## Wilbur Ross According to the FITM, the aggregate fundamentals have rolled over and are beginning to point directionally south for the loonie: Oil has lost momentum, and rate differentials are not particularly flattering for the CAD (Chart 13). That being said, the CAD has greatly lagged these same fundamentals, probably as investors have been pondering the potential negative implications for NAFTA and Canada of the Trump administration. Our ITTM suggests that with this handicap taken into account, the CAD may not be a short after all (Chart 14). However, because the CAD is more sensitive to the trend in the broad U.S. dollar and general commodity prices than anything else, we prefer to express a positive bias on the loonie by buying it against the AUD, a commodity currency that does not trade at the same discount to its ITTM. The Swiss Franc Chart 15Inflationary Dynamics Should##br## Continue To Weigh On The Franc Chart 16No Clear Timing##br## Signals Yet Even if flat for the past year or so, the directional fundamentals on the Swiss franc vis-à-vis the USD still seems to be in a long-term bear market (Chart 15). This simply highlights the fact that with the U.S. economy able to generate some inflationary dynamics while Switzerland continues to suffer from pronounced deflationary anchors, U.S. real rates have more room to move upward than Swiss ones. In terms of timing, the ITTM is in the neutral zone, suggesting that there is no particularly compelling reason to buy or short USD/CHF at the current juncture (Chart 16). The SNB is unofficially targeting a floor under EUR/CHF around 1.06 to tame the deflationary impulse in Switzerland. While the Swiss economy is improving, it is not yet strong enough to handle a removal of this policy. In all likelihood, this means that for the rest of 2017, USD/CHF will remain a near-perfect mirror image of EUR/USD. The Australian Dollar Chart 17Iron Ore Prices: From Friend To Foe Chart 18No Valuation Cushion For AUD AUD/USD has not been able to break above 0.77, and the reason simply is that the forces embedded in the FITM have sharply rolled over (Chart 17). Not only have commodity prices stopped appreciating - with iron prices, the most crucial determinant of Australia's terms of trade down 21% - but U.S. short rates and long rates have been going up relative to Australia. Most disturbing for Australia, unlike the CAD it does not possess any cushion when analyzed through the prism of our ITTM (Chart 18). This suggests that the deteriorating Australian fundamentals are likely to be directly translated into a lower AUD/USD. Moreover, historically, previous undershoots in the AUD were followed by an overshoot. We do not think this time is any different; but the dovish slant of the RBA and the drubbing received by iron ore prices suggest that if the AUD overshoots, it will be because it may not fall as fast as its fundamentals at first. If that is the case, we do expect a catch-up later this year. As previously mentioned, the relative dynamics between the Canadian and Australian ITTM suggest that investors in commodity currencies should short AUD/CAD. Moreover, on a longer-term basis, we also favor oil producers over metal ones. The supply dynamics in the oil market are much more favorable than for metals. Not only have many global oil producers cut down their output, our sister publication Commodity And Energy strategy expects the OPEC + Russia agreement to be extended for the rest of 2017.8 Meanwhile, metal production cutbacks have been much more timid. The New Zealand Dollar Chart 19NZD Suffers From ##br##Similar Ills As AUD... Chart 20...However Inflationary Backdrop##br## Is More Favorable The fundamentals for the New Zealand dollar have also rolled over after having pointed to a strong Kiwi since February 2016 (Chart 19). Interestingly, the rollover in the NZD FITM has not been as sharp as the rollover in the Australian Dollar's FITM. The ITTM does argue that as with the CAD, the NZD does have a healthy margin of maneuver before the deteriorating fundamentals become a bidding constraint (Chart 20). In fact, the recent NZD weakness may have exaggerated the underlying deterioration in NZ data. The recent stronger-than-expected inflation data may prompt investors to reconsider their very dovish take on the RBNZ. Our preferred fashion to take advantage of the NZD's discount to its ITTM is also against the AUD. Both currencies are very exposed to EM and China shocks, and both currencies display a similar beta to the USD. As such, it is very rare for the NZD to trade at a discount to the ITTM while the AUD is at equilibrium. With the New Zealand domestic economy in better shape than that of Australia, our bet is that both currencies will have to converge, which should weigh on AUD/NZD. The Norwegian Krone Chart 21NOK Fundamentals Have Worsened ##br##Even With Firm Oil Prices Chart 22Not A Good Time To##br## Buy The Krone Yet Like other currencies, the fundamentals for the Norwegian krone have begun to roll over. The sharpness of that turnaround is particularly striking when one considers that oil prices