Europe

Highlights For the time being, our cyclical stance is to underweight the globally-sensitive Energy, Materials and Banks sectors versus Healthcare - in both the equity and credit asset-class. Combined with our expectation of a weakening pound/euro, this necessarily means the following European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands and Sweden. Underweight: Italy, Spain, and Norway. We anticipate shifting to a more cyclical sector (and country) allocation by the late summer, especially on dips. Feature It is worth reminding readers that picking mainstream equity markets1 is overwhelmingly about the industry sectors and dominant stocks that you are buying, wittingly or unwittingly. Picking equity markets is seldom about the prospects of the underlying domestic economies or head-to-head valuations.2 Chart of the WeekGlobal Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) The usual top-down approach to picking stock markets ignores two dominant features of these markets. First, they have huge variations in their sector exposures. Second, large industry sector groups like Energy, Banks, Healthcare and Technology tend to move en masse under the influence of global or regional rather than domestic drivers. The combination of these two features means that for most stock markets, the sector (and dominant company) impact swamps the effect that comes from the domestic economy. Right now, by far the most important consideration for country pickers is the relative outlook for the globally-sensitive Energy and Banks sectors versus the more defensive Healthcare. As an example, consider the choice between Spain and Switzerland. Spain's IBEX is at the mercy of its huge weighting to Banks, dominated by Santander and BBVA; while Switzerland's SMI is at the mercy of its similarly dominant weighting in the Healthcare sector, via Novartis and Roche. Box I-1 - Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks (Chart 2). France (CAC) is underweight Banks and Basic Materials (Chart 3). Italy (MIB) is overweight Banks (Chart 4). Spain (IBEX) is overweight Banks (Chart 5). Netherlands (AEX) is overweight Technology, underweight Banks (Chart 6). Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy (Chart 7). And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound (Chart 8). Switzerland (SMI) is overweight Healthcare, underweight Energy (Chart 9). Sweden (OMX) is overweight Industrials (Chart 10). Denmark (OMX20) is overweight Healthcare and Industrials (Chart 11). Norway (OBX) is overweight Energy (Chart 12). The U.S. (S&P500) is overweight Technology, underweight Banks (Chart 13). It follows that if Banks underperform Healthcare, it is highly likely that Spain's IBEX will underperform Switzerland's SMI, irrespective of the performances of the Spanish and Swiss domestic economies. For long-term investors, the large skews in sector exposure also mean that a head-to-head comparison of country valuations can be very misleading. At first glance, Spain, trading on a forward price to earnings (PE) multiple of 15.5, appears 15% cheaper than Switzerland, trading on a multiple of over 18. But this head-to-head difference just reflects the impact of forward PEs of Banks at 11 and Healthcare at 18. The Bank sector's lower multiple does not necessarily make it better value than Healthcare. Unlike two developed economies - whose long-term growth prospects tend to be broadly similar - two industry sectors could end up experiencing very different structural growth outcomes. Which would justify very different multiples. Despite its low multiple, a structural underweight to Banks might nonetheless be a good strategy if the sector's structural growth outlook is poor. In such a case, the low multiple is potentially a value trap. Picking Stock Markets The Right Way To reiterate, the decision to overweight or underweight a mainstream equity index should not be based on your view of the country's underlying economy - unless, of course, the country is the potential source of a major tail-risk event. Instead, the decision should be based on your over-arching sector view, combined with the country's skews to specific dominant stocks and sectors (Box I-1). Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7, Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12 and Chart I-13 should leave readers in absolutely no doubt. A market's dominant sector skew is by far the most important determinant of its relative performance. Chart I-2Germany (DAX) Is Overweight Chemicals,##br## Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Chart I-3France (CAC) Is Underweight Banks##br## And Basic Materials France (CAC) Is Underweight Banks And Basic Materials France (CAC) Is Underweight Banks And Basic Materials Chart I-4Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Chart I-5Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Chart I-6Netherlands (AEX) Is Overweight Technology,##br## Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Chart I-7Ireland (ISEQ) Is Overweight Airlines (Ryanair) ##br##Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Chart I-8The U.K. (FTSE100) Is Effectively ##br##Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound Chart I-9Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Chart I-10Sweden (OMX) Is ##br##Overweight Industrials Sweden (OMX) Is Overweight Industrials Sweden (OMX) Is Overweight Industrials Chart I-11Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Chart I-12Norway (OBX) Is ##br##Overweight Energy Norway (OBX) Is Overweight Energy Norway (OBX) Is Overweight Energy Chart I-13The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks Which brings us to the key consideration for country allocation right now: how to allocate to the sectors that feature most often in the skews: Energy and Banks versus Healthcare. For Energy relative performance, note the very strong recent connection with the global 6-month credit impulse. The downswing in the impulse - heralding a very clear growth pause - lines up with the setback in energy and resource prices and the underperformance of these globally-sensitive equity sectors (Chart of the Week and Chart I-14). Meanwhile, in the most recent mini-cycle, Banks' relative performance is tracking the bond yield almost tick for tick (Chart I-15). There are two reasons. For banks, lower bond yields presage both slimmer net interest margins and weaker economic growth. Chart I-14Commodity Price Inflation Is Just Tracking ##br##The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Chart I-15Financials Are Just Tracking ##br##The Bond Yield Financials Are Just Tracking The Bond Yield Financials Are Just Tracking The Bond Yield So for both Energy and Banks relative performance the overriding question is: when will this mini-downswing end? To answer this question, we note that we are 4-5 months into the global mini-downswing, whose average duration tends to be around 8-9 months. On this basis, now is a little too early to switch to an aggressively pro-cyclical sector allocation. But we would look for potential opportunities by the late summer, especially on sharp dips. Hence, for the time being our cyclical stance is to underweight the globally-sensitive Energy (and Materials) and Banks versus Healthcare. Combined with our expectation of a weakening pound/euro, this necessarily means the following European country allocation: Overweight: France,3 Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands, and Sweden. Underweight: Italy, Spain, Netherlands and Norway. Clearly, if you have a different cyclical and over-arching sector view, you will arrive at a different country allocation. That's fine. The important point is that the stock and sector skew approach is the right way to pick between mainstream equity indexes. Financials Drive The European Credit Market Finally, an over-arching sector view is also highly relevant for the European corporate credit market. In the euro area, the credit market is heavily skewed towards bank and other financial sector bonds, which account for almost half of euro area corporate bonds by value. By comparison, the U.S. credit market is not so skewed to one dominant sector. Hence, the outlook for the European credit asset-class hinges on the prospects for one sector: Financials (Chart 16). With the European high yield credit spread already close to a 20-year low, we would again wait for a better opportunity before adding aggressively to the European credit asset-class. Chart I-16Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In the developed world. 2 Please also see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015. 3 But expect a small near-term countertrend underperformance in the CAC40. See page 11. Fractal Trading Model* There are no new trades this week. Last week's trade, long nickel / short palladium has made an encouraging countertrend move at the classic limit of a trend. 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-17 Long Nickel / Short Palladium Long Nickel / Short Palladium 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Italy cannot rely on currency devaluation to make up for poor competitiveness, as it did before the euro; Italian voters are becoming more Euroskeptic - the elections due by May 2018 pose a serious risk, as do elections thereafter; Necessary structural reforms, not in the cards at present, would be painful and could exacerbate the Euroskeptic trend in Italy; The mere suggestion of a referendum on the euro would cause a banking crisis ... though voters would likely decide to stay in the Euro Area; The ECB will surprise on the dovish side; EUR/USD will weaken slightly below parity by mid-2018; European equities will continue to outperform U.S. equities. Feature European politics have been a boon to investors in 2017 (Chart 1). Instead of destabilizing populism, investors have gotten promises of pro-market reforms. This positive development is as we expected: we dubbed European politics "a trophy red herring" in our 2017 Strategic Outlook1 and predicted the pro-market turn in France.2 Alas, Italy remains a Sword of Damocles hanging over Europe's head. Whereas public sentiment in Europe has turned decisively in favor of integration since 2013, it remains indecisive in Italy (Chart 2). The Italian "median voter" continues to flirt with Euroskepticism, which explains why the country's anti-establishment parties have not softened their Euroskepticism to the same degree as their peers elsewhere in Europe. Chart 1European Stocks Outperform American European Stocks Outperform American European Stocks Outperform American Chart 2Italians Doubting The Euro Monetary Union Italians Doubting The Euro Monetary Union Italians Doubting The Euro Monetary Union In this report, we attempt to answer several questions concerning Italy: What is structurally wrong with Italy? Why is Euroskepticism appealing to Italian voters? What would happen if Euroskeptics won the upcoming election and called a referendum on Euro Area membership? What would happen if Italy left the Euro Area? Italy's Purgatory: Aversion To Creative Destruction Italy has a structural productivity problem (Chart 3). Given weak labor force and productivity growth, Italy will be in and out of recessions for much of the next decade as its growth rate oscillates around zero. Particularly concerning is the steep decline in the country's total factor productivity, which suggests that Italians struggle to make use of technological innovation and that the economy is extremely inefficient. Chart 3 There is a vast literature detailing the structural problems of the Italian economy.3 We focus on the three most important impediments: The unproductive South, the Mezzogiorno, remains Europe's backwater; The public sector is riven with inefficiencies; Education and innovation remain sub-par. The first problem with Italy is that it remains an extremely bifurcated economy. Its northern regions, particularly Lombardy, are as wealthy as any in Europe (Map 1). Productivity rates and education standards are on par with core Europe (Chart 4). However, the Mezzogiorno has consistently pulled the aggregate Italian averages down (Chart 5). Chart Chart 4 Chart 5 As the industrialized North was rebuilt after the Second World War, and as productivity and labor force growth rates surged, the backwardness of the Mezzogiorno was conveniently ignored. Since the late 1990s, however, productivity rates have declined in all of the developed world. For Italy, this means that the one-third of the population that lives in the unproductive South is no longer a rounding error. At its root, Italy's problem is that its unification in 1861, the Risorgimento, never went far enough to integrate the south and thus left a bifurcated economy that exemplifies the north-south divide in Europe as a whole.4 Several of the reform efforts undertaken by the Matteo Renzi-led Democratic Party (PD) government have sought to address the disparity between the North and the Mezzogiorno. However, these reforms will take time to bear fruit. Previous efforts have fallen short due to half-hearted implementation. The second structural problem is that Italy's public sector is large, riven with inefficiencies, and largely funded via corporate taxes due to poor overall tax collection. Italy's social security contributions are high, accounting for about 13% of GDP. Of this burden, the employer contribution rate is one of the highest in the world, only surpassed by France and Germany (Chart 6). Chart 6 Chart 7 Despite a developed-world tax burden, Italy has a developing-world system of tax collection. For example, its VAT revenue ratio is well below the OECD average, at the level of an emerging market (Chart 7).5 If the VAT revenue ratio was improved to the OECD average, Italy would see its VAT receipts rise by about €45 billion per year (enough to recapitalize all of its banks, for example, or reduce employers' social security contributions by a third). Not only is tax collection of poor quality, but paying taxes is exorbitantly difficult. The World Bank's "Paying Tax" indicator - which measures the cost and time of paying taxes - nestles Italy between Kenya and São Tomé at 126th out of 190 spots! For comparison sake, its Mediterranean peers Spain and Portugal are 37th and 38th respectively on the same index while even Greece is significantly better at 64th.6 Italy again ranks with EM countries on the World Bank's overall "Doing Business" report (Chart 8). It scores extremely low in the category of "enforcing contracts," where it finds itself sandwiched between the Gambia and Somalia, at the 108th rank! It takes more time - three years - to enforce a contract in Italy than in Pakistan, Egypt, and Mozambique. Chart 8 Public sector inefficiencies are not a result of nostalgia for Roman-era bureaucracy. Instead, Italy's administrative hurdles are a means to stifle domestic creative destruction and protect its numerous small and medium-sized businesses - many family-owned - from competition. Instead of fostering competition through innovation and investment, Italian industrial policy since the Second World War has largely relied on currency depreciation to boost competitiveness. This strategy ceased to be effective with the adoption of the euro, but the country never pushed through painful reforms to adjust to the new reality. While it is difficult to prove a counterfactual, we are not sure that even currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 9 illustrates. Finally, Italy's educational system is in need of a massive overhaul. Some improvement in educational attainment was apparent by 2015 (Chart 10). However, the quality of Italian education is still woefully inadequate if measured by the results of post-secondary and tertiary education on literacy proficiency (Chart 11). Chart 9Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Chart 10 Chart 11 Italian firms are not making up for the poor educational attainments of the labor force with higher investment in knowledge-based capital - software, research, training, or management (Chart 12). There are likely three reasons for this outcome. First, low productivity begets low potential GDP growth, which hurts firms' top line prospects and incentives to invest. Second, decades of reliance on currency devaluation for competitiveness has discouraged Italian corporates from investing in R&D. Third, a plethora of small Italian family-owned businesses lack the resources to leverage their intellectual property with management and technology to become globally competitive. Chart 12 Last time Italy faced a painful recession - 1992-1995 - it did what had worked best since the Second World War: it devalued its way out of trouble (Chart 13A). Yet a comparable devaluation did not work for Italy in recent years, with exports failing to lead the way to recovery despite a 20% drop in EUR/USD since mid-2014 (Chart 13B). Why? Chart 13ACurrency Devaluation Has Not ##br##Worked This Time Around (I) Currency Devaluation Has Not Worked This Time Around (I) Currency Devaluation Has Not Worked This Time Around (I) Chart 13BCurrency Devaluation Has Not ##br##Worked This Time Around (II) Currency Devaluation Has Not Worked This Time Around (II) Currency Devaluation Has Not Worked This Time Around (II) Many of Italy's exports go to Euro Area peers. In 1995, the percentage was 48%, today it is 41%. As such, the devaluation in the 1990s was against those peers, allowing Italian exports to the EU Common Market to surge. Nonetheless, the lack of any growth in exports still does not make sense, given the large depreciation in the euro and the fact that 60% of Italy's exports are still destined for non-Euro Area markets. Bottom Line: Italy has failed to keep up in competitiveness over the past twenty years precisely because its reliance on devaluation worked wonders for the economy in the pre-euro era. Instead of committing itself to structural reforms, Italy has preserved its post-Second World War institutions that were expressly designed to limit creative destruction and domestic competition. Unlike France, which has largely an arithmetic problem, Italy has a genuine productivity problem. For Italy to boost economic growth, it will have to do a lot more than adjust a few labor laws or raise the retirement age (both of which it has already done!). It needs deep structural reforms that are impossible without a strong electoral mandate that gives the next government sufficient political capital for reforms. Such a mandate is unlikely to come in the next election, leaving Italy in a purgatory of its own making. Political Risks: An Assessment Current polls show that the ruling, center-left PD is running neck-and-neck with the anti-establishment and Euroskeptic Five Star Movement (M5S) (Chart 14). Also in the mix are the center-right Forza Italia (FI), of former Prime Minister Silvio Berlusconi, which has itself flirted with mild Euroskepticism, and the staunchly anti-EU Lega Nord (LN). The power of Italy's establishment and Euroskeptic parties is perfectly balanced (Chart 15) ahead of the general election, which has to take place before May 20, 2018. The exact date is as yet unclear, with President Sergio Mattarella insisting that it take place after parliament passes a new electoral law that will make the electoral system uniform for both houses of parliament. A recent agreement between the main four parties on an electoral bill broke down, again pushing the date to the second quarter of next year. With the election now likely a year away - and with European populists in retreat across the continent - should investors breathe a sigh of relief? Chart 14Euroskeptic Five Star Movement Challenges Ruling Democrats Euroskeptic Five Star Movement Challenges Ruling Democrats Euroskeptic Five Star Movement Challenges Ruling Democrats Chart 15Euroskeptics Roughly Equal To Establishment Parties In Polls Euroskeptics Roughly Equal To Establishment Parties In Polls Euroskeptics Roughly Equal To Establishment Parties In Polls No. Italy remains the political risk in Europe. There are three broad reasons we remain concerned about Italian politics: The Median Italian Voter Is Flirting With Euroskepticism Policymakers are not price makers in the political marketplace, but price takers. The price maker is the median voter.7 In Europe, the Euroskepticism of the median voter has been massively overstated by the media and markets. Across the Euro Area, support for the common currency has surged since 2013 (Chart 16), likely reflecting an improving economy and the deeply held belief among European voters that continental integration is an intrinsic good. It took some time for anti-establishment politicians to sound off the median voter, but when they did, they adjusted their stances. As such, initially Euroskeptic anti-establishment parties across the continent - from Greece's SYRIZA and Spain's Podemos to Finland's "Finns Party" - have abandoned overt Euroskepticism and moved towards the middle ground on European integration. Politicians who have refused to be price takers - and insisted on campaigning from an inflexible, Euroskeptic position - were punished by the political marketplace (case in point: Marine Le Pen). Italy, however, has not seen a recovery in support for European integration. This is in large part due to the fact that the Italian economy has remained a laggard since 2012 (Chart 17). But it may also reflect the fact that the siren song of currency depreciation remains appealing to a large segment of the Italian electorate. Both M5S and Lega Nord have been vociferously arguing that Italy was far more competitive before joining the Euro Area and that simple currency devaluation would turn Italy from a land of locusts into a land of milk and honey. Chart 16Support For The Euro Has Risen Everywhere Else Support For The Euro Has Risen Everywhere Else Support For The Euro Has Risen Everywhere Else Chart 17Lagging Economy Has Hurt Support For The Euro Lagging Economy Has Hurt Support For The Euro Lagging Economy Has Hurt Support For The Euro Italy's Relationship With The EU Is Transactional We have long contended that both European patricians and plebeians support further integration.8 Chart 18 shows that a strong majority of Europeans is outright pessimistic about the future of their country outside of the EU. Why? Because, as Chart 19 suggests, the EU stands for geopolitical stability and a stronger say in the world. Chart 18Most Europeans Fear Life Outside The EU Most Europeans Fear Life Outside The EU Most Europeans Fear Life Outside The EU Chart 19 For a majority of Europeans, the European project is essential for peace and stability in Europe. We would argue that this is not just a product of two world wars in the twentieth century. It is also a product of newfound Russian assertiveness, migration crisis, and a growing ideological distance between Europe and its former security guarantor, the U.S. Italians, on the other hand, appear to be significantly more "transactional" than their European peers. For example, Chart 19 shows that Italians stand apart in being significantly less concerned about "peace" and having a "stronger say in the world." A plurality of Italians has also become confident in the country's future outside of the EU (Chart 20). Italians also appear to have the most negative perception of immigrants, perhaps due to the fact that they are at the frontline of Europe's migration crisis (Chart 21). Chart 20Italians Not So Afraid Of Life Outside The EU Italians Not So Afraid Of Life Outside The EU Italians Not So Afraid Of Life Outside The EU Chart 21 Why such a discrepancy in views between Italy and the rest of the continent? First, Italians have traditionally had a much more parochial view of the world. Regional differences matter a lot more to Italians than continental ones. Italians are already being asked to subsume one identity (regional) for another (national), so going a step further (supranational) may be too much. Data suggests that about half of all Italians are unwilling to go further (Chart 22). Second, Italy joined the EU as a considerably less developed economy than its core European peers. As such, membership was always sold to Italians from a transactional perspective and thus they do not give supremacy to geopolitical over economic forces. Chart 22Italians Less Likely To See Themselves As Europeans Italians Less Likely To See Themselves As Europeans Italians Less Likely To See Themselves As Europeans Elections Are Unlikely To Be Cathartic Italian Euroskeptics have consistently performed well in the polls for well over a year. Short of a significant surge in support for Matteo Renzi's PD, which we doubt will happen, polls are likely to continue to be tight until the election. The anti-establishment M5S performed extremely poorly in the June 11 municipal elections, failing to make the second-round run-off of the mayoral election in any of the major