Japan

Highlights We do not view October's equity downdraft as a signal to further trim risk assets to underweight. Nonetheless, stocks have not yet fallen enough to justify buying either. The economic divergence between the U.S. and the rest of the world is intensifying and showing up in relative EPS trends. We believe earnings growth is set to drop sharply in the Eurozone and Japan. The viciousness of the bond selloff in October is worrying. The good news is that the Treasury curve steepened and the selloff mostly reflected higher real yields, rather than inflation expectations. Both facts suggest that the Treasury rout was reflective of strong U.S. growth, rather than a signal that the Fed is overly restrictive. Our sense is that the fed funds rate has not yet reached the economic choke point, but it is critical to watch for signs of trouble. This month we focus on key monetary indicators. Our "R-Star" indicator is deteriorating, but is not yet in the danger zone for risk assets. It is possible that we will upgrade risk assets back to overweight if stocks in the developed markets cheapen further, as long as our monetary indicators are not flashing red and the U.S. earnings backdrop remains upbeat. However, the risks are formidable and show no signs of abating. Indeed, our global economic indicators continue to deteriorate and we might be headed for a brief manufacturing recession outside of the U.S. A Democratic win in the U.S. mid-terms might spark a knee-jerk equity selloff, but Congress is unlikely to unravel any of the fiscal stimulus currently in place through 2019. The Administration's foreign policy remains a larger risk for equities. Our high conviction view is that President Trump will continue to use a "maximum pressure" approach for Iran and China that will spark additional fireworks. Another growing risk is an oil price spike above US$100/bbl in early 2019, causing significant economic damage. Chinese policy stimulus is underwhelming and the credit impulse remains weak. In the absence of real policy action in China, the prospect of continuing Fed tightening means that it is too early to bottom-fish in emerging markets. The market is still underestimating the U.S. inflation outlook and the amount of Fed tightening over the next 12-18 months. We continue to recommend a neutral stance on global equities (with a preference for developed over emerging markets), a below-benchmark duration bias, and an overweight allocation in cash. Feature October's market action confirmed that we have entered a period of elevated volatility as investors digest the inevitability of rising U.S. interest rates. We do not view the downdraft in equity markets as a signal to further trim risk asset exposure to underweight. Nonetheless, stocks have not yet fallen enough to justify buying either. We took profits and downgraded risk assets to benchmark in June, placing the proceeds into cash. Our primary motivation was the advanced nature of the U.S. economic cycle, stretched valuations, heightened geopolitical tensions, the risk of a Chinese "hard landing" and upside potential for U.S. inflation and global bond yields. We did not foresee a recession either in the U.S. or the other major economies in the near future. Nonetheless, we concluded that the risk/reward balance did not favor staying overweight risk assets. A number of culprits could be blamed for October's pullback, but in reality the market has been primed for some profit-taking for a long while and so any little excuse could have been used by investors to sell. Fed Chair Powell's "long way to go" comment seemed to push the teetering equity market over the edge. He challenged the market's view that the fed funds rate is getting close to neutral, implying that the Fed is not close to pushing the pause button. The Treasury curve steepened as the market discounted a higher cyclical peak in the fed funds rate. Could it be that bond yields have reached a "choke point" where tightening financial conditions are derailing the economic expansion? The global economic deceleration is intensifying, but the U.S. economy still appears to be enjoying solid momentum outside of housing. We do not yet see any major dark clouds forming in the U.S. corporate earnings picture either, as discussed below. Moreover, the bond selloff in October mostly reflected rising real yields (rather than inflation expectations), and the curve steepened. Both facts suggest that the Treasury selloff was reflective of U.S. strong growth, rather than a signal that the Fed is now outright restrictive. Nonetheless, the issue is particularly tricky in this cycle because the equilibrium, or neutral, fed funds rate is undoubtedly somewhat lower than in past expansions. Given the uncertain level of the neutral rate, investors must be on the lookout for signs that interest rates are beginning to bite. Markets And The Fed Cycle BCA has long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. We begin by decomposing the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction, as follows (Chart I-1 and Chart I-2): Phase I begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above our estimate of the equilibrium rate (shown as a dashed line in Charts I-1 and I-2). Phase II represents the latter stages of the tightening cycle, when the Fed hikes its target rate above equilibrium in a deliberate effort to cool an overheating economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate breaks below its equilibrium level until it bottoms. Chart I-1Stylized Fed Rate Cycle Chart I-2Fed Funds Rate And Equilibrium The tough part is estimating the neutral level of the fed funds rate. It is a theoretical concept - the level that is consistent with an economy at full employment with no upward or downward pressure on inflation or growth. The Fed lifts the fed funds rate above neutral when it wishes to dampen the economy and temper inflationary pressure. Economic theory ties the equilibrium interest rate to the pace of expansion of the supply side of the economy, or potential GDP growth. Our approach is to combine the CBO's estimate of potential GDP growth with a smoothed version of the actual fed funds rate, to account for the fact that the equilibrium rate periodically deviates from potential growth. The historical track record of this framework is compelling. The latest update of our analysis of equity returns during the four phases was published by BCA's U.S. Investment Strategy Service.1 The level of the fed funds rate relative to its equilibrium has mattered much more than the direction of rates for historical S&P 500 price returns (Table I-1 and I-2). Price returns during Phases I and IV (when the fed funds rate is below equilibrium) trounce returns during Phases II and III (when the funds rate is in restrictive territory). This is especially the case after adjusting returns for inflation. Table I-1Tight Policy Is Hazardous To Stocks' Health, ... Table I-2...Especially In Real Terms Further breaking down the historical returns into 12-month forward EPS estimates and 12-month forward multiples, it turns out that multiples usually contract when the Fed is tightening. However, during Phase I this is more than offset by the increase in forward earnings estimates, such that equity investors enjoy positive returns until rates move into restrictive territory in Phase II. Our sense is that we are still in Phase I, implying that it is too early to expect more than a correction in risk assets based solely on the U.S. monetary policy cycle. The fed funds rate has been rising, but so too has the equilibrium rate according on our measure. Powell's latest comments suggest that the Fed agrees. That said, it is a cliche to say that this cycle has been different in many ways. Nobody knows exactly where the neutral rate is today. This means that we must be on watch for signs that the fed funds rate has already crossed into restrictive territory. We looked at the behavior of a raft of monetary and credit indicators around the time that the fed funds rate broke above the estimated neutral rate in the past. None of them have been reliable across all business cycles since the 1970s, but the best ones are shown in Chart I-3: Growth in M1 generally begins to decelerate as the fed funds rate approaches neutral and falls into negative territory shortly thereafter. Bank liquidity is defined as short-term assets as a percent of total bank credit. It usually peaks just before rates become restrictive, and begins to fall quickly as the fed funds rate surpasses the equilibrium level. We interpret bank liquidity as a proxy for banks' willingness to provide funding liquidity that enables institutional investors to take positions. The peak level of bank liquidity differs across tightening cycles, but it is never a good sign when it begins to trend lower. Consumer credit growth has a somewhat spotty track record as an indicator of monetary restraint, but it has often peaked around the time that the Fed enters Phase II. The BCA Fed Monitor is an indicator designed to gauge the pressure on the Fed to adjust policy one way or the other. It generally peaks in "tight money required" territory just before, or coincident with, the shift from Phase I to Phase II. A shift of the Monitor into "easy money required" territory would suggest that policy has become outright restrictive, and that a peak in the fed funds rate is approaching. Chart I-3BCA R-Star Indicator And Its Components Combining the four into one indicator removes some of the noise of the individual series. The BCA "R-Star" Indicator is shown in the top panel of Chart I-3. A dip in this indicator below the zero line would warn that we have entered Phase II and that the equity bull market is out of time. Chart I-4 shows the BCA R-Star indicator again, along with the S&P 500, EPS growth and profit margins. It is shaded for periods when the R-Star indicator is below zero. The lead time has varied across the economic cycles and it is far from a perfect predictor. Nonetheless, when the indicator is negative it has generally been associated with falling stock prices, decelerating profit growth and eroding profit margins. The indicator has edged lower this year, but is not yet in the danger zone. Chart I-4BCA R-Star Indicator And The U.S. Profit Cycle Finally, we are of course watching the yield curve. Its recent steepening suggests that U.S. growth justifies higher bond yields and that policy has not yet become outright restrictive. Global Growth Divergence Continues... We do not see compelling evidence from the flow of U.S. economic data that higher rates are derailing the expansion, although there are a couple of worrying signs, suggesting that growth has peaked. The backdrop is quite supportive for consumer spending: tax cuts, robust employment gains, rising wages and elevated confidence. The fact that the household saving rate is relatively high means that consumers have the wherewithal to boost the pace of spending if they wish. Motor vehicle sales have moderated, but this is to be expected when the economic cycle is advanced. The replacement cycle for U.S. business investment still has further to run. The average age of the non-residential housing stock is the highest since 1963. Both capex intention surveys and the recent easing in lending standards for commercial and industrial loans suggest that U.S. capital expenditures will be well supported, although there has been some softness in the former recently (Chart I-5). Chart I-5U.S. Capex Outlook Is Bright That said, the soft U.S. housing data are a concern, especially because a peak in residential investment as a share of GDP has been a good (albeit quite early) leading indicator of recessions. It is difficult to fully explain why housing is losing altitude given all the tailwinds supporting demand, including solid household formation (see last month's Overview). Mortgage rates have increased but affordability is still favorable. It could be that the supply side, rather than demand, is the problem: tight lending standards, zoning restrictions and the high cost of building. Still, a continued housing downtrend relative to GDP would be a challenge to our view that there will be no recession in 2019. While the U.S. economy is enjoying strong momentum, the same cannot be said for the rest of the global economy. A raft of items has weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, rising oil prices, emerging market turbulence, the return of Italian debt woes and the continuing slowdown in the Chinese economy. The global PMI is beginning to erode from a high level (Chart I-6). The softening in world activity appears to be concentrated in capital spending. Growth in capital goods imports for an aggregate of 20 countries continues to decelerate, along with industrial production for capital goods and machinery & electrical equipment in the major advanced economies. Chart I-6Global Capex Is Softening Meanwhile, our favorite global leading indicators are flashing red (Chart I-7). BCA's Global LEI has broken below the boom/bust line and its diffusion index suggests further downside. The Global ZEW and the BCA Boom/Bust indicator are holding just below zero. The global credit impulse is also still pointing down. Chart I-7Global Leading Indicators Flashing Red Among the advanced economies, Europe and Japan are most vulnerable to the slowdown in global trade and capital spending. Industrial production growth has already stalled in both economies and their respective LEIs are heading south fast (Chart I-8). Chart I-8Global Divergence ...Affecting Relative Earnings Trends It is thus not surprising that corporate EPS growth has peaked in the Eurozone and Japan. The macro data that drive our top-down EPS growth models suggest that the profit situation is going to deteriorate quickly in the coming quarters. The peak in industrial production growth suggests that the corporate top line will lose more steam. Meanwhile, nominal GDP growth has decelerated sharply in both economies, in absolute terms and relative to the aggregate wage bill (Chart I-9). These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our model (Chart I-10). Chart I-9Diverging Macro Trends... Chart I-10...Implies Different EPS Outlook The earnings situation is completely different in the U.S. It is still early in Q3 earnings season, but company reports have been upbeat so far. The macro variables that feed into our top-down U.S. EPS model point to both continuing margin expansion and robust top line growth (Chart I-9). Nominal GDP growth has surged to more than 5% on a year-ago basis, while the expansion in the economy's wage bill has been steady at under 5%. It is also very impressive that industrial production growth continues to accelerate, bucking the global trend. We assume that U.S. GDP growth moderates from this year's hectic pace in 2019, but stays well above-trend because of the lingering fiscal tailwind. Impressively, the indicators we are following suggest that S&P 500 profit margins still have some upside potential, at least in the next quarter or two (Chart I-11). Nonetheless, we make the conservative assumption that margins will narrow somewhat in 2019. Plugging this macro scenario into our model, it suggests that EPS growth will decelerate to a still-solid 10% pace by the end of 2019. The impact on corporate profits from the rise in bond yields so far will be minimal. It is only now that the yield on the average corporate bond has reached the average coupon on outstanding debt. This means that it will require further increases in yields from here to have any meaningful impact on corporate interest expense. Chart I-11U.S. Margin Indicators Still Upbeat The U.S. economic and earnings backdrop is robust enough that we would be tempted to upgrade our risk asset allocation back to overweight if the S&P 500 moves even lower in the near term. Nonetheless, a number of key risks keep us at benchmark for now. (1) U.S. Foreign Policy The U.S. mid-term election is less than two weeks away as we go to press. Our geopolitical team places the odds of a Democratic House takeover at 65%, and the odds of a Senate takeover at 40%. Investors should expect a knee-jerk equity selloff if the Democrats manage to grab both parts of Congress. However, any damage to risk assets should be fleeting because the Democrats would not be able to unravel any of President Trump's main economic policies. Voters are not demanding budget discipline from either party, despite the surging federal deficit (Chart I-12). We highlighted in a recent Special Report that we foresee little political backlash against fiscal profligacy because of the shift-to-the-left by the median voter.2 The Trump tax cuts are here to stay. Chart I-12No Political Backlash To Big Deficits In fact, our geopolitical team argues that the odds would increase for an infrastructure plan and even of an immigration deal, if President Trump comes to the middle ground on some of his demands.3 The implication is that fiscal policy will remain highly stimulative in 2019, before the initial thrust begins to wear off in 2020. The Administration's foreign policy, however, remains a key risk for equities. Our high conviction view is that President Trump will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. President Trump has threatened to lift the tariff to 25% by the end of the year in order to pile even more pressure on Beijing. This would represent a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. The risk is that the Chinese government not only hikes tariffs on U.S. exports, but also retaliates against U.S. firms with operations in China. Even more dangerously, a trade war with China could escalate into a military conflict in the South China Sea. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not. Once the election is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes led to a breakthrough with North Korea. Unfortunately for the markets, we do not expect that this tactic will work as smoothly with Iran and China. (2) Rising Probability Of An Oil Shock The Administration's pressure on Iran adds to the already high risk of an oil price spike above US$100 per barrel in early 2019. While oil demand growth is slowing somewhat, exports from two of OPEC's largest producers - Iran and Venezuela - are falling precipitously. Global oil inventories are drawing down, while spare capacity is perilously low, leaving little in the way of readily available backup supply to deal with an unplanned production outage. The confluence of these factors is setting the global oil market up for a supply shock according to our energy experts (Chart I-13). Chart I-13Increasing Risk Of An Oil Spike It is important to differentiate between a steady demand-driven rise in the price of oil and a rapid supply-driven oil price spike. The former can be bond-bearish by forcing inflation expectations higher at a time when strong economic growth is also pushing up real bond yields. Nonetheless, equity prices could continue rising in this scenario as the robust economic backdrop outweighs the impact of higher yields. In contrast, an oil price spike that is driven by supply restrictions might initially be negative for bond prices, but ultimately would produce a deflationary impulse by depressing real economic activity. It could even be the catalyst for a recession. A supply-driven oil spike would be outright bearish for risk assets and may prove to be the trigger for a shift from benchmark to underweight for global stocks and corporate bonds. The risk facing corporates in the next economic downturn is one of the topics covered in this month's Special Report, beginning on page 21. The report looks at the structural changes to the economy and financial markets that have occurred because of the Great Recession and financial crisis. (3) EM Pain Is Not Over In the absence of policy stimulus in China, the prospect of continuing Fed tightening means that it is too early to bottom-fish in emerging markets. Emerging Asia is at the epicenter of the global trade and capital spending slowdown. The sharp deceleration in Taiwanese and Korean export growth rates suggests that growth in world industrial production and forward earnings estimates are not yet near a bottom (Chart I-14). Chart I-14Asian Exports Softening... Softening Chinese domestic demand is adding to the gloom. Chart I-15 shows that efforts by the Chinese authorities to curtail corporate debt have been bearing fruit. In response to the regulatory and administrative tightening, smaller financial institutions are not building up the working capital required to expand their loan book. As a result, the Chinese credit impulse remains weak and shows no sign of a bottom, despite the uptick in the latest reading on M3 growth. Chinese policy stimulus is underwhelming, confirming the view we expressed in the September BCA Overview. Xi Jinping has not yet abandoned his structural goals and shadow bank crackdown, which are weighing on overall credit expansion. Chart I-15...And No Growth Impulse From China Second, EM financial conditions continue to tighten (Chart I-15). Our currency strategists point out that many factors lie behind this deterioration in the EM financial conditions index, including the collapse in performance of carry trades, the dollar's ascent, and rising U.S. interest rates that are boosting the cost of servicing foreign currency EM debt. In turn, tighter EM financial conditions are contributing to the global manufacturing slowdown in a self-reinforcing negative feedback loop. EM Asia is particularly at risk to this loop, but Europe, Japan and commodity producers are also vulnerable. Some market commentators have argued that the Fed will soon have to back off its rate hike campaign in the face of global financial market stress. However, the FOMC's pain threshold is higher than at any time since the Great Recession because the domestic economy is showing signs of overheating. The correction in risk assets would have to get a lot worse before the Fed blinks. Meanwhile, the U.S. again passed on the chance to label China a currency manipulator. This opens the door to another downleg in the RMB, especially if the U.S./China trade war escalates. Additional RMB weakness would spell more trouble for EM assets. The implication is that any bounce in EM currencies or asset prices represents a selling opportunity for those investors not already short. Our EM strategists expect at least another 15% drop in share prices before the risk-reward profile of this asset class improves. (4) Italian Debt Crisis The main problem with the Italian economy is that the private sector saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. Unlike Germany, Italy cannot export its savings to the rest of the world through a large trade surplus because it does not have a hypercompetitive economy. Nor can the Italian government risk running afoul of the bond vigilantes by emulating Japan's strategy of absorbing private-sector savings with large budget deficits. The implication is that Italy is stuck in a low-growth trap that is feeding political pressure to shed the EU's fiscal straight jacket. We believe that the populist government will be the first to blink, but it may require more bouts of financial stress to force capitulation. A 4% level on the 10 year BTP yield is a likely threshold for a compromise. Above that level, Italian banks become insolvent based on the market value of their holdings of Italian debt. In the meantime, rising global bond yields worsen Italy's tenuous financial situation, with possible contagion into global financial markets. Investment Conclusions: The U.S. bond market is waking up to the likelihood that U.S. short-term rates are going higher than previously expected, suggesting that recent investment themes will persist for a while longer. We continue to recommend a neutral stance on global equities (with a preference for developed over emerging markets), a below-benchmark duration bias, and an overweight allocation in cash. The bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (Chart I-16). Investors judge that some combination of tepid global economic momentum and tame U.S. core inflation temper the Fed's need or ability to take rates much higher. We disagree, based our own assessment of the U.S. economy and our out-of-consensus inflation view (see this month's Special Report). Rising volatility and/or a weaker global growth pulse are unlikely to prompt the Fed to bail out of its tightening campaign as quickly as it did in early 2016. Chart I-16Market Expectations For The Fed Still Too Complacent Meanwhile, our indicators suggest that the divergence between the red-hot U.S. economy and cooling global activity will continue, implying more upside potential for the U.S. dollar. We expect another 5-10% rise against most currencies, with the possible exception of the Canadian dollar. It is difficult to identify a "choke point" for bond yields in advance. A 10-year Treasury yield north of 3.7% might cause us to call the peak in yields and to become even more defensive on risk assets, but it will be critical to watch our monetary indicators. Indeed, we would be tempted to upgrade stocks back to overweight if the global selloff progresses much further, in the absence of negative reading from the monetary indicators or an inverted yield curve. The earnings backdrop will continue to be a tailwind for the U.S. equity market at least into early 2019. In contrast, profit growth in the Eurozone and Japan is set to disappoint market expectations. The U.S. equity market will therefore outperform, particularly in unhedged terms. Stay at benchmark on corporate bonds versus governments in the U.S. and Eurozone. Avoid emerging market assets and commodities. The main exception is oil, which is increasingly at risk of a spike above $100/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst October 25, 2018 Next Report: November 29, 2018 1 Please see U.S. Investment Strategy Special Report "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018, available at usis.bcaresearch.com 2 Please see The Bank Credit Analyst "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated July 2018, available at bca.bcaresearch.com 3 Please see BCA Geopolitical Strategy Weekly Report "A Story Told Through Charts: The U.S. Midterm Election," dated September 19, 2018, available at gps.bcaresearch.com II. The Long Shadow Of The Financial Crisis The Great Recession and financial crisis cast a long shadow that will affect economies, policymakers and investors for years to come. The roots of the crisis are already well known. The first of a two-part series looks forward by examining the areas where we believe structural change has occurred related to the economy or financial markets. First, the financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. Debt and market liquidity are two key concerns. Corporate leverage will not cause the next recession. Nonetheless, when one does occur, corporate spreads in the U.S. and (to a lesser extent) the Eurozone will widen by more for any given degree of recession. This reflects a low interest coverage ratio, poor market liquidity, the downward trend in credit quality and covenant erosion. Second, the shock of the Great Recession and its aftermath appears to have affected the relationship between economic slack and inflation. Firms have been extra reluctant to grant wage gains. However, we argue that the "shell shock" effect will wane. The fact that inflation has been depressed for so long may actually cultivate the risk that inflation will surprise on the upside in the coming years. Investors should hold inflation-protection in the inflation swaps market, or by overweighting inflation-linked bonds versus conventional issues. Third, the events of the last decade have left a lasting impression on monetary policymakers. They will err on the side of allowing the economy to overheat and inflation to modestly overshoot the target in the major economies, despite signs of financial froth. The Fed will respond only with a lag to the current fiscally-driven surge in U.S. growth, leading to a boom/bust economic scenario. Central bankers will have no trouble employing unorthodox policies again in the future, and will be willing to push the boundaries even further during the next recession. Expect aggressive manipulation of the long-end of the yield curve when the time arrives to ease policy. We may also observe more coordination between monetary and fiscal policies. Fourth, global bond yields fell to unprecedented levels, reflecting both structural and cyclical headwinds to demand growth. A dismal productivity performance is another culprit. Productivity growth is poised to recover to some extent, while some of the growth headwinds have reached an inflection point. We do not expect nominal bond yields to return to pre-Lehman norms, and yields could even fall back to previous lows in the case of a recession. Nonetheless, we expect a yield pattern of higher lows and higher highs over the coming business cycles. The 10-year anniversary of the Lehman shock this autumn sparked an avalanche of analysis on the events and underlying causes of the Great Recession and financial crisis. It is a woeful story of greed, a classic bubble, inadequate regulation, new-fangled financial instruments, and a globalized financial system that spread the shock around the world. The crisis cast a long shadow that will affect economies, policymakers and investors for many years to come. The roots of the crisis are well known, so we will not spend any time going over well-trodden ground. Rather, this Special Report looks forward by examining the areas where we believe structural change has occurred related to the economy or financial markets. In Part I, we cover the corporate bond market, the inflation outlook, central bank policymaking and equilibrium bond yields. Part II will look at the debt overhang, systemic risk in the financial sector, asset correlations, the cult of equity and the rise of populism. While not an exhaustive list, we believe these are the key areas of structural change. (1) Corporate Bond Market: Leverage And Downgrade Risk The financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. Debt and market liquidity are two key concerns. An extraordinarily long period of extremely low interest rates was too much for corporate CEOs to pass up. However, because the durability of the economic recovery was so uncertain, it seemed more attractive to hand over the borrowed cash to shareholders than to use it to aggressively expand productive capacity. The ongoing equity bull market rewarded CEOs for the financial engineering, serving to create a self-reinforcing feedback loop. And so far, corporate bondholders have not policed this activity. The result is that the U.S. corporate bond market has grown in leaps and bounds since 2009 (Chart II-1A and Chart II-1B). The average duration of the Bloomberg Barclays index has also risen as firms locked in attractive financing rates. The same is true, although to a lesser extent, in the Eurozone. Chart II-1AU.S. BBB-Rated Share Rising... Chart II-1B...Same In The Eurozone Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, investors will begin to worry about the growth outlook if interest rates continue to rise. The U.S. national accounts data suggest that interest coverage remains relatively healthy, but this includes large companies such as some of the FAANGs that have little debt and a lot of cash. The national accounts data are unrepresentative of the companies that are included in the Bloomberg Barclays corporate bond index, which are heavy debt issuers. To gain a clearer picture, we calculated a bottom-up Corporate Health Monitor (CHM) for a sample of U.S. companies that provides a sector and credit-quality composition that roughly matches the Bloomberg Barclay's index. The CHM is the composite of six critical financial ratios. Chart II-2 highlights that the investment-grade (IG) CHM has improved over the past two years due to the profitability sub-components. However, the debt/equity ratio has been in a steep uptrend. Interest coverage does not appear alarming by historical standards at the moment, but one can argue that it should be much higher given the extremely low average coupon on corporate bonds, and given that profit margins are extraordinarily high in the U.S. The rapid accumulation of debt has overwhelmed these other factors. Evidence of rising leverage is broadly based across sectors and ratings. Chart II-2U.S. IG Corporate Health Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. To gauge the risk, we estimate the change in the interest coverage ratio over the next three years for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt.1 For our universe of Investment-grade U.S. companies, the interest coverage ratio would drop from a little over 7 to under 6, which is close to the lows of the Great Recession (denoted as "x" in Chart II-3). Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. The "o" in Chart II-3 denotes the combination of a 100 basis-point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. The overall interest coverage ratio plunges close to all-time lows at 4½. Chart II-3Interest Coverage To Plunge... These simulations imply that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. Rating agencies have undertaken some downgrading related to shareholder-friendly activity, but downgrades will proliferate when the agencies realize that the economy is turning and the profit boom is over (Chart II-4). Banks will belatedly tighten lending standards, adding to funding pressure for the corporate sector. Chart II-4...And Ratings To Be Slashed Fallen Angels The potential for a large wave of fallen angels means that downgrade activity will be particularly painful for corporate bond investors. The surge in lower-quality issuance has led to a downward trend in the average credit rating and has significantly raised the size of the BBB-rated bonds relative to the IG index and relative to the broader universe of corporate bonds including high yield (Chart II-5, and Chart II-1A).2 The downward trend in credit quality predates Lehman, but events since the Great Recession have likely reinforced the trend. Chart II-5Lower Ratings And Longer Duration Studies show that bonds that get downgraded into junk status can perform well for a period thereafter, suggesting that investors holding a fallen angel should not necessarily sell immediately. Nonetheless, the process of transitioning from investment-grade to high-yield involves return underperformance as the spread widens. Poor market liquidity and covenant erosion will intensify pressure for corporate spreads to widen when the bear market arrives. Market turnover has decreased substantially since the pre-Lehman years, especially for IG (Chart II-6). The poor liquidity backdrop appears to be structural, reflecting regulation that has curtailed banks' market-making activity and prop trading, among other factors. Chart II-6Poor Market Liquidity The Eurozone corporate bond market has also seen rapid growth and a deterioration in the average credit rating. Liquidity is an issue there as well. That said, the Eurozone corporate sector is less advanced in the leverage cycle than the U.S. Interest coverage ratios will fall during the next recession, but this will be concentrated among foreign issuers - domestic issuers are much less at risk to rising interest rates and/or an economic downturn.3 Bottom Line: Corporate leverage will not cause the next recession. Nonetheless, when one does occur, corporate spreads in the U.S. and (to a lesser extent) Eurozone will widen by more for any given degree of recession. Current spreads do not compensate for this risk. (2) Inflation Undershoot Breeds Overshoot Inflation in the U.S. and other developed economies has been sticky since the financial crisis. First, inflation did not fall as much in the recession and early years of the recovery as many had predicted, despite the worst economic contraction in the post-war period. Subsequently, central banks have had trouble raising inflation back to target. In the U.S., core PCE inflation has only recently returned to 2%. Several structural factors have been blamed, but continuing tepid wage growth in the face of a very tight labor market raises the possibility that the inflation-generating process has been fundamentally altered by the Great Recession. In other words, the relationship between slack in the labor market (or market for goods and services) and inflation has changed. In theory, inflation should rise when the economy's output is above its potential level or when the unemployment rate is below its full-employment level. Inflation should fall when the reverse is true. This means that the change (not the level) in inflation should be positively correlated with the level of the output gap or the labor market gap. Chart II-7 presents the change in U.S. core inflation with the output gap. Although inflation appears to have become less responsive to shifts in the output gap after 1990, it has been particularly insensitive in the post-Lehman period. Chart II-7The U.S. Phillips Curve: RIP? One reason may be that the business sector was shell-shocked by the Great Recession and financial crisis to such an extent that business leaders have been more reluctant to grant wage gains than in past cycles. Equally-unnerved workers felt lucky just to have a job, and have been less willing to demand raises. Dampened inflation expectations meant that low actual inflation became self-reinforcing. We have some sympathy with this view. Long-term inflation expectations have been sticky at levels that are inconsistent with the major central banks meeting their inflation targets over the long term. This suggests that people believe that central banks lack the tools necessary to overwhelm the deflationary forces. The lesson for investors and policymakers is that, while unorthodox monetary policies helped to limit the downside for inflation and inflation expectations during and just after the recession, these policies have had limited success in reversing even the modest decline that did occur. That said, readers should keep in mind a few important points: One should not expect inflation to rise much until economies break through their non-inflationary limits. The major advanced economies have only recently reached that point to varying degrees; Inflation lags the business cycle (Chart II-8). This is especially the case in long 'slow burn' economic expansions, as we have demonstrated in previous research; and The historical relationship between inflation and economic slack has been non-linear. As shown in Chart II-9, U.S. inflation has tended to accelerate quickly when unemployment drops below 4½%. Chart II-8U.S. Inflation Lags The Cycle Chart II-9A Kinked Phillips Curve Shell Shock Is Fading We believe that the "shell shock" effect of the Great Recession on inflation will wane over time. Indeed, my colleague Peter Berezin has made the case that the fact that inflation has been depressed for so long actually cultivates the risk that inflation will surprise on the upside in the coming years.4 Central bankers have been alarmed by the economic and financial events of the last decade. They also cast a wary eye on Japan's inability to generate inflation even in the face of massive and prolonged monetary stimulus. Policymakers at the FOMC are determined to boost inflation and inflation expectations before the next economic downturn strikes. They are also willing to not only tolerate, but actively encourage, an overshoot of the 2% inflation target in order to ensure that long-term inflation expectations return "sustainably" to a level consistent with meeting the 2% target over the long term. In other words, the Fed is going to err on the side of too much stimulus rather than too little. This is an important legacy of the last recession (see below). Meanwhile, other structural explanations for low inflation are less powerful than many believe. For example, globalization has leveled off and rising tariff and non-tariff barriers will hinder important global supply chains. Our research also suggests that the rising industrial use of robots and the e-commerce effect on retail prices have had only a small depressing effect on U.S. inflation. Bottom Line: The Phillips curve relationship has probably not changed in a permanent way since Lehman went down. It is quite flat when the labor market is not far away from full employment, but the relationship is probably non-linear. As the unemployment rate drops further, the business sector will have no choice but to lift wages as labor becomes increasingly scarce. The kinked nature of the Phillips curve augments the odds that the Fed will eventually find itself behind the curve, and inflation will rise more than the market is expecting. The same