have remained resilient, despite their recent weakness (Chart 21). NOK has taken the cue from the FITM and has weakened in line with fundamentals. Is it time to lean against this weakness and buy the NOK now? We doubt it. The NOK may benefit against the USD if the euro overshoots in the wake of the French election. However, the NOK has yet to correct previous overshoots, and the fact that it currently trades in line with the ITTM suggests that it provides very little insulation against any further deterioration in its own fundamentals (Chart 22). In the longer term, we are more positive on the NOK. It is cheap based on long-term models that take into account Norway's stunning net international position of 203% of GDP. Moreover, the high inflation registered between 2015 and 2016 is now over as the pass-through from the weak trade-weighted krone between 2014 and 2015 is gone. This means that the PPP fair value of the NOK has stopped deteriorating. The Swedish Krona Chart 23Dollar Strength Has Dislodged ##br##The SEK From Fundamentals Chart 24Taking Momentum Into Account##br## The SEK Is Not Cheap The SEK continues to display one of the highest beta to the USD of all the G10 currencies. As a result, when the USD is strong, even if fundamentals do not warrant it, the SEK is especially weak. The rally in the USD in the second half of 2016 took an especially brutal toll on the krona, which has dissociated itself from its pure fundamentals. If the dollar follows the recent improvement in its own FITM, then SEK too will weaken despite its apparent undershoot (Chart 23). Now, however, the SEK's weakness will follow the deterioration in directional fundamentals. The timing model corroborates this picture. The ITTM takes into account the trend of USD/SEK, and when this is done, the undervaluation of the SEK disappears (Chart 24). Over the next three to nine months, we expect U.S. rates to have more upside relative to European ones than is currently priced in by markets. Therefore, we anticipate the USD to strengthen further, and as a corollary, the SEK will suffer especially strongly under these circumstances. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report, "Assessing Fair Value In FX Markets," dated February 26, 206, available at fes.bcaresearch.com and gis.bcaresearch.com 2 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound," Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 3 Michael T. Kiley (January 2013). 4 Please see Yin-Wong Cheung, and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 5 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016). 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016). 7 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach," Working Paper No.85, European Central Bank (November 2001). 8 Please see Commodity And Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Lean against depressed and euphoric interest rate expectations. The ECB will remove or fade the negative deposit rate, with an outside chance that it happens this year. The U.K. economy will determine the nature of Brexit - not the other way round. The snap General Election doesn't change anything. Expect an ongoing narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. Expect the following order of currency performance: euro first, pound second, dollar third. Expect the FTSE100 to outperform the Eurostoxx50. Feature The interplay between interest rate expectations - in the U.K., U.S. and euro area - is one of the most important factors in explaining what has happened, what is happening, and what will happen, to financial markets. Chart of the WeekBrexit Depression Has Unwound; ##br##Trump Euphoria Hasn't... Yet Interest rate expectations convincingly explain the movements in the U.S. T-bond/German bund yield spread, the U.S. T-bond/U.K. gilt yield spread, euro/dollar, and pound/dollar. Thereby, they also explain FTSE100/Eurostoxx50 relative performance which is just an (inverse) currency play. Chart I-2, Chart I-3, Chart I-4, Chart I-5 and Chart I-6 should leave readers in absolutely no doubt. Chart I-2Interest Rate Expectations Explain The ##br##T-Bond/German Bund Yield Spread Chart I-3Interest Rate Expectations Explain The##br## T-Bond/U.K. Gilt Yield Spread Chart I-4Interest Rate Expectations ##br##Explain Euro/Dollar Chart I-5Interest Rate Expectations##br## Explain Pound/Dollar Chart I-6Pound/Euro (Inversely) Explains ##br##FTSE100/Eurostoxx50 Lean Against Depressed And Euphoric Interest Rate Expectations Last year's shock victories for Brexit and Trump dramatically swung the market mood towards the U.K. and U.S. economies. After Brexit, the knee-jerk response was depression; after Trump, the knee-jerk response was euphoria. But extreme mood swings to depression and euphoria are rarely justified, and ultimately tend to unwind. Responding to last year's dramatic mood swings, U.K. and U.S. interest rate policy - both actual and expected - moved very sharply in opposite directions. Following the Brexit vote, the BoE cut the base rate by a quarter percent, and the rate expected two years out plunged by three