cities. However, we would fade the significance of this result given the national polls. As such, the best hope for investors is that anti-establishment forces suffer a modest defeat in next year's election. Short of a strong economic recovery that significantly reduces unemployment, an election win for the Italian establishment will not be as cathartic as the just-concluded election in France. And what are the odds of an outright Euroskeptic win? They are low, below 20%. M5S has no incentive to form a weak minority government, support an establishment-led government, or enter a risky coalition with Euroskeptic Lega Nord. It understands that remaining in the opposition would allow it to reap the benefits when the eventual coalition between establishment parties loses steam. The most likely scenario in next year's election is either an establishment Grand Coalition (40%), or a minority center-left government led by the ruling PD and supported on a case-by-case basis by the other parties (40%).9 Neither outcome is likely to survive the entire length of the mandate. Bottom Line: The long-term problem for investors is that the Euroskeptic narrative appears to be quite appealing to a large proportion of the Italian public. As such, even if the market avoids a crisis in 2018, one will likely emerge by 2020. The only way to avoid it would be a strong electoral mandate for deep structural reforms that boost productivity, which is not a likely outcome of the next election. But even if such reforms were initiated, we assume that their short-term consequences would be economic and political pain, which would sour support for establishment parties further and potentially deepen Euroskeptic sentiment in the country. As such, in the rest of the report, we examine what investors should expect in case the anti-establishment parties eventually take power in Italy. While such an outcome is unlikely in 2018, it may happen eventually. Leaving The Euro Is A Panacea... The political analysis above begs a simple question: Why are Italians more likely to be lured by the sirens of leaving the Euro Area than the French or Spanish have been? Fundamentally, the Italian experience is one of relatively successful devaluations. In the early 1990s, Italy was also suffering from a period of un-competitiveness, which prompted the current account to move from a 0.6% of GDP surplus in 1987 to a 2.5% of GDP deficit in 1992 (Chart 23). This deterioration reflected two factors. One was the notorious European Exchange Rate Mechanism (ERM), which forced European currencies to move in lockstep with each other. The second was the fact that Italian unit labor costs had been in a bull market relative to the rest of the European community countries, rising by 380%, 140%, and 370% against German, France, and the Netherlands, respectively, between 1970 and 1991. Thanks to this confluence of events, Italy was in a bind. By early 1992, Italian real wages were contracting. More than a surge in inflation, this contraction reflected intensifying competitive pressures and the implementation of fiscal austerity (Chart 24). Investors ended up punishing Italian assets; Italian yields moved up, with spreads relative to Germany widening from 350 basis points to 750 basis points by September 1992. Chart 23Lack Of Competitiveness Caused Current Account Deficits... Lack Of Competitiveness Caused Current Account Deficits... Lack Of Competitiveness Caused Current Account Deficits... Chart 24...And Contributed To Falling Real Wages ...And Contributed To Falling Real Wages ...And Contributed To Falling Real Wages By that point, Italian authorities chose to let the previously stable lira fall, resulting in a 30% devaluation versus the deutschemark by the end of Q1 1993. Thanks to this easing, by the beginning of 1994 Italian spreads had fallen back below 300 basis points. However, the Italian economy was still under duress, real wages were still contracting, and financial markets revolted again. By February 1995, Italian spreads had gone back up to 480 basis points. In the spring of 1995, the pressures came to a boiling point and the lira was once again devalued versus the deutschemark, suddenly plunging by an additional 20% or so. After this painful adjustment, real wage growth moved back into positive territory, the current account deficit morphed into a surplus, and the economy recovered. Moreover, thanks to the previous wave of fiscal austerity and the rebound of the economy, the government's primary balance, which stood at a deficit of nearly 4% of GDP in 1987, hit a 5% surplus by 1998. Chart 25Domestic Demand Never Recovered From Financial Crisis Domestic Demand Never Recovered From Financial Crisis Domestic Demand Never Recovered From Financial Crisis So why is this experience so important? Today, Italy already runs a large current account surplus of 2.5% of GDP. But unlike in the 1990s, this improvement reflects first and foremost a contraction in imports, itself the symptom of an ill domestic economy. However, like in the early 1990s, the Italian economy remains tired. Real GDP is still 7% below its 2008 peak, while domestic demand continues to linger at a stunning 8.5% below its pre-GFC levels (Chart 25). Real wages are contracting at a 1.4% pace as the unemployment rate remains more than 2.5% above the OECD's estimate of NAIRU. Real estate prices, after having contracted from 2012 to 2016, are only growing in the low single digits. Capex generally is also tepid. This situation suggests that Italy needs even easier monetary policy than what it is getting from the ECB. As the argument goes, if Italy were to devalue its currency today, it would be able to boost its exports, ease domestic monetary conditions, and create the ideal circumstances for generating growth. Moreover, to push the argument to its extreme - something populist politicians are prone to do - Italy should ditch the euro and re-dominate its debt in lira. The Bank of Italy could then monetize this debt to keep interest rates low. Since Italy runs a primary fiscal surplus of 1.4% of GDP, Italy does not need to access the debt market for a few years, and thus it would be irrelevant if it loses access to the market. In other words, outside of the euro, a world of Chianti and creamy cannolis awaits the Italians. ... Well, Maybe Not If this seems too nice to be true, that is because it is. The exit-and-devalue narrative misses the point that financial markets and conditions matter a great deal. The problem with this story is the banking sector. The Italian banking sector is presently saddled with NPLs of €330bn, representing 74% of the banking system's capital and reserves (Chart 26). In and of itself, this is a big problem. However, it is a manageable one, especially with the backstops created by European institutions, notably the support of the ECB. However, without Europe's backstop, this debt load becomes a lot harder to manage. And that's only part of the problem. A deeper issue is the large holdings of treasury bonds (BTPs) of Italian banks. Currently, Italian banks hold 10% of their assets in BTPs, an amount equivalent to 90% of their capital and reserves (Chart 27). In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of breakup - as estimated by Dhaval Joshi who writes our European Investment Strategy sister service - of 20% over the subsequent five years (Chart 28).10 Chart 26Italian Banks Carry Loads Of Bad Loans Italian Banks Carry Loads Of Bad Loans Italian Banks Carry Loads Of Bad Loans Chart 27Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Chart 28Italian Spreads Signal Euro Break-Up Threat Italian Spreads Signal Euro Break-Up Threat Italian Spreads Signal Euro Break-Up Threat Now, if Italy comes to be governed by Beppe Grillo's M5S, markets will move fast to discount an eventual referendum on Italy's euro membership - even if only a non-binding and consultative referendum, which would still have a powerful political effect.11 In this environment, it is unlikely that the ECB would support Italian assets. The ECB has already played an active role in Italian politics. It was a September 2011 letter by Mario Draghi and Jean-Claude Trichet that prompted the resignation of Berlusconi in November 2011. It was only after Italian policymakers committed to structural reforms that Draghi was willing to utter his famous "whatever it takes" pledge of ECB support. There is practically no chance that the ECB would extend such a guarantee to an M5S-led government looking to play chicken with the Euro Area and default on Italian debt. Chart 29A Drop In Credit Impulse Would Herald Recession A Drop In Credit Impulse Would Herald Recession A Drop In Credit Impulse Would Herald Recession This is why the situation could become nasty, and fast. With only 53% of Italians in favor of the euro, pricing in a 50% probability of Italy leaving the Euro Area would result in BTP-bund spreads of around 900 basis points! In the process, Italian bonds could lose 40% to 50% of their value - assuming that German bunds rally on risk aversion flows - which would result in a potential 35% to 45% hit to Italian banks' capital and reserves. Even if markets remained relatively calm, and BTP prices only fell by 25% to 30%, investors would discount bank capital by around 25%. With the large overhang of NPLs, Italian banks would be for all intent and purposes insolvent. We already expect the Italian credit impulse to become a drag on Italian growth in 2018, but if banks are threatened with insolvency as a result of political dynamics, this same credit impulse is likely to fall at rates not experienced since the GFC. This would result in yet another recession in Italy (Chart 29). Like in Greece in 2015, we would expect that this economic pain would prompt Italian voters to rethink their inclination to leave the Euro Area. In other words, the mere thought of exiting the Euro Area would bring forward the cost of such a strategy, giving voters essentially a preview of their future pain. Moreover, with 45% of BTPs held in private hands outside of Italy, and Italy's foreign debt hanging at 126% of GDP, Europeans outside of Italy have a lot of Italian exposure. This suggests that the financial channel of transmission would cause stress in the European banking sector outside of Italy as well. As a result, in all likelihood, this threat would prompt the return of dovish language by the ECB that could weigh on the euro. The fall in the euro would also nullify Italians' need to exit the Eurozone. Even if the scenario above looks remote, the euro could fall as soon as markets begin discounting an M5S victory. For example, in Canada, the Parti Quebecois won the 1994 election promising a referendum on the question of Quebec independence. As a result of that electoral victory, the loonie quickly dipped by 6%. A move back to EUR/USD 1.05 in case of a Beppe Grillo victory thus sounds reasonable as the market would quickly move to discount some probability of an eventual euro referendum in Italy. Bottom Line: The mere suggestion of a referendum on the euro in Italy would have immediate market consequences. The result would be the almost instantaneous insolvency of large portions of the country's banking system, the loss of ECB support, deposit flight, and an almost certain recession. The relationship between politics, markets, and the economy is therefore dynamic, with non-linear outcomes. As markets discount a higher probability of Italian Euro Area exit, voters will discount a higher probability of non-optimal economic outcomes. As such, we highly doubt that Italian voters - who remember, are only flirting with Euroskepticism - would commit to a future outside of the Euro Area. What If Italy Says Arrivederci? What if we have misjudged Italian voters and they vote to exit the Euro Area regardless of the costs? Based on the IMF's External Sector Report's Individual Economy Assessments, the Italian real effective exchange rate is overvalued by around 25% against Germany alone and around 15% against a GDP-weighted average of Germany, France, Spain, Netherlands, and Belgium. However, these amounts grossly underestimate the potential fall in the lira. These estimates are based on competitiveness measures alone, and they do not take into account the negative domestic economic developments associated with falling BTP prices and impairments to banks' balance sheets. Such economic malaise would prompt a massive easing of policy by the newly empowered Bank of Italy, which would also weigh on the lira. Additionally, the Bank of Italy would have little credibility. This would be doubly so in a M5S-led government intent on pursuing unorthodox policy choices. Historically, Italy has been tolerant of elevated inflation, which means that investors would likely bid up inflation protection on Italian assets, a process that would weigh on Italian real interest rates. Additionally, Italian households and businesses would likely ratchet up their own inflation expectations. As a result, this would drive Italian inflation higher and prompt even more downward pressure on real rates. This is the perfect recipe for a downward spiral in the lira against the euro. In this kind of environment, the lira could fall 75% against the euro. Would Italy become a trade champion with this magnitude of currency devaluation? Doubtful. As we have mentioned, Italy's competitiveness problems are not just a function of domestic labor costs relative to those of the rest of the Euro Area. They also reflect the fact that Italy has not moved up the value chain and is competing head-to-head with EM nations that have a much lower cost base. Additionally, the purpose of the euro was to prevent precisely the kind of competitive currency devaluation that plagued Europe in the post-war period. If Italy ditches the euro and devalues its currency by 50% or more, then the other European nations are likely to punish Italy with tariffs, defeating one of the key reasons to re-introduce the lira in the first place. The last thing Europeans would want to establish is a precedent of a major European economy massively devaluing against its Common Market peers for economic gain. This would be the undoing of not just the Euro Area, but European integration itself. In fact, Italy is contractually obligated - as is every EU member state other than Denmark and the U.K. - to obtain EMU membership under the Maastricht Treaty that establishes the European Union. While such a contractual obligation is irrelevant in the face of a sovereign nation's decision to abrogate an international treaty, it does give Italy's EU peers the legal cover to evict Italy from the Common Market should it break its Maastricht pledges. What about the dynamics of the euro itself? After all, without its weakest major member, the Euro Area will be stronger and the euro will become more competitive. However, the early 1990s experience is once again instructive. During the first phase of devaluation of the lira from 1992 to 1994, the deutschemark too came under pressure. This pressure also reflected the fact that the USD was rising between Q3 1992 and the beginning of 1994. However, by early 1995 the deutschmark had recouped all its loss versus the USD (Chart 30). We would expect similar dynamics to be at play, and again, a lot will depend on the dollar's trend. We expect the dollar index (DXY) to peak in 2018 around 108-110, or a bit more than 10% above current levels. This would hurt the euro. Moreover, the likely need for a dovish ECB to ease the blow to the European banking system (from potentially large losses on any Italian assets) would add to the downward pressure on the euro. As a result, an Italian exit should result in a fall to EUR/USD 0.9. However, this would represent a massive buying opportunity. The euro would be extremely cheap, and the economy would ultimately handle the Italian shock (Chart 31). Chart 30Lira Devaluation Temporarily Dragged Down The Deutschemark Lira Devaluation Temporarily Dragged Down The Deutschemark Lira Devaluation Temporarily Dragged Down The Deutschemark Chart 31An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity Additionally, the pain that Italy would incur as it faced currency collapse, runaway inflation, and loss of market access to the EU Common Market should act as a strong deterrent for future Euro Area exit attempts. As such, while the probability of Italy's Euro Area exit may be higher than zero, the probability of any subsequent exits is essentially zero. We would therefore expect any euro selloff to be violent but brief. Chart 32Italian Public Debt: Stuck In Muck Italian Public Debt: Stuck In Muck Italian Public Debt: Stuck In Muck Bottom Line: We doubt Italy will ever leave the euro. In all likelihood, the economic pain caused by the mere thought of a referendum would be enough to deter Italians from voting for what would amount to economic suicide. Instead, we would expect Italy to muddle through: its public debt dynamics will worsen, but it will not implode. The IMF expects the government debt-to-GDP ratio to fall toward 125% of GDP by 2022 (Chart 32). We think this is too optimistic. It relies on a big drop in the private sector's investment-saving gap. We think that Italy's entrenched productivity deficit and lack of investment opportunities south of the Alps will ensure that savings remain in excess of investment by a similar degree as today. This would cause the public debt-to-GDP ratio to move toward 140% of GDP by the middle of next decade. This is not a great scenario, but it is not a catastrophe either. In exchange for modest reforms, the ECB would continue to support Italy with dovish monetary policy and unfettered access to emergency liquidity. As a result, we expect European interest rates to remain slightly below what average Eurozone numbers would justify. As such, we continue to anticipate no hike in the ECB's repo rate for the foreseeable future. This, along with greater labor market slack in Europe than the U.S., underpins our view that EUR/USD will ultimately weaken slightly below parity. Investment Conclusions All other things being equal, currency devaluation is a valuable reflationary tool. In Italy's case, however, there are two impediments to using it. First, Italy has lost competitiveness precisely because it relied on the FX lever in the past. Its governance, education, and economic institutions have atrophied as domestic interest groups favored protecting themselves against creative destruction. Second, when it comes to politics, "all other things are rarely equal." It is highly unlikely that the rest of Europe would idly stand back while Italy switched to the lira and devalued it against the euro. This is for three reasons: First, it would set a dangerous precedent for other EU member states if Italy, the Euro Area's third-largest economy and the world's eighth largest, was allowed to reflate via competitive devaluation. Second, it is unlikely that Euro Area peers would accept Italy's devaluation amidst a globally low growth context where export market share is already tough to come by. Third, Italy's government would likely be led by populist, anti-establishment policymakers who would represent a domestic political threat to Italy's European neighbors. As such, it would be in the interest of the rest of Europe to ensure that a M5S-led Italy collapsed after leaving the Euro Area, and then begged to re-enter the core European club. The investment conclusions from the analysis above are very state dependent and represent a playbook for investors going forward. Right now, with the probability of an outright M5S victory low, our base case scenario remains unchanged. The euro will weaken by mid-2018 to slightly below parity as the ECB will maintain a more dovish policy stance than the Fed. European equities are likely to continue to outperform U.S. equities. However, if Beppe Grillo manages to eke out a majority in 2018 or later, investors might be in for a bumpy ride. The euro's fall from grace is likely to be much swifter and European assets could suffer a period of volatility and underperformance relative to the U.S. Ultimately, European stocks will resume their upward relative trajectory as any Italian referendum is likely to result in Italy staying in the euro. Finally, in the highly unlikely case that Italy votes to leave the Euro Area, the euro could plunge to EUR/USD 0.9; European assets, banks especially, could suffer greatly against their U.S. counterparts; and bund yields would likely fall below 0%. The lira would fall by 75% against the euro and Italian bonds would suffer losses north of 50%, in local currency terms. As Italy plunged to its post-Euro Area Inferno, however, we would expect European assets to represent the buying opportunity of a lifetime. Italy's fall from grace would only tighten European integration going forward. 1 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Please see OECD, "Economic Surveys: Italy 2017," available at oecd.org; and Sara Calligaris, et al.,"Italy's Productivity Conundrum," European Commission, dated May 2016, available at ec.europa.eu. 4 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 5 The VAT revenue ratio (VRR) is defined as the ratio between the actual value-added tax (VAT) revenue collected and the revenue that would theoretically be raised if VAT was applied at the standard rate to all final consumption. This ratio gives an indication of the efficiency and the broadness of the tax base of the VAT regime in a country compared to a standard norm. 6 Please see World Bank Group and PwC, "Paying Taxes 2017," available at www.pwc.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 3, 2011, and Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 9 A minority government would, however, have to obtain a confidence vote in both chambers of the Italian Parliament in order to govern, as per Article 94 of the Italian Constitution. 10 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com. 11 According to Article 75 of the Italian Constitution, referendums are not permitted in the "case of tax, budget, amnesty and pardon laws, in authorization or ratification of international treaties." Nonetheless, a Euroskeptic government could still call for a non-binding referendum on the euro. While its result would not create a legal reality for Italian exit from the Euro Area, it would create a political one. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com We Read (And Liked) ... Why Nations Fail - The Origins Of Power, Prosperity, And Poverty Why Nations Fail is as much about why nations succeed as why they fail.1 World history is replete with examples of the latter, whereas the former is a rarity even today. Economist Daren Acemoglu and political scientist James A. Robinson seek to answer why that is so. Distilling the book to its bottom line is challenging. There is no neat theory of how the world works. Instead, the authors tell their story through case studies replete with "critical junctures," "path dependency," and "small differences." Acemoglu and Robinson do not peddle in false parsimony, but rather try to develop a narrative that explains a complex process. While they never make the point explicitly, the authors define success as a combination of geopolitical relevance (power), escaping the "middle income trap" (prosperity), and some level of equality (escaping poverty). A country that achieves some semblance of all three, and maintains it for a long time, is "successful." At the heart of successful economies is the process of creative destruction. And at the heart of each example of failed states - from the Roman Empire to the Soviet Union - are impediments to such destruction. The recipe to success therefore boils down to "having an idea, starting a firm, and getting a loan." The discipline of economics - and its disciples at the IMF and the World Bank - would appear to be more than capable of taking it from there. But they are not. Why? For Acemoglu and Robinson, the empirical evidence is overwhelmingly stacked against economics and its practitioners. Armies of developmental economists have failed to bring billions of people out of poverty and many of their suggestions have in fact been detrimental. Economics is incapable of resolving the problem of development because it "has gained the title Queen of the Social Sciences by choosing solved political problems as its domain."2 And societal development is a political problem. The first such political problem that Acemoglu and Robinson attempt to explain is the paradox of development. Why don't leaders always choose prosperity? History is replete with examples of how elites actively subvert creative destruction, which is paradoxical given that it would make their societies wealthier and more powerful in the collective sense. From the patricians of Rome, elites of Venice, the szlachta of Poland, the samurai of Japan, to the landed aristocracy of England prior to the Glorious Revolution, those in positions of power consciously limit economic progress. The answer lies in political institutions. When political power is exclusive, unchecked, and limited to a select-group, its value increases. The more power one gains, the greater the political, economic, and societal rewards one can extract from it. The reverse is true when political institutions are inclusive, checked, and open to upwardly mobile entrepreneurs. In that case, the value of political power declines and thus elites are less likely to expend resources to protect their access to it. As such, the key conditions for economic development are inclusive political institutions that allow non-elites to petition the government, keep it in check through an independent judiciary, call it to account with free media, and eventually participate in governing directly. These inclusive political institutions are, in turn, more likely to give rise to inclusive economic institutions, which enshrine the process of creative destruction at the heart of the country's political and economic system. Why is it so difficult to engineer development? Because most trained economists working for international developmental agencies are focused on changing economic institutions. They take the politics of a country as an a priori. However, it is politics that determines economics, not the other way around. A powerful example in the book is the process of de-colonization in Africa. Despite a dramatic change of political leadership, post-colonial governments preserved the extractive economic institutions set up by their former colonial masters. Why? Because they never bothered to truly enfranchise their citizens. In other words, they kept the exclusive political institutions of colonialism largely in place. Once that decision was made, it was inevitable that extractive economic institutions would remain in place as well. In fact, in most examples, economic institutions became more extractive and political institutions more exclusive. Acemoglu and Robinson published their book in 2012, at the height of the "Beijing Consensus" narrative. It is easy to see how most of their examples are applicable to China today, particularly the chapter dealing with the decline of the Soviet Union. The message is that rapid economic growth under exclusive political institutions is possible, but unsustainable. China will therefore either evolve its political institutions or face the fate of the Soviet Union. We generally tend to agree with this analysis, but time horizons are difficult to gauge. For example, Acemoglu and Robinson themselves admit that the Soviet Union grew rapidly for 40 years before it faced limits and 60 years before it collapsed. By those measures, Chinese policymakers may still have decades before crisis forces their hand. A much more interesting question, one that Acemoglu and Robinson spend very little time discussing, is what happens to societies where elites capture political institutions and alter them from inclusive to exclusive? Two examples they detail briefly are the Roman and Venetian republics. In both, relatively inclusive political systems with inclusive economic institutions were captured by rapacious elites who then proceeded to limit access to both with the particular intention of limiting creative destruction. For global investors, this is the process that will have greater implications than the run-of-the-mill collapse of authoritarian and semi-authoritarian regimes. The entire global financial system today depends on the domestic stability of countries like the U.S. and the U.K., perhaps the most successful political systems in the world. And yet, voters in both are itching for radical change as a reaction to elite overproduction and growing income inequality. On one hand, voter discontent could lead to a messy political process, if not an outright revolution, that reestablishes the inclusive institutions that have underpinned their prosperity and power for centuries. On the other, it could lead to the collapse of the inclusive republic and the rise of an exclusive empire. 1 Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 2 Economist Abba Lerner, quoted at the end of Chapter 2 by the authors. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com

Highlights The European Central Bank's ultra-dovish policies have depressed the value of the euro and, by extension, boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result of this and labor shortages, wages in central Europe are rising rapidly, and inflation is accelerating. The Polish and Czech central banks will be forced to hike rates sooner than later. Hungary's central bank will lag behind. Go long the PLN versus the IDR. Stay long the CZK versus the euro and the PLN against the HUF. Feature Inflation in central Europe is picking up and will continue to rise (Chart I-1). The main driver is surging wage growth in central Europe. Considerable acceleration in wage growth, in Poland, Hungary and the Czech Republic signifies genuine inflationary pressures that could very well spread. Based on this, our primary investment recommendation is to be long the PLN and CZK versus the euro and/or EM currencies. Labor Shortages There is a shortage of labor in the central European manufacturing economies of Poland, Hungary and the Czech Republic. This partially reflects similar trends in Germany and its increased use of outsourcing to central European countries. Escalating wage growth (Chart I-2) in central European economies denotes widening labor shortages. Chart I-1Inflation Is Rising In CE3 Inflation Is Rising In CE3 Inflation Is Rising In CE3 Chart I-2Labor Shortages = Higher Wages Labor Shortages = Higher Wages Labor Shortages = Higher Wages Indeed, our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - has surged of late across all central European countries (Chart I-3). The same measure for Germany is at a 27-year high (Chart I-3, bottom panel). Chart I-4A and Chart I-4B illustrate both components of the ratio: the number of job vacancies has skyrocketed to all-time highs and the number of unemployed people has dropped to multi-decade lows as well. Chart I-3Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Chart I-4AA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Chart I-4BA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Importantly, it is not the case that labor shortages are occurring because people are discouraged and giving up on their search for work. The participation rate for all these countries has risen to its highest level since data have been available. In brief, a rising share of the population in these countries is either working or actively looking for a job. (Chart I-5). Finally, their working age population is shrinking (Chart I-6), with Germany being the exception because of immigration inflows (Chart I-6, bottom panel). Chart I-5Labor Participation Rate Is ##br##High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Chart I-6...While Working Age ##br##Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 Robust labor demand has been occurring in central Europe because of the ongoing manufacturing boom in the region. Given central Europe's extensive supply chain linkages to German manufacturing, the artificial cheapness of the euro that the ECB engineered has boosted the German economy and by extension central Europe's manufacturing boom. Germany: A Cheap Currency And Export Boom The ECB's ultra-accommodative policy has suppressed the value of the euro, and caused German exports to mushroom (Chart I-7, top panel). Chart I-7ECB Policies Have Been ##br##A Boon For German Exports ECB Policies Have Been A Boon For German Exports ECB Policies Have Been A Boon For German Exports A cheap common European currency has boosted Germany's manufacturing competitiveness and has led to rising demand for German exports. An overflow of manufacturing orders in Germany in turn has led to labor shortages in central Europe via increased German outsourcing. Currency appreciation is the conventional economic adjustment in a country with a flexible exchange rate and an export boom coupled with a large current account surplus. However, this has not occurred in Germany in recent years. This is because of the ECB's ultra-easy policies. The euro has depreciated even as the German and euro area overall current account has mushroomed (Chart I-7, bottom panel). Since the currency has not been allowed to appreciate in nominal terms, the real effective exchange rate will inevitably appreciate via inflation - rising wages initially and broader inflation increases later. In our opinion, the best currency valuation measure is the real effective exchange rate based on unit labor costs. Our basis is that this measure reflects both changes in productivity and wages - i.e. it reflects genuine competitiveness. Chart I-8 demonstrates Germany's real effective exchange rate based on unit labor costs in absolute terms compared to other advanced manufacturing competitors like the U.S., Japan, Switzerland and Sweden. Based on this measure, it is clear that Germany continues to enjoy a significant comparative advantage on the manufacturing world stage among advanced manufacturing economies. It is only less competitive versus Japan. Chart I-8Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Bottom Line: The ECB's ultra-dovish policies have depressed the value of the euro and boosted German manufacturing. This has boosted central European manufacturing and demand for labor. Germany Is Passing The Inflation Baton To Central Europe Despite a historic low in the unemployment rate and ongoing labor shortages, German wages have not risen by much (Chart I-9). Our hunch is that German companies faced with some labor shortages have been increasing their use of outsourcing. Central European economy's export to Germany have boomed, especially after the euro started depreciating circa 2010 (Chart I-10). Chart I-9German Wage Inflation Is Muted German Wage Inflation Is Muted German Wage Inflation Is Muted Chart I-10Growing Dependence On ##br##Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Being the lower marginal cost producer in the region, central European economies have benefited from German competitiveness and the cheap euro. Outsourcing is economically justified because German wages are still four times higher than in Poland, Hungary and the Czech Republic. (Chart I-11). Even though Germany's productivity is higher than in central Europe, manufacturing wages adjusted for productivity are still higher than in central European economies (Chart I-12). Therefore, it still makes sense for German businesses to outsource more to lower-cost producers in central Europe. Chart I-11CE3 Wage Bill Is Cheaper ##br##Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... Chart I-12...Even After Adjusting ##br##For Productivity ...Even After Adjusting For Productivity ...Even After Adjusting For Productivity Faced with strong orders as well as a lack of available labor, businesses in central European countries have been competing for labor by raising wages. Unlike in Germany, manufacturing and overall wages in Poland, Hungary and the Czech Republic have recently surged (Chart I-2 on page 3). Wages are rising more so in Hungary and the Czech Republic since they have smaller labor pools compared to Poland. Notably, wage growth has exceeded productivity growth, and unit labor costs have been rising rather rapidly (Chart I-13). Chart I-13Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Higher unit labor costs amid rising output denote genuine inflationary pressures. Producers faced with rising unit labor costs and shrinking profit margins will attempt to raise prices. Given that income and demand are strong, they will partially succeed - meaning genuine inflationary pressures in central Europe are likely to intensify. Since the beginning of the ECB's accommodative monetary policy, Germany has been able to avoid the fallout of higher wages because it has been able to outsource a portion of its production to other countries, namely central Europe. The problem is that the supply of labor in central Europe is now drying out, so its price will naturally rise. If Germany did not have the labor pool of CE3 available as a resource, German wage inflation would be significantly higher by now because companies would have been forced to employ Germans more rapidly, paying more in labor costs. Bottom Line: Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. Overheating In Central Europe Various inflation measures are showing signs that inflation is escalating in CE3. With rising wages and unit labor costs, these trends will continue. Consequently, output gaps in central European economies are closing or have closed, warranting further increases in inflation (Chart I-14). Money and credit growth are booming, which is further facilitating the rise in inflation (Chart I-15). Finally, employment growth is very robust and retail sales are strong (Chart I-16). Chart I-14Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Chart I-15Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Chart I-16Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Bottom Line: A cheap euro has supercharged German demand for central European labor at the time when the pool of available labor in CE3 is shrinking. This has generated genuine inflationary pressures in the region. Conclusions And Investment Recommendations 1. The Polish and Czech central banks will hike rates sooner than later. This will boost their currencies. The Hungarian central bank will lag and the HUF will underperform its regional peers. CE3 currencies are set to appreciate, especially the CZK and the PLN: stay long the PLN versus the HUF, and the CZK versus the euro. We recommended going long PLN/HUF and long CZK/EUR on September 28 2016 due to stronger growth and rising inflationary pressures. This week's analysis reinforces our conviction on these trades. In the face of rising inflationary pressures, the Czech National Bank (CNB) and the National Bank of Poland (NBP) will be less reluctant to tighten policy than the National Bank of Hungary (NBH) and the ECB. This will drive the PLN and CZK higher relative to the EUR and HUF. The NBH is unlikely to tighten policy while credit growth is still weak. Given strong political pressure for faster economic growth, our bias is that the NBH is more interested in ending six years of non-existent credit growth rather than containing inflation. The ECB is unlikely to tighten policy either, given the still-poor structural growth outlook among the peripheral European economies. A new currency trade: go long the PLN versus the IDR, while closing our short IDR/long HUF trade with a 9% loss. This is based on our expectations that central European currencies will appreciate versus their EM peers, and the PLN will do better than the HUF. 2. Relative growth trajectory favors Central European economies relative to other EM countries. Such economic outperformance and resulting currency appreciation will be a tailwind to CE3 equity performance versus EM in common currency terms. Continue overweighting CE3 equity markets within the EM benchmark. We recommended equity traders go long CE3 banks / short euro area banks on April 6, 2016. This position has not worked out due to a significant rally in euro area banks since Brexit. However, euro area banks remain less profitable and overleveraged compared to their central European counterparts. As such they will likely underperform in the coming months. 3. In fixed income, we have the following positions: Overweight Hungarian sovereign credit within an EM sovereign credit portfolio. Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. A new trade: Receive 1-year Hungarian swap rates / Pay 10-year swap rates. As structural inflationary pressures become rampant in the Hungarian economy, the market will start pricing in rate hikes further down the curve, and the yield curve will consequently steepen (Chart I-17). Polish and Czech bonds offer better value relative to bunds as investors stand to gain from currency appreciation as well as an attractive spread. (Chart I-18). Chart I-17Bet On Yield Curve ##br##Steepening In Hungary Bet On Yield Curve Steepening In Hungary Bet On Yield Curve Steepening In Hungary Chart I-18Polish & Czech Bond Offer Value ##br##Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Risk Budgeting: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". Tracking Error Of Our Portfolio: We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Our current tracking error is just under ½ of that limit. We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Feature Last September, we introduced a model portfolio framework to Global Fixed Income Strategy.1 This was done to better communicate our investment research into actionable ideas more in line with the day-to-day decisions and trade-offs made by professional bond managers. We followed that up with the addition of performance measurement tools to more accurately track the returns of our model bond portfolio versus a stated benchmark.2 We are now initiating the final piece of our model bond portfolio framework in this Special Report - introducing a risk management component to identify cumulative exposures and guide the relative sizes of our suggested tilts. Our goal is to translate our individual investment recommendations into the language of a "risk budget", i.e. how much of the desired volatility of the portfolio would we suggest placing into any single trade idea. This will allow our readers to apply our proposed tilts - based on how much conviction (i.e. "risk") we allocate to each position - to their own portfolios which may have different risk limits and return expectations. For example, our current recommendation to overweight U.S. corporate debt, both Investment Grade (IG) and High-Yield (HY) represents nearly 1/3 of our estimated total portfolio risk, by far our largest source of potential volatility both in absolute terms and versus our benchmark index (Table 1). Overweighting U.S. corporates, both versus U.S. Treasuries and Euro Area equivalents, is one of our highest conviction trades at the moment. A client who may choose to run a lower risk portfolio can still follow our recommendation by placing enough into U.S. corporates so that 33% of the desired portfolio volatility will come from those positions. Table 1Risk Allocation In Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio In the rest of this Special Report, we will discuss some of the various ways to measure fixed income portfolio risk, apply them to our model portfolio, and introduce some measures to monitor our aggregate portfolio volatility. Going forward, we will closely watch our established metrics and position sizes to ensure that the combination of our individual investment recommendations that we discuss on a week-to-week basis does not create a portfolio that is potentially more volatile than desired. Risk Measurement In Fixed Income Portfolios While investors are typically focused on meeting return targets for their portfolios, the other side of the equation - managing portfolio volatility - is often less stressed. This is especially true during bull markets for any asset class. Investors may become complacent if returns meet or exceed their targets when, in fact, excess returns may have actually been earned through overly risky positions that could have easily not worked in the investors' favor. In the current macro environment, where many financial asset prices are at new highs with stretched valuations and with most of the major global central banks incrementally moving towards less accommodative monetary policy stances, risk management should be even more important for investors. Overly concentrated positioning could now lead to considerable portfolio losses, especially if measuring risk with a metric that is flawed or incomplete, which can lead to a false sense of security. With that in mind, we consider some typical risk measurement metrics used by fixed income investors: Duration: Duration is usually the most popular risk metric for fixed income portfolios as it measures interest rate sensitivity. Duration is defined as the percentage change in a portfolio or asset resulting from a one percentage point change in interest rates. While it provides a solid base understanding of interest rate risk, it does make a simplifying assumption that there is a linear relationship between interest rates and bond prices. Value-At-Risk: Value-At-Risk (VaR) is a statistical technique that measures the loss of an investment, or of an entire portfolio, over a certain period with a given level of confidence. However, there are two considerable flaws with this approach. First, the VaR output suggests a portfolio can lose at least X%, it does not actually indicate how big the potential loss could be. Instead, using a measure such as Historical VaR, if a portfolio has a long enough track record, can better quantify potential losses. Second, VaR is highly susceptible to estimation errors. Certain assumptions on correlations and the normality of return distributions can have a substantial impact on VaR readings. Table 2Value At Risk Of Our Benchmark Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio In Table 2, we show the Historical VaR (HVAR) of our benchmark index, calculating the potential monthly loss using data going back to 2005. On that basis, the worst expected monthly loss for our benchmark is -1.6% (using a 95% confidence interval) and -2.1% (using a 99% confidence interval). Tracking Error: Tracking error measures the volatility of excess returns relative to a certain benchmark. It is a standard risk measure used by a typical "real money" bond manager with a benchmark performance index, like a mutual fund. Tracking error does not offer information on alpha generation (i.e. how much you can expect to beat your benchmark based on your current investments), it simply indicates how much more volatile a portfolio is expected to be versus its benchmark. As our model portfolio returns are measured on a relative basis to our stated bond benchmark index, tracking error is quite appropriate as our main risk metric. A Historical Examination Of Our Portfolio When we first created our model portfolio, we also introduced a benchmark index against which we could measure our performance. Our customized benchmark differs from typical multi-sector measures like the Barclays Global Aggregate Index in that it has a broader scope, including sectors that can have credit ratings below investment grade such as High Yield corporates. The benchmark does, however, exclude smaller regions that we only occasionally discuss such as Sweden, Portugal, Norway and New Zealand. These smaller markets offer comparatively poor liquidity and we want our benchmark to be as investible as possible. Nevertheless, our customized benchmark has been highly correlated to the Barclays Global Aggregate Index over the past decade. As our portfolio has not had a full year of return data, its history is quite limited. Still, in our first performance review conducted two months ago, we indicated that our portfolio had been very closely tracking our customized benchmark. We have since increased our positions in our highest conviction views and our tracking error has risen noticeably and now sits at just over 40bps (Chart 1). Within our model portfolio, we are setting an expected excess return target of 100bps per year. That means that we are setting a goal of beating our benchmark index returns by one full percentage point per year. Given that we are measuring our performance versus currency-hedged benchmarks that are primarily rated investment grade or better, 100bps of annual excess return is a reasonable target. We are also setting a limit where the excess return/tracking error ratio should aim to be equal to 1 each year. This is under the simple assumption that we want an equal amount of return over our benchmark for our expected excess volatility versus our benchmark. On that basis, we are setting our tracking error "limit" at 100bps per year. That suggests that our current tracking error is relatively low. However, correlations between the individual components of our benchmark index have been rising over the past couple of years (Chart 2). Therefore, running a relatively low overall level of risk at a time where diversification among the positions within our portfolio is now harder to achieve, and when the valuations on most government bond and credit markets look rich, is prudent. Chart 1Higher Tracking Error, But Still Well Below Our Target Higher Tracking Error, But Still Well Below Our Target Higher Tracking Error, But Still Well Below Our Target Chart 2Correlations Across Fixed Income Sectors Have Been Rising Correlations Across Fixed Income Sectors Have Been Rising Correlations Across Fixed