arguments apply to the Bank of England and possibly even the European Central Bank. Gold offers some protection against inflation risk, but the precious metal is still quite expensive in real terms. Investors would be better off simply buying inflation-protection in the inflation swaps market or overweighting inflation-linked bonds over conventional issues. (3) Monetary Policy: Destined To Fight The Last War There are several reasons to believe that the shocking events of the crisis and its aftermath have left a lasting impression on monetary policymakers. Several factors suggest that they will err on the side of allowing the economy to overheat and inflation to modestly overshoot the target: Inflation Persistence: As discussed above, there is a greater awareness that it is difficult to lift both actual inflation and inflation expectations once they have fallen. Some FOMC members believe that long-term inflation expectations are still too low to be consistent with the Fed meeting its 2% inflation target over the long term. A modest inflation overshoot in this cycle would be beneficial, according to this view, in the sense that it would boost inflation expectations and thereby raise the probability that the FOMC will indeed meet its goals over the long term. It might also encourage some discouraged workers to re-enter the labor market. Some policymakers also believe that the Fed is not taking much of a risk by pushing the economy hard, because the Phillips curve is so flat. Zero Bound: Low inflation expectations, among other factors, have combined to dramatically reduce the level of so-called r-star - the short-term rate of interest that is neither accommodative nor restrictive in terms of growth and inflation. R-star is thought to be rising now, at least for the U.S., but it is probably still low by historical standards across the major economies. This increases the risk that policy rates will again hit the lower bound during the next recession, making it difficult for central banks to engineer a real policy rate that is low enough to generate faster growth.5 Fighting the Last War: Memories of the crisis linger in the minds of policymakers. The global economy came dangerously close to a replay of the Great Depression, and policymakers want to ensure that it never happens again. Some monetary officials have argued that a risk-based approach means that it is better to take some inflation risks to limit the possibility of making a deflationary policy mistake down the road. Fears that the major economies are now more vulnerable to deflationary shocks seem destined to keep central banks too-easy-for-too-long. Central bankers will also be quicker and more aggressive in responding when negative shocks arrive in the future. This applies more to the U.S., the U.K. and Japan than the European Central Bank, but even for the latter there has been a clear change in the monetary committee's reaction function since Mario Draghi took over the reins. Financial Stability Concerns Policymakers are also more concerned about financial stability. Pre-crisis, the consensus among the monetary elite was that financial stability should play second fiddle to the inflation target. It was felt that central banks should focus on the latter, and pay attention to signs of financial froth only when they affect the inflation outlook. In practice, this meant paying only lip service to financial excess until it was too late. It was difficult to justify rate increases when inflation was not threatening. It was thought that macro-prudential regulation on its own was enough to contain financial excesses. Today, policymakers see financial stability as playing a key role in meeting the inflation target. It is abundantly clear that a burst bubble can be highly deflationary. Some policymakers still believe that aggressive macro-prudential policies can be effective in directly targeting financial excesses. However, others feel there is no substitute for higher interest rates; as ex-Governor Jeremy Stein stated, interest rates get "in all the cracks". Moreover, the Fed does not regulate the shadow banking sector. The Fed is thus balancing concerns over signs of financial froth against the zero-bound problem and fears of the next deflationary shock. We believe that the latter will dominate their policy choices, because it will still be difficult to justify rate hikes to the public when there is no obvious inflation problem. In the U.S., this implies that the economic risks are skewed toward a boom/bust scenario in which the FOMC is slow to respond to a fiscally-driven late cycle mini-boom. Inflation and inflation expectations react with a lag, but a subsequent acceleration in both forces the Fed to aggressively choke off growth. Policy Toolkit Central bankers will be quite willing to employ their new-found policy tools again in the next recession. The new toolbox includes asset purchases, aggressive forms of forward guidance, negative interest rates, and low-cost direct lending to banks and non-banks in some countries. Policymakers generally view these tools as being at least somewhat effective, although some have argued that the costs of using negative interest rates have outweighed the benefits in Europe and Japan. The debate on how to deal with the zero-bound problem in the U.S. has focused on lifting r-star, including raising the inflation target, adopting a price level target, policies to boost productivity, and traditional fiscal stimulus. Nonetheless, ex-Fed Chair Yellen's comments at the Jackson Hole conference in 2016 underscored that it will be more of the same in the event that the zero bound is again reached - quantitative easing and forward guidance.6 No doubt, the major central banks will rely heavily on both of these tools in order to manipulate yields far out the curve. Forward guidance may be threshold-based. For example, policymakers could promise to keep the policy rate frozen until unemployment or inflation reaches a given level. Now that central bankers have crossed the line into unorthodox monetary policy and inflation did not surge, future policymakers will be willing to stretch the boundaries even further in the event of a recession. For example, they may consider price-level targeting, which would institutionalize inflation overshoots to make up for past inflation undershoots. It is also possible that we will observe more coordination between monetary and fiscal policies in the next recession. The combination of fiscal stimulus and a cap on bond yields would be highly stimulative in theory, in part by driving the currency lower. Japan has gone half way in this direction by implementing a yield curve control (YCC) policy. However, it has failed so far to provide any meaningful fiscal stimulus since the yield cap has been in place. It also appears likely that central bank balance sheets will not return to levels as a percent of GDP that existed before the crisis. An abundance of bank deposits at the central bank will help to satisfy a structural increase in the demand for cash-like risk-free assets. Maintaining a bloated balance sheet will also allow central banks to provide substantial amounts of reverse repos (RRPs) into the market, which should improve the functioning of money markets that have been impaired to some degree by regulation. We do not expect that a structural increase in central bank balance sheets will have any material lasting impact on asset prices or inflation. We believe that inflation will surprise on the upside, but not because central banks will continue to hold significant amounts of government bonds on their balance sheets over the medium term. Bottom Line: The implication is that the monetary authorities will have a greater tolerance for an overshoot of the inflation target than in the past. The Fed will respond only with a lag to the fiscally-driven surge in U.S. growth, leading to a boom/bust economic scenario. During the next recession, policymakers will rely heavily on quantitative easing and forward guidance to manipulate the yield curve (after the policy rate reaches the lower bound). (4) Bond Prices: Structural Factors Turning Less Bullish Perhaps the most dramatic and lasting impact of the GFC has been evident in the global bond market. Government yields fell to levels never before observed across the developed countries and have remained extremely depressed, even as the expansion matured and economic slack was gradually absorbed. Real government bond yields are still negative even at the medium and long parts of the curve in the Eurozone and Japan (Chart II-10). It is tempting to conclude that there has been a permanent shift down in global bond yields. Chart II-10Real Yields Still Depressed Equilibrium bond yields are tied to the supply side of the economy. Potential GDP growth is the sum of trend productivity growth and the pace of expansion of the labor force. Equilibrium bond yields may fall below the potential growth rate for extended periods to the extent that aggregate demand faces persistent headwinds. The headwinds in place over the past decade include fiscal austerity, demographics, household deleveraging, increased regulation and lingering problems in the banking sector that limited the expansion of credit, among others. These headwinds either affect the desire to save or the desire to invest, the interplay of which affects equilibrium bond yields. Some of these economic headwinds predate 2007, but the financial crisis reinforced the desire to save more and invest less. Space limitations prevent a full review of the forces that depressed bond yields, but a summary is contained in Appendix 1 and we encourage interested readers to see our 2017 Special Report for full details.7 The Great Supply-Side Shortfall Falling potential output growth in the major advanced economies also helped to drag down equilibrium bond yields. The pace of expansion in the global labor force has plunged from 1¾% in 2005, to under 1% today (Chart II-11). The labor force has peaked in absolute terms in the G7, and is already shrinking in China. Chart II-11Slower Labor Force Expansion... Productivity growth took a dramatic turn for the worst after 2007 (Chart II-12). The dismal productivity performance is not fully understood, but likely reflected the peaking in globalization, increased regulation and the dramatic decline in capital spending relative to GDP. The latter was reflected in a collapse in the growth rate of the global capital stock (Chart II-13). In the U.S., for which we have a longer history of data, growth in the capital stocks has lead shifts in productivity growth with a 3-year lag. Firms have also been slower to adopt new technologies over the past decade. Chart II-12...And Lower Productivity Chart II-13Productivity And Investment The resulting impact on the level of GDP today has been nothing short of remarkable. The current IMF estimate for the level of potential GDP in 2018 is 10% lower than was projected by the IMF in 2008 (Chart II-14). There has been a similar downgrading of capacity in Europe, Japan and the U.K. Actual GDP has closed the gap with potential GDP to varying degrees in the major countries, but at a much lower level than was projected a decade ago. Paul Krugman has dubbed this the "Great Shortfall". Chart II-14A Permanent Loss Of Output The Great Shortfall was even greater with respect to capital spending. For 2017, the IMF estimates that global investment was more than 20% below the level implied by the pre-crisis trend (Chart II-15). Reduced credit intermediation, from a combination of supply and demand factors, was a significant factor behind the structural loss of economic capacity according to the IMF study.8 Chart II-15Permanent Scars On Capital Spending By curtailing the business investment relative to GDP for a prolonged period, major economic slumps can have a permanent effect on an economy's long-term prospects. The loss of output since the financial crisis will never be regained. That said, bond yields in theory are related to the growth rate of productivity, not its level. The IMF report noted that there may even be some long-lasting effects on the growth rate of productivity. The crisis left lingering scars on future growth due to both reduced global labor force migration and fertility rates. The latter rose in the decade before the crisis in several advanced economies, only to decline afterward. Households postponed births in the face of the economic and financial upheaval. The IMF argues that not all of the decline in fertility rates will be reversed. An Inflection Point In Global Bond Yields On a positive note, the pickup in business capital spending in the major countries in recent years implies an acceleration in the growth rate of the capital stock and, thus, productivity. In the U.S., this relationship suggests that productivity growth could rise by a percentage point over the coming few years (Chart II-13). This should correspond to a roughly equivalent rise in equilibrium bond yields. Moreover, some of the other structural factors behind ultra-low interest rates have waned, while others have reached an inflection point. For example, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool as people retire and begin to deplete their nest eggs. Household savings rates will trend sharply lower in the coming years. Again, we encourage readers to read the 2017 Special Report for a full account of the structural factors that are shifting in a less bond-bullish direction. QE Reversal To Weigh On Bond Prices And let's not forget the unwinding of central bank balance sheets. The idea that central bank asset purchases on their own had a significant depressing effect on global bond yields is controversial. Some argue that the impact on yields occurred more via forward guidance; quantitative easing was a signal to markets that the central bank would stay on hold for an extended period, which pulled down yields far out the curve. This publication believes that QE had a meaningful impact on global bond yields on its own (Chart II-16). Nonetheless, either way, the Fed is now shrinking its balance sheet and the European Central Bank will soon end asset purchases. This means that the private sector this year is being forced to absorb a net increase in government bonds available to the private sector for the first time since 2014 (Chart II-17). Investors may demand juicier yields in order to boost their allocation to fixed-income assets. Chart II-16Reverse QE To Weigh On Bonds Chart II-17Private Investors Will Have To Buy More We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors still have an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2027 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-18). The implied path of real rates in the U.S. looks more reasonable, but there is still upside potential. Moreover, there is room for the inflation expectations component of nominal yields to shift up, as discussed above. Chart II-18Real Yields Still Too Low Another way of making this point is shown in Chart II-19. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is still very low by historical standards. Market expectations are equally depressed for the 5-year/5-year forward rate for the U.S. and the other major economies. Chart II-19Market Expectations Still Low Bottom Line: Global bond yields fell to unprecedented levels due to a combination of cyclical and structural factors. The bond-bullish structural factors were reinforced by shifts in desired savings and business investment as a result of the Great Recession and financial crisis. Some of these structural factors will linger in the coming years, but others are shifting in a less bond-bullish direction. We do not expect nominal bond yields to return to pre-Lehman norms, and yields could even return close to previous lows in the case of a recession. Nonetheless, we expect a yield pattern of higher lows and higher highs over the coming business cycles. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix 1: Key Factors Behind The Decline In Equilibrium Global Bond Yields The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. A key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. China became a major source of global savings after it joined the WTO, and its large trade surplus was recycled into the global pool of savings. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. The increase in ex-ante savings and reduction in ex-ante capital spending resulted in a substantial drop in equilibrium global interest rates. The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie. A positive labor supply shock should benefit global living standards in the long run, but the adjustment costs related to China's integration into the global economy imposed on the advanced economies were huge and long-lasting. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. Moreover, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners. This represents a headwind to growth that requires lower interest rates all along the curve. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. 1 We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. 2 The average credit rating for the U.S. is unavailable before 2000 in the Bloomberg Barclays index. However, other data sources confirm the long-term downward trend. 3 Please see The Bank Credit Analyst Special Report "Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector," dated May 31, 2018, available at bca.bcaresearch.com 4 Please see Global Investment Strategy Special Reports "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018 and "1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018, available at gis.bcaresearch.com 5 The lower bound is zero in the U.S., but is in negative territory for those central banks willing to impose negative rates on the banking sector. 