quarters of a percent. In contrast, following the Trump victory, the Federal Reserve twice hiked the Fed funds rate by a quarter percent, and the rate expected two years out surged by more than a percent. Meanwhile, throughout all this activity, the ECB repo rate and deposit rate were anchored at zero and -0.4% respectively, and the interest rate expected two years out remained in negative territory. Fast forward to today, and the U.K. interest rate expected two years out has fully unwound the Brexit vote depression - the expected BoE policy rate two years out stands exactly where it stood before the EU Referendum. In contrast, the expected Fed policy rate two years out retains its Trump euphoria (Chart of the Week). Meanwhile, the expected ECB policy rate two years out remains anchored close to the realistic limit of negativity. To reiterate, the extreme market moods of depression and euphoria are rarely justified, and tend to unwind. On this basis, we can say that policy rate expectations in relative terms now have the scope to: Get less depressed in the euro area. Remain broadly unchanged in the U.K. Get less euphoric in the U.S.1 Hence, on a 12-month horizon, expect a continued narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. For currencies, expect the following order of performance: euro first, pound second, dollar third. And therefore, expect the FTSE100 to outperform the Eurostoxx50. Brexit: A Reductionist View Many millions of words have been written about Brexit, and we suspect that many millions more will be written. But true to our reductionist philosophy, we can reduce those millions of words to a single sentence. Brexit was, is, and always will be, about the trade-off between national sovereignty and access to the European single market. Irrespective of the vote to leave the EU and the start of the divorce proceedings, the full spectrum of possibilities in this trade-off is still open to the U.K. At one extreme the U.K. could get a full divorce, and thereby regain absolute national sovereignty in all areas including law and immigration. But in this full divorce, the EU27 would regard the U.K. as a complete outsider whose status is little different to say, Russia. At the other extreme, the U.K. could near enough replicate its current economic and political relationship with the EU27 in a 'pseudo-marriage'. Technically, the U.K. would be divorced, but practically, there would be only minor differences to being married. Although the U.K. would lose its official place at the EU top table, in all likelihood the EU27 would still listen to the British voice given the U.K.'s size and global standing. But in this pseudo-marriage the EU27 would exact a cost: the U.K. could not regain any national sovereignty. All points on the spectrum between a full divorce and a pseudo-marriage are now available to the U.K. The relationship that the U.K. ends up with depends on the trade-off that the British public - and therefore its political representatives in the government and parliament - will accept. In turn, this will depend on the evolution of the economy and standards of living. A strong economy will embolden the British public to want something close to a full divorce. Conversely, a weakening economy might be blamed, rightly or wrongly, on Brexit. In which case, public opinion would shift towards something closer to a pseudo-marriage. Therefore, the causality runs from the economy to Brexit, not from Brexit to the economy. The U.K. economy will determine where the U.K. ends up on the Brexit spectrum - at least, in terms of the initial deal. The snap General Election doesn't change anything. Nor is the General Election a game changer for the pound. The preceding section demonstrated that relative interest rate expectations - rather than Brexit per se - are driving the pound. We expect the BoE to remain relatively inactive because empirically, U.K. real consumption is hyper-sensitive (inversely) to inflation. When inflation is too high, real consumption growth is undermined, making it difficult to hike rates; and when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-7). This ties the hands of the BoE, and explains why the post EU Referendum emergency rate cut has been the BoE's only interest rate change since early 2009! Chart I-7Why The Bank Of England's Hands Are Tied While rate expectations can get less depressed in the euro area, and less euphoric in the U.S., they are likely to change least in the U.K. Hence, we like the pound less than the euro; but we like the pound more than the dollar. Role Playing On The ECB Governing Council We are writing ahead of the ECB policy meeting, but we do not anticipate any substantive announcements - given that we are only half way through the French Presidential Election. In the absence of major developments, the euro's strong recent advance might take a tactical breather. But what then? Some people argue that ECB policy should be based not on the aggregate euro area economy, but instead on the weaker links in the euro area economy. These arguments have some merit, as the ECB - unlike other