Income Sectors Have Been Rising This is another way that we can control the overall riskiness of our model portfolio. Not only by how much of our risk budget (tracking error) that we want to allocate to each of our recommended positions, but also how big of a risk budget do we want to run at any given point in time. If we see more assets trading at cheap valuations, then we could choose to run a higher tracking error than when most assets look expensive. Bottom Line: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Measuring The Contribution To Risk From Our Market Tilts In our model portfolio, we include a wide range of geographies and sectors from the global fixed income universe. Understanding the risk contribution of each position to the overall portfolio provides a clearer picture as to where our potential risks lie, and by how much. To measure the risk contribution of each of our individual recommendations to our overall portfolio volatility, we used the following formula: wA * E CovAB * wB Where W = the weight of any single asset in our portfolio and COV is the covariance between the asset and other assets in the portfolio. As such, an asset's contribution to risk is a function of its weight in the portfolio and its covariance with the other assets. Importantly, since we are measuring our model portfolio performance in terms of excess returns, we examined each position's contribution to risk relative to the benchmark. All calculations begin in late 2005, when return data is available for all of the assets in our portfolio. The results are summarized in Table 1 on Page 1. Our portfolio tilts are based off of our four highest conviction themes. They include: Stronger global growth led by the U.S. The U.S. economy should expand at a faster pace in the latter half of the year on the back of a rebound in consumption and strong capital spending, all supported by solid income growth and easy financial conditions. We have expressed this theme through our overweight allocation to U.S. corporate debt. While our U.S. Corporate Health Monitor is flashing that balance sheets are becoming increasingly strained, easy monetary conditions and an expansionary economic backdrop should continue to support excess returns for U.S. corporates. More Fed rate hikes than expected. We expect U.S. economic and corporate profit growth to remain robust due to accommodative monetary conditions, diminishing slack and resilient consumption. As such, the Fed will continue tightening policy by more than what markets are currently pricing in. This theme is expressed through an underweight position in U.S. Treasuries, which accounts for 17% of our volatility versus 24% for that of the benchmark. This wide spread relative to the benchmark is a substantial source of our tracking error, but one that we are comfortable running given our view that U.S. Treasury yields are too low. Chart 3Realized Bond Volatility Has Been Declining Realized Bond Volatility Has Been Declining Realized Bond Volatility Has Been Declining Rising tapering risks in Europe. Our expectation is that the European Central Bank (ECB) will be forced to announce a slower pace (tapering) of bond buying starting next year, given the current robust economic expansion in Europe that is rapidly absorbing spare capacity. An ECB taper announcement is expected to lead to rising longer-term global bond yields, mostly via rising term premia. We are expressing that view in our portfolio through our overall underweight interest rate duration stance. Our current portfolio duration is 5.6 years versus our benchmark duration of 7.0 years. That is a large tilt that represents a significant portion of our tracking error, but given our view that U.S. Treasuries also look overvalued, running a large overall duration underweight does correlate to our conviction level. Rising geopolitical risks and banking sector issues in Italy. Geopolitical risks remain elevated leading up to parliamentary elections in 2018, and Italian banks remain undercapitalized with non-performing loans still in an uptrend. Therefore, we are underweight Italian debt, though this is a smaller deviation of portfolio risk versus our benchmark (around 2%), given the smaller size of Italy in our benchmark. Purely looking at geography and sector selection, our four highest conviction views make up almost 80% of the active portfolio risk that we are "running" in our model portfolio. That number may seem high but, as described earlier, our realized portfolio volatility has been quite low (Chart 3). That suggests that there could be some degree of underlying diversification within our recommended portfolio given lower correlations of certain assets to the rest of the portfolio. This is a topic that we will investigate more deeply in future Weekly Reports. Bottom Line: We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Introducing Our Recommended Global Fixed Income Portfolio", dated September 20 2016, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "An Initial Look At The Performance Of Our Model Bond Portfolio", dated April 18 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Table 4 Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio

Highlights The Federal Reserve stuck to its guns, which lifted the U.S. dollar despite a disastrous CPI report. We agree with the Fed's assessment and expect U.S. inflation to pick up, clearing the way for higher interest rates and a stronger dollar. With three dissenters voting in favor of higher rates, the Bank of England meeting delivered a hawkish surprise. However, the inflation surge will continue to weigh on consumer spending, limiting the capacity of the BoE to increase rates. Stay short cable, but use any rally in EUR/GBP above 0.88 to short this cross. The Canadian economy is strong, and the CAD should perform well on its crosses. However, USD/CAD downside is limited. Go short EUR/SEK. Feature This week was replete with central bank meetings, most crucially the Federal Reserve and the Bank of England, which provided much-needed color on the near-term future direction of global monetary policy. While the BoE does face a serious rise in inflation, it is still focused on the risks to U.K. growth. In contrast, the Fed mostly ignored the disastrous inflation report released the morning before its policy announcement and kept its focus on the underlying strength in the U.S. economy. We believe both institutions are pursuing the appropriate strategy for their respective economies. The Fed: Straight Ahead Fed Chair Janet Yellen and her gang increased the fed funds rate by 25 basis points to 1-1.25% and pre-announced the parameters around the reduction in the Fed's balance sheet size. On the balance sheet front, the Fed removed any doubt that it will begin reducing its asset holdings this year. Additionally, the Fed provided its new set of forecasts for growth, inflation, unemployment, and interest rates. While it increased its growth forecast for 2017 to 2.2% from 2.1%, it curtailed its core PCE deflator forecast for 2017 by 0.3 percentage points to 1.6%. However, in line with its conviction that the soft patch in inflation is temporary, it kept its 2018 and 2019 core PCE forecasts at 2%. The Fed did also acknowledge that the equilibrium unemployment rate was lower than it believed in March, decreasing its long-term estimate by 0.1% to 4.6%. However, despite recognizing that NAIRU has fallen, the Fed still thinks the labor market is tight. It proceeded to curtail its unemployment rate forecasts by 0.2% in 2017 to 4.3%, and by 0.3% in 2018 and 2019 to 4.2%. Congruent with these forecasts, the Fed did not adjust its intended path for interest rates. It still expects to hike rates once more in 2017, and three more times in both 2018 and 2019. As a result of these policy changes and the intentions associated with the new set of forecasts, the dollar recouped its CPI report-induced decline, and gold suffered. Most interestingly, the market seems to believe that the Fed is entering the realm of policy mistakes as the 2-10-year yield curve flattened considerably, and inflation expectations plunged to their lowest levels since November 4, 2016 (Chart I-1). But is the Fed really making a mistake? We do not think so. Simply put, we agree with the Fed that underlying economic momentum in the U.S. is real, and that both wage growth and inflation will turn the corner this summer. To begin with, our composite capacity utilization gauge, based on both industrial capacity and labor market utilization, is now fully into "no slack" territory. Historically, this has given the Fed the green light to increase interest rates. There is no mystery behind this relationship: when this indicator is above the zero line, inflation pressures emerge and wage growth accelerates (Chart I-2). This time is unlikely to prove different. Chart I-1A Policy ##br##Mistake? A Policy Mistake? A Policy Mistake? Chart I-2Conditions In Place For Higher##br## Inflation And Rates Conditions In Place For Higher Inflation And Rates Conditions In Place For Higher Inflation And Rates Supporting this assessment, many indicators show that the recent slowdown in wage growth will prove a temporary phenomenon. First, the spread between the Conference Board's "jobs plentiful" and "jobs hard to get" series still points to accelerating average hourly earnings (Chart I-3). Second, the labor market is likely to remain healthy. True, the fastest pace of job creation is behind us, a key symptom that labor market slack is vanishing, but some of our favorite employment indicators - such as Janet Yellen's labor market condition index and the NFIB job openings and hiring plans subcomponents - have picked up again (Chart I-4). In an environment of little slack, this might not translate into impressive nonfarm payroll numbers, but most likely faster wage growth. Chart I-3Wages Will Pick Up Wages Will Pick Up Wages Will Pick Up Chart I-4Yes, The Labor Market Is Healthy Yes, The Labor Market Is Healthy Yes, The Labor Market Is Healthy Third, capex intentions are still perky. Historically, capex intentions have tightly correlated with wages, and even the recent softness in wages was forecast by these intentions. This is simply because capex tends to require labor. When corporate investment materializes as worries about the durability of final demand hits cyclical lows, this is generally an environment that requires bidding up the price of labor - i.e. wages. This is precisely the current economic backdrop (Chart I-5). While the slowdown in bank credit to enterprises has caused many commentators to worry about the outlook for capex, we do not share these concerns. For one, although businesses may not have been tapping bank loans in Q1, they have been aggressively borrowing in the bond market (Chart I-6, top panel). Moreover, credit standards are now easing anew, and small firms are reporting little difficulty in accessing credit (Chart I-6, bottom panel). Chart I-5Good Outlook For Growth And Wages Good Outlook For Growth And Wages Good Outlook For Growth And Wages Chart I-6I Need Credit; No Problem! I Need Credit; No Problem! I Need Credit; No Problem! With respect to consumption, weren't retail sales on the soft side as well? Here again, we need to step back. Real retail sales continue to grow at a healthy 4.2% annual pace; meanwhile, the so-called control group - which affects GDP computations - was flat in May, but the April number was revised to 0.6% month-on-month, suggesting real consumption will be robust in Q2. In fact, federal income tax withholdings, a good proxy for household income growth, is also accelerating, further supporting consumption (Chart I-7). Overall, we agree with the Fed that the economy is on its way to escaping from its recent soft patch and that wage growth will accelerate. Ryan Swift, who writes our sister U.S. Bond Strategy service, has also recently argued that the U.S. Philips curve remains alive and well, and that wages and inflation will thus pick up again.1 Our own work does highlight the potential for not just wage growth but core CPI to also perk up. U.S. real business sales have been very strong of late, which historically has been a good leading indicator of core inflation (Chart I-8, top panel). Labor market dynamics tell a similar story. Our unemployment diffusion index is also a good leader of core CPI, and after a soft patch is now pointing to firming underlying inflation (Chart I-8, bottom panel). Chart I-7Real Consumption Will Trudge Along Real Consumption Will Trudge Along Real Consumption Will Trudge Along Chart I-8Inflation Soft Patch Will End Inflation Soft Patch Will End Inflation Soft Patch Will End Therefore, we expect the recent negative inflation surprise in the U.S. to reverse. Moreover, inflation surprises in the U.S. are also likely to beat those of the euro area. To a very large extent, Europe's positive inflation surprise, especially relative to the U.S., reflected the 2014 collapse in the euro. The recent stability in the euro since March 2015 further reinforces that the boost to European relative monetary conditions is dissipating, and that European inflation surprise will not outpace the U.S. going forward (Chart I-9). Chart I-9U.S. Inflation Surprises ##br##Will Pick Up Versus Europe's U.S. Inflation Surprises Will Pick Up Versus Europe's U.S. Inflation Surprises Will Pick Up Versus Europe's Chart I-10Diverging Policy ##br##Expectations Diverging Policy Expectations Diverging Policy Expectations This is very important, as these relative inflation surprise dynamics have been the key factor underpinning divergent expectations behind ECB policy and the Fed's path. While investors have increasingly brought forward the ECB's first hike, they have aggressively curtailed the number of hikes expected in the U.S. over the next two years (Chart I-10). If, as we expect, relative inflation surprises do once again move in favor of the U.S., this gap will disappear, supporting the dollar in the process. Bottom Line: The Fed is right to stay the course. The economy continues to display momentum, and the inflation soft patch should soon dissipate. Moreover, U.S. economic surprises are bottoming. As such, we expect market expectations for inflation and interest rates to move back toward the Fed's forecast, lifting the U.S. dollar in the process. BoE Dissenters Grab The Headlines, But... The poor BoE is in an infinitely more tenuous situation than the Fed. Core inflation continues to pick up, but economic uncertainty is also on the rise. This dichotomy is most pronounced when it comes to wages. At 2.6%, core inflation is now outpacing wage growth, thus real income levels are contracting (Chart I-11). This is problematic because at 65% of GDP, the U.K. is an economy fundamentally driven by consumer spending. As Chart I-12 illustrates, when inflation picks up and puts downward pressure on real wages, consumption sags. Therein lies the BoE's conundrum. Chart I-11U.K.: Inflation Everywhere, But Not In Wages U.K.: Inflation Everywhere, But Not In Wages U.K.: Inflation Everywhere, But Not In Wages Chart I-12The BOE's Dilemma The BOE's Dilemma The BOE's Dilemma Despite the three dissenters who voted in favor of a hike this week, we expect the BoE to continue to favor not lifting rates, leaving its accommodation in place.2 Household inflation expectations remain well moored, but a further relapse in growth could prompt a widening of the output gap and produce entrenched deflationary expectations down the line - something BoE Governor Mark Carney and his colleagues want to avoid at all costs. Chart I-13U.K. FDI At Risk U.K. FDI At Risk U.K. FDI At Risk Some investors have been wondering out loud about the likelihood of a "soft Brexit" coming back on the agenda, arguing that it would support the pound. Remaining in the common market is, after all, an unmitigated positive for the U.K. But to be part of the common market, the U.K. also has to adopt the sacrosanct freedom of movement of people. We remain unconvinced that the British will budge on this point. Brexit was first and foremost a rejection of neo-liberal ideals that have been perceived as detrimental to the British middle class. And no point has been and continues to be more contentious than immigration. With the EU absolutely unwilling to dilute freedom of movement, access to the common market for the U.K. remains a distant dream. Moreover, with the British median voter switching to the left, a topic discussed in last Friday's Geopolitical Strategy Service Special Report on the election, British politics are likely to become less business friendly.3 Compounding this issue, U.K. industrial production is flat on an annual basis, bucking the global improvement seen last year and implying that the falling pound has not boosted competitiveness in the U.K. manufacturing sector. Together these forces suggest that the recent upsurge in FDI inflows into the U.K. could reverse in coming quarters (Chart I-13), a big problem for a country with a current account deficit of more than 4% of GDP and deeply negative real rates. Ultimately, the pound is cheap, trading at a one-sigma discount to its fair value. This means the market is well aware of the negatives that are weighing on sterling. Thus, the risks to GBP are well balanced. As a result, we expect GBP/USD to finish the year toward 1.2 because of our expectation of USD strength. EUR/GBP has limited upside, and rises above 0.88 should be used to build short positions. Bottom Line: The BoE decision was in line with expectations, but the market was nonetheless surprised by the fact that three MPC members dissented and voted for a rate hike. Sure, British inflation is on the rise, but this is hurting household real incomes, and thus consumption. These dynamics limit the upside risk to policy rates. We think that GBP could weaken against the USD; we would use moves above 0.88 to short EUR/GBP. The Bank Of Canada Volte Face Despite a 5% fall in oil prices this week, the CAD has appreciated 1.2% against the USD. Behind this impressive move has been Monday's speech by Senior Deputy Governor Carolyn Wilkins, in which she hinted that the Bank of Canada's next move will be a hike, coming sooner than investors have been anticipating. The BoC assessed that the negative impact of the fall in oil prices in 2014-'15 has passed, and that domestic strength in the Canadian economy has become self-sustaining. With the output gap expected to close in Q2 2018, the logical path for policy is tighter. Do the indicators warrant such a view? Yes: Canadian employment is quite strong, growing at a 1.8% annual pace. Unemployment too has fallen substantially. Capacity utilization is elevated in the manufacturing sector, thanks to a decade of low corporate investment. If our assessment of the U.S. capex cycle is correct, Canadian goods exports should pick up, adding to capacity and inflationary pressures in the country (Chart I-14). Our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits, and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth. Canadian LEIs and PMIs are all strong. Canadian house prices continue to forge ahead, growing at a 14% annual rate, which will additionally support Canadian consumption. This picture highlights that the BoC does have room to adjust its forward guidance, especially if the Fed stays on its desired path. Today, not only are investors the most short CAD since early 2007, but the loonie is cheap relative to real rate differentials (Chart I-15). As a result of these distortions, CAD could respond very positively to continued reaffirmation by the BoC that policy may become tighter. Chart I-14O Canada O Canada O Canada Chart I-15CAD At A Discount To Rates CAD At A Discount To Rates CAD At A Discount To Rates Practically, due to our broad bullish outlook on the USD, we find the most interesting way to play CAD strength is through its various crosses. Thus, we remain short EUR/CAD, short AUD/CAD, and long CAD/NOK. Bottom Line: The Canadian economy has escaped its funk. True, the long-term risks associated with the housing bubble will ultimately come home to roost. However, in the short term, the BoC is finding room to lift its forward guidance. As a result, CAD is likely to move higher on non-USD crosses. EUR/SEK Is A Short EUR/SEK should weaken in the coming quarters. To begin with, EUR/SEK is trading at a 7% premium against its PPP fair value. Additionally, the real trade-weighted SEK stands at a one-sigma discount to its long-term fundamental fair value, which further highlights the SEK's upside potential versus the euro, the main trading counterparty of Sweden (Chart I-16). Valuations are not enough to motivate a position. Economics need to join the ball. Today, the Swedish output gap is positive while that of Europe remains negative. Unsurprisingly, Swedish core inflation has overtaken that of the euro area (Chart I-17). Moreover, while we have argued at length why euro area core inflation is likely to disappoint going forward,4 pressure on Swedish resources is such that Swedish core inflation is likely to display additional upside (Chart I-18). Chart I-16SEK Is Cheap SEK Is Cheap SEK Is Cheap Chart I-17Swedish Core Inflation Is Outpacing Europe's Swedish Core Inflation Is Outpacing Europe's Swedish Core Inflation Is Outpacing Europe's Chart I-18Swedish Core Inflation Will Rise Further Swedish Core Inflation Will Rise Further Swedish Core Inflation Will Rise Further This means there will be attractive relative policy dynamics between the Riksbank and the ECB in the coming months. If the ECB has to tighten policy, the Riksbank has an even better case to be hawkish. If, however, the global economic environment prevents the ECB from tightening and forces it toward an easing bias, these global deflationary pressures should prove more muted in Sweden. Thus, we expect that Swedish policy will tighten relative to the ECB's, despite the economic and inflation environment. Chart I-19CPI Expectations Differential Will Push ##br##Policy Toward A Lower EUR/SEK CPI Expectations Differential Will Push Policy Toward A Lower EUR/SEK CPI Expectations Differential Will Push Policy Toward A Lower EUR/SEK Additionally, inflation expectations are pointing toward a lower EUR/SEK. The recent Swedish Prospera inflation survey showed that economic agents are expecting a pickup in inflation. As a result, market-based inflation expectations in Sweden have outperformed those in Germany, pointing to a lower EUR/SEK (Chart I-19). Essentially, this reflects potential changes in the relative direction of policy between the two currencies. The big risk to this view is that Stefan Ingves, the Riksbank governor, continues to be one of the most dovish policy makers in the world. However, his term ends on January 1, 2018, and unless he is renewed for another six years, his words and desires will increasingly lose their ability to affect markets. Bottom Line: The Swedish economy is increasingly moving closer to an inflationary environment. This cannot yet be said about the euro area. With inflation expectations sharply moving up in Sweden versus the euro zone, investors should begin betting against EUR/SEK. Housekeeping We are closing our short USD/JPY trade this week at a 4.2% profit. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report titled, "Low Inflation And Rising Debt", dated June 3, 2017, available at usbs.bcaresearch.com 2 Moreover, one of the dissenters was Kristin Forbes, who was attending her last meeting as a member of the MPC. 3 Please see Geopolitical Strategy Special Report titled, "U.K. Election: The Median Voter Has Spoken", dated June 9, 2017, available at gps.