6 For more background on the zero bound debate, the usefulness of a large central bank balance sheet and ways to lift r-star, please see The Bank Credit Analyst Special Report "Herding Cats At the Fed," dated October 2016, available at bca.bcaresearch.com 7 Please see The Bank Credit Analyst Special Report "Beware Inflection Points In The Secular Drivers Of Global Bonds," dated April 27, 2017, available at bca.bcaresearch.com 8 The Global Economic Recovery 10 Years After the 2008 Financial Meltdown. IMF World Economic Outlook, October 2018. III. Indicators And Reference Charts Our proprietary equity indicators remained bearish in October and valuation is still stretched, suggesting that it is too early to buy stocks. Our Willingness-to-Pay (WTP) indicators for the U.S. and Japan are both heading down. The Eurozone WTP has flattened-off recently, but is certainly not bullish. The WTP indicators track flows, and this provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our Revealed Preference Indicator (RPI) for stocks continues to issue a sell signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, underlining the idea that caution is warranted. Our Monetary Indicator continues to hover in negative territory for stocks, but interestingly it is not deteriorating even as the Fed tightening campaign endures and bond yields have risen. Our Technical Equity Indicator appears poised to break down, but as of the end of October it was not giving a sell signal. The Speculation Indicator is still elevated, but the Composite Sentiment Indicator is in the middle of the range. It does not appear that the latest equity selloff was driven mainly by an unwinding of frothy market sentiment. Nonetheless, value has not improved enough to justify bottom-feeding on its own. On balance, our indicators continue to suggest that the underlying supports of the U.S. equity bull market are eroding. The U.S. earnings backdrop is still providing support overall, although there was a tick down in October in the U.S. net earnings revisions ratio and in positive-minus-negative earnings surprises. The backdrop for Treasurys has not changed, despite October's painful selloff. Valuation (still slightly cheap) and technicals (oversold by almost 2 standard deviations) imply that the countertrend pullback near month-end will continue into November. Beyond a near-term correction, though, complacency about inflation and the Fed's ability to hike rates to at least the level of the FOMC voters' median projection points to looming capital losses. The dollar is quite expensive on a purchasing power parity basis, and its long-term outlook is not constructive, but policy and growth divergences with other major economies will likely keep the wind at its back in the near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Historically, the dollar exhibits positive seasonality in October and November. Technical and valuation indicators suggest that this year will be no exception. Continuing divergence between U.S. and global growth, rising interest rates, and Italian risks point in this direction as well. However, long positioning in the dollar along with the rebound in the China Play Index are creating non-negligible risks to this bullish dollar view. As a result, investors should overweight dollar exposure in their portfolio, but hedge the above risks by buying NZD/USD and selling EUR/JPY. Feature Through most of September, the dollar traded on the heavy side. However, in the last two trading days of the month, the greenback managed to regain some composure. As October and November have historically been strong months for the DXY (Chart I-1), this week we review if this seasonal pattern will once again hold. The balance of evidence suggests that the historical norm is likely to repeat itself, and that the dollar will continue to rally for the next six months or so, though there are a few risks that should be hedged against. Chart I-1Entering A Seasonally Strong Period For The Dollar Technicals: No Obstacle For A Strong Dollar An argument rooted in seasonality is a reasoning based on technical factors. Currently, technical indicators continue to paint a supportive backdrop for the greenback. First, by the beginning of the summer, based on its 13-week rate-of-change measure, the dollar index had reached overbought levels. Faced with this hurdle, the dollar's rally essentially took a pause, with the DXY rising only 0.5% since June 28, compared to its 6.4% rally between April 10 and June 28. However, through this side-move, the dollar's overbought conditions resolved themselves, and now the greenback's 13-week rate of change is back in neutral territory (Chart I-2, top two panels). Normally, a sideways correction tends to be a sign that a currency's underlying support remains strong. On the other hand, the euro's oversold correction is also now complete, but the euro has remained on a slightly more pronounced downward path over the same period (Chart I-2, bottom two panels). Chart I-2Short-Term Overbought Conditions Have Been Cleared Second, the fractal dimension measure for the trade-weighted dollar shows that despite the recent phase of dollar strength that began in September, the dollar's uptrend is not yet ready to exhaust itself (Chart I-3). The fractal dimension is a measure of groupthink promoted by Dhaval Joshi, head of BCA's European Investment Strategy. It compares the short-term and long-term variance of any asset to gauge if long-term and short-term investors are holding the same positions. If they do, risks are high that a paucity of buyers (or sellers in bear markets) may develop, resulting in a trend reversal as all investors are already similarly positioned. This fractal dimension flagged a yellow card for the dollar in June, but it was only followed by the sideways move described above. Now that the dollar is gaining some vigor, the recent pickup in this indicator suggests that this rally can run further. Chart I-3No Groupthink In The Dollar Third, while the dollar needed to digest some short-term overbought conditions, cyclical indicators like the Coppock Oscillator are still nowhere near overbought (Chart I-4, top two panels). By the spring of 2018, the dollar had reached massively oversold territory on a cyclical basis, and it is now in the midst of a powerful rebound. If history is any guide, once the Coppock Oscillator turns, it is likely to move much more than it has so far, indicating that the dollar rally has legs. However, the euro's Coppock Oscillator looks like it still possesses ample downside, as downdrafts never end at the current level of readings (Chart I-4, bottom two panels). Chart I-4Cyclical Oscillators Still Favor The USD Bottom Line: Technical indicators are currently not arguing against the normal seasonal strength in the USD. The short-term overbought conditions present at the beginning of the summer have evaporated, the dollar's trading action does not show meaningful evidences of groupthink, and a key cyclical momentum measure has further upside. Short-Term Valuations: No Obstacle Here Either An additional factor that might prevent the dollar's normal seasonal strength from realizing itself is the current valuation picture. Here again, there is little to worry about. As Chart I-5 illustrates, our Fundamental Intermediate Term Model and our Intermediate-Term Timing Model do not show any mispricing in the USD. The dollar is trading in line with our two augmented interest rate parity valuation metrics - two indicators that have historically been useful in spotting potential periods of USD risk. Chart I-5No Evident Mispricing In The Dollar Economic And Financial Market Developments Still Support The Dollar With no danger for the dollar from a technical and valuation standpoint, economic and financial market developments will likely hold the key to the dollar's outlook. First, economic divergences remains fully at play. As Chart I-6 illustrates, the U.S. economy is handily outperforming the rest of the world as the ISM Manufacturing Index has not been dragged down by the weakness observed outside the U.S. Historically, the gap between the ISM and the world's PMI leads the dollar's gyrations as the greenback is ultimately the factor forcing U.S. and global growth to converge. This time around, the growth gap suggests that the dollar has a few more months of strength ahead of itself. Moreover, Arthur Budaghyan writes in BCA's Emerging Market Strategy service that China's deleveraging campaign will continue to hinder global export growth (Chart I-7) - a sector of the economy with little weight in the U.S. This means that the growth gap between the U.S. and the rest of the world may widen further. Chart I-6Economic Divergences Support The Dollar Chart I-7China Deleveraging Points To Weaker Trade Second, the U.S.'s economic strength may be a problem for a large swath of the global economy. It is often assumed that strong U.S. growth lifts global demand through exports, undoing some of China's negative impact in the process. However, this does not take into account that U.S. rates determine the global cost of capital. The U.S. economy is currently much stronger than the rest of the world, and the U.S. private sector is not as burdened by debt as is the case outside the U.S. (Chart I-8). This makes the U.S. more capable of handling higher interest rates than the rest of the world. As a result, this year, the rise in both 10-year Treasury yields and TIPS yields has been met with pain in assets levered to global growth, like the German DAX and EM stock prices, as well as EM and commodity currencies (Chart I-9). Chart I-8The U.S. Has A More Robust Balance Sheet Chart I-9Higher U.S. Yields Hurt Assets Levered To Global Growth This is in sharp contrast with the U.S. The market and the Federal Reserve are coming to grips with the reality that the U.S. neutral rate is increasing, courtesy of robust household balance sheets, strong capex intentions, rising inflationary pressures and a large dose of fiscal stimulus. Thus, despite the rise in interest rates, the U.S. yield curve has started to steepen anew, even as global asset markets have been suffering (Chart I-10). Fed Chairman Jerome Powell has even given his subtle acquiescence to this move. Indeed, last week he argued that the Fed's policy might still be quite accommodative as the neutral rate may be sitting well above the current level of the fed funds rate. Chart I-10The U.S. Yield Curve Is Steepening Anew Third is the question of Italy. Italian yields continue to rise both in absolute terms and relative to German bunds. Some of this reflects the stress created by higher global real yields, which hurt the outlook for Italian growth and hence point toward a worsening debt load, which requires a higher risk premium in BTPs. But there is more to the widening in Italian spreads. Italy is setting its budget for next year, and is engaging in a war of words with Brussels. The Five Star Movement / Lega Nord Coalition wants to set a 2.4% of GDP deficit for 2019, much more than the previously agreed 0.8% penciled by the previous government this past spring. This is still within the 3% limit of the EU's Growth and Stability pact, but the European Commission and investors are concerned as Italy's public debt-to-GDP is already 133% - and this 2.4% deficit rests on extremely rosy growth assumptions. As a result, markets are punishing Italian bonds. This is a problem because when Italian yields rise, Italian banks suffer. Dhaval Joshi has argued in BCA's European Investment Strategy that a move in BTP yields to 4% could render the whole Italian banking system insolvent, as it would wipe out excess capital of EUR30 billion.1 Since the entire German, French, Spanish, Dutch, Austrian, Belgian, Greek, Irish and Portuguese banking systems still have low capital reserves, their combined EUR 479 billion exposure to Italy is fast becoming a Sword of Damocles. As a result, a war of words between Rome and Brussels - one that could last until December - could cause further tumult in European bank shares, and force the European Central Bank to stay on the defensive longer than it wishes to. This would hurt the euro and by symmetry, help the dollar. Bottom Line: Economic and financial market developments still support the dollar. The outperformance of U.S. growth relative to the rest of the world is likely to continue to be felt in the form of a stronger dollar in the coming months, especially as global exports remains negatively affected by China's deleveraging. Moreover, rising U.S. borrowing costs are so far having a limited impact on U.S. growth, but generating potent headwinds for activity outside the U.S. Finally, Italy is likely to remain a sore spot for Europe over the next two to three months, one that may weigh on the ECB's ability to provide any hawkish guidance this year. Risks To The View The view that the dollar can continue to rally is not without impediments. The first and most obvious one is that speculators have already aggressively bought the dollar (Chart I-11, top panel). This makes the greenback vulnerable to any unexpected improvement in global growth. Chart I-11Risks For The Dollar The second impediment is that a temporary reprieve in the global growth slowdown could well be materializing as we speak. G10 economic surprises have regain some vigor, and the diffusion index of BCA's Global Leading Economic Indicator has been rebounding (Chart I-11, bottom two panels). The third risk is that the China Play Index we introduced 10 weeks ago is rebounding (Chart I-12). This indicator, based on AUD/JPY, Swedish industrial stocks denominated in dollars, iron ore prices, Brazilian stocks and EM high-yield bonds, is very sensitive to Chinese reflation, or at the very least to how investors expect Chinese reflation to evolve going forward. This may reflect the fact that the People's Bank of China has injected liquidity into the banking system by cutting the Reserve Requirement Ratio four times this year, or that local government borrowings have increased. Chart I-12Investors May Be Betting On Chinese Reflation However, these three factors remain risks, not our base case. After all, net speculative positions in the dollar can stay elevated for extended periods, and the Chinese stimulus that is helping the China Play Index and maybe even the G10 surprise index still pales in comparison to the size of the aggregate deleveraging that is causing total social financing to weaken. Another risk to monitor is Fed Chairman Powell. The likelihood that he dials down his hawkish rhetoric on the elevated neutral fed funds rate in the coming weeks is significant. This could cause a temporary setback in Treasury yields and global rates - one that is likely to be welcomed by global risk assets but that may cause temporary indigestion for the dollar. Bottom Line: Three key risks could invalidate our thesis that the dollar strengthens this fall. They are: the large overhang of speculative longs in the greenback, a potential temporary stabilization in global growth, and markets pricing in Chinese stimulus. Additionally, Fed Chairman Powell may walk back some of his hawkish comments from last week, which would impact global bond yields and help global risk assets, but weigh on the dollar. Investment Implications Faced with this outlook, what should investors do? We continue to recommend holding a cyclically bullish dollar stance. Long DXY makes sense at this juncture, with upside toward 102 by Q1 2019, Implying a fall in EUR/USD below 1.10. However, the risks highlighted above are also non-negligible. This means that holding some hedges makes perfect sense. This summer, we recommended selling USD/CAD. As Chart I-13 illustrates, the loonie has been the best performing G10 currency - the only one that managed to eke out a gain against the greenback this summer (top panel of Chart I-13). This means that mean-reversion is not likely to be the CAD's friend going forward. It may thus not be the best instrument anymore to hedge against USD weakness. Instead, Chart I-13 proposes that the three currencies best placed to benefit from any mean reversion if the USD weakens are the SEK, the AUD, and especially the NZD. The NZD is extremely oversold now, which suggests that it could benefit greatly if the dollar were to experience any period of weakness. Moreover, the NZD has traditionally been highly levered to EM asset prices and Asian growth conditions. As a result, if the rebound in the China Play Index ends up hurting the USD, the NZD is likely to be the prime beneficiary. Chart I-13G10 Currency Returns Moreover, the kiwi money markets are currently pricing in a 12% probability of interest rate cuts by the Reserve Bank of New Zealand over the coming four months. While a lack of inflation means that the environment is not propitious for the RBNZ to increase rates, a rate cuts seems farfetched: the Official Cash Rate remains well below the average level of growth experienced over the past three years, whether in nominal or real terms. In other words, monetary policy remains extremely accommodative, despite the fact that the output gap is closed and the unemployment rate stands below full employment (Chart I-14). Chart I-14The RBNZ Will Not Cut Rates Finally, shorting EUR/JPY may well prove to be the best protection if the Fed's leadership guides bond yields lower. As Chart I-15 shows, EUR/JPY performs well when bond yield rise, which explains why this cross has managed to strengthen despite the recent weakness in EM asset prices this year. Hence, if a dollar correction is not driven by global growth converging upward toward the U.S., but instead is driven by the Fed backtracking from its recent hawkish rhetoric, then EUR/JPY will suffer considerably. Chart I-15Short EUR/JPY: A Hedge Against Falling Bond Yields As a result, we recommend investors with long USD exposure hedge their bets by taking on a bit of long NZD/USD exposure and some short EUR/JPY exposure as well. Bottom Line: Since the seasonal and cyclical outlook is favorable to the greenback, it makes sense for investors to maintain a dollar-bullish bias in their portfolio. However, the tactical risks to the dollar created by a potential rebound in non-U.S. growth or a potentially dovish Fed are meaningful. As a result, some hedges should be maintained to mitigate net positive exposure to the dollar. We recommend buying NZD/USD and selling EUR/JPY in order to achieve optimal protection from these risk factors. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Weekly Report, titled "Italy, Bond Vigilantes, And Bubbles", dated October 4, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: The unemployment rate surprised positively, coming in at 3.7%. Moreover, initial jobless claims also surprised positively, coming in at 207 thousand. However, while nonfarm payrolls underperformed expectations, coming in at 134 thousand, this miss was compensated by important positive revisions to 270 thousand for August. DXY has risen by roughly 1.4% this week. Overall, we continue to be positive on the dollar, given that inflationary pressures in the U.S. will continue to put upward pressure on interest rates. Moreover, China is tightening monetary conditions, which will continue to act as a drag on global growth. This environment will benefit the green back until at least the beginning of 2019. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: Retail sales yearly growth surprised to the upside, coming in at 1.8%. However, core inflation underperformed expectations, coming in at 0.9%. Finally, both the composite and manufacturing Markit PMI, also surprised negatively, coming in at 54.1 and 53.2 respectively. Rising U.S. yields as well as renewed concerns about Italy have lowered EUR/USD by roughly 2% this past couple of weeks. We are negative on the euro on a cyclical basis, given that euro area inflationary dynamics are tightly linked to global economic activity, which will likely be armed by China's monetary tightening. Thus, inflation, and consequently rates, will stay low in the euro area for the time being. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Machinery orders yearly growth outperformed expectations, coming in at 12.6%. Moreover, the leading economic Index also surprised to the upside, coming in at 104.4. Finally, overall household spending yearly growth also surprised to the upside, coming in at 2.8%. USD/JPY has been falling for the past week and a half. We are negative on the yen on a cyclical basis, given that YCC is likely to stay in place for the foreseeable. After all, Japanese inflation expectations remain moribund. Moreover, the expected negative fiscal shock next year will also weigh on aggregate demand. All of these factors, combined with slowing global growth will continue to widen rate differentials, which will create upside in USD/JPY. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Manufacturing production yearly growth surprised to the upside, coming in at 1.3%. However, Halifax house prices yearly growth underperformed expectations, coming in at 2.5%. Finally, Markit Services PMI underperformed expectations, coming in at 53.9. GBP/USD has been flat since the middle of September. The European Union has been much more conciliatory than anticipated, causing the pound to rally. However, we will continue to watch the negotiations closely, given that very little geopolitical risk is currently priced into the pound at the moment, which means it will continue to be whipshawed with inevitable setbacks in the negotiations. We remain long GBP vol. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has fallen by roughly 2.5% over the past couple of weeks, mostly due to the spike in U.S. real yields and the fall in emerging market assets. We continue to be bearish on the Australian dollar, as the Australian economy is the most sensitive G10 currency to policy tightening in China. Moreover, the Australian economy has a very indebted household sectors, which makes it difficult for the RBA to hike rates in the current environment. Investors who wish to express this bearish view on the AUD can do so by shorting AUD/CAD, as the CAD will likely benefit from rising oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has fallen by nearly 3%. Overall, we are bearish the kiwi, as continued tightening by both the fed and Chinese authorities will keep putting pressure on risk assets like the NZD. Moreover, the momentum in volatility continues to be a negative sign for high yield currencies like NZD. That being said, once volatility momentum becomes negative high carry trades like NZD/CHF will prove to be attractive. Moreover, investors looking to hedge their long dollar positions should look to buy the NZD, as rate expectations in New Zealand have likely hit a bottom. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: While the net change in employment outperformed expectations significantly, coming in at 63.3 thousand, the devil was in the detail; full time employment contracted by 17 thousand jobs. On the other hand, the participation rate also surprised to the upside, coming in at 65.4%. However, housing starts surprised negatively, coming in at 189 thousand. USD/CAD has gone up by roughly 1.2% the past 2 weeks. We are closing our short USD/CAD trade this week, as we think the tactical upside for the CAD is now limited. Investors looking to hedge their long dollar exposure should instead look to buy the kiwi. That being said we continue to be positive on the Canadian dollar against the Australian dollar, as oil will further outperform base metals. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Headline inflation underperformed expectations, coming in at 1%. Moreover, the SVMW Purchasing manager's Index also surprised negatively, coming in at 59.7. Finally, real retail sales yearly growth also underperformed expectations, coming in at 0.3%. EUR/CHF has risen by roughly 1.7% this past two weeks. Overall, we are bearish on the franc on a long-term basis, as inflationary forces are too tepid in Switzerland for the SNB to move away from its ultra-dovish monetary policy. Moreover, the strength in the franc over the past few months will likely drive prices down, adding further fuel to the SNB's easy money campaign. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Headline and core inflation both outperformed expectations, coming in at 3.4% and 1.9% respectively. Moreover, manufacturing output growth also surprised to the upside, coming in at -0.1%. However, register unemployment surprised negatively, ticking up to 2.3%. USD/NOK has risen by roughly 1% the past couple of weeks, in spite of rising oil prices. We have long argued that USD/NOK is more sensitive to real rate differentials than to oil prices. Given that we expect real U.S. rates to have additional upside, we continue to be bullish on this cross. That being said, the NOK could outperform other commodity currencies like the AUD and the NZD, as the relative performance of oil in the commodity space will provide a cyclical lift to the NOK against these currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2%. Moreover, consumer confidence also surprised to the upside, coming in at 103.6. However, manufacturing PMI underperformed expectations, coming in at 55.2. USD/SEK has risen by roughly 2.7% the past couple of weeks. Overall, we are bullish on the krona on a long term basis, as monetary policy is too easy in Sweden given Sweden's current inflationary backdrop, which means that the path of least resistance for rates is up. Nevertheless, the policy tightening by Chinese authorities could continue to weigh on global growth. This means that the SEK could have some downside on a 3 to 6 month horizon. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights European and Japanese wages have firmed significantly, suggesting upside to inflation in these economies. However, the gain in European wages will soon reverse, as the slowdown in global trade percolates through the European economy. The ECB will not raise rates sooner or faster than currently discounted in markets, and German Bunds remain attractive in currency hedged terms. Japanese wage growth seems more sustainable but Japanese inflation expectations remain anchored to the downside, and Japan will suffer from a fiscal shock when the consumption tax is increased next October. Japan's YCC policy will remain in place for at least another 18 months, and fixed-income investors should continue to overweight JGBs in currency-hedged fixed income portfolios. Feature The pick-up in wage growth this summer in the euro area and Japan has been an interesting development. It raises the risk that inflation in these two economies is about to hit an inflection point. Since growth has returned to these two regions, if inflation were to join the party, the European Central Bank and the Bank of Japan would finally be able to follow in the Federal Reserve's footsteps and begin increasing rates sooner rather than later. This week we explore whether or not inflationary pressures are building in Europe and Japan, and whether or not the expected policy path of the ECB and the BoJ needs to be re-assessed. While cyclical pressures are growing, clouds above the global economy - the EM space in particular - suggest that the policy path currently anticipated by money markets is just right, and no glaring mis-pricings are evident. Euro Area: A Dawn Is Not A Sunrise The Necessary Condition For Inflation Is Here... There is no denying that we have seen massive improvements in the euro area economy. In fact, we would argue that the euro area has finally hit a stage where the necessary condition for a re-emergence of inflation has been met: Economic slack has vanished. There seems to be little spare capacity in the aggregate euro area economy. Today the OECD measure for the output gap stands at +0.5% of GDP. Additionally, a basic approach comparing the level of industrial production to a simple statistical filter further confirms this assessment, showing that production stands 2% above trend (Chart 1). The capacity utilization measure published by the European Commission goes one step further, showing that utilization is at its highest level since 2008. This represents a very significant change from the days of 2011-2015, when capacity utilization stood below the average that prevailed from the time of the euro's introduction (Chart 2). Chart 1No More Slack In Europe Chart 2Capacity Utilization Is At Previous Cycle Peaks The labor market has been a particular source of concern for euro area watchers. After all, how can an economy generate any domestic inflationary pressures if wages remain depressed? On that front too, there is plenty to rejoice about. The gap between the euro area's unemployment rate and the OECD's estimate of the non-accelerating rate of unemployment (NAIRU) has nearly fully disappeared. Historically, such an occurrence has been associated with a rise in European core inflation (Chart 3). In fact, the ECB's labor underutilization survey is now at its lowest level in 10 years. Moreover, in its various business conditions surveys, the European Commission asks firms whether labor is a factor limiting production. With the exception of Italy, the number of firms reporting that labor shortages are a problem in most of the major economies stands at or near record highs (Chart 4). This confirms the simple impression provided by the gap between the unemployment rate and NAIRU that the labor market is beginning to create generalized inflationary and wage pressures. Chart 3Diminishing Labor Market Slack Leads##br## To Growing Inflationary Pressures Chart 4Labor Shortages In ##br##The Euro Area ...But The Sufficient Conditions Remain Murkier While the tight labor market suggests that wages have cyclical upside, is it even true that higher wages do lead to higher inflation in the euro area? The answer is yes. Chart 5 shows that euro area wages tend to lead core CPI by approximately three quarters, with an explanatory power of nearly 87%. This makes sense. Higher wages increase the cost of production for businesses, which results in cost-push inflation. This is even more true if wages rise in real terms, which boosts household's income and supports consumption. Thus, it is likely that the recent spike in wages will lead to higher core inflation. Despite this positive backdrop, some key cyclical worries remain. First, our CPI diffusion index for the euro area, measuring the breadth of inflation increases within the subcomponents of the CPI, is in free-fall. Historically, this has been a worrying sign for core inflation, and for both nominal and real wages (Chart 6). Chart 5In Europe, Wages ##br##Lead Core CPI Chart 6But CPI Diffusion Index Suggests Real Wages ##br##And Core CPI Could Hit A Speed Bump The bigger risk originates from outside the euro area. We have shown in the past that EM shocks can have a disproportionate impact on European economic activity.1 This link seems to run deeper than we had originally realized. As Chart 7 shows, euro area nominal and real wages tend to follow the trend in European exports to EM and China. The logical conclusion is that export shocks end up affecting the whole economy by depressing profits, capex and the willingness of firms to provide wage increases to their employees. This also ends up reverberating into consumption as both nominal and, more importantly, real wages suffer. Today, weakening exports to EM and China suggest that European wages may soon roll over. This would take the wind out of price inflation as well, since wages lead core CPI by roughly three quarters. BCA's Foreign Exchange Strategy service as well as our Emerging Market Strategy sister publication have already highlighted that EM economies are likely to slow further in the coming quarters as China works to de-lever - a process which has already begun (Chart 8).2 Thus, the negative impact of EM on European growth and wages is likely only to grow over the coming quarters. The euro area leading economic indicator (LEI) has already picked up on these dynamics. The deterioration in the LEI suggests that real wages are likely to soon suffer, which will further dent euro area consumption and weigh on core inflation (Chart 9). Chart 7Exports To EM Are The Culprit##br## Behind This Speed Bump Chart 8Limited Upside Ahead##br## In Chinese Growth Chart 9Euro Area LEI Confirms##br## The Message From Exports Adding up those various message we conclude that while we could soon see some upside in inflation via a pass-through of the recent pick-up in wages, the upside is likely to prove transitory as the euro area economy will soon feel the deflationary impact of the slowdown in EM economic activity. What Will The ECB Do? The ECB will end its asset purchase program at the end of this year. Money markets are currently pricing in a full 25-basis-point hike in interest rates by March 2020. However, various formulations of the Taylor Rule suggest that euro area interest rates should already be higher than they currently are (Chart 10). What are interest rates likely to really do in relation to this date? Despite these hawkish Taylor Rule estimates, we think the ECB is likely to wait and see. As we highlighted above, the slack in the euro area economy is dissipating, and therefore inflationary pressures are bound to build up. However, the slowdown in EM that is reverberating through global trade will weigh on inflation over the coming six months. Additionally, we need to monitor developments in shadow policy rates.3 After the Fed began tapering its asset purchases in 2014, the U.S. shadow rate increased by roughly 300 basis points. While the actual fed funds rate was not raised until the end of 2015, the implied tightening from the rise in the shadow rate was enough to cause both U.S. and non-U.S. growth to slow sharply in 2015. Since bottoming in November 2016, the ECB's shadow rate has increased by 450 basis points. Even if European monetary conditions remain accommodative, this is a large and sudden shock to absorb - one that goes a long way in explaining the sudden contraction in the euro area credit impulse (Chart 11). Chart 10Does Europe Really Need Higher Rates? Chart 11Large Tightening In Euro Area Shadow Rate Ultimately, while the reduction in the euro area economic slack is real, the aforementioned dynamics are worrisome. Hence, we do not think that the ECB will want to prematurely kill off the recovery. Memories of the policy mistake of 2010, when the ECB raised rates in a too-weak economy, are still very much alive on the ECB's Governing Council. This means that a small first hike of less than 25 basis points in late 2019 or early 2020 seems appropriate, as there should be more convincing evidence by then that the economy can tolerate higher interest rates. Hence, there does not seem to currently be any mis-pricing in the European interest rate curve since investors are correctly pricing in a full 25-basis points of hikes from the ECB by March 2020. Investment Implications We continue to recommend U.S. investors hold European bonds while hedging the currency exposure back into U.S. dollar. A hedged 10-year Bund currently yields 3.66%, compared to 3.2% for a 10-year Treasury note. The picture above does not suggest that Bund yields will have enough upside to generate the capital losses needed to offset this yield pick-up, especially as Treasury prices suffer greater potential downside. This also means that once hedging costs are taken into account, European fixed-income investors are better off staying at home than playing in the U.S. government bond market. The impact for EUR/USD is more complex. The U.S. Overnight Index Swap (OIS) curve is currently pricing in roughly three rate hikes by the Fed over the next 12 months. BCA think that there could be even more U.S. rate hikes as the Fed continues to follow a 25 basis-points-per-quarter pace. Thus, we do not see the spread between U.S. and euro area interest rates narrowing in a more bullish direction for the euro Moreover, currencies trade on more than just interest rate differentials. The dollar has historically responded favorably to slowing EM growth. Moreover, as we highlighted three weeks ago, since the U.S. balance of payments is currently in surplus, this means that the U.S. is sucking in liquidity from the rest of the world.4 This is another way of saying that the world is buying more dollars than the U.S. is supplying. As a result, the dollar could continue to experience upside versus the euro over this period from factors beyond simple rate differentials. Bottom Line: The euro area economic slack has greatly dissipated and the medium term outlook for inflation is improving. Moreover, the recent pick-up in euro area wages suggest that core CPI could also pick up in the coming months. However, this increase in inflation is likely to prove temporary. Before inflation can increase durably, Europe will first have to digest the deflationary impact of slowing EM economies and global trade. This means that the ECB is likely to proceed with policy normalization very cautiously. The current pricing of 25 basis points of hikes by March 2020 is sensible. Hence, investors should continue to overweight Bunds hedged back into dollars in global fixed income portfolios. Moreover, EUR/USD could experience additional weaknesses on a 12-month basis. Japan: Fragile Progress, But Not Enough This past June, Japanese wage growth hit rates not seen in 21 years. This is enough to begin wondering if Japan is finally escaping its two-decades-long deflationary trap. After all, as Chart 12 shows, Japanese wages are a slow but nonetheless leading indicator of core inflation. Giving even more comfort to forecasts of higher Japanese inflation is the fact that, after falling continuously from the bubble peak in the early 1990s until Q1 2017, Japanese land prices have been slowly but surely increasing. Inflationary pressures in Japan are building up because the economy is at full employment. According to the BoJ, the output gap stands at +1.9% and has been positive for two years. The unemployment rate is at a stunningly low level of 2.4%, and the active job opening-to-applicant ratio stands at a four-decade high. The implications of this backdrop are evident. Chart 13 shows the demand/supply condition component of the Tankan survey of Japanese businesses, both in the manufacturing and non-manufacturing sectors. It has historically been a good explanatory variable for wage developments in Japan, and currently points to additional strength. Chart 12Rising Japanese Wages Should Boost Core Inflation Chart 13Capacity Pressures Are Lifting Japanese Wages Despite these positive developments, there remain some nagging worries. For one, the pick-up in wages seems strange in an economy where total hours worked are not rising (Chart 14). Moreover, Japanese households are currently increasing their savings ratio, which means that while they might be earning more, they are keeping this money in their bank accounts rather than spending it (Chart 14, bottom panel). As a result, there has been a limited pass-through of the recent wage acceleration into higher consumption. Additionally, like in Europe, the Japanese economy is at risk from foreign shocks. While the domestic economy seems robust, foreign machinery orders have been weakening. Industrial production has followed this path, decelerating sharply (Chart 15). Historically, Japanese inflation is very sensitive to the level of broader economic activity, so this weakening trend in industrial activity points to limited upside for overall inflation. Chart 14Weird Dynamics In Japan Chart 15Japan: The Domestic Front Is Healthy, The Foreign One Is Not The biggest problem faced by the BoJ, however, remains the weakness in inflation expectations. In the eyes of the Japanese central bank, the reason why Japanese realized inflation and wage growth have remained tepid is because decades of low inflation have created embedded expectations among the Japanese to not expect rising prices. Today, Japanese inflation expectations are once again weakening, a common occurrence when global growth slows (Chart 16). Additionally, Japan could hit a fiscal cliff of sorts next year. In October 2019, the consumption tax will increase from 8% to 10%. The last such increase - a three-percentage point hike in 2014 - caused a major slowdown in economic activity that had a deep deflationary impact. While the increase this time around is smaller and the Japanese economy is stronger than in 2014-2015, it remains to be seen how the country handles the shock of a fiscal tightening via a higher sales tax, especially if exports to EM remain on their downward path. The BoJ is likely to be very cognizant of this risk. Currently, the low level of inflation means that the real BoJ policy rate is in line with that of the U.S., a much stronger economy (Chart 17, top panel). Since Japan still faces a fiscal cliff next year and inflation expectations have not yet been unmoored to the upside, the current increase in wages is not enough to push the BoJ to abandon its Yield Curve Control (YCC) policy. What about QQE? The low shadow rate means that the BoJ does not need to buy assets anymore (Chart 17, bottom panel). Yet, the problem for Japan is that QQE possesses a strong signaling component. Ending this program is likely to cause markets to price in the end of YCC, which would drive nominal rates higher and thus result in both higher real rates and a significant tightening in monetary policy. As a result, we expect QQE to remain in place so that YCC will stay credible. However, the program is likely to have a slower pace of buying than before and will be too small to fully absorb the new issuances of JGBs by the MoF (Chart 18). Chart 16The BoJ's ##br##Number 1 Problem Chart 17The Signaling Effect Of QQE Is##br## Still Needed Because Of YCC... Chart 18...But QQE Doesn't Need To Be ##br##Quite As Large Anymore In terms of signposts that would signal to us to begin betting on an end to YCC, we continue to target three things that must ALL happen in unison, highlighted by BCA's Chief Global Fixed Income Strategist, Rob Robis, in February:5 USD/JPY rises at least to the 115-120 range; Japanese core CPI and nominal wage inflation both rise above 1.5%; 10-year JGB yields reaching an overvalued extreme, based on a model that includes potential GDP, BoJ purchases and the level of 10-year Treasury yields. So far, none of these conditions has been met. In fact, the slowdown in global trade and EM activity could even threaten the current improvement witnessed in wages. As a result, we expect all three of these developments to only happen in 2020, leaving Japanese yields with very limited upside. Investment Implications Japanese fixed-income investors continue to be subsidized to remain at home and avoid U.S. Treasuries. Because short rates in Japan are so low, the yield on 10-year U.S. Treasuries hedged into yen yield is 0.05%, less than the 0.16% yield on 10-year JGBs. At the same time, U.S. fixed income investors are incentivized to buy JGBs and hedge the currency exposure into dollars. Additionally, with the BoJ unlikely to abandon its YCC program for potentially two more years, JGBs with up to 10-year maturities are unlikely to suffer capital losses. Largely for this reason, BCA's Global Fixed Income Strategy's recommended model bond portfolio, maintains a large overweight position in JGBs, but only for maturities less than 10 years as the BoJ's YCC program is not focused on yields beyond the 10-year point. Regarding the yen, the outlooks is treacherous. On one hand, a strong USD implies a weaker yen. So do higher 10-year Treasury yields, especially if JGB yields possess little upside. On the other hand, weakness in the EM space tends to result in a stronger yen as carry trades get unwound. Due to these bifurcated risks, we do not recommend buying the yen against the dollar. However, we think that at current levels the yen remains an attractive play against the euro and against the Australian dollar, especially on a six- to nine-month basis. Bottom Line: Japanese wages have enjoyed significant upside, but Japanese inflation expectations remain moribund. Moreover, Japan is likely to experience a negative fiscal shock next year as the consumption tax will once again be increased. These two risks, in addition with slowing global growth, mean that the BoJ is unlikely to abandon YCC until well into 2020. As a result, investors should continue to overweight JGBs with maturities of less than 10-years hedged back into U.S. dollars in a global fixed income portfolio. USD/JPY should enjoy further upside on a 12-month basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "ECB: All About China", dated April 7, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com and Emerging Markets Strategy Special Report, titled "Deciphering Global Trade Linkages", dated September 27, 2018, available at ems.bcaresearch.com 3 The shadow rate is a measure of the impact of the various unorthodox policy initiatives implemented by central banks in the wake of the great financial crisis. It tries to express the effect of those measures in terms of the implied levels of policy rates that would have needed to prevail for the economy to generate the same performance if asset purchases had not been implemented. 