central banks - has to contend with a permanent existential threat. On this basis, let's finish this week with a role playing exercise. Imagine you're on the ECB Governing Council, and the weak link that worries you is euro area bank fragility, particularly in some of the southern member states. Your own (ECB) analysis, illustrated in Chart I-8, shows that extreme accommodative monetary policy has had a negligible net impact on bank profitability. The QE component has probably been a mild net positive - admittedly, a flatter yield has dragged down banks' net interest margins; but it has also generated profits in banks' bond portfolios; and in so far as QE has boosted economic growth, it has reduced bank charge-offs. Chart I-8What Is The Point Of The ECB's Negative Deposit Rate? But the negative deposit rate - charging banks for excess liquidity - has been a clear drag on bank profitability. And there is little evidence that it has encouraged lending. What would you do? Even if the ECB is setting policy for the euro area weak links, the central bank's own analysis suggests that it should remove, or at least fade, the negative deposit rate. Our central expectation is for this to happen early next year, with an outside chance that it is even sooner. With expectations for ECB policy rates still anchored close to the realistic limit of negativity, the euro exchange rate has cyclical upside. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Assuming that the U.S. government does not approve inappropriate fiscal stimulus. Fractal Trading Model* This week's trade is to go long the FTSE100 versus the IBEX35 with a profit target and stop loss of 4%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. There are also some worrying signs in our global forward-looking growth indicators for 2018, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. first-quarter economic data. They also went too far in pricing out U.S. fiscal action. It is positive for risk assets that centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. Italian elections could be troublesome, but that is a story for next year. The fact that China finally appears willing to apply pressure to Pyongyang is good news. North Korea might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. Disappointing U.S. Q1 real GDP growth largely reflects weather and seasonal adjustment factors. The deceleration in bank credit growth is also temporary. The window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals remain constructive. Importantly, signs of improving pricing power in the U.S. corporate sector are finally emerging, which should allow margins to expand somewhat in the coming quarters. The bond rally has depressed yields to a level that makes fixed-income instruments highly vulnerable to a reversal of the factors that sparked the rally. Market expectations for the fed funds rate are far too benign. The ECB will announce the next tapering step later this year, and may remove the negative deposit rate. But the central bank will not be in a position to lift the refi rate for some time. Yield spreads will shift in a way that allows one last upleg in the U.S. dollar. The recent pullback in oil prices will not last, as OPEC and Russia manage global stockpiles lower this year. Feature Chart I-1Reflation Trades Returning? Traders and investors gave up on the global reflation story in early April, sending the 10-year U.S. Treasury yield below the year's trading range. Missile strikes, European elections and U.S. saber rattling regarding North Korea lifted the allure of safe havens such as government bonds (Chart I-1). At the same time, the Fed was unwilling to revise up the 'dot plot', doubts grew over the ability of the Trump Administration to deliver any stimulus and U.S. data releases disappointed. The major equity indexes held up well against the onslaught of bad news, but looked increasingly vulnerable as April wore on. The market gloom was overdone in our view, and it appears that financial markets have now returned to a 'risk on' phase. It is difficult to forecast the ebb and flow of geopolitical news so we cannot rule out another bout of risk aversion. Nonetheless, the global economic backdrop remains upbeat and tensions regarding North Korea have eased. President Trump also unveiled his Administration's tax reform plan, raising hopes of a fiscal boost to the economy. Moreover, investors have read too much into the distorted U.S. first quarter data, and our corporate pricing power indicators support our constructive earnings view in 2017. There are clouds hanging over the outlook for 2018, but the backdrop will favor risk assets for most of this year. Investors should remain overweight equities versus bonds and cash, and bullish the dollar. Geopolitics Weigh On Risk Tolerance President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. The fact that China finally appears willing to apply pressure to Pyongyang is good news. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. The safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances. Chart I-2Macron Appears Set For Victory Turning to Europe, investors breathed a sigh of relief following the first round of the French Presidential election. The pre-election polls turned out to be correct, and our Geopolitical Team has no reason to doubt the polls regarding the second round (Chart I-2). We expect Macron to sweep to victory on May 7 because Le Pen will struggle to get any voters from the candidates exiting the race. What should investors expect of a Macron presidency? A combination of President Macron and a right-leaning National Assembly should be able to accomplish some reforms. Several prominent center-right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister. This is positive for the markets as it means that French economic policy will be run by the center-right, with an ultra-Europhile as president. Over in the U.K., the big news in April was Prime Minister Theresa May's decision to hold a snap election, which reduces the risk of a "hard Brexit". The current slim 12-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories who would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservatives are able to increase their seats in Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. U.S. Fiscal Policy: Positive For 2017, But Long-Term Negative Chart I-3Long-Term U.S. Budget Pressures The drama will be no less interesting in Washington in the coming weeks. As we go to press, Congress is struggling to pass a bill to keep the U.S. government running through the end of fiscal year 2017 (the deadline is the end of April). We expect a deal will get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. Both events could see temporary safe-haven flows into Treasurys. However, markets may have gone too far in pricing-out tax cuts or fiscal stimulus. For example, high tax-rate companies have given back all of their post-election equity gains. Even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. "Dynamic scoring" will be used to support the argument that the tax cuts will self-funding through faster growth. We also expect that Trump will get his way on at least a modest amount of infrastructure spending. The so-called Trump trades may wither again in 2018, but we see a window this year in which the stock-to-bond total return ratio lifts as growth expectations rebound. Looking further ahead, it seems likely that the U.S. budget deficit is headed significantly higher. Health care and pension cost pressures related to population aging are well known (Chart I-3). A recent Special Report by BCA's Martin Barnes highlighted that "it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlement programs and preventing a massive rise in the budget deficit."1 There is simply not enough non-defense discretionary spending to cut. Larger U.S. Federal budget deficits could lead to a widening fiscal risk premium in Treasury yields, although that may take years to show up. Perhaps more importantly, the U.S. government sector will be a larger drain on the global pool of available savings in the coming years. We highlight in this month's Special Report, beginning on page 20, that there are several key macro inflection points under way that will temper the "global savings glut" and begin to place upward pressure on global bond yields. A Temporary Soft Patch Or Something Worse? The first quarter GDP report for the U.S. is due out as we go to press, and growth is widely expected to be quite weak. The retail sales and PCE consumer spending data have fed concerns that the U.S. economy is running out of gas, despite the surge in the survey data such as the ISM. We believe that growth fears are overdone. Financial markets should be accustomed to weak readings on first quarter GDP. Over the past 22 years, the first quarter has been the weakest of the four on 12 occasions, or 55% of the time. Second quarter GDP growth has been faster than Q1 growth 70% of the time. A large part of the depressed Q1 GDP growth rate and lackluster "hard data" readings likely reflect poor seasonal adjustment and weather distortions. The "soft" survey data are more consistent with the labor market. Aggregate hours worked managed to increase by 1.5% at an annualized rate in Q1. If GDP growth really was barely above zero, this would imply an outright decline in the level of labor productivity. Even in a world where structural productivity growth is lower than it was in the past, this strikes us as rather implausible. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have pulled back from their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in the weather-impacted "hard" data in May and June. What about the slowdown in commercial and industrial loan growth and corporate bond issuance late in 2016 and into early 2017? This is a worry, but it partly reflects the lagged effects of the contraction in capital spending in the energy patch. C&I loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that the defaults have waned, this process will soon go into reverse. Higher profits more recently have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 bn in issuance in Q1, the highest level on record (Chart I-4). The rest we chalk up to uncertainty surrounding the U.S. election. The recent spikes in the political uncertainty index correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November. There has been a close correlation between these spikes and the deceleration in C&I loan growth. CEOs are also holding back on capex in anticipation of new tax breaks from Congress. The good news is that bond issuance has rebounded strongly in January and February of this year (Chart I-5). The soft March U.S. CPI release also appeared to be quirky, showing a rare decline in the core price level in March (Chart I-6). However, the March reading followed two months of extremely strong gains and it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart I-4U.S. Bank Credit Slowdown Is Temporary Chart I-5U.S. Corporate Bond Issuance Is Rebounding Chart I-6U.S. Inflation: Sogginess Won't Last Global Economic Data Still Upbeat For the major industrialized economies as a group, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4½% in February on a year-over-year basis (Chart I-7). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession that was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart I-8). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the six months to March (Chart I-9). Chart I-7Global Pick-Up On Track Chart I-8Manufacturing Rebound Is Not About Energy Chart I-9U.S.: Non-Energy Production Surging The weak spot on the global data front has been capital goods orders (Chart I-7). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart I-7, third panel). Improving CEO sentiment, accelerating profit growth and activity surveys all suggest that capital goods orders will catch up in the coming months. That said, one risk to our positive capex outlook in the U.S. is that the Republicans fail to deliver on their promises. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital spending. As for China, the economic data are holding up well and deflationary pressures have eased. Fears of a debt crisis have also ebbed somewhat. That said, fiscal and monetary stimulus is fading and it is a worrying sign that money and credit growth have decelerated because they tend to lead production. Our China experts believe that growth will be solid in the first half of the year, but they would not be surprised to see a deceleration in real GDP growth in the second half that would weigh on commodity prices. Bond Market Vulnerable To Fed Re-Rating A rebound in the U.S. activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A May rate hike is unlikely, but we would not rule out June. The bond market is vulnerable to a re-rating of the path for the fed funds rate because only 45 basis points of tightening is priced for the next 12 months. This is far too low if growth rebounds as we expect. The FOMC also announced that it intends to start shrinking its balance sheet later this year by ceasing to reinvest both its MBS and Treasury holdings. Our bond strategists do not think this by itself will have much of an impact on Treasurys because yields will continue to be closely tied to realized inflation and the expected number of rate hikes during the next 12 months (Chart I-10). Fed policymakers are trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. It is a different story for mortgage-backed securities, however, where spreads will be pressured wider by the lack of Fed purchases. All four of our main forward-looking global economic indicators appear to have topped out, except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past (Chart I-11). Nonetheless, all four are still consistent with robust growth. They would have to weaken significantly before they warned of a sustained bond bull market. Chart I-10Shrinking Fed Balance Sheet: ##br##Bearish For Bonds? Chart I-11Leading Indicators: ##br##Some Worrying Signs The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is the most concerning at the moment. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The bottom line is that global bond yields have overshot on the downside: underlying U.S. growth is not as weak as the Q1 figures suggest; market expectations for the fed funds rate are too benign; the Republicans will push ahead with tax cuts and infrastructure spending; the global economy has healthy momentum, and the majority of the items on our Duration Checklist suggest that the bond bear market will resume; the ECB will announce another tapering of its asset purchase program this autumn, placing upward pressure on the term premium in bond yields across the major markets; and the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. We recommend keeping duration short of benchmarks within fixed-income portfolios. One Last Leg In The Dollar Bull Market Chart I-12ECB In No Hurry To Lift Rates While we see upside for the money market curve in the U.S., the same cannot be said in the Eurozone. The economic data have undoubtedly been robust. The composite PMI is booming and capital goods orders are in a clear uptrend. Led by gains in both manufacturing and services, the composite PMI