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Chairwoman Janet Yellen has halted the dollar selloff for now, with the DXY finally seeing some upside. Following the press conference, the greenback sits 1.2% above the lows seen prior to the Fed policy meeting. We share the view of the Fed and the expect markets to converge over time toward the Fed's forecasts. Additionally, Yellen confirmed that there is still one more hike on the table this year. We believe the market continues to underprice these factors, concentrating too much on what amounts to a temporary soft patch. As we have said in the past, these factors will continue to widen rate differentials between the U.S. and its G10 counterparts. Report Links: Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 EUR/USD dropped on the news of a weak trade balance figure of EUR 19.6 bn, below the expected EUR 27.2 bn. Generally, EUR/USD has remained reasonably static as euro weakness was muted by equal dollar weakness, but recent Fed hawkishness has broken this trend. Draghi's hawkishness is tepid at best and the Fed hiking rates this Wednesday, as well as Yellen reiterating that another hike will be seen later this year will continue to help U.S. policy anticipations relative to Europe. As a result, rate differentials are likely to widen, and the euro to soften. The little appreciation in the euro earlier this week, was a result the following positives: German ZEW Survey's Current Situation went up to 88, beating expectations of 85; Euro Area ZEW Survey's Current Situation also went up to 37.7 from 35.1. Report Links: Look Ahead, Not Back - June 9, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: Domestic corporate goods prices grew by 2.1% YoY, against expectations of 2.2%. Machinery orders yearly growth came in at 2.7%, underperforming expectations by a wide margin. Industrial production yearly growth stayed flat at 5.7%. Ultimately, economic activity in Japan will largely depend on the currency. With the yen appreciating for most of 2017, it will be difficult for the Japanese economy to improve sustainably. At this point, we are closing our USD/JPY trade, as the correction in the U.S. dollar has run its course. Meanwhile, we remain bearish on NZD/JPY, as the rising dollar and the tightening in Chinese monetary conditions will deliver a formidable one-two punch to risk assets, and thus weigh on this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production contracted by 0.8% on a YoY basis, underperforming expectations. Manufacturing production yearly growth stayed flat, also underperforming. Meanwhile, both core and headline inflation came in above expectations, at 2.6% and 2.9% respectively. Yesterday the BoE came in more hawkish than expected, as Ian McCafferty and Michael Saunders joined Kristin Forbes voting and dissented in favor offor a hike. Meanwhile, in their monetary policy summary the BoE stated that inflation will stay above target for an "extended period". Following the report, EUR/GBP plunged by about 0.8%. We are now not positive on the pound, as core inflation is now outpacing wage growth, a development that should weigh on demand due to the decline in real income. This development could cause GBP/USD and EUR/GBP to reach 1.2 and 0.92 respectively to reach 1.2 by year end, but any move in EUR/GBP above 0.88 should be used to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Data out of Australia was mixed this week: National Australia Bank's Business Confidence declined to 7 from 13; Westpac Consumer Confidence fell to -1.8% from -1.1%; However, the unemployment rate dropped to 5.5%, with full-time employment growing by 52,100, and part-time employment shrinking by 10,100. Most of the movement in the AUD was dominated by the employment data, seeing a broad-based increase versus other G10 currencies. While oil prices kept the CAD and NOK at bay, Chinese industrial production and retail sales increased at a 6.5% and 10.7% annual rate, respectively. Iron ore and copper, commodities important to Australia, however, saw little action, but coal saw a slight upside. The above dynamics resulted in the AUD outperforming other currencies versus the USD, and EUR/AUD weakened massively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Electronic card retail sales grew by 5.2% year-on-year, increasing from 4.2% the month before. However, the current account deficit came in at 3.1% of GDP against expectations of 2.7%. Meanwhile, yearly GDP growth came in at 2.5%, underperforming expectations. The kiwi rallied this week as expectations of a dovish fed weighed on the dollar, although most of these gains vanished following the FOMC press conference. We continue to be positive on the NZD relative to the AUD, given that the kiwi economy is in much better footing than the Australian one. However, upside for NZD/USD is limited, as this cross has reached highly overbought levels. Furthermore, the tightening in Chinese monetary conditions will become a headwind for a sustainable rally in the NZD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The downside in oil continues as EIA crude oil stocks decreased by 1.661 million barrels, less than the expected 2.739 million. AUD/CAD and NZD/CAD rallied on the news, while CAD/NOK levelled off. In the commodity space, we remain most positive on the Canadian economy. While oil prices are a hurdle, business and consumer confidence, as well as PMIs remain robust, and the BoC expects the output gap to close in Q2 2018. Our Commodity and Energy Strategy team continues to believe that OPEC cuts and increased oil demand will eventually curtail inventories. We therefore expect our short AUD/CAD trade to prove profitable as markets begin to digest these developments. While the CAD looks good on its crosses, the resumption of the dollar bull market will limit the USD/CAD's downside. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Yesterday, in their monetary policy statement, the SNB reasserted its dovish bias, pledging to keep its extremely accommodative monetary policy in the years to come. Their inflation outlook changed little, upgrading the near term slightly while downgrading the longer term outlook. It is important to consider that when the SNB states that they expect that inflation will reach only 1.5% by the first quarter of 2020, they do so assuming the LIBOR rate stays at -0.75%. Meanwhile, they also signaled that they will stay active intervening in the currency market, with SNB president Thomas Jordan reiterating that the Franc “remains significantly overvalued”. We had previously stated that the implied floor put under EUR/CHF by the SNB could be removed by the end of this year. However, this scenario now seems unlikely, given the strong commitment by the SNB to remain accommodative. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Following a sell-off for most of the beginning of the week, USD/NOK has rebounded sharply, following the FOMC interest rate decision. Furthermore, the disappointing draw in oil inventories also contributed to the surge in USD/NOK. We continue to be bearish on the NOK, given that inflation is still receding in Norway. Recent data supports this, with core inflation and producer prices falling from anewApril. Furthermore, any surge in the U.S. dollar will provide a tailwind to USD/NOK given that this cross is highly sensitive to the dollar. Another cross where we are positioned towe use to take advantage of gain from Norway's economic weakness difficulties is CAD/NOK. The Canadian economy is on ain much stronger footing than the Norwegian one, and the rally in the dollar has historically been a tailwind for this cross. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden's economy is developing as expected, with headline inflation reading at the expected level of 1.7%, with a 0.1% monthly increase. Although inflation decreased from the previous 1.9% reading, the Riksbank's Resource Utilization Indicator - historically, a reliable indicator for core inflation - continues to point up, indicating that core inflation will accelerate further. We are putting on a short EUR/SEK trade on the basis of long-term valuations being in the favor of the krona. With a closed output gap, Sweden's economy is more advanced in its business cycle than the euro area', which points to a further bifurcation in inflation rates between the two. These factors will also warrant a quicker removal of policy support from the Riksbank than the ECB. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship may not end up changing dramatically - which is good news for the pound in the long term. Our 6-12 month preference for currencies is euro first, pound second, dollar third. The euro area economy will perform at least in line with the U.S. economy through 2017, so the T-bond/German bund yield spread will continue to compress. Long euro area retailers, short U.S. retailers has catch-up potential. The focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Feature Brexit Will Become A Fake Divorce Theresa May's stinging reversal at the ballot box last Thursday has left some people wondering: will Brexit actually happen? The answer is very likely yes, but this is no longer the right question to ask. Chart I-1 Jeremy Corbyn's resurgent Labour Party, the Scottish National Party, the Liberal Democrats and pro-European Conservatives now form a parliamentary majority which proposes that a non-EU U.K. negotiates tariff-free access to the single market and customs union.1 In such an arrangement, the U.K. and EU would be technically divorced. But economically and financially, the relationship would not be so different to being married. In effect, Brexit would become a fake divorce. Unfortunately, there is a flipside. The U.K. would be unable to reclaim swathes of sovereignty over its borders and its law. This is because the tariff-free movement of goods, services and capital is, in theory, indivisible from the free movement of people. Furthermore, EU law would transcend national law in the regulation and policing of the single market's so-called 'four freedoms'. Admittedly, the four freedoms are an unachieved - and arguably unachievable - ideal. But they are an aspiration which EU policymakers do not want Brexit to threaten. Angela Merkel recently put it in very strong terms: "Cherry-picking (from the four freedoms) would have disastrous consequences for the other 27 member countries... Tariff-free access to the single market can only be possible on the conditions of respecting the four basic freedoms. Otherwise one has to talk about limits to access" Hence, Brexit reduces to a trade-off between the extent of tariff-free access to the European single market that the U.K. wants to keep, and the extent of national sovereignty it is willing to concede (Chart of the Week). Economically and financially, it is largely irrelevant whether the U.K. gets tariff-free access to the single market via a bespoke free-trade arrangement or via membership of an off-the-shelf structure like EFTA or the EEA.2 The much bigger question is: in order to keep most of its tariff-free access to the single market, will the U.K. now downgrade its plans to "take back full control" of its borders and law? Following last Thursday's stunning election result - and its impact on parliamentary composition (Chart I-2 and Chart I-3) - the answer seems to be yes. The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship might not end up changing dramatically. Chart I-2 Chart I-3 Euro First, Pound Second, Dollar Third Avoiding a dramatic change in the U.K./EU economic and financial relationship reduces the risk of a major disruption to the U.K. economy and the need for further emergency easing from the Bank of England. Thereby, it is good news for the pound in the long term. That said, our 6-12 month preference for currencies is euro first, pound second, dollar third. The crucial point is that currencies and bond market relative performance depends front and centre on the evolution of relative interest rate expectations. In turn, the evolution of relative interest rate expectations must ultimately follow relative economic performance, as evidenced in hard data such as GDP growth, inflation and job creation. Over a period of a few months, central banks can look through hard data on the basis that the data is noisy or "transient". But over periods of 6 months and longer, the noisy and transient excuse wears thin. Central banks' strong commitment to data-dependency means that their actions and/or words must follow the hard data. No ifs, buts or maybes. Hence, relative interest rate expectations ultimately follow relative economic performance (Chart I-4 and Chart I-5). We are unashamedly republishing these two charts from last week because they prove the point so powerfully. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in the U.S. (Chart I-6). In which case, relative interest rate expectations will continue to converge, the T-bond/German bund yield spread will continue to compress, and euro/dollar will ultimately drift higher. Chart I-4Relative Interest Rate Expectations Must Follow ##br##Relative Economic Performance Relative Interest Rate Expectations Must Follow Relative Economic Performance Relative Interest Rate Expectations Must Follow Relative Economic Performance Chart I-5Relative Bond Yields Must Follow Relative##br## Economic Performance Relative Bond Yields Must Follow Relative Economic Performance Relative Bond Yields Must Follow Relative Economic Performance Chart I-6Only A Modest Decline In The Euro Area ##br##6-Month Credit Impulse Only A Modest Decline In The Euro Area 6-Month Credit Impulse Only A Modest Decline In The Euro Area 6-Month Credit Impulse The Eurostoxx50 Is Not A Play On The Euro Area Economy. So What Is? Does it follow that the Eurostoxx50 equity index will outperform? Not necessarily. Unlike for currencies, interest rates and bond yields, the connection between relative economic performance and relative equity market performance is weak, or even non-existent. Note that the Eurostoxx50 has underperformed the S&P500 this year even though the euro area economy has outperformed. Chart I-7The Global Growth Pause ##br##Has Hurt Cyclicals The Global Growth Pause Has Hurt Cyclicals The Global Growth Pause Has Hurt Cyclicals The reason is that the over-arching driver of an equity market's relative performance is its skew to dominant international sectors and international stocks. The Eurostoxx50 has a higher exposure to the global growth cycle via its dominant weighting in Financials and Resources; conversely the S&P500 has a higher exposure to the less globally-sensitive Technology and Healthcare sectors. The defining sector skew has penalised the Eurostoxx50 versus the S&P500 because globally-sensitive cyclicals have strongly underperformed in a very clear global growth pause. Furthermore, the ever-reliable global 6-month credit impulse strongly suggests that the global growth pause will persist through the summer (Chart I-7). This begs the question: is there a way for equity investors to play the resilient performance of the euro area economy? The answer is yes. But before explaining how, a quick note of caution. An aggregate small cap equity index is not a good way to play a domestic economy. This is because the dominant characteristic of small cap stocks - in aggregate - is their very high beta. Hence, rather than a strong play on the domestic economy, investors are effectively buying highly leveraged exposure to market direction. Great when markets are rising, but painful when they are falling, irrespective of how the domestic economy is faring. Instead, a good equity play on relative economic performance is the relative performance of retailers (Chart I-8). Drilling down further, the relative performance of home improvement retailers is an even purer play (Chart I-9) - given that household spending on home improvement is closely tied to the domestic economic cycle. Chart I-8Retailers Are A Good Play On Relative ##br##Economic Performance Retailers Are A Good Play On Relative Economic Performance Retailers Are A Good Play On Relative Economic Performance Chart I-9Euro Area Home Improvement Retailers ##br##Can Now Ourperform Those In The U.S. Euro Area Home Improvement Retailers Can Now Outperform Those In The U.S. Euro Area Home Improvement Retailers Can Now Outperform Those In The U.S. On the expectation that the euro area economy will perform at least in line with the U.S. economy,3 the equity market play would be long euro area retailers, short U.S. retailers. In particular, long euro area home improvement retailers, short U.S. home improvement retailers has a lot of catch-up potential. And the focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In simple terms, the single market defines the zone of tariff-free trade for European countries with each other. Whereas the customs union defines the zone of a single set of rules and tariffs for European countries to trade with the rest of the world. Membership of the customs union allows goods and services that enter from the rest of the world to then move around Europe unhindered. 2 The European Free Trade Association (EFTA) is a free trade area consisting of Iceland, Liechtenstein, Norway and Switzerland. Iceland, Liechtenstein, and Norway participate in the EU single market through their membership of the European Economic Area (EEA). Whereas Switzerland participates through a set of bilateral agreements with the EU. 3 Based on growth in real GDP per head. Fractal Trading Model* Long nickel / short tin hit its 6.5% profit target and is now closed. This week's trade is to switch to long nickel / short palladium with a 10% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long Nickel / Short Palladium Long Nickel / Short Palladium 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 I-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Trump's failures have helped fuel the bull market; Yet inflation and Trump legislative wins will embolden the Fed; The U.K. will have yet another election by 2019; Dodd-Frank repeal is a no go ... but small banks may get relief; The Tea Party just found its hard constraint ... in Kansas. Feature Investors in South Africa surprised us last week. The first question on everyone's mind was "Will Trump be impeached?" Our answer that impeachment is highly unlikely at least until the midterm elections was received with suspicion.1 The perspective of our South African clients is understandable. Their domestic assets have been underpinned since Trump's election by a phenomenon we like to call "the Trump put." The thesis posits that U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively. The result is a weak dollar, lower 10-year Treasury yields, and a rally in global risk assets (Chart 1). Of course, stubbornly weak inflation and disappointing Q1 GDP numbers bear responsibility as well as Trump (Chart 2). Chart 1The 'Trump Put' The 'Trump Put' The 'Trump Put' Chart 2Weak Inflation Fueling Bull Market Weak Inflation Fueling Bull Market Weak Inflation Fueling Bull Market For our South African clients, the fate of President Trump is irrelevant. What matters is that the American political imbroglio continues, reducing the likelihood of a hawkish mistake from the Fed, and thus keeping EM risk assets well bid. The market has generally agreed. Several assets associated with Trump's populist agenda have reversed their gains since the election. The yield curve, small caps, and high tax rate equities have all shown signs of disappointment with the Trump agenda (Chart 3). If the Trump put were to continue, we would expect U.S. bonds and stocks to rally, DXY to continue to face headwinds, and international stocks to outperform U.S. stocks. That said, the proxies for Trump's agenda in Chart 3 are starting to perk up. They may be sniffing out some positive political signs, such as the movement in the Senate on the bill repealing the Affordable Care Act (Obamacare). The budget reconciliation procedure - a process by which Republicans in Congress intend to avoid the Democrat filibuster in the Senate - requires Obamacare to be resolved before the House and the Senate can take up tax reform.2 If Obamacare clears Congress's calendar by the August recess, the odds of tax reform (or merely tax cuts) being passed by the end of 2017 will rise considerably. Second, former Director of the FBI James Comey's testimony was a non-event. We refused to cover it in these pages as we expected it to be theatre. The market had already digested everything that Comey was going to say, given that he had leaked the juiciest components of his testimony weeks ahead of the event. Chart 3Consensus On Trump Policy Failure? Consensus On Trump Policy Failure? Consensus On Trump Policy Failure? Chart 4 Third, President Trump's approval rating with Republican voters remains resilient (Chart 4). If the worst has passed with the Russian collusion investigation - which we expect to be the case now that Comey's testimony has come and gone with little relevance - we could see GOP voters rally around the president. Several clients have pointed out that our measure is less relevant given the decline in voters who identify as Republicans (Chart 5). We disagree. As long as Republican voters vote in Republican primaries, they can act as a constraint on GOP members in Congress who are thinking of abandoning the president's populist agenda. This brings us to the main event: the economy. Our colleague Ryan Swift, who writes BCA's U.S. Bond Strategy, could not care less about the ongoing political drama. As Ryan has argued in a cogent report that we highly recommend to clients, the Fed's median projection for two more 25 basis point rate hikes before the end of the year, and for PCE inflation to reach 1.9% (Chart 6), is not going to happen if inflation continues to disappoint over the summer.3 The market seems to be saying that a PCE of 1.9% is unlikely. Core PCE inflation is running at only 1.54% year-over-year through April, and will probably stay low in May given that year-over-year core CPI fell from 2% in March to 1.89% in April. Chart 5Fewer People Call Themselves Republicans Fewer People Call Themselves Republicans Fewer People Call Themselves Republicans Chart 6Inflation Relapse Would Scratch Fed Hikes Inflation Relapse Would Scratch Fed Hikes Inflation Relapse Would Scratch Fed Hikes Ryan's Philips Curve model, however, disagrees with the market. The model looks to approximate Chair Yellen's own philosophy for forecasting inflation, which she outlined in a September 2015 speech.4 Specifically, BCA's U.S. Bond Strategy models core PCE as a function of: 12-month lag of core PCE; Long-run inflation expectations from the Survey of Professional Forecasters; Resource utilization; Non-oil import prices relative to overall core PCE. BCA's core PCE model is sending a strong signal that the market's inflation expectations are overly pessimistic (Chart 7). Even after stressing the model under several adverse scenarios, Ryan concludes that it is very likely that core PCE inflation will indeed approach the Fed's 1.9% forecast by year-end. The U.S. economy is quickly running out of slack, with unemployment at a 16-year low of 4.3%. The broader U-6 rate, which includes marginally attached workers and those in part-time employment purely for economic reasons, has dropped to its pre-recession print of 8.4% (Chart 8). Chart 7Market Too Pessimistic On Inflation Market Too Pessimistic On Inflation Market Too Pessimistic On Inflation Chart 8U.S. Labor Market Running Out Of Slack U.S. Labor Market Running Out Of Slack U.S. Labor Market Running Out Of Slack Wages are also rising, with the underlying trend in wage growth having accelerated from 1.2% in 2010 to 2.4% (Chart 9). The acceleration has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 10). Chart 9Wages Heating Up Wages Heating Up Wages Heating Up Chart 10Wage Improvements Broad-Based Wage Improvements Broad-Based Wage Improvements Broad-Based BCA's Chief Global Strategist, Peter Berezin, therefore expects the Fed to raise rates in line with its own expectations. In fact, the Fed could expedite the pace of rate hikes if aggregate demand accelerates later in the year.5 It will be difficult for the Fed to ignore macroeconomic data, even if, from a political perspective, the Trump put continues. The analogy we use with clients in meetings is that of the U.S. economy as a camp fire around which the various market participants - bond and equity investors, foreign and domestic, etc. - are huddled. According to our sister publications that conduct macroeconomic research, that campfire is well lit. And according to our political research, "Uncle Donny" had a few too many drinks and is about to pour some bourbon on the fire to show the kids a good time. Chart 11Bond Bulls Feeding On Trump Failures Bond Bulls Feeding On Trump Failures Bond Bulls Feeding On Trump Failures For the Trump put to continue, we would have to see a combination of the following: GOP voters begin to abandon President Trump; Congress remains embroiled in Obamacare debates through FY2017, only seriously picking up on tax reform and other agenda items in FY2018. Greater doubts would undermine the recent uptick in assets tied to Trump's policy agenda (Chart 11). Impeachment concerns heat up again due to new revelations that implicate President Trump directly. So far impeachment talk has not correlated with the rally in Treasuries but it could do so if new evidence comes to light. Perhaps Robert Mueller, the former FBI director and special counsel investigating Russia's role in the election, will drop another bombshell later this year. In addition, for the Trump put to continue our colleagues Ryan and Peter would have to be wrong about the economy and inflation. For investors interested in playing the Trump put, and allocating funds to EM assets in particular, we would caution against it. However, given that BCA's bond and FX views have been challenged over the past several months by the Trump put, we understand why many of our clients are itching to chase the global asset rally. The summer months will be critical. Does Brexit Still Mean Brexit? We posited last week