4 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergences Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 5 Please see Global Fixed Income Strategy Special Report, titled "What Would It Take For The Bank Of Japan To Raise Its Yield Target", dated February 13, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Recommended Allocation We don't see any change over the next six to 12 months to the current trends of strong U.S. growth, continuing Fed hikes, rising long-term interest rates, and an appreciating dollar. We stay neutral on global equities and continue to favor the U.S. and, to a degree, Japan. Given rising rates, a strengthening dollar, ongoing trade war and moderate slowdown in China, we expect EM assets to sell off further. We forecast the 10-year U.S. Treasuries yield to rise to 3.5% by H1 2019, and so we stay underweight fixed income, short duration, and continue to prefer TIPs. We are only neutral on credit within the (underweight) fixed-income bucket. We shift our equity sector weightings to reflect the GICS recategorization. We recommend a neutral on the new internet-heavy Communication sector, and underweight on Real Estate. We have a somewhat defensive sector bias, with overweights in Consumer Staples and Healthcare. Alternative risk assets, such as private equity and real estate, look increasingly overheated. We prefer hedge funds and farmland at this stage of the cycle. Overview More Of The Same When there's been a strong trend, it's always tempting to be contrarian and argue for a reversal. Tempting but, at the moment, we think wrong. This year has been characterized by a strong U.S. economy but slowing growth elsewhere, the outperformance of U.S. equities (up 10% year-to-date, compared to a 4% decline in the rest of the world), rising U.S. interest rates, dollar appreciation, and a big sell-off in emerging markets. While a short-term correction is always possible, we don't see a fundamental end to these trends over the next 6 to 12 months. Chart 1U.S. Growth Still Looks Strong Chart 2Growth In Europe And Japan Has Slipped U.S. growth is likely to remain strong. Consumer and business sentiment are both close to record highs; wage growth is beginning (finally) to accelerate; capex intentions are buoyant; and fiscal stimulus will add 0.7% to GDP growth this year and 0.8% next, as the budget deficit widens to close to 6% of GDP (Chart 1). Europe and Japan, by contrast, have slowed this year: both are more exposed to emerging markets than is the U.S.; fiscal policy in neither is particularly accommodative; and European banks suffer from weak loan growth and their EM exposure (Chart 2). The one trigger that would cause global ex-U.S. growth to accelerate relative to U.S. growth is a massive stimulus in China similar to 2009 and 2015. We think this unlikely because the authorities have reiterated their commitment to deleveraging and structural reform. Chinese credit growth and money supply data have as yet shown no signs of picking up, but they should be monitored carefully (Chart 3). Chart 3Chinese Stimilus, What Stimilus? Chart 4Republicans Like Trump's Tough Trade Talk An end to the trade war might also reverse the trends. U.S. markets have shrugged off the risk of escalating retaliatory tariffs on the (reasonable) grounds that trade has relatively little impact on the U.S. It is hard to see an end-game to the tariff war. President Trump's popularity has risen since he got tough on trade (Chart 4). He has changed his mind on many areas of policy during his career, but he's always consistently argued that the U.S. deficit shows that its trading partners treat it unfairly. The probability is high that the 10% tariff on $200 billion of Chinese goods will rise to 25% in January, and is eventually extended to all Chinese imports. It is equally unlikely that Xi Jinping will make concessions, since he can't be seen to bend to U.S. pressure and won't put at risk the crucial "Made in China 2025" plan. Chart 5Phillips Curve Working Again Although tariffs may not hurt U.S. growth much, they could be inflationary. The price of washing machines, the subject of the earliest tariffs in January, rose by 18% over the next four months. This is just another reason why it's unlikely that the Fed will slow its pace of rate hikes. With the labor market now clearly tight, there are signs that the Phillips curve is beginning to reassert itself (Chart 5), and wage growth is accelerating. With core PCE inflation at its 2% target and the impact of fiscal stimulus still coming through, the Fed will feel comfortable about maintaining its current schedule of one 25 basis point hike a quarter until there are signs that the economy is slowing.1 Could the sell-off in emerging markets cause the Fed to move to hold? In the 1990s Asia Crisis, only when the fall in Asian stocks started to affect the U.S. economy (with, for example, the manufacturing ISM going below 50) and the U.S. stock market, did the Fed ease policy (Chart 6). Eventually, the slowdown in the rest of the world might start to hurt the U.S. In the past, when the global ex-U.S. Leading Economic Indicator has fallen below zero, it has usually been followed by U.S. growth also faltering (Chart 7). Chart 6In 1998, Fed Cut Only When EM Hurt The U.S. Chart 7When The World Slows, Often U.S. Does Too Table 1What To Watch For Having in June lowered our recommendation on global equities to neutral (but keeping our overweight on U.S. stocks), we continue to monitor the factors that would make us turn negative on risk assets (Table 1 and Chart 8). None of them is yet flashing a warning signal, but it seems likely that we will need to move to an outright defensive stance sometime in H1 2019. One final key thing to watch: any signs that U.S. earnings growth is slipping. Much of the outperformance of U.S. equities this year is simply explained by better earnings growth, partly due to the tax cuts. Analysts' forecasts for 2019 have so far been very stable. If they start to be revised down, perhaps because of higher wages and export sales being dampened by the strong dollar, that would also be a signal to switch out of U.S. equities (Chart 9). Chart 8What To Watch For? Chart 9Will Analysts Revise Down EPS Forecasts? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Is The Fed Turning Dovish? Chart 10Fed Policy Still Accomodative Many investors interpreted Fed Chair Powell's speech at Jackson Hole in August dovishly. Powell questioned whether "policymakers should navigate by [the] stars": r* (the neutral rate of interest) and u* (the natural rate of unemployment), since these are uncertain. He emphasized that policy will be data dependent. We read it differently. Powell also pointed out that "inflation is near our 2 percent objective, and most people who want a job are finding one", and concluded that a "gradual process of normalization remains appropriate". A speech in September by Lael Brainard, a dovish FOMC member, reinforced this. She separated the long-run neutral rate (the terminal rate in the Fed dot plot) from the short-term neutral rate (Chart 10, panel 1). Her conclusion was that "with fiscal stimulus in the pipeline and financial conditions supportive of growth, the shorter-run neutral interest rate is likely to move up somewhat further, and it may well surpass the long-run equilibrium rate." In other words, the Fed needs to continue its gradual pace of hikes. The market does not see it that way. Futures markets have priced in that the Fed will raise rates until June (when the Fed Funds Rate will be 2.75-3% in nominal terms) and then stop (panel 2). But this implies that the Fed will halt once the FFR is at the (current estimate of the) neutral rate. But inflation is likely to pick up further over the next 12 months. And the Fed is worried that, despite rate hikes, financial conditions haven't tightened much (panel 3). So we expect the Fed to keep tightening until there are signs that growth is slowing. Is The Worst Over For Emerging Markets? Chart 11Excess Debt Is Underlying Cause Of EM Sell-Off Since the plunge in the Argentinian peso and Turkish lira, currencies in most emerging markets have fallen sharply. Does this present a buying opportunity for investors, or is there more contagion to come? While a short-term rebound is not impossible, we remain very negative on the outlook for most emerging market assets. Fed policy and rising U.S. interest rates can be seen as the trigger for, but not the underlying cause of, the recent sell-off. Since 1980 (Chart 11), there have been only two instances where EM stock prices collapsed amid rising U.S. rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. But both occurred because of poor EM fundamentals. We see similar underlying problems today. EM dollar-denominated debt as a share of GDP and exports is as high as it was during the Asia Crisis in the late 1990s. In addition, the EM business cycle will continue to decelerate in the medium term, as evidenced by falling manufacturing PMIs. Consequently, EM corporate earnings growth is slowing, and we expect it to fall meaningfully in this downturn. EM economies have become increasingly dependent on Chinese growth for their export demand. China is slowing, but we expect limited credit and fiscal stimulus from the authorities given their shift in focus towards de-leveraging and reforming the financial sector. Additionally, global trade is also weakening as seen by falling Asian exports and sluggish container freight movements. EM central banks have responded to currency weakness by raising rates, which in turn will lead to rising local currency bond yields and tightening financial conditions. A tightening of liquidity will slow money and credit creation, ultimately weighing on domestic demand. Moreover, with an accelerating U.S. economy, the U.S. dollar will continue to strengthen, eventually tightening global liquidity. We continue to advocate an underweight position in EM assets. Share prices will not bottom until EM interest rates fall on a sustainable basis, or until valuations reach clearly over-sold levels, which they have not yet. Chart 12The New Sectors Look Very Different What Just Happened To GICS? Following Real Estate's 2016 separation from Financials to become the 11th sector within GICS, September 28 2018 marked an even more disruptive change to equity classification. The change, aimed at keeping up with innovation and the current market structure, affects three of the 11 sectors: Telecommunication Services, Consumer Discretionary, and Information Technology (Chart 12). In short, the Telecommunication Services sector, once a value, low-weight, low-beta, high-yield, defensive sector is broadened and renamed Communication Services, offering broad-based coverage of content on various internet and media platforms. It includes the Media group, as well as selected companies from Internet & Direct Marketing Retail, taken out of Consumer Discretionary. Additionally, selected companies from the Internet Software & Services, as well as Application and Home Entertainment Software move into the new sector from IT. The E-commerce group also grows, with selected companies moving out of IT into Consumer Discretionary. Telecom/Communication, which previously behaved like Utilities, has turned into a high-growth, low-dividend sector. It is also a cyclical rather than defensive. It should trade at much higher multiples than its previous incarnation. IT is also no longer be the same. The sector, which once represented nearly 20% of the ACWI index, has shrunk to 13%, now mostly comprises hardware and software companies, after losing constituents such as Alphabet, Facebook, and Tencent. Chart 13Three Ideas To Enhance Risk-Adjusted Return Where To Find Yield In A Low-Return Environment? BCA's House View in June downgraded equities to neutral and moved cash to overweight. For U.S. investors, holding cash is quite attractive, as the yield on three-month Treasury bills is above 2%, higher than the 1.8% dividend yield on equities. But investors in Europe and Japan face negative yields on cash. Our recent Special Report analyzed three investment instruments that could enhance a balanced portfolio's risk-adjusted returns (Chart 13).2 Floating-Rate Notes. FRNs tend to be issued by government-sponsored enterprises and investment-grade corporations. They offer a nice yield pick-up over short-term U.S. Treasuries with significantly shorter duration. However, they do carry credit risk and so performed poorly in the 2007-9 recession. We, therefore, recommend investors fund these positions from their high-yield bucket. Leveraged Loans. These are floating-rate senior-secured bank loans. However, secured does not mean safe. Most are sub-investment grade and can be very illiquid, because physical delivery is often needed. They tend to be positively correlated with junk bonds but negatively correlated with the aggregate bond index. This suggests that adding bank loans to a portfolio can add diversification, and that replacing some high-yield holdings with bank loans can generate a sub-investment grade basket with a better risk/reward profile. Danish Mortgage Bonds. DMBs are covered mortgage bonds, with an average duration of five years and offering a yield to maturity of around 2% in Danish Krone. They have a strong track record: not a single bond has defaulted in the 200-year history of the market. This makes the market very attractive to euro zone and Japanese investors struggling with low bond yields. We find that adding DMBs to a standard bond portfolio significantly improves its risk/return profile. The main snags are that this is a fairly small market with a total outstanding market value of DKR2.7 trillion (around USD400 billion) - and is already 23% owned by foreigners. Global Economy Overview: The global economy will continue to be characterized by significant divergences. U.S. growth remains robust, pushing up inflation to the Fed's 2% target. By contrast, European and Japanese growth has weakened so far this year, meaning that central banks there remain cautious about tightening. Meanwhile, emerging markets will continue to deteriorate, faced with an appreciating dollar, rising U.S. interest rates, and lack of a big stimulus in China. U.S.: The ISM manufacturing index hit a 14-year high, above 60, in September before falling back slightly, to 59.8, in October. Core PCE inflation has reached 2%, the Fed's target. Wage growth, as measured by average hourly earnings, has finally begun to accelerate, reaching 2.9% YoY. With consumption and capex likely to remain robust, and the effect of fiscal stimulus not peaking until early next year, the U.S. economy will continue to grow strongly through 2019 (Chart 14). Only the recent slowdown in housing (probably caused by higher interest rates) remains a concern, but the sector is probably too small to derail overall economic growth. Chart 14Divergences Continue: U.S. Strong... Chart 15...Rest Of The World Weakening Euro Area: The decline in growth momentum seen since the start of the year has probably now bottomed. Both the PMI and ZEW indexes appear to have stabilized at a moderately positive level (Chart 15, panel 1). Core CPI inflation remains stable at about 1%, though headline inflation has been pushed up by higher oil prices. In this environment the ECB will be slow to raise rates, probably waiting until September next year and then hiking by only 10 basis points. Japan: The external sector has weakened, as shown by the industrial production data and leading economic indicators, probably because of slowing growth in China. However the domestic sector is showing signs of life, with corporate profits growing by more than 20% year-on-year, and capex rising at a rapid pace (6.4% YoY in Q2). However core inflation remains barely above zero, and therefore the Bank of Japan will continue its Yield Curve Control policy for the foreseeable future. Emerging Markets: Chinese growth continues to slow moderately, with the Caixin manufacturing PMI exactly at 50 (Chart 15, panel 3). The key question now is whether the authorities will implement massive stimulus, as they did in 2009 and 2015. The PBOC has cut rates and the government announced that it is bringing forward some fiscal spending. But the priority remains to deleverage and push ahead with structural reform. We do not expect, therefore, to see a significant acceleration of credit growth. Elsewhere in EM, central banks have significantly raised interest rates to defend their currencies, and this is likely to trigger recession in many countries within the next six months. Interest rates: Monetary policy divergences are likely to continue. The Fed will hike by 25 basis points a quarter until there are signs that growth is slowing and that tightness in the labor market is easing. Inflation is not showing signs of dramatic acceleration but, with the labor market so tight, the Fed will want to take out insurance against a future sharp rise. By contrast, the ECB and BOJ have no need to tighten (Chart 15, panel 4). Accordingly, we expect to see US long-term interest rates rise, with the 10-year Treasury bond yield reaching 3.5% in the first half of 2019. Chart 16When Will Earnings Turn Down? Global Equities Stay Cautious: We turned cautious on equities in the previous Quarterly Strategy Outlook,3 by upgrading the low-beta U.S. equity market to overweight at the expense of the high-beta euro area, by taking profit in our pro-cyclical tilt and moving to more defensive sectors, and by maintaining our core position of overweight DM relative to EM. Those moves proved to be effective as DM outperformed EM by 6%, the U.S. outperformed the euro area by 7.5%, and defensives outperformed cyclicals by 1.2%. Because of the sharp underperformance of EM equities relative to DM peers, it's tempting to bottom-fish EM equities. However, we suggest investors refrain from such an urge because we think it's too early to take such risk (see nexts section below). We therefore maintain our defensive tilts in both regional and country allocation and global sector allocation (see table at the end of the report). Equity valuations are less stretched than at the beginning of the year, due to strong earnings growth. However, BCA's global earnings model shows that earnings growth will slow significantly next year (Chart 16, panels 1 & 2). With earnings growth for every sector in positive territory, and the DM profit margin near a historical high, it would not take much for analysts to revise down earnings expectations (bottom 3 panels). Reflecting the GICS sector reclassification, we have initiated a neutral on the Communication sector and an underweight on the Real Estate sector. Chart 17EM Underperformance To Continue Continue To Underweight EM Vs. DM Equities Underweight EM equities vs. the DM counterparts has been a core position in GAA's global equity portfolio (in U.S. dollars and unhedged) this year. Despite the significant performance divergence over the past few months, we recommend investors continue to underweight EM equities, for the following reasons: First, BCA's House View is for the U.S. dollar to strengthen further, especially against EM currencies. This does not bode well for the EM equity performance relative to DM equities, given the close correlation of this with EM currencies (Chart 17, panel 1); Second, Chinese economic growth plays an important role in the EM economy. China's large weight in the EM equity index also makes the link prominent. With increasing concern from the trade war with the U.S., Chinese imports are likely to deteriorate, implying the sell-off in EM shares may have further to go (panel 2); Third, EM earnings growth is closely correlated with money supply as shown in panel 3. Forward earnings growth will have to be revised down given the slowing in money growth. Finally, even though EM equity valuations are now cheap on an absolute basis, EM equities have mostly traded in history at a discount to DM. Currently, the discount is still in line with historical averages (panel 4). Chart 18Real Estate Sector Looks Vulnerable Sector Allocation: Underweight on Real Estate and Neutral on Communication With the recently implemented GICS reclassification, involving the creation of a new Communication Services Sector by moving the media component in Consumer Discretionary and the internet companies in IT to the old Telecom Services sector (see section below for more details), we are reviewing our global sector allocations. Since we were already neutral on IT and Telecom Services, and since the new Communication sector is dominated by internet companies, it's natural to be neutral on the new Communication sector. Real Estate was lifted out of the Financials sector in 2016 to be a separate sector. But we did not include this sector previously in our recommendations because it mostly consists of commercial real estate (CRE) investment trusts. In our alternative asset coverage, we had preferred direct real estate due to its lower correlation with equities in general. In July this year, however, we downgraded exposure to direct real estate.4 It's much easier to reduce REITS holdings than direct CREs. As such, we take this opportunity to initiate an underweight on the Real Estate sector, mainly because of the less favorable conditions in both the macro backdrop and industry fundamentals. From a macro perspective, the tailwind from declining interest rates has turned into a headwind as interest rates rise. Over the past few years, the relative performance of Real Estate to the overall equity index has been closely correlated with the rise and fall of the long-term interest rates. BCA expects 10-year interest rates to trend higher. This does not bode well for the sector's equity performance going forward (Chart 18, panel 1). Industry fundamentals look vulnerable as well. The occupancy rate has already started to decline (panel 2). CRE prices have been making new highs on an inflation-adjusted basis, fueled by a historically high level of CRE loans and low level of loan delinquencies (Chart 18, panels 3 and 4). All these make the CRE sector extremely vulnerable. Government Bonds Maintain Slight Underweight On Duration. The U.S. 10-year government bond yield traded in a tight range in Q3 between 2.8% and 3.1%. With the current yield at 3.07% and the most recent inflation reading below expectations, it's tempting to take a less bearish view on duration, especially given the weakness in EM economies and EM asset prices. We agree that the spillover from weak global growth into the U.S. might cause the Fed to pause its gradual 25bps-per-quarter rate hike cycle at some point in 2019; however, markets currently have priced in only two rate hikes in the entire year of 2019, which means the risk is already priced in. With increasing pressure from rising supply, we still see rates rising over the next 9-12 months and so our short duration recommendation for government bonds is unchanged (Chart 19). Chart 19Rising Supply Will Push Up Rates Chart 20TIPS Breakevens Have A Little Further To Go Favor Linkers Vs. Nominal Bonds. BCA's U.S. Bond Strategy still believes that the U.S. TIPS break-evens will reach to our target range of 2.3%-2.5% because core inflation should remain close to the Fed's 2% target going forward. The latest NFIB survey supports this view as wage pressure is still on the rise, with reports of compensation increases near a record high (Chart 20). Compared to the current breakeven level of 2.1%, this means 10-year TIPS have upside of 20-40bp, an important source of return in the low-return fixed-income space. Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 21Spreads Not Attractive After being overweight for over two years, last quarter we turned neutral on corporates, including high-yield credits, within a global bond portfolio. Developed market corporate bonds have performed poorly in 2018 led by weak returns in the Financials sector and steepening credit curves.5 On the positive side, global corporate health (Chart 21) has been improving, led by the resilience of the U.S. economy and tax cuts that have put corporations in a cyclically healthier position. However, this may not be sustainable as the tightening labor market is pushing up wage growth, which will pressure margins. Interest coverage has fallen in recent years despite strong profitability and low borrowing costs. The risk of downgrades will rise when the earnings outlook weakens or borrowing costs start to rise. An additional concern is that weaker global ex-U.S. growth and a stronger dollar will weigh on U.S. corporate revenues. In the euro area, interest coverage and liquidity continue to improve, supported by easy monetary policies that have lowered borrowing costs. However, with the ECB set to end its corporate bond purchase program along with purchases of sovereign bonds at the end of the year, euro area corporate bonds will lose a major support. In Japan, leverage has been steadily falling and return on capital rising, pushing up the interest coverage multiple to 9.6x, the highest in developed markets. With Japanese corporate profits at an all-time high, default risk is low. The BoJ's forward guidance suggests no tightening until 2020, giving corporates a low cost of borrowing and probably a weak currency. Excess spread from U.S. high-yield bonds after adjusting for expected default losses is 226 bps, slightly below the long-run mean of 247 bps. Most indicators suggest that default losses will remain low for the next 12 months, but it will be critical to track real-time indicators such as job cuts to see if there is any deterioration in growth which might start to push up default rates. With a global corporate bond portfolio, we prefer Japanese and U.S. credits to euro area corporates. Chart 22Prefer Oil Over Metals Commodities Energy (Overweight): Oil prices will continue to be driven by demand/supply fundamentals. We believe that that supply shocks will have more influence on the crude oil price over the coming months than will lower demand from EM (Chart 22, panel 2). U.S. sanctions on Iranian oil exports are estimated to take 800K-1M barrels a day out of global supply. We also factor in the risk of political collapse in Venezuela and outages in Iraqi and Libyan production, which would push oil prices higher. BCA's energy team forecasts that Brent crude will average $80 until year-end, and $95 by the end of the first half of next year.6 Industrial Metals (Neutral): An appreciating dollar along with weaker consumption of base metals in China, the world's largest consumer, are likely to keep industrial metals' prices depressed and to increase volatility over the next few months (panel 3). Additionally, the easing of U.S. sanctions on some Russian oligarchs connected with aluminum producer Rusal is likely to keep a lid on aluminum prices for now. Precious Metals (Neutral): Gold has been weak despite global uncertainties and political tensions arising from the U.S.-China trade spat, Middle East politics, and EM weakness. Since we see further upside in inflation in the coming months and remain concerned about global risk, gold remains an attractive hedge. However, rising real interest rates and the strong dollar will limit the upside (panel 4). Chart 23Further Upside For The Dollar Currencies U.S. Dollar: The dollar has continued its appreciation over the past couple of months, propelled by a moderately hawkish Fed and strong economic data. We see further upside to inflation, though the latest print fell short of expectations. Tighter financial conditions in the U.S. will add further upside to the currency on a broad trade-weighted basis, as well as against other majors (Chart 23, panels 1 and 2). EM Currencies: Dollar appreciation, higher interest rates, increasing trade tensions, and a slowdown in China, have put pressure on EM currencies. We expect these conditions to continue. Sharp interest rate hikes in Argentina and Turkey have not stopped the fall, probably because markets anticipate that the hikes will trigger recessions in these countries. Euro: Weak European economic data and downward growth revisions have put downward pressure on the currency. Additionally, looming political uncertainty in Italy, Europe's large exposure to EM, and continuing trade-war tensions make it likely that the euro will decline further (panel 4). The ECB confirmed its plan to end asset purchases by year-end, but is likely to raise rates only in late 2019. We maintain our view that EUR/USD will weaken to at least 1.12. GBP: Brexit issues continue to affect the pound: the only driver that could push GBP higher would be if both the European Union and the U.K. parliament agree to Theresa May's "Chequers plan". However, with strong opposition from both pro-Brexit Conservative MPs and the Labour Party, the chance of approval seem low. We remain bearish on the pound until there is more clarity on how Brexit will pan out and expect increasing volatility until then. Chart 24Signs Of Overheating In Alts? Alternatives Alternative assets under management continue to grow to record highs, driven by positive sentiment, the global search for yield, and the need for uncorrelated returns. However, there are increasing signs of overheating in the core areas of this market. We analyze our allocation recommendations using a framework of three buckets: 1) return enhancers, 2) inflation hedges, 3) volatility dampeners. Return Enhancers: In H1 2018, private equity (PE) outperformed hedge funds by 6.4% (Chart 24). However, last quarter we recommended investors pare back on their PE allocations and increase hedge funds. Rising competition in PE has pushed deal valuations to new highs, and we expect to see funds raised in 2018-2019 produce poor long-term returns because of higher entry valuations.7 Within the hedge fund space, we recommend investors shift to macro hedge funds, as the end of the business cycle approaches. Inflation Hedges: In H1 2018, commodity futures outperformed direct real estate by over 7%. We remain cautious on commercial real estate (CRE). Loans to CRE have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. As central banks tighten monetary policy, financial stress is likely to appear in CRE. CRE prices peaked in late 2016 and have subsequently moved sideways, partly due to the downturn in shopping malls and retail. Commodity futures, on the other hand, have performed well on the back of rising energy prices. However, we expect increased volatility in commodities due to supply disruptions in oil, and a further slowdown in EM demand. Volatility Dampeners: In H2 2018, farmland and timberland outperformed structured products by 3%. Timberland has a stronger correlation with economic growth via the U.S. housing market. This year, lumber prices have fallen from over $600 to $340, mostly due to speculative action in the futures market. However, this will ultimately impact income from timber sales. Farmland is more insulated from the economy since food demand is autonomous consumption. Structured products face pressures as rising rates push lower-quality tranches closer to default. Investors should favor farmland over timberland, and maintain only a minimum allocation to structured products. Risks To Our View Our main scenario, as outlined in the Overview, is that this year's trends will continue. What might cause them to change? Chart 25China Has Cut Rates A Bit Chart 26...But Fiscal Spending Not Yet Picking Up The biggest risk is Chinese policy. A big stimulus, in line with those in 2009 and 2015, would boost growth in emerging markets, Europe and Japan, push up commodity prices, and weaken the dollar. The PBoC has cut rates (Chart 25) and lowered the reserve requirement. The government has said it will bring this year's budget plans forward, though for now fiscal spending is slowing compared to last year (Chart 26). Faced with a major slowdown and devastating trade war, the Chinese authorities would doubtless throw everything at the problem. But, up until that point, their priority remains deleverage and reform, and so we expect them to do no more than moderately cushion the downside. Chart 27Are Speculators Too Long The Dollar? As always, a major factor is the U.S. dollar, which we expect to appreciate further, as the Fed tightens more than the market expects, and U.S. growth outpaces the rest of the world. What's the most likely reason we're wrong? Probably a situation like 2017, when speculators were very long the dollar just as growth in Europe started to accelerate relative to the U.S. Today, speculative positions are moderately long the dollar, but against the euro and yen not as much as in early 2017 (Chart 27). Aside from a Chinese reflation, it is hard to see what would propel an ex-U.S. growth spurt. True, Japanese capex and wages are showing some signs of life. But Japan worryingly intends to raise VAT in late 2019. And Europe faces considerable political risks - Brexit, Italy, troubled banks, contagion from Turkey - that make it unlikely that confidence will rebound. 1 For more details on this, please see section “What Our Clients Are Asking: Is The Fed Turning Dovish?” in this report. 2 Please see Global Asset Allocation Special Report, "Searching For Yield In A Low Return Environment," dated September 14, 2018 available at gaa.bcaresearch.com 3 Please see Global Asset Allocation "Quarterly - July 2018," dated July 2, 2018 available at gaa.bcaresearch.com 4 Please see Global Asset Allocation "Quarterly - July 2018," dated July 2, 2018 available at gaa.bcaresearch.com 5 Please see Global Fixed Income Strategy Weekly Report titled "A Performance Update On Global Corporate Bond Sectors," dated September 4, 2018 available at gfis.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds of Oil-Price Spike in 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl," dated September 20, 2018. 7 Please see Global Asset Allocation Special Report on private equity, "Private Equity: Have We Reached The Top?," dated September 26, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart I-1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart I-2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart I-1Markets Expect No Fed Hikes Beyond Next Year Chart I-2Fiscal Policy Is More Expansionary In ##br##The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart I-3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart I-4). Chart I-3U.S. Private-Sector Nonfinancial Debt Is ##br##Rising At Close To Its Historic Trend Chart I-4U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart I-5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart I-6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart I-5The Quits Rate Is Signaling Upside For Wage Growth Chart I-6The Personal Savings Rate Has Room To Fall A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart I-7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart I-8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart I-9). Chart I-7Low Housing Inventories Will Support ##br##Home Prices And Construction Chart I-8Housing Affordabiity Is Not Yet Stretched Chart I-9Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart I-10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart I-11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. Chart I-10U.S. Corporate Debt Not That High By Global Standards Chart I-11Interest Coverage Ratio Is Above Its Historic Average An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart I-12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart I-13). Chart I-12Banks Have Been Reducing Their ##br##Exposure To The Corporate Sector Chart I-13Historically, The Dollar Has Moved ##br##In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart I-14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart I-15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart I-14EM Dollar Debt Is High Chart I-15Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart I-16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart I-17). Chart I-16China: Debt And Capital ##br##Accumulation Went Hand In Hand Chart I-17China: Rate Of Return On Assets ##br##Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. Chart I-18China Saves A Lot The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart I-18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart I-19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart I-20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart I-19The RMB Is Still Quite Strong Chart I-20USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart I-21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart I-22). Chart I-21Euro Area Credit Growth Has Flatlined Chart I-22Spain Most Exposed To Vulnerable EMs Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart I-23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart I-24). Chart I-23Italian/Bund Spreads Signal Lingering Fiscal Strain Chart I-24Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart I-25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart I-25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart I-26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart I-27). Chart I-26EM Assets: Valuations Not Yet At Washed Out Levels Chart I-27EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart I-28), and a temporary countertrend decline in yields becomes quite probable. Chart I-28Bond Sentiment Is Extremely Bearish Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart I-29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart I-30). In contrast, China represents less than 15% of global oil demand. Chart I-29When Bremorse Sets In Chart I-30China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart I-31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart I-32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart I-31Canadian Dollar Still Somewhat ##br##Cheap Versus The Aussie Dollar Chart I-32Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin Chief Global Strategist Global Investment Strategy September 28, 2018 Next Report: October 25, 2018 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. APPENDIX A APPENDIX A CHART IMarket Outlook: Equities APPENDIX A CHART IIMarket Outlook: Bonds APPENDIX A CHART IIIMarket Outlook: Currencies APPENDIX A CHART IVMarket Outlook: Commodities APPENDIX B Long-Term Return Prospects Are Slightly Better Outside The U.S. Long-Term Return Prospects Are Slightly Better Outside The U.S. Long-Term Return Prospects Are Slightly Better Outside The U.S. Long-Term Return Prospects Are Slightly Better Outside The U.S. II. Is It Time To Buy Value Stocks? Per the most commonly referenced growth and value indexes, growth has been outperforming value for over 11 years, the longest stretch in the history of the series. Growth's extended winning streak has split investors into two camps: those who believe that value is finished because of overexposure and shortened investor timeframes, and those who are trying to identify the point at which reversion to the mean will ensue. In this Special Report, we argue that the traditional off-the-shelf