rose from 56.4 in March to 56.7 in April, a six-year high. The current PMI reading is easily consistent with over 2.0% real GDP growth (Chart I-12). This compares favorably to the sub-1% estimates of trend growth in the euro area. Private sector credit growth reached 2½% earlier this year, the fastest pace since July 2009. Despite this good news, the ECB is in no rush to lift interest rates. The central bank will taper its asset purchase program further in 2018, but ECB President Draghi has made it clear that he will not raise the refi rate until well after all asset purchases have been completed, which probably will not be until late 2019 at the earliest (although the ECB could eliminate the negative deposit rate to ease the pressure on banks). Unemployment is still a problem in Spain and Italy, while core CPI inflation fell back to just 0.7% in March. The euro could strengthen further in the near term if Macron wins the second round of the French elections, easing euro break-up fears. Nonetheless, we expect the euro to trend lower on a medium-term horizon versus the dollar as rate expectations move further in favor of the greenback. Some real rate divergence is already priced into money and currency markets, but there is room for forward real spreads to widen further, possibly pushing the euro to parity versus the dollar before this cycle is over. We are also bullish the dollar versus the yen for similar reasons. On a broad trade-weighted basis, we still expect the dollar to rally by another 10%. Positive Signs For U.S. Corporate Pricing Power Chart I-13U.S. Corporations Gaining Pricing Power Turning to the equity market, it is still early days for Q1 U.S. earnings, but the results so far are positive for a pro-risk asset allocation. After a disappointing Q4, positive Q1 earnings surprises for the S&P 500 are on track to match their highest level in two years, with revenue surprises also materially higher than previous quarters. At the industry level, banks and capital goods companies stand out: the former registered an earnings beat of nearly 8%, and it was nearly 12% for the latter. We highlighted the positive 2017 outlook for U.S. corporate profits in our March 2017 Monthly Report. Earnings growth is in a catch-up phase following last year's profit recession, which was related to energy prices and a temporary slowdown in nominal GDP growth relative to aggregate labor costs. Proprietary indicators from our sister publication, the U.S. Equity Sectors Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart I-13). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly-based across industries (as shown by the diffusion index in the chart). As a side note, the Profit Proxy provides some evidence that recent softness in core CPI inflation will not last. Second, the upward march of wage growth appears to be taking a breather (Chart I-13). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching perpetually-optimistic bottom-up estimates for 2017 (Chart I-14). Many companies have supported per share profits in this expansion via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart I-15 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same is true for GDP. Chart I-14U.S. Profit Model Is Very Upbeat Chart I-15U.S. Corporate Finance Cycle Comparison Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity issuance since 2009, which includes the impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions (positive values shown in Chart I-15 represent net equity withdrawals). CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Nonetheless, buybacks have boosted EPS growth by almost 2% over the past year according to our proxy (Chart I-16). We expect this tailwind to continue given the positive reading from our Capital Structure Preference Indicator (third panel). Firms have a financial incentive to issue debt and buy back shares when the indicator is above zero. Stronger global growth should continue to power an acceleration in corporate earnings outside the U.S. over the remainder of the year. Chart I-17 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Our profit indicators remain constructive for the U.S., Eurozone and Japan. Chart I-16Incentive To Buy Back ##br##Stock Remains Strong Chart I-17Global Profit ##br##Growth On The Upswing It is disconcerting that the rally in oil prices has faltered in recent days as investors worry that increased U.S. shale production will thwart OPEC's plans to trim bloated inventories. A breakdown in oil prices could spark a major correction in the broader equity market. Indeed, commercial oil inventories finished the first quarter with a minimal draw. The aim of last year's agreement between OPEC and Russia to remove some 1.8mn b/d of oil production from the market in 2017 H1 was to get visible inventories down to five-year average levels. They are well short of that goal. Without trimming stockpiles to more normal levels, storage capacity remains too close to topping out, which raises the risk of another price collapse. This is an extremely high-risk scenario for states like Saudi Arabia, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. This is the reason why our commodity strategists expect the OPEC/Russia production cuts to be extended when OPEC meets on May 25. This will significantly raise the odds that OECD commercial oil stocks will be drawn down to more normal levels. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. Investment Conclusions Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. Admittedly, some of the U.S. data have been disappointing given the extremely upbeat survey numbers. There are also some worrying signs in our global forward-looking growth indicators, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. economic data in the first quarter. They also went too far in pricing out U.S. fiscal action. As for European political risk, centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. There are legitimate reasons to be concerned about the economic and profit outlook in 2018. Nonetheless, we believe that the window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals are constructive. The passage of market-friendly fiscal policies in the U.S. later in 2017 will be icing on the cake. Perhaps more importantly, we are finally seeing signs that pricing power in the U.S. corporate sector is improving, allowing margins to expand somewhat in the coming quarters. Our profit models remain upbeat for the major advanced economies and for China. It has been frustrating for those investors looking for an equity buying opportunity. Despite the surge in defensive assets such as gold and Treasurys, the major equity bourses did not correct by much. Value remains stretched in all of the risk asset classes. Nonetheless, investors should stay positioned for another upleg in the stock-to-bond total return ratio in the coming months. Perhaps the largest risk lies in the bond market. The rally has depressed yields to a level that makes bonds highly vulnerable to a reversal of the factors that sparked the rally. Within an underweight allocation to fixed-income in balanced portfolios, investors should overweight investment- and speculative-grade corporate bonds in the U.S. and U.K. We are more cautious on Eurozone corporates as the ECB's support for that sector will moderate. Looking ahead to next year, our bond strategists foresee a shift to underweight credit given the advanced nature of the releveraging cycle in the U.S. corporate sector. Our other recommendations include: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. in currency-hedged terms. Continue to favor defensive over cyclical equity sectors in the U.S. for now, but a shift may be required later this year. Overweight the dollar versus the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market. Recent underperformance is a buying opportunity. Value has improved and cyclical conditions favor small caps. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst April 27, 2017 Next Report: May 25, 2017 1 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies and Fantasies," dated April 5, 207, available at bca.bcaresearch.com II. Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The Saving ##br##And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Chart II-6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The modest correction in April did not improve equity valuation by much in any of the major markets. Our U.S. valuation metric is still hovering just below the +1 sigma mark, above which would signal extreme overvaluation. Measures such as the Shiller P/E ratio are flashing red on valuation, but our indicator takes into consideration 11 different valuation measures. Technically, the U.S. equity market still has upward momentum, while our Monetary indicator is neutral for stocks. The Speculation index indicates some froth, although our Composite Sentiment indicator has cooled off, suggesting that fewer investors are bullish. The U.S. net revisions ratio is hovering near zero, but it is bullish that the earnings surprise index jumped over the past month. First-quarter earnings season in the U.S. has got off to a good start, while the global earnings revisions ratio has moved into positive territory for the first time in six years (see the Overview section). Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little 'dry power' left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. April's rally in the U.S. bond market dragged valuation close to neutral. However, we believe that the market is underestimating the amount of Fed rate hikes that are likely over the next year. Now that oversold technical conditions have been absorbed, this opens the door the next upleg in yields. Bonds typically move into 'inexpensive' territory before the monetary cycle is over. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, the dollar has shifted down this year to meet support at the 200-day moving average and overbought conditions have largely, but not totally, been worked off. We still believe there is more upside for the dollar, despite lofty valuation readings, due to macro divergences. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China