that the extraordinary election in the U.K. was about austerity and, more importantly, about repudiating the Conservative Party's fiscal policies.6 This remains our view. The most investment-relevant message to take from the election is that U.K. fiscal policy will become easier over the life of the coalition government, while monetary policy remains stuck in D - for dovish. This should weigh on the pound over the course of the year. That said, investors will begin to wonder about the longevity of the coalition between the U.K. Conservative Party and Northern Ireland's Democratic Unionist Party (DUP). In practice the coalition will have only a five-seat majority, which would be tied for the second-smallest margin since Harold Wilson in 1964 (Chart 12). Technically it is an even smaller one-seat majority. U.K. governments with a majority of fewer than ten seats are rare and usually only last one-to-two years (Harold Wilson's four-seat 1974-79 run is an exception). This bodes ill for May's government - that is, if she survives today's brewing leadership challenge from within her party. Chart 12 We have no idea if the election means a softer Brexit as we have no idea - and neither does anyone else - what that means. Generally speaking, the wafer-thin majority for the Tories means the following: "No deal is better than a bad deal" is no longer going to be acceptable to the government or the public; London will end up paying a larger "exit fee" than it probably thinks it will; There will be no favorable deal for the U.K.'s financial industry. In essence, the U.K. clearly has the weaker hand in the upcoming negotiations. Cheers went up in Brussels. Does this change anything? First, we never bought the argument that the U.K. had a strong negotiating position because continental Europeans want to export BMWs to consumers in Britain. The EU is a far bigger market for the U.K. than the U.K. is for the EU (Chart 13). On this measure alone, the U.K. was always going to be the underdog in the negotiations. Chart 13The U.K. Lacks Leverage The U.K. Lacks Leverage The U.K. Lacks Leverage Chart 14 Second, the influence of Tory Euroskeptics has been reduced. That might appear counterintuitive, given that May wanted to reduce their influence by getting a bigger majority. However, it is highly unlikely that she will get the ultimate EU deal through Westminster, with a five-seat majority, without at least some votes from the opposition. Euroskeptics will therefore either remain quiet and compliant or force May to seek a deal that Labour MPs could agree to. Which brings us to the very likely scenario that the final deal will not pass Westminster without a new election. As we argued right after the referendum, the U.K. will likely have a "Brexit election" sometime in 2019.7 There is no way around it now. At very least the ruling alliance will face a contradiction in trying to soften Brexit while maintaining a strict stance on immigration. And given the weak majority, if Labour does not play ball, the Tories will have to call a new election on the basis of the deal they conclude. Chart 15 The good news for the Conservative Party is that the polls continue to show that a majority of U.K. voters support Brexit (Chart 14). Furthermore, the two Brexit-lite campaign promises by the Labour Party and the Liberal Democrats were the least preferred policies ahead of the election (Chart 15, see next page). However, the election also saw a complete collapse in support for Euroskeptic-leaning parties, in terms of share of the overall vote (Chart 16). Could Brexit ultimately be reversed? Certainly the odds have risen. Furthermore, there does appear to be some regret amongst U.K. voters, with a recent survey showing a decline in national identification: now more Britons identify as "also European" than ever (Chart 17). Nonetheless, a full reversal of Brexit will still require an exogenous shock, such as a recession or a geopolitical calamity that convinces the U.K. that they need Europe. Investors should remain vigilant of the polls. A clear trend reversal in Chart 14 would constitute a political opportunity for the opposition parties to campaign on a new referendum. Chart 16Euroskeptics Collapsed In The U.K. Euroskeptics Collapsed In The U.K. Euroskeptics Collapsed In The U.K. Chart 17 Bottom Line: Odds of a softer Brexit have certainly risen as the Tories face considerable domestic constraints in their negotiating strategy with the EU. We continue to believe that the negotiations will not be acrimonious and therefore the pound will not fall below its lows on January 16. However, it may re-test that 1.2 level due to a coming mix of easy fiscal and monetary policy over the course of the year. U.S.: Doing A Number On Dodd-Frank Better put a strong fence 'round the top of the cliff, Than an ambulance down in the valley! - Joseph Malins, "The Fence or the Ambulance," 1895 The Republican-controlled U.S. House of Representatives passed the Financial CHOICE Act of 2017 by a vote of 233-186 on June 8. This is the GOP's second major attempt, after the Affordable Care Act, to rewrite a signature law of President Obama's administration. This time it is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, known simply as "Dodd-Frank," that is on the docket. The bill's prospects in the Senate are dim. President Trump promised to "do a number" on Dodd-Frank shortly after coming into office, by which he meant dismantling the law. The so-called "CHOICE Act" put forward by Jeb Hensarling (R-TX) now goes to the Senate, where it faces a high hurdle because Democrats can filibuster it, forcing the GOP to summon 60 votes. So the question is what kind of a "number" can the GOP actually do to Dodd-Frank, and does it matter? First a little bit of background.8 Dodd-Frank cleared Congress in the wake of the subprime financial crisis, July 2010. It had both a quixotic and a more pragmatic aim: the first to reduce the likelihood of future financial crises, and the second to improve the ability of regulators to stem risks as they emerge. The law has never been fully implemented and is best understood as a work in progress. The law grants the Federal Reserve and other agencies greater powers of oversight, prevention, and crisis management. In particular it ensures that the Fed would regulate not only banks but also non-bank investment companies and other financial firms (such as the giant insurance company AIG that had to be bailed out at the height of the crisis). It also frees the Fed of the responsibility to rescue failing institutions or dismantle them, handing those duties over to others, while still enabling the Fed to act as lender of last resort. The key provisions are as follows: Impose tougher capital standards: In keeping with the international Basel III banking reforms,9 Dodd-Frank tried to ensure that banks were better fortified against liquidity shortages in future. The new standards would apply both to domestic banks and foreign banks with American subsidiaries. Orderly Liquidation Authority: The Federal Deposit Insurance Corporation (FDIC), a major institution born amidst the Great Depression, would take over the responsibility of liquidating failing firms in the event of a crisis - assuming Treasury's go-ahead due to the systemic importance of the failing firm. Additional measures would hold the entire financial sector responsible for the bill if the FDIC made losses in the process. Each firm would have to maintain a "living will" to make the resolution process easier in the event of disaster. A new Financial Stability Oversight Council: Chaired by the Treasury Secretary and consisting of the various financial regulatory bodies, this council would identify systemically important financial companies, monitor them, and take actions to prevent crises. A new Consumer Financial Protection Bureau: The brainchild of Senator Elizabeth Warren (D-MA), the anti-Wall Street firebrand, the bureau would be funded by the Fed but otherwise entirely independent of it, and tasked with patrolling the banks on behalf of consumers. The Volcker Rule: The rule, named after former Fed Chair Paul Volcker, would force banks to curtail a number of short-term, high-risk trading activities on their own accounts, including derivatives, futures, and options, unless to hedge risks or serve bank customers. This was viewed as a partial reinstatement of the Glass-Steagall law, a Depression-era law that separated commercial and investment banking but was repealed by President Clinton in 1999. Republicans want to overturn Dodd-Frank to increase financial sector profits, credit growth, economic growth, and animal spirits. Lending has arguably suffered as a result of the new regulations (Chart 18). The share of bank loans to overall bank credit has remained subdued, reflecting bank behavior under QE and possibly also risk-aversion under tighter regulation (Chart 19). Chart 18Lending Growth Hampered By Dodd-Frank? Lending Growth Hampered By Dodd-Frank? Lending Growth Hampered By Dodd-Frank? Chart 19Banks Holding Reserves Instead Of Lending Banks Holding Reserves Instead Of Lending Banks Holding Reserves Instead Of Lending Republicans would also satisfy an ideological goal of reducing state involvement, which grew as a result of the law. In addition, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over a ten-year period.10 A very small amount, but again in line with GOP's political bent. The way the CHOICE Act would work is to create an "escape hatch" that would allow banks that maintain capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills, and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. This is supposed to boost lending, earnings, and growth. About 70% of the $18 trillion in U.S. banking assets belongs to banks defined by Dodd-Frank as "systemically important." The eight U.S. banks defined as "globally systemic important banks" account for about $9 trillion in assets and are unlikely to take advantage of the Republicans' escape hatch because they would then have to raise new capital and yet would still be subject to international Basel III regulations even if exempted from Dodd-Frank. The CBO estimates that banks holding about 2% of the bank assets held by systemically important banks (i.e. $252 billion) would opt out of Dodd-Frank (Chart 20). Chart 20 Further, the CBO estimates that, among non-systemically important banks (30% of $18 trillion total banking assets), the banks that both meet the 10% leverage ratio and would opt out of Dodd-Frank account for about 7% of U.S. banking assets ($1.26 trillion) (see Chart 20 above). Community banks (with assets under $10 billion each) and credit unions are especially likely to do so. Therefore, if the Republican bill were to become law, banks comprising something like $1.5 trillion in U.S. banking assets would become less restricted and eligible to adopt riskier trading practices free of Dodd-Frank policing. The greatest impact will be in areas with a higher concentration of small banks and credit unions than elsewhere. These U.S. banks would also, arguably, become more likely to take excessive risks and fail at some future point. Using probabilistic models for bank failures, the CBO found that the U.S.'s Deposit Insurance Fund would only suffer an additional $600 million in losses over the next ten years as a result of this increase in risk. It is a credible estimate but the reality could be far costlier if more and more banks gain the ability to bypass regulation or if banks significantly change their behavior to take advantage of the regulatory loophole. Other aspects of the bill would: Repeal the FDIC's orderly liquidation fund: The private sector would largely take over the responsibility for managing liquidations. The CBO estimates that the federal government would save an estimated $14.5 billion in liquidation costs over ten years. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: Within one year of passage, the Government Accountability Office (GAO) would audit the Fed's board of governors and the Federal Reserve regional banks, including their handling of monetary policy. The Fed's open market committee (FOMC) would also have to establish a new interest rate target, based on economic parameters, which the GAO would monitor. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. It would be re-branded as the Consumer Law Enforcement Agency and have its power to oversee institutions with more than $10 billion in assets taken away, making it, in effect, a monitor of small banks only. Cut penalties for violating regulations: However, outright criminality would be punished more severely. Various authorities and institutions would be tweaked, mostly in accordance with the general aim of reducing regulatory burdens on the financial sector. So, what options do the Republicans have going forward?11 Republicans either need 60 votes to defeat a Senate filibuster or they need procedural work-arounds like budget reconciliation. Chart 21Small Banks Benefit From Dodd-Frank Repeal Small Banks Benefit From Dodd-Frank Repeal Small Banks Benefit From Dodd-Frank Repeal Some Republicans claim that certain elements of the rewrite can be tucked into a reconciliation bill. However, reconciliation requires a single, concentrated policy focus. The GOP is currently undertaking an unprecedented two budget reconciliation bills in a single year: first, the FY2017 reconciliation procedure to repeal Obamacare, and second, the FY2018 procedure to cut taxes. Rewriting Dodd-Frank is a far cry from either health care or tax reform. Dodd-Frank measures crammed into either of these bills would likely be revoked under the so-called "Byrd Rule" which keeps the reconciliation process focused and excludes extraneous material.12 So it is unlikely that this method will work. The FY2018 budget resolution will be a critical signpost. Second, it is hard to see how a bipartisan rewrite of Dodd-Frank is possible. Dodd-Frank was the Democrats' signature response to the subprime mortgage debacle and broader financial crisis. They will not participate in dismantling it. We cannot see eight Democrats joining Republicans in the Senate for what Senator Sherrod Brown (D-OH) has called "collective amnesia." However, there is one general principle that could find its way into law: the idea of giving small, regional banks a reprieve from Dodd-Frank requirements. Even Fed Chair Janet Yellen has tentatively supported giving these banks a break.13 These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio. Politicians could at least attempt to make a popular argument for easing the burden on small community banks and credit unions, which are often vital to local communities. The same cannot be said for the Dodd-Frank rewrite as a whole, which smacks of granting impunity to Wall Street. Still, we think that even a bill focused exclusively on helping small banks would have trouble passing on its own. The legislative agenda is too busy in 2017; while 2018 will see midterm elections, when few candidates will want to appear soft on Wall Street. Instead, a provision helping small banks could pass if tacked onto the larger budget bill or bills for FY2018, if not later. It would have to be made palatable to Democrats, or else it would be perceived as a "poison pill" and risk adding to the numerous risks of government shutdown over the budget this fall. Other than these legislative options, the Trump administration can ease regulation, or relax enforcement, through executive action, as it has already promised to do. Assuming America's financial sector will get a reprieve, investors could capitalize on it by favoring small U.S. bank equities over large bank equities. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to fall back in the subsequent months, has recently perked up (Chart 21). Relative earnings have been flat over the same period. If Dodd-Frank is partially watered down, these banks should see earnings improve, which should drive up their share prices. Our colleagues at BCA's U.S. Equity Strategy are positive on global bank equities, particularly European and American ones. The latter are still relatively affordable as they undertake the long trek of recovery after a once-in-a-generation crisis (Chart 22). U.S. banks have notably better fundamentals than peers in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates (Chart 23).14 Chart 22The Long, Hard Road Of Recovery The Long, Hard Road Of Recovery The Long, Hard Road Of Recovery Chart 23U.S. Banks Well Positioned Globally U.S. Banks Well Positioned Globally U.S. Banks Well Positioned Globally In addition, the FiscalNote Financial Sector Index suggests that the flow of legislative and regulatory proposals has been steadily getting less onerous on the financial sector.15 Chart 24 is an aggregation of the favorability scores - which assess whether the bill is likely to be favorable or unfavorable to the sector - for all U.S. Congressional legislation that is determined to be relevant to the financial sector since 2006. It provides a snapshot of the regulatory environment for the financial sector at any given point in time. Chart 24Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Risks to the view? Republicans could somehow squeeze a broader Dodd-Frank rewrite through the budget reconciliation process. We think the probability of this is less than 10%. Financially, this would deliver a bigger jolt to the financial sector, and financial stocks, than currently expected. But it would still benefit small banks more than large ones. Politically, a full repeal could add to Republican woes in 2018 - particularly if it is their only legislative achievement. It may well be political suicide to contest the 2018 midterm election on two pieces of legislation: one that denies millions of Americans health insurance and another that favors Wall Street. A full rewrite would also probably increase systemic financial risks. Even deregulation just for the small banks would do so. Lawmakers, focused on restraining the "too big to fail" giants, could end up clearing the way for excesses among the pygmies. That said, excessive regulation can also fuel shadow banking, a risk in itself. And the next crisis may well emanate from somewhere other than the financial sector. Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked onto the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The Trump election rally for bank stocks has mostly fallen back. Now is an opportunity to favor small banks versus large ones on expectations of Trump getting tax cuts passed and regulatory easing of some kind. Kansas: Where Seldom Is Heard A Discouraging Word A chill went through the Tea Party's collective spine on June 6 when two-thirds of the GOP-controlled Kansas legislature overrode the veto of GOP Governor Sam Brownback to repeal a 2012 budget law that slashed taxes on income, small business, and retail sales. You heard that right: Republicans in one of America's reddest states just overrode their leader in order to increase taxes. And it was the largest tax hike in state history. We will spare our readers the nitty-gritty details of the Brownback saga. Suffice it to say that the Tea Party-friendly Kansas legislature slashed state taxes and spending under Brownback's leadership in May 2012. Brownback called it a "real live experiment" of conservative economic principles and argued that the tax cuts would pay for themselves through faster growth. Art Laffer, of "Laffer Curve" fame, allegedly consulted on these measures via the conservative American Legislative Exchange Council. The medicine proved more dangerous than the illness. Since 2012, the state has burned through a budget surplus and growth has slowed (Chart 25). Both Moody's and S&P downgraded Kansas debt. Employment gains have lagged those of neighboring states. Beginning in October 2013, Brownback began to slip in public opinion polls (Chart 26). Cuts to core government services, especially education, caused a tide of criticism. In an extraordinary development, a hundred establishment Republicans supported his Democratic opponent in the 2014 gubernatorial election. He won by a margin of 3.7% but soon afterwards fell out of favor with the public. Chart 25 Chart 26 A series of confrontations with the Kansas Supreme Court hastened his decline, mostly over education funding, which is guaranteed by the state constitution. Brownback, the legislature, and various activist groups attempted to strong-arm the courts, including by ousting four members of the Supreme Court in the 2016 elections. All four retained their posts. The new budget law raises $1.2 billion in income taxes over two years by revoking swathes of the 2012 law, particularly the income tax exemption for business owners and professionals. Brownback duly vetoed the legislation and was promptly overridden by two-thirds of a legislature that is 70% Republican. This is a remarkable event for a state as ideologically conservative as Kansas. What does it mean nationally? There are two reasons that the Kansas experiment will have a limited impact on Republican thinking nationally: Kansas has a balanced budget law (Section 75-3722), while D.C. does not ... and this helped increase the pressure on the administration; Brownback is the least popular governor of any governor in the United States (Chart 27). The blame for the whole fiasco may fall on him personally, distracting from the policy failure. Chart 27 Nevertheless, we think Kansas has set the high-water mark for an aggressive Tea Party agenda in the U.S. that focuses on fiscal conservativism to the exclusion of everything else. Republicans will take note that even as conservative of a state as Kansas has a limit when it comes to spending cuts. It was the cuts to education - which resulted in shorter schoolyears in some districts, and various other disruptions - that fatally wounded Brownback's public standing. Thus public demand for core services is a real constraint on the extent to which taxes can be slashed. Bottom Line: We expect the Trump administration to go forward with tax cuts. But we also think that Trump will get far less in spending cuts than his budget proposals pretend. As such, we expect the GOP tax reform agenda to blow out the budget deficit, a path that Kansas could not legally (or politically) take. This will be the path of least resistance for Congressional Republicans who want to slash taxes yet fear they may not survive the spending cuts necessary to pay for them.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 4 Please see Janet L. Yellen, "Inflation Dynamics and Monetary Policy," Philip Gamble Memorial Lecture, University of Massachusetts-Amherst, September 24, 2015, available at www.federalreserve.gov. 5 Please see BCA Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, and Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Brexit - Next Steps," dated July 1, 2016, available at gps.bcaresearch.com. 8 We are particularly indebted to Ben S. Bernanke's account in The Courage To Act: A Memoir Of A Crisis And Its Aftermath (New York: Norton, 2015), pp. 435-66. 9 Please see BCA U.S. Investment Strategy Special Report, "Preparing For Basel III: Who Will Win, Who Will Lose?" dated September 12, 2011, available at usis.bcaresearch.com. 10 Congressional Budget Office, "H.R. 10, Financial CHOICE Act of 2017," CBO Cost Estimate, May 18, 2017, available at www.cbo.gov. 11 The Republicans managed to repeal one aspect of Dodd-Frank with a simple majority via the Congressional Review Act, an option that is now closed. U.S. oil, gas, and mineral companies can now be somewhat less transparent about payments made to foreign governments to gain access to resources. Proponents claim U.S. resource companies will gain competitiveness; opponents claim corruption will increase, particularly in foreign countries. 12 Please see Bill Heniff Jr., "The Budget Reconciliation Process: The Senate's 'Byrd Rule,'" Congressional Research Service, November 22, 2016, available at fas.org. 13 Please see Yellen's February testimony to the Senate Banking Committee, e.g. "Yellen Wants To Ease Regulations For Small Banks," Associated Press, February 14, 2017, available at www.usnews.com. 14 Please see BCA U.S. Equity Strategy Weekly Report, "Girding For A Breakout," dated May 1, 2017, available at uses.bcaresearch.com, and Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, and "Wind Of Change," dated November 11, 2016, available at gss.bcaresearch.com. 15 The FiscalNote Policy Index measures regulatory risk daily for sectors, industries, and individual companies from every legislative and regulatory proposal. Using proprietary machine-learning-enabled natural language processing algorithms, FiscalNote ingests and processes thousands of legislative and regulatory policy events, scoring each for relevance, favorability, and importance to affected sectors. 16 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com.