indexes are poor proxies for true value. Their methodology strays quite far from the principles enumerated by Benjamin Graham, the father of value investing, and Fama and French, the researchers who demonstrated that lower-priced stocks have outperformed over time. The headline S&P 500 indexes currently differentiate between growth and value stocks using simplistic metrics that introduce considerable sector bias, reducing the difference between growth and value to a binary choice between Tech and Financials. Using tools developed by BCA's Equity Trading Strategy service, we create sector-neutral U.S. value and growth indexes that correct for the off-the-shelf indexes' flaws, and broaden the range of metrics Fama and French employed to make style distinctions. The ETS-derived indexes appear to better distinguish between value and growth stocks. The ETS value-versus-growth portfolio beat its Fama and French counterpart by four percentage points annually over its 22-year life. We join our custom value and growth indexes to Fama and French's to study the impact of macro variables on relative style performance over time for the purpose of gaining insight into the most opportune points to shift between styles. Relative style performance has not corresponded consistently or robustly enough with the business cycle, inflation, interest rates, or broad market direction to support reliable style-decision rules. We find that monetary policy settings, as defined by our stylized fed funds rate cycle, are a consistently reliable predictor of relative style performance. Per the fed funds rate cycle, tight policy is most conducive to value outperformance. From this perspective, value's decade-long slump is not a surprise, given that the ultra-accommodative tide has been lifting all boats. There is no rush to increase value exposure while policy remains easy, but investors should look to load up on value once policy becomes tight, using the metrics in our ETS model to identify true value stocks. We expect that the policy inflection will occur sometime in the second half of 2019, or the first half of 2020. Growth stocks have been on a tear for the longest stretch in the history of the series, based on the most commonly referenced growth and value indexes, even if their gains haven't yet matched the magnitude of the 1990s (Chart II-1). It is no surprise, then, that growth stocks are as expensive as they have ever been, outside of the tech-bubble era in the late 1990s. Many investors are thus wondering if the next "big trade" is to bet on an extended reversion to the mean during which value regains the ground it has given up. Chart II-1A Lost Decade For Value Stocks In this Special Report, we argue that the traditional off-the-shelf indexes are not very good at differentiating growth from value stocks. Trends in relative performance have much more to do with sector performance than intrinsic value, making the indexes a poor proxy for investors who are truly interested in selecting stocks based on their value and growth profiles. We create U.S. value and growth indexes that are unaffected by sector performance, using stock selection software provided by BCA's Equity Trading Strategy service. The results will surprise readers who are used to dealing with canned measures of value and growth. What Is Value Investing? Value investing principles have been around at least since the days when Benjamin Graham was a money manager himself. Style investing has been a part of the asset-management lexicon for four decades. Yet there is no universally agreed-upon definition of a value stock versus a growth stock. Based on our reading of Graham's Intelligent Investor, we submit that an essential element of value investing is the identification of stocks that are temporarily trading below their intrinsic value. The temporary drag may persist for a while - stock markets can remain oblivious to fundamentals for extended stretches - but it is ultimately expected to dissipate. Value investing is a play on negative overreaction or neglect, and dedicated value investors have to be contrarians, not to mention contrarians with strong stomachs. The temporary nature of undervaluation is a recurring theme in Graham's book. The stock market's ever-present proclivity toward overreaction ensures a steady supply of value opportunities: "The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.1" "[W]hen an individual company ... begins to lose ground in the economy, Wall Street is quick to assume that its future is entirely hopeless and it should be avoided at any price.2" "[T]he outstanding characteristic of the stock market is its tendency to react excessively to favorable and unfavorable influences.3" Graham viewed security analysis as the comparison of an issue's market price to its intrinsic value. He advised buying stocks only when they trade at a discount to intrinsic value, offering an investor a "margin of safety" that should guard against significant declines. His favorite measure for assessing intrinsic value was a sober, objective estimate of average future earnings, grossed-up by an appropriate multiple. A low price-to-average-earnings ratio was the linchpin of his margin-of-safety mantra. Decades after Graham's heyday, University of Chicago professors Eugene Fama and Kenneth French bestowed the academy's seal of approval on value investing. Their landmark 1992 paper found that low price-to-book ("P/B") stocks consistently and convincingly outperformed high P/B stocks.4 Several "growth" and "value" indexes have been developed over the years, but they bear no more than a passing resemblance to Graham's, and Fama and French's, work. It is important to realize that the off-the-shelf indexes are far from an ideal proxy for the value factor that Fama & French tried to isolate. Traditional Growth And Value Indexes Are Wanting The off-the-shelf growth and value indexes shown in Chart II-1 all share similar cyclical profiles, with only small differences in long-term returns. Given the similarity of the indexes, we will focus on Standard & Poor's/Citigroup methodology for the purposes of this report.5 The headline S&P 500 indexes currently differentiate between growth and value stocks using the following metrics: 3-year growth rates in EPS, 3-year growth rates in sales-per-share, and 12-month price momentum; along with valuation yardsticks including price-to-book, price-to-earnings, and price-to-sales. Companies with higher growth rates in earnings and sales, and better price momentum, are classified as growth stocks, while those with lower valuation multiples are considered value stocks. Several stocks are cross-listed in both indexes, which is baffling and counterproductive for an investor seeking to implement a rigorous style tilt.6 Table II-1 contains a summary of the current sector breakdowns for the S&P 500 Growth and Value indexes. Table II-2 sheds light on each index's aggregate geographical and U.S. business cycle exposure, the former of which is based on our U.S. Equity Strategy service's judgment. Table II-1Current S&P 500 Style Index Exposures Table II-2The Value Index Has Less Global ##br##And Late Cyclical Exposure Growth is currently heavily weighted in Health Care, Technology and Consumer Discretionary sectors, while value has a high concentration of Financials, Energy and Consumer Staples (Table II-1). Table II-2 shows that the growth index has a clear current bias toward sectors with global economic exposure that typically outperform the broad equity market late in the business cycle. The value benchmark flips growth's global/domestic exposure, and has slightly more exposure to defensive sectors, while splitting its cyclical exposure evenly between early and late cyclicals. Sector Dominance Unfortunately, the reigning methodology creates a major problem - shifts in the relative performance of growth and value indexes are dominated by sector performance. Financials' higher debt loads, and banks' low-margin operations, depress their multiples relative to nonfinancial firms. Thus, Financials hold permanent residency in the off-the-shelf value indexes. Conversely, Tech stocks perennially account for an outsized proportion of most growth indexes' market cap. Value-versus-growth boils down to a binary choice between Financials and Tech.7 The growth/value price ratio has closely tracked the Technology/Financials price ratio since the late 1990s (Chart II-2, top panel). The correlation was much less evident before 1995, when Tech stocks accounted for a much smaller share of market capitalization. Chart II-3 demonstrates that the positive correlation between growth/value and Tech has steadily climbed over the decades to almost 1, while the correlation with Financials has become increasingly negative (currently at -0.75). Chart II-2The S&P 500 Style Indexes Merely Mimic Relative Sector Performance Chart II-3Style Capture In contrast, the Fama/French approach, which focuses exclusively on price-to-book while ensuring equal representation for large- and small-market-cap stocks, appears much less affected by sector skews; the growth/value index created from their data has not tracked the Tech/Financials ratio, even after 1995 (Chart II-2, second panel). Moreover, note that the extended downward trend in the Fama/French growth/value ratio is consistent with other academic research that shows that value stocks outperform growth over the long-term. The off-the-shelf indexes show the opposite, but that is because they are merely tracking the long-term outperformance of Tech relative to Financials. The bottom line is that the standard indexes incorporate flawed measures of growth and value that limit their usefulness for true style investing. Conventional Wisdom With respect to style investing and the economic cycle, the prevailing conventional wisdom holds that: Inflation - Growth stocks perform best during times of disinflation and persistently low inflation, whereas value stocks perform best during periods of accelerating inflation; Interest Rates - Periods of high and rising interest rates favor value stocks at the expense of growth; and Business Cycle - It is believed that growth stocks outperform value during recessions, because the latter tend to be more highly leveraged to the economic cycle than their growth counterparts. According to the conventional view, value stocks shine in the early and middle phases of a business cycle expansion. Growth stocks return to favor again in the late states of an expansion, when investors begin to worry about the pending end to the business cycle and are looking for reliable and consistent earnings growth. Do the traditional measures of growth and value corroborate this conventional wisdom? Chart II-4 shows that the S&P value/growth index and headline CPI inflation have both trended lower since the early 1980s, but there has been no tendency for value to outperform when inflation rises. Value has shown some tendency to outperform during rising-rate phases since the mid-1980s, but the relationship with the level of the fed funds rate is stronger than its direction, as we discuss below. The growth-over-value relationship with the business cycle is complicated by the tech bubble in the late 1990s, which heavily distorted relative sector performance. The Citigroup measure of growth began to outperform very late in the cycle and through the subsequent recession in some business cycles (1979-1981, 1989-1991, and 2007-2009; Chart II-5). The early and middle parts of the cycles, however, were a mixed bag. Chart II-4Spiting The Conventional Wisdom Chart II-5No Consistent Relationship With The Business Cycle The bottom line is that there appears to be some rough correspondence between the Citigroup index and the interest rate and growth cycles, but it is too variable to point to reliable rules for shifting between styles. Ultimately, determining the direction of the growth and value indexes is more about forecasting relative Tech and Financials performance than it is about identifying cheap stocks. A Better Value Approach We identify four broad shortcomings of off-the-shelf value indexes: They exclusively use trailing multiples, a rear-view mirror metric. They rely on simple price-to-book multiples, which flatter serial acquirers. They rely entirely on reported earnings, which are an imperfect proxy for cash flow. A share of stock ultimately represents a claim on its issuer's future cash flows. They make no attempt to place relative metrics into historical context. Without a mechanism to compare a particular segment's valuation relative to its history, structurally low-multiple stocks will be over-represented and structurally high-multiple stocks will be under-represented. BCA's Equity Trading Strategy (ETS) platform provides a way of differentiating value from growth stocks that avoids these problems. The web-based platform uses 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top decile of stocks ranked using the "BCA Score" methodology has outperformed stocks in the bottom decile by over 25% a year. The overall BCA Score includes all 24 factors when ranking stocks, but to develop our custom value index, we use only the five valuation measures in the ETS database: trailing P/E, forward P/E, price-to-tangible-book, price-to-sales and price-to-cash flow. Every quarter we rank the stocks within each of the 11 sectors based on an equally-weighted composite of the five valuation measures. Note that we are using the data to rank stocks only against other stocks in the same sector. We calculate the total return from owning the top 30% of stocks by value in each sector. We do the same with the bottom 30% and refer to this as our "growth" index.8 We then compute an equally-weighted average of the total returns for the growth indexes across the 11 sectors. We do the same for the value indexes. By comparing stock valuation only to other stocks in the same sector, this approach avoids the sector composition problem suffered by the off-the-shelf measures. Chart II-6 compares the ETS value/growth total return index to the Fama/French value/growth index. Data limitations preclude comparing the two measures before 1996, but the ETS index confirms the Fama/French result that value trumps growth over the long term. The ETS index follows a similar cyclical profile to the Fama/French index from 1997 to 2009, rising and falling in tandem. The two series subsequently diverge: per the criteria ETS uses to identify value and construct an index, lower-priced stocks have outperformed higher-priced ones for most of this expansion, while the Fama/French methodology suggests the reverse. Chart II-6The ETS Model Builds On Fama And French's Work By avoiding sector composition problems and using a wider variety of value measures, the ETS approach appears to be a superior measure of value. An investor that consistently over-weighted value stocks according to the ETS approach would have outperformed someone who did the same using the Fama methodology by an annual average of four percentage points from 1996 to 2018. The history of our ETS index only covers two recessions, limiting our ability to gauge its performance vis-Ã -vis a variety of macro factors, so we extend the ETS index back to 1926 using the Fama/French index. While joining two indexes with different methodologies is less than ideal, we feel the drawbacks are outweighed by the benefit of observing growth and value relative performance across more business cycles. The top panel of Chart II-7 shows U.S. real GDP growth, shaded for recessions. The bottom panel presents our extended ETS value/growth index, shaded for declines of more than 10%. The shaded periods overlap in many, but not all, cycles (indicated by circles in the chart). That is, growth stocks have tended to outperform during economic downturns, although this is not a hard-and-fast rule. Chart II-7No Hard-And-Fast Relationship With The Business Cycle... Value-over-growth relative returns exhibit some directionality with the overall equity market when looking at corrections (peak-to-trough declines of at least 10%, as shaded in the top panel of Chart II-8), though it should be noted that it is nearly impossible to flag a correction in advance. The relationship weakens when considering bear markets, i.e. peak-to-trough declines of at least 20%, which can be forecast with at least some reliability.9 The bottom panel is the same as in Chart II-7; the extended ETS index, shaded for periods of significant value stock underperformance. The correspondence between the shaded periods is hardly perfect, and there does not appear to be a practical style exposure message, even if an investor could call corrections in advance. Chart II-8...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years Valuation Relative valuation also provides some useful information on positioning, though it is not always timely. Chart II-9 presents an aggregate valuation measure for the stocks in our value index relative to that of the stocks in our growth index. Value stocks are expensive relative to growth when the valuation indicator is above +1 standard deviation, and value is cheap when the indicator is less than -1 standard deviation. Historically, investors would have profited if they had over-weighted value stocks when the valuation indicator reached the threshold of undervaluation, although subsequent outperformance was delayed by as much as a year in two episodes. In contrast, the valuation indicator is not useful as a 'sell' signal for value stocks because they can remain overvalued for long periods. Value was overvalued relative to growth for much of the time between 2009 and 2016. Value stocks have cheapened since then, although they have yet to reach the undervaluation threshold. The Fed Funds Rate Cycle While relative style performance may generally lean in one direction or another in conjunction with the business cycle, inflation, interest rates, or broad equity-market performance, there are no hard-and-fast rules. It is difficult to formulate any sort of rotation view between styles, and history does not inspire confidence that any such rule would generate material outperformance. The monetary policy backdrop offers a path forward. We have found the fed funds rate cycle offers a consistent guide to equity and bond returns in other contexts, and our Global ETF Strategy service has found a robust link between the policy cycle and equity factor performance.10 We segment the fed funds rate cycle into four phases, based on whether or not the Fed is hiking or cutting rates, and whether policy is accommodative or restrictive (Chart II-10). Our judgment of the state of policy is derived from comparing the fed funds rate to our estimate of the equilibrium fed funds rate, the policy rate that neither encourages nor discourages economic activity. Chart II-9Sizeable Undervaluation Flags Turning ##br##Points, But You May Have To Wait A While Chart II-10The Fed Funds Rate Cycle As defined by Fama and French, value stocks outperform growth stocks by a considerable margin when monetary policy is restrictive (Table II-3 and Chart II-11, top panel). Considering value and growth stocks separately, both perform extremely well when policy is easy (Chart II-11, second panel), but growth stocks barely advance when policy is tight, falling far behind their value counterparts. A strategy for generalist investors may be to seek out value exposure when policy is tight, while investing without regard to styles when it is easy. Table II-3The State Of Monetary Policy Is The ##br##Best Guide To Style Performance Chart II-11The State Of Monetary Policy Drives Style Performance Investment Conclusions: U.S. equity sectors that have traditionally been considered "growth" have outperformed value sectors for an extended period. The long slump has led some investors to argue that value investing is finished, killed by a combination of overexposure and short-term performance imperatives. Other investors see value's long drought as an anomaly, and are looking for the opportune time to bet on a reversal. We are in the latter camp. The difficulty lies in finding an indicator that reliably leads value stocks' outperformance. Most macro measures are unhelpful, though broad market direction offers some insight, as stocks with low price-to-book multiples have outperformed their high-priced peers by a wide margin during bear markets. Bear markets aren't the most useful timing guide, however, because