Highlights Global Growth: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. Global Inflation: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Feature Have bond investors now become too pessimistic on global growth and inflation prospects? This is a question worth asking after the sharp decline in longer-dated government bond yields witnessed since the peak in mid-March. The benchmark 10-year yield has fallen during that period by -43bps in the U.S., -21bps in Germany, -24bps in the U.K., -45bps in Canada and -54bps in Australia. Granted, there has been a bit of softer news on both growth and, more importantly, inflation readings in several economies in the past couple of months. Those pullbacks, however, have been relatively modest compared to the severe bull-flattening bond rally seen in most developed economies (Chart of the Week). Chart of the WeekAn Overreaction From Bond Investors An Overreaction From Bond Investors An Overreaction From Bond Investors Global leading economic indicators are still pointing to faster growth over the latter half of the year, led by easing financial conditions given booming equity and credit markets. With most major economies either at full employment (U.S., U.K., Japan, Australia) or approaching full employment (Euro Area, Canada), accelerating growth will ensure that the recent downtick in global inflation will not persist for long - especially if oil prices begin to move higher again as our commodity strategists expect. This week brings several major central bank meetings with an opportunity to change the bullish tone in the bond markets. The Federal Reserve, the Bank of England (BoE) and the Bank of Japan (BoJ) all meet, although only the Fed is expected to deliver another rate hike that is now heavily discounted in the markets. The BoE's hands are now effectively tied, even with high U.K. inflation, after last week's election outcome where the ruling Conservatives lost their majority government, thus ensuring even more uncertainty over the contours of the Brexit process. The BoJ is also stuck in a bind, with surprisingly strong Japanese economic growth but shockingly weak inflation. This is also the situation that the European Central Bank (ECB), Bank of Canada and Reserve Bank of Australia are facing, to a lesser extent: solid domestic growth but without enough inflation to force any immediate tightening of monetary policy. These sorts of mixed messages and conflicting signals also exist in the bond markets in the developed world, as we discuss in this Weekly Report. Our conclusion is that yields have now priced in too much pessimism and the balance of risks points to yields rising again in the months ahead, led by U.S. Treasuries. A Big Move In Yields For Such A Small Change In Growth... Looking at the change in government bond yields within the major developed markets since the peak on March 13th (Table 1) shows a few important facts: Table 1A Bull Flattening Of Global Yield Curves Since March Alternative Facts In The Bond Market Alternative Facts In The Bond Market The largest yield declines were in the U.S., Canada & Australia; The smallest declines were in the U.K., the Euro Area and Japan - unsurprisingly, the countries where central banks are engaged in large bond purchase programs; Lower market-based inflation expectations have played a role in the bond rally, coinciding with softer energy prices and declines in realized inflation outcomes; Real yields (i.e. nominal yields minus inflation expectations) have fallen sharply in the U.S., Canada & Australia; Yield curves have bull-flattened everywhere; Breaking the curve moves into real yield and inflation expectations components shows that both contributed to the flatter yield curves. The U.S. Treasury action stands out compared to the others. There has also been a 103bp flattening in the 2-year/10-year TIPS real yield curve, while the TIPS breakeven curve has steepened by 64bps. This is the result of the -89bp drop in 2yr breakevens, which now sit at 1.38% - well below the current U.S. headline CPI inflation rate of 2.2%. Even allowing for any potential liquidity issues that can distort the precise interpretation of shorter-dated TIPS breakevens, the market appears to be expecting a bigger drop in inflation in the next couple of years than both the Fed and the Bloomberg consensus of economic forecasters (Table 2).1 This U.S. move stands out relative to the other countries, where there has been very little change in 2-year inflation expectations (using CPI swaps instead of breakeven rates from inflation-linked bonds). With the headline U.S. unemployment rate now at a cyclical low of 4.3%, and with the broader U-6 measure, now down to a decade low of 8.4%, we anticipate a recovery in realized inflation, and TIPS breakevens, in the next few months. The source for the broader downturn in global inflation expectations is a bit of a mystery. While some cyclical global growth indicators like manufacturing PMIs have fallen a bit in some countries, most notably the U.S. and China, they are still at strong levels above 50 that point to faster economic growth (Chart 2). Leading economic indicators (LEIs) are also still pointing to some acceleration in the latter half of 2017 although, admittedly, the list of countries with rising LEIs has been diminishing in recent months. We see that as a potential sign of slower growth next year, but not for the rest of 2017. Table 2Consensus Growth & Inflation Forecasts Alternative Facts In The Bond Market Alternative Facts In The Bond Market Chart 2Global Economic Upturn Still Intact bca.gfis_wr_2017_06_14_c2 bca.gfis_wr_2017_06_14_c2 Bottom Line: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. ...And Inflation Of course, some of the decline in inflation expectations can be attributed to softer readings on realized inflation over the past few months. Yet the markets seem to have overreacted a bit to that move, as well. The run of stronger-than-expected inflation outcomes has taken a breather in both the developed and emerging world, as evidenced by the rolling over of the Citigroup inflation surprise indices (Chart 3). Yet those indices remain at high levels and are not pointing to a meaningful, extended pullback in realized inflation. Chart 3Global Inflation Data Has Cooled A Bit Global Inflation Data Has Cooled A Bit Global Inflation Data Has Cooled A Bit The pullback in global energy prices since March has played a role in softer headline inflation in most countries. That decline has been part of a broader move lower in commodity prices that is likely related to less reflationary monetary and fiscal policies out of the world's biggest commodity consumer, China. However, our colleagues at BCA Commodity & Energy Strategy have noted that export and import volumes in the emerging economies accelerated sharply in the first quarter of 2017. Given that there is a strong correlation between trade volumes and oil demand in the emerging markets, this bodes well for a rebound in global oil demand. Combined with the "OPEC 2.0" production cuts, the demand-supply balance in world oil markets is likely to turn positive in the months ahead, which will allow oil prices to return to a range close to $60/bbl by year-end.2 A move in oil prices back to that level would help arrest the downturn in overall commodity price indices, and help stabilize goods CPI inflation in the developed economies in the latter half of 2017 (Chart 4). This should help boost global inflation expectations, and eventually bond yields, as the downturn in energy prices has shown very little pass-through into non-energy inflation in the developed world (Chart 5). Chart 4Disinflationary Impulse##BR##From Energy Will Soon Fade... Disinflationary Impulse From Energy Will Soon Fade... Disinflationary Impulse From Energy Will Soon Fade... Chart 5...Although The Impact On##BR##Inflation Has Been Modest ...Although The Impact On Inflation Has Been Modest ...Although The Impact On Inflation Has Been Modest Yet that stability of non-energy inflation visible in the charts masks many of the cross-currents seen across countries and within countries. Services CPI inflation remains strong in the U.S. at 3%, and has accelerated to 2% in both the U.K. and the Euro Area (Chart 6). Yet at the same time, both services and core inflation are falling rapidly towards 0% in Japan, despite a solid economic upturn and tight labor market. The situation is even more confusing in Canada, where wage inflation has fallen to below 1% but services inflation has picked up to 3%. Australia is in a similar boat, with services inflation above 3% but wages growing at only 2%. The divergence between the inflation outcomes across the countries can also be seen in our headline CPI diffusion indices, which measure the number of CPI sectors that are witnessing accelerating rates of inflation. The diffusion indices in the U.S., Japan and Canada are all at low levels, with the majority of CPI components seeing slowing rates of inflation, yet overall inflation seems to be holding up well despite the breadth of the "downturn", at least based on past correlations (Chart 7). The opposite is true in the Euro Area and Australia, where a majority of inflation components are growing faster, yet overall inflation is only moving slowly higher. Only in the U.K. is there a clear robust rise in the breadth of inflation (90% of CPI components accelerating) and overall inflation (headline CPI expanding at around 3%). Chart 6Underlying Inflation Has Not##BR##Slowed Much (Except In Japan) Underlying Inflation Has Not Slowed Much (Except In Japan) Underlying Inflation Has Not Slowed Much (Except In Japan) Chart 7Mixed Signals From The##BR##Global CPI Diffusion Indices Mixed Signals From The Global CPI Diffusion Indices Mixed Signals From The Global CPI Diffusion Indices Given all these diverging signals within the national inflation data, we are surprised that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the oil price decline as the main cause of the lower expectations, rather than a more pernicious drop caused by expectations of slowing economic growth and cooling domestic inflation pressures. Given the BCA view that oil prices have likely reached bottom and will begin to move higher, the decline in global inflation expectations is likely to also end soon. Bottom Line: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy For The Second Half Of 2017 The outlook for government bond yields in the remaining months of the year will be driven by decent global growth and rising inflation expectations. Our Central Bank Monitors continue to point to the need for tighter monetary policy in every major developed market excluding Japan (Chart 8), leaving bond yield exposed to any unexpected moves from central bankers. This is especially problematic in the U.S., where fed funds futures now discount only a 25-30% probability of a Fed rate hike in September and December after the expected hike at this week's FOMC meeting (Chart 9). With the U.S. OIS curve pricing in only 48bps of hikes over the next 12 months, the Treasury market is exposed to a Fed moving more aggressively in meetings later in 2017. Chart 8Our Central Bank Monitors Still##BR##Calling For Tighter Policy (Ex Japan) Our Central Bank Monitors Still Calling For Tighter Policy (Ex Japan) Our Central Bank Monitors Still Calling For Tighter Policy (Ex Japan) Chart 9Markets Will Be Surprised##BR##By The Fed Later This Year Markets Will Be Surprised By The Fed Later This Year Markets Will Be Surprised By The Fed Later This Year In Europe, the ECB talked up a more positive economic growth story at last week's policy meeting, eliminating the language suggesting that rate cuts would be necessary because the growth recovery was still fragile. No signal was given about slowing the pace of ECB asset purchases, which was not a surprise given the still-low readings on core inflation in the Euro Area. The ECB did slightly downgrade its inflation projections for the next two years, with core inflation now expected to rise to 1.8% by 2019. Our Months-to-Hike measure for the Euro Area now out to 29 months, indicating that the first ECB rate hike is now expected in November of 2019 (Chart 10). Our view remains that the ECB will look to taper asset purchases before contemplating any rate hikes, and will likely signal a move to slow the pace of bond buying at the September policy meeting. While we agree that a rate hike is unlikely until 2019, the current market pricing does leave European bond markets exposed to any upside surprises in inflation over the next year. For now, we continue to recommend a neutral allocation to core European government bonds, with a curve steepening bias, while focusing Peripheral exposure on Spain relative to Italy. We envision moving to underweight Europe over the summer if the growth and inflation data continue to point to an eventual ECB taper, especially given the strong comparisons between Europe now and the pre-Taper Tantrum period in the U.S. in 2012-13 (Chart 11). Chart 10No ECB Hikes##BR##Expected Until 2019 No ECB Hikes Expected Until 2019 No ECB Hikes Expected Until 2019 Chart 11Bunds Still Following The U.S.##BR##Post-QE Experience Bunds Still Following The U.S. Post-QE Experience Bunds Still Following The U.S. Post-QE Experience In Japan, we expect the BoJ to continue to target a 0% 10yr JGB yield for some time, in order to ensure that there is enough currency weakness to keep headline inflation from decelerating (Chart 12). This will especially be true if our call for higher U.S. interest rates comes to fruition and USD/JPY begins moving higher again. We continue to recommend an overweight position on Japan with government bond portfolios, given the low yield beta of JGBs to the other bond markets (Chart 13). Chart 12The BoJ Will Do "Whatever It Takes"##BR##To Keep The Yen Soft The BoJ Will Do "Whatever It Takes" To Keep The Yen Soft The BoJ Will Do "Whatever It Takes" To Keep The Yen Soft Chart 13Stay Overweight##BR##Low-Beta JGBs Stay Overweight Low-Beta JGBs Stay Overweight Low-Beta JGBs Finally, we continue to recommend long CPI swaps positions in both the Euro Zone and Japan, and an overweight in U.S. TIPS versus nominal Treasuries, as a way to play for the rebound in global inflation expectations that we are expecting over the balance of 2017. However, given the disturbing downturn in core inflation readings in Japan, we are implementing a tight stop-loss level at 0.4% on our long 10yr Japan CPI swaps position (Chart 14). Chart 14Stay Long CPI Swaps##BR##In Europe & Japan (With A Stop) Stay Long CPI Swaps In Europe & Japan (With A Stop) Stay Long CPI Swaps In Europe & Japan (With A Stop) Bottom Line: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The FOMC projections for growth in the headline Personal Consumption Expenditure (PCE) deflator from the latest set of forecasts released in March called for inflation of 1.9% in 2017 and 2.0% in 2018. The gap between the headline measures of CPI inflation and PCE deflator inflation has averaged about 50bps in recent years, so that implies that the Fed is expecting CPI inflation to be much higher than the 1.38% 2-year TIPS breakeven. 2 Please see BCA Commodity & Energy Strategy Weekly Report, "Strong EM Trade Volumes Will Support Oil", dated June 8 2017, available at ces.bcaresearch.com. Recommendations Alternative Facts In The Bond Market Alternative Facts In The Bond Market Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The current economic and profit environment supports our stance of favoring stocks over bonds. The Fed will need to see more evidence to alter its gradual path for rates. Although valuations remain elevated, they are not a great market timing tool. Margins are expanding according to the S&P 500 data, and we expect this to continue in the second half of the year. But a peak in margins next year could be the justification to scale back on overweight positions in stocks, in anticipation of slower EPS growth. Corporate balance sheets continued to deteriorate in the first quarter, but that is not enough to warrant cutting back on corporate bond positions within fixed-income portfolios. Watch real short-term rates and bank C&I lending standards, as an exit warning. Feature Environment Remains Supportive For Stocks Over Bonds Investors are wondering whether the equity and currency/bond markets are living on different planets. The dollar and Treasurys seem to be priced for sluggish economic growth, less inflation and no fiscal stimulus. Yet, the S&P 500 is stubbornly holding above the 2,400 level. Many believe that the only reason that stocks got to this level in the first place is the prospect of tax cuts, deregulation and infrastructure spending. If true, then it is only a matter of time before equity investors capitulate. We look at it another way. Yes, equities initially received a boost following the U.S. election on hopes for tax reform. But indicators such as the ratio of small-to-large-cap stocks, or high-tax companies relative to the S&P 500, suggest that the stock market has priced out all chances of any tax reform. The overall stock market has performed well despite this because of the favorable profit backdrop. The fact that Corporate America can generate such profits despite a lackluster economy is impressive. Moreover, the recent softening in inflation has led many to believe that the Fed can proceed even more slowly than the market previously believed, leading to a bond rally. This is quite a bullish backdrop for equities. One does not have to conclude that the bond and stock markets are living on different planets. The backdrop is also positive for corporate bonds versus Treasurys, despite the fact that corporate health continues to deteriorate (see below). Turning to politics, the political consequences of the extraordinary U.K. general election are still not clear. The outcome of the election does not change our core views on the U.S. dollar, equity or bond markets. The dollar has rallied, Treasury yields are higher and U.S. equity prices moved up as this report was being prepared on Friday, June 9. Looking ahead, the coalition-building process in the U.K. will take time as the horse-trading between parties proceeds. Nonetheless, our high conviction view is that the investment implications are in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. A key takeaway for investors is that, aside from Brexit, domestic fiscal policy is the driving issue in British politics. Austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Moreover, the Brexit process will continue, albeit of a potentially more "softer" variety and with a somewhat higher probability of eventual reversal.1 Will They Or Won't They? A 25-basis point rate hike is likely this week, but the FOMC will need more evidence on the direction of inflation and the economy before significantly changing the timing and pace of rate hikes or economic forecasts. The market is fully pricing in the anticipated 25-basis point rate bump, but beyond that, there is not much agreement between the Fed and the market on interest rates or economic projections. Nonetheless, as the Fed prepares its June forecast and dot plots, policymakers and the market are on the same page in terms of the labor market, inflation, and the economy in the next few years. The unemployment rate (4.3% in May 2017) is below the Fed's forecasts for 2017 (4.5%) and longer run (4.7%). The consensus outlook for the unemployment rate keeps it below the Fed's path through the end of 2018 (Chart 1, panel 3). Even assuming that the 120,000 pace of job growth in the past three months persists, the unemployment rate would remain below the Fed's view of NAIRU (Chart 2). Our unemployment rate projections are based on a stable labor force participation rate and a 1% gain in the working age population. Chart 1Fed, Market And Reality##BR##Not Too Far Apart Fed, Market And Reality Not Too Far Apart Fed, Market And Reality Not Too Far Apart Chart 2The Unemployment Rate##BR##Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios However, a closer look at what policymakers have said about prices and the trajectory of inflation in recent years suggests that the market and the Fed are not that far apart. At +1.7% in April, the PCE deflator remains near the FOMC's projection of 1.9% for this year and 2.0% in the long run. Bloomberg consensus estimates for inflation for this year and next are above the top end of the Fed's forecast range (Chart 1, panel 2). The FOMC's May minutes state that "participants generally continued to expect that inflation would stabilize around the Committee's two percent objective over the medium run as the effects of transitory factors waned." The market is still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with the economy below the Fed's estimate of full employment. We will discuss the Phillips curve in a post-GFC world in an upcoming edition of The Bank Credit Analyst. As we discussed in last week's report,2 GDP growth in 2017 is on track to exceed the Fed's 2017 target (2.1%) and is already running ahead of the Fed's GDP projection (1.8%) for the long term. The consensus forecast for GDP in 2018 and 2019 is at the upper end of the Fed's range set in March (Chart 1, panel 1). Despite the general agreement between the Fed and the market on certain aspects, they diverge on the outlook for the fed funds rate in the next 18 months (Chart 3). As of June 9, the Fed sees a total of six quarter-point rate hikes by the end of 2018. The market sees just two in the same period. The Fed and market are still far apart on rates in 2019. However, the disconnect between the Fed and the market is not as large as it was in early 2015. This disagreement was a major factor in the equity market pullback in the first few months of 2016 (Chart 3). Neither the recent weakness in the economic data nor softer-than-expected inflation readings will be enough to prompt a significant shift from the Fed in terms of the 'dot plot'. The economic surprise index has been declining for 63 days since peaking in early- to mid-March, but remains consistent with slow growth, not a recession. Economic data tends to disappoint for an average of 90 days after the economic surprise index is above 40, as it was in late 2016/early 2017 in the wake of the U.S. election (Chart 4). Chart 3Disconnect Between Fed##BR##And Market On Rates Disconnect Between Fed And Market On Rates Disconnect Between Fed And Market On Rates Chart 4Economic Surprise Index Has Rolled Over##BR##Since Early To Mid March Economic Surprise Index Has Rolled Over Since Early To Mid March Economic Surprise Index Has Rolled Over Since Early To Mid March Bottom Line: It would take a significant deterioration in the economy and labor market and in the benign inflation environment to alter the Fed's gradual rate hike plan. A backdrop of gradual hikes and eventually, a smaller balance sheet, will continue to foster the conditions under which stocks have outperformed bonds since 2009. We believe that the recent Treasury rally is overdone because the market has gone too far in revising down the path of Fed rate hikes. A re-evaluation of the outlook could see bond yields jump, sparking a small equity correction. This is not enough of a risk to scale back on equities versus bonds. Valuations, Earnings And Margins: An Update U.S. equities remain overvalued and would be even more extended if not for low rates. However, they are attractively priced relative to competing assets, such as corporate bonds and Treasurys. Valuation is not a great tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we don't foresee a sustained pullback in stocks. Looking beyond our tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Our BCA valuation indicator has deteriorated since we last published it in March 2017 and shows that U.S. equities remain expensive.3 Individually, two of the three components of the Valuation index remain in overvalued territory. The Earnings Group remains at a record high (aside from the tech bubble). The Balance Sheet group shows the same profile. Only the Yield Group, which compares stock prices with various nominal and real interest rates, suggests that equities are undervalued. Thus, U.S. stock prices are vulnerable to a sharp jump in rates, which supports our view that U.S. equity markets will perform well in an economic and inflation backdrop that allows the Fed to raise interest rates and unwind its balance sheet gradually (Chart 5). While tax cuts and infrastructure spending might provide the equity market with a "sugar high", it probably would not last long because fiscal stimulus would bring forward Fed rate hikes. Moreover, Chart 6 shows that U.S. stocks remain favorably priced relative to competing assets such as corporate bonds, Treasurys and residential housing. That said, equity valuation measures such as price-to-book or price-to-sales make the market vulnerable to shocks. Chart 5U.S. Stocks##BR##Are Overvalued... U.S. Stocks Are Overvalued... U.S. Stocks Are Overvalued... Chart 6Stocks Look Less Expensive##BR##Relative To Competing Assets Stocks Look Less Expensive Relative To Competing Assets Stocks Look Less Expensive Relative To Competing Assets Inflated valuations alone are not enough to trigger a bear market or even a significant correction in U.S. equities. Outside of aggressive Fed tightening, we will become more defensive when profits come under pressure. On this score, the decline in Q4 profits according to the NIPA data is concerning. We are in a period where margins based on the NIPA data are diverging from the S&P's measure. Like corporate earnings, there is more than one data source for profit margin data, and the data itself is a mix of art and science. In the long run, the S&P-based margin data and the data derived from the NIPA accounts tend to move together. Over shorter time horizons, however, these two metrics may diverge. The NIPA margins peaked in 2014 and have moved steadily lower since then, but the BEA-derived profit data are not closely watched by investors and are subject to significant revision. On the other hand, margins based on S&P data are followed closely by the markets, are not subject to revision and have been moving higher since end of 2015. In the past 55 years, the peak in NIPA margins has often led the S&P data at peaks; the caveat is that it is unclear whether the NIPA data led in real time because of the endless revision process for GDP and profit data.4 The margin series based on S&P data tends to lead heading into margin troughs, but it is not a reliable signal. During the long economic expansion in the 1960s, both indicators topped out around the same time (1966-67). The NIPA derived margins peaked in 1975 as the S&P margins troughed, and later in the decade, the zenith in NIPA margins peaked three years before the S&P version. Similar to the current decade the long expansion in the 1980s saw a mid-decade collapse in oil prices and margins. In the late 80s, NIPA and S&P measures peaked almost simultaneously, which was three years before the crest in equity prices. The 1990s saw unabated margin expansion through 1997 for NIPA margins; the expansion in S&P-based margins lasted until 1999 (Chart 7). Chart 7Margins, Like Profits Are Mix Of Art & Science Margins, Like Profits, Are Mix Of Art & Science Margins, Like Profits, Are Mix Of Art & Science History also shows that falling margins do not always mean declining EPS growth. In the past 40 years, when the U.S. economy was not in recession, corporate EPS growth was very high on average when margins rose. It was mostly a wash when margins dropped, with slightly negative EPS growth on average. There were two episodes (late-1990s and mid-2000s) when margins fell, but EPS growth was strongly positive (Chart 8). The stock market can also rise significantly even after margins peak for the cycle. Chart 8EPS Can Grow Even As Margins Contract EPS Can Grow Even As Margins Contract EPS Can Grow Even As Margins Contract According to S&P data we are in a phase of climbing margins and we expect EPS growth to further accelerate into year end, peaking at just under 20%, before moderating in 2018. If profit growth decelerates in 2018 and the S&P measure of margins begins to narrow again, it would send a strong signal to trim exposure, especially given lofty equity valuations (Chart 9). Chart 9Profit Growth And Margins Both Rising Profit Growth And Margins Both Rising Profit Growth And Margins Both Rising Bottom Line: Rich valuations in U.S. equities will be overlooked as most investors are focused on the S&P and not the NIPA margins. EPS growth will decelerate sharply when margins resume their mean reversion, which could be the catalyst for a major correction or bear market in stock prices. We do not expect this scenario to play out until 2018 at the earliest. Meanwhile, rising margins and profits trump expensive multiples for U.S. equities. Stay long. Corporate Bonds: Kindling And Sparks Last week's U.S. Flow of Funds release allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart 10). The level of the CHM moved slightly deeper into "deteriorating health territory." The deterioration in the Monitor over the past few years is largely reflected in the profit-related components of the CHM, including the return on capital, cash flow coverage and free cash flow-to-total debt. Chart 10Deteriorating Since 2015, But... Deteriorating Since 2015, But... Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years. Indeed, it is one of the oldest and most reliable indicators in BCA's stable of indicators. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. A blowout requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to rise, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist usually occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. Even now, inflationary pressures are so muted that the Fed can proceed quite slowly. It will be some time before real short-term interest rates are in restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. As an aside, recent weakness in the growth rate of C&I loans has contributed to concerns over the health of the U.S. recovery. However, the easing in lending standards this year points to an imminent rebound in C&I loan growth (Chart 11). Our model for C&I loans, based on non-residential fixed investment, small business optimism and the speculative-grade default rate, supports this view. Chart 11C&I Loan Growth Set To Rebound C&I Loan Growth Set To Rebound C&I Loan Growth Set To Rebound The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart 12 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, has eased on a 4-quarter moving average basis (although it ticked up in Q1 on a 2-quarter basis; Chart 13). As a result, ratings migration has improved (i.e. easing net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The moderating appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart 12Still Some Value In##BR##High-Yield Corporates Still Some Value In High-Yield Corporates Still Some Value In High-Yield Corporates Chart 13Net Transfers To Shareholders##BR##Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle, for reasons we outlined in the April 17, 2017 Weekly Report. In a nutshell, value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Bottom Line: Corporate balance sheets are still deteriorating but risk assets, including corporate bonds, should continue to outperform Treasurys and cash in the near term. We will look to downgrade risk assets when core inflation moves closer to the Fed's 2% target, which would trigger a more aggressive FOMC tightening campaign and tighter bank lending standards. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see the Geopolitical Strategy Client Note "U.K. Election: The Median Voter Has Spoken, published on June 9, 2017. Available at gps.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?" June 5, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "How Expensive Are U.S. Stocks", dated March 13, 2017 available at usis.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation and the Fed", May 8, 2017. Available at usis.bcaresearch.com.

Highlights The ECB's meeting was in line with expectations, the governing council increased its growth forecast, decreased its inflation forecast, removed it easing bias, but maintained that easy policy was key to support its objectives. Going forward, growth will have to remain just as strong for European inflation dynamics to emerge. Financial conditions between the U.S. and the euro area are moving in favor of U.S. growth, and thus, the USD. EUR/USD momentum is stretched, but it can rise further. EUR/USD at 1.15 in the coming weeks is a risk to our view. However, EUR/USD forecasts have already been ratcheted upward, and their capacity to lift the euro is losing steam. Feature The European Central Bank hit the mark yesterday with a performance that was bang on in terms of expectations, as illustrated by the euro's muted response. The governing council increased its growth forecast by 0.1% each year and curtailed its inflation forecast by an average of 0.2% until 2019, inclusively (Table I-1). Moreover, while the ECB statement removed its future easing bias, in the press conference ECB President Mario Draghi made it crystal clear that this was because deflationary risks were evaporating, but the economy still needed extremely easy conditions in order to stay on the trajectory envisioned by the ECB. Chart I- As a result, despite this adjustment in forward guidance, the ECB elected to keep its asset purchases in place, even leaving the door open for time extensions and size increases if conditions warrant. After all, in the eyes of the ECB - and it is an assessment we share - the great performance of the European economy has been and remains dependent on the continuation of a very easy policy stance. In this optic, we study the outlook for growth dynamics in Europe, especially in relation to the U.S., as this is what will determine the future path of relative policy. If European policy can move in a more hawkish fashion relative to the Federal Reserve as well as current expectations, then the euro bear market will be over. Growth And Financial Conditions For the euro to rally further, the ECB has to be able to beat market expectations and the Fed has to continue to underwhelm. So far this has not happened, but markets are forward looking and are behaving as if both central banks will follow these paths. To expect a tightening of ECB policy relative to the Fed's, European growth will have to continue outperforming U.S. growth. As we argued last week, the slack in the European jobs market is much greater than that in the U.S.1 Without outstanding growth, European inflationary dynamics will remain hampered by low wage growth. Meanwhile, the Fed is facing an environment congruent with high rates (Chart I-1), something that markets are ignoring as they are only anticipating two more hikes into June 2019, beyond the one anticipated next week. So what kind of future growth dynamics are we anticipating? World growth may not be about to plunge, but global activity is set to soften as China and the U.S. have been tightening monetary conditions in an environment replete with excess capacity. Indicators are already responding to this policy shift. Our diffusion index of global leading economic indicators has already rolled over sharply, a precursor to softening global LEIs (Chart I-2). This is a bigger problem for Europe than the U.S. Since 2010, the beta of euro area LEIs to global LEIs has been around 0.8, while for the U.S. the sensitivity is around 0.2. Thus, deteriorating growth conditions are a greater handicap for Europe, a region still much more reliant on trade and manufacturing as sources of growth. Chart I-1The Fed And Its Mandate The Fed And Its Mandate The Fed And Its Mandate Chart I-2Global Growth Passing Its Zenith Global Growth Passing Its Zenith Global Growth Passing Its Zenith Meanwhile, purely domestic economic conditions have been buoyant in the euro area and quite morose in the U.S., though the picture seems to be reversing. To make this judgment, we begin by evaluating a global growth factor, a global economic force that lifts or pulls down all boats, similar to a tide. Such a global growth factor should not just affect various countries through trade, but it should also impact their economies through financial linkages. In order to evaluate this phenomenon, we conducted a Principal Component Analysis (PCA) of the LEIs of 21 countries. We found that the combined factor 1 and factor 2 explains nearly 50% of global growth dynamics (Chart I-3). Once we estimated this global growth factor, we then proceeded to estimate how much it contributes to LEI gyrations in the U.S. and euro area, using the factor loadings of both relative to the two main components revealed by the PCA. With that information in hand, we then simply subtracted the European and U.S. impact from their respective LEIs. What is left reflects purely endogenous changes in the LEIs for the euro area and the U.S. This same procedure can be applied to any country. Through this exercise, we can see very well that European domestic conditions have been rebounding sharply since 2012. However, the pure domestic element of the U.S. LEIs has been falling steadily since late 2014, shortly after the U.S. dollar began its 27% rally (Chart I-4). Chart I-3The Tide That##br## Lifts All Boats The Tide That Lifts All Boats The Tide That Lifts All Boats Chart I-4A Look At Purely Domestic##br## Growth Dynamics A Look At Purely Domestic Growth Dynamics A Look At Purely Domestic Growth Dynamics To a large degree, these differentiated dynamics make sense. 2012 marked the apex of the euro area crisis. The improvement in the domestic component of the European LEIs coincided with Mario Draghi's "whatever it takes" speech. This moment was crucial as it resulted in the normalization of private sector borrowing costs across the Eurozone. Thanks to the ensuing compression in break-up risk premia, Italian and Spanish private lending rates collapsed by 110 and 240 basis points over the following 24 months, respectively. Easy money was finally being transmitted to the private sector. Chart I-5Massive Tightening In 2014 Massive Tightening In 2014 Massive Tightening In 2014 In the U.S., the deterioration began after the dollar perked up massively, but also, after the Fed began tapering its purchases of securities, events associated with a 300 basis-point increase in the Wu-Xia shadow fed funds rate (Chart I-5). The combined effect of this monetary tightening resulted in a significant brake on economic activity, one made most evident by the deceleration in the domestic component of the LEIs. These forces seems to be reversing. Today, the dollar is trading in line with its March 2015 level, and while the fed funds rate has increased by 75 basis points, this still pales in comparison to the large increase in the shadow fed funds rates recorded between May 2014 and November 2015. Meanwhile in Europe, the lagged effects of the massive 15% decline in the trade-weighted euro between June 2014 and March 2015 is dissipating. These monetary dynamics partially explain why the domestic element of the European LEIs is rolling over while the U.S. one is improving. However, we think financial conditions play a larger role. U.S. financial conditions have greatly eased in recent months, while financial conditions in Europe have been deteriorating, suggesting domestic growth conditions will follow a similar path (Chart I-6). These crosscurrents are especially evident when looking at the relative European and U.S. domestic growth impulses vis-a-vis their relative financial conditions. Currently, the purely endogenous elements of growth in the euro area look set to roll over against those of the U.S. So if the international and domestic elements of growth in Europe are set to slow relative to the U.S., when should these dynamics begin to affect market pricing? Historically, the German Ifo survey has been one of the most reliable bellwethers of European economic activity. The same can be said of the ISM in the U.S. While the ISM rolled over three months ago, the Ifo is still at all-time highs. However, historically, one of the most reliable leading indicators of the Ifo has been none other than the ISM itself. Hence, the likelihood that the Ifo rolls over sharply by September is high, especially in the context of the observations made above (Chart I-7). With expectations that European growth will remain strong but that the U.S. is incapable of generating inflation, a weak ISM is well known, but a weak Ifo would be a surprise. Chart I-6Follow The Financial Conditions Follow The Financial Conditions Follow The Financial Conditions Chart I-7Where The ISM Goes, The IFO Follows Where The ISM Goes, The IFO Follows Where The ISM Goes, The IFO Follows When the Ifo underperforms the ISM, the euro tends to suffer (Chart I-8). This was not true in 2001, but back then the euro was trading 15% below its long-term fair value, and the U.S. was entering a recession. Today, the euro is trading at a more modest 5% discount to its long-term fair value, and BCA believes the U.S. is not on the verge of a recession. Moreover, on a short-term basis, the euro is already trading 6% above its interest rate and risk-aversion implied tactical fair value. Chart I-8If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro These dynamics also imply that the massive positive skew in economic surprises between the euro area and the U.S. should soon end, which is likely to prompt a re-think of the relative monetary policy stance between the ECB and the Fed, and therefore put an end to the recent sharp rally in the euro. Bottom Line: The ECB did not surprise markets this week. Yet, Mario Draghi made it very clear that despite an upgrade to forward guidance, the path toward achieving the central bank's inflation target continues to require very easy policy. How easy? Our view is that based on global dynamics and financial conditions, European growth could slow in the coming months, delaying the point in time when the euro area output gap closes. Meanwhile, investors are too conservative regarding the U.S.'s growth and inflation prospects, and therefore are not anticipating enough rate hikes from the Fed. What To Do With Momentum? The key issue for now is that the euro's momentum is extremely powerful and hard to fight. Indeed, the euro seems to have dissociated from fundamentals. While aggregate real rate differentials continue to move in favor of the U.S. dollar, the euro is ignoring these dynamics and instead has become overtaken by powerful flows into the euro area (Chart I-9). These dynamics may be stretched, but they could still have additional room to run. Non-commercial traders have fully purged their short bets on EUR/USD, and they have accumulated the most long-euro positions in three years. Additionally, our composite sentiment indicator, based on the positioning, sentiment, and 13-week rate-of-change in the currency, is now at elevated levels relative to the past three years (Chart I-10). The violence of these shifts highlights an improving risk-reward ratio to shorting the euro, but this could be of little solace: historically, both the composite sentiment measure and positioning in the euro have hit much higher levels. Technical indicators point to similar dilemmas. Both the EUR/USD intermediate-term technical indicator and its 13-week rate of change have hit levels congruent with a reversal (Chart I-11). However, these indicators have also displayed inertia in the past, with occasions such as in 2013, where their elevated readings did not preclude a higher EUR/USD. Chart I-9EUR/USD Is A Lone Wolf EUR/USD Is A Lone Wolf EUR/USD Is A Lone Wolf Chart I-10EUR/USD Is Overbought But...(1) EUR/USD Is Overbought But...(1) EUR/USD Is Overbought But...(1) Chart I-11EUR/USD Is Overbought But...(2) EUR/USD Is Overbought But...(2) EUR/USD Is Overbought But...(2) As a result, we are highly cognizant of the risks to our positive bet on the DXY (which due to its near 60% weighting in the euro is equivalent to a short euro bet). But the good news in the euro seems well priced in. In line with the 8% surge in the euro this year, the average analyst forecast for the euro for Q4 2017 moved from EUR/USD 1.05 to EUR/USD 1.12 (Chart I-12, top panel). Recent peaks in the euro have materialized when these forecasts hit 1.13, which we are very close to. At these levels, the optimism toward Europe seems fully discounted. Chart I-12When To Be Contrarian In FX When To Be Contrarian In FX When To Be Contrarian In FX In fact, the gap between the euro itself and the forecast is now decreasing (Chart I-12, bottom panel). This suggests that each new forecast upgrade is lifting the euro less and less, implying that buyers have already internalized these increasing forecasts and need ever better news, especially on the wage and inflation front, to lift the euro higher. Hence, while worried that the EUR/USD could move to 1.15 in a blink of an eye before reversing, we remain cautiously optimistic on our negative EUR/USD and our positive DXY stances. Bottom Line: At this point, the key problem with our view is that momentum is clearly in the euro's favor, a dangerous position for euro bears. While most indicators highlight that EUR/USD is overbought, these same metrics could in fact remain overbought for longer. However, investors have already massively upgraded their EUR/USD forecasts suggesting that much news is in the price, especially as each successive upgrade is showing diminishing returns in their capacity to lift EUR/USD spot rates. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Capacity Explosion = Inflation Implosion", dated June 2, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The soft patch in the U.S. economy continues: Unit labor costs growth has softened to 2.2%, a less-than-expected pace of 2.5%; Non-Manufacturing/Services sectors are looking weak with both PMI and ISM measures underperforming; Consumer credit also grew by USD 8.2 bn, underperforming the expected USD 15.5 bn. As a result, the dollar remains weak. While the data is worrying, we stand with the Fed's view. The Fed will hike in June, and when this soft patch proves temporary, it is likely that a September hike will materialize. With the ECB constrained in its capacity to move to a hawkish stance, it is possible for the USD to see some upside sooner rather than later. Report Links: Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro has witnessed a particularly strong two months due to positive surprises in data, but momentum somewhat slowed this week due to mixed data: Services PMI in Spain, Italy and France underperformed expectations, while Germany and the overall euro area outperformed; Retail sales increased at a 2.5% annual rate; German factory orders increased by 3.5% annually, which was less than expected. Even worse they contracted by 2.1% on a monthly basis; Overall GDP growth in the euro area outperformed expectations, being revised to 1.9%. Furthermore, Draghi reiterated the need for extremely easy conditions in order to stay on the path to reach the target inflation rate, especially as inflation forecasts were downgraded. If the European data cannot keep up with its current blistering pace, investors should again begin to wonder about the ECB's capacity to move away from what remain a dovish stance. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent economic data has been mixed in Japan: Consumer confidence came in at 43.6, increasing from last month. Bank lending annual growth came in at 3.2%, beating expectations. However, GDP annualized growth was greatly revised downward to 1%. Although we continue to be bullish on the yen on a short term basis, it would be preferable to play yen strength by shorting NZD/JPY rather than USD/JPY, as we believe that the correction in the U.S. dollar has run its course. Thus, we are looking to exit our short USD/JPY trade once it reaches 108. On a cyclical basis, the yield curve target implemented by the BoJ, along with a hawkish fed will weigh on Japanese real rates vis-à-vis U.S ones and consequently push the yen downward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data has been mixed in the U.K.: Construction PMI came in at 56, blowing past expectations. Halifax house price annual growth came in at 3.3%, also outperforming expectations. However, Markit Services PMI came below expectations at 53.8. The results of the elections happening as of the date of this writing will create some volatility in the pound. A greater majority government by the conservatives would likely be a boost to the pound, as it will give Prime Minister May more leeway when negotiating the exit of the U.K. from the European Union. On the other hand, if labor wins enough seats to create a hung parliament, the pound could suffer as political uncertainty will once again reign supreme. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The Aussie experienced an upbeat week, appreciating almost 2.5%. A few positive data was recorded: TD Securities Inflation increased at a 2.8% annual rate, more than the previous 2.6% reading; GDP growth increased 1.7% annually, beating both yearly and quarterly expectations. Chinese imports were very strong, coming in at 22% growth on an annual pace, suggesting continued intake by the Middle Kingdom of what Australia exports. The GDP was a key driver in this week's rally. However, while the headline number was great, the details were more worrisome. Inventories led GDP growth, while exports subtracted most from it. This is peculiar considering that terms of trade increased at a 24.8% annual rate. This also predates the near 40% decline in iron ore futures. The trade balance for April also missed expectations greatly, coming in at 555 million, compared to the expected 1.95 million, setting up a poor start for Australia's second quarter. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The kiwi economy continues to improve: Headline and core inflation have both surpassed the 2% threshold, reaching 2.2% and 2.3% respectively in the first quarter of 2017. Meanwhile, nominal retail sales are growing at a healthy 7.5%. Considering the continued strength in the kiwi economy, the NZD should continue to outperform the AUD on a cyclical basis, given that Australia is much more sensitive to a slowdown in Chinese economic activity, which is beginning to suffer in response to the tightening campaign by the PBoC. On the other hand the upside for the NZD against the U.S. dollar remains limited. Not only is NZD/USD overbought on a short term basis, but the tight correlation between the kiwi and commodity prices should eventually weigh on this currency. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD went through a rough patch this week: The seasonally-adjusted measure of PMIs delivered a disappointing 53.8 reading compared to the expected 62; Building permits are contracting at a 0.2% monthly pace; Housing starts increased at 194,700, which was less than expected; On the plus side, house price growth was at 3.9% yoy, beating expectations of 3.3%. Oil was also a big player in the loonie's weakness. Crude oil inventories were higher than expectations by roughly 6 million barrels: a 3.464 million barrels decline in inventories was expected, while inventories increased at a 3.295 million barrels. The CAD remains oversold, but we remain bullish on it in the G10 space as investors have rarely been so short the Canadian currency as they currently are. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent economic data in Switzerland has been very positive: The unemployment rate came in at 3.2%, beating expectations. Headline inflation came in at 0.5%, higher than last month and beating expectations. Yesterday, the ECB underwehlmed bulls, as ECB president Mario Draghi stated that asset purchases will "run until the end of December 2017, or beyond, if necessary". We expect the ECB to ultimately find it very difficult to switch to a hawkish bias, especially relative to relative to other central banks, as pricing power in the euro area remains muted. On the other hand, Switzerland is slowly recovering, and a removal of the implied floor by the SNB on EUR/CHF could happen as early as the end of the year. Thus, we are already shorting this cross to take advantage of such an event. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 On Wednesday, oil inventories rose by 3.3 million against expectations of a 3.5 million draw. This caused oil prices to plunge by almost 4%. Nevertheless, the response of USD/NOK has been somewhat muted. This is in part due to the fact that real rate differentials matter more than oil for USD/NOK. Indeed, while oil is down almost 15% on the year, the NOK has actually appreciated slightly in the year against the dollar, given that rates in the U.S. have decreased substantially during the year. Thus, given that we expect a more hawkish Fed than the market anticipates, we are USD/NOK bulls. Additionally, we are also bullish on CAD/NOK, as the Norges Bank is likely to have a much more dovish bias than the BoC going forward. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The SEK has been depreciating this week on the back of disappointing industrial production figures, with the yearly measure increasing at a meagre 0.8% pace, much less than the anticipated 4.2%. Moreover, IP experienced a monthly contraction of 2.4%. Additionally, the recent Financial Stability Report also highlighted that "further measures need to be introduced to increase the resilience of the household sector and reduce risks", as well as vulnerabilities in the Swedish banking system. While we think USD/SEK's weakness is nearing its end, EUR/SEK will likely see some weakness in the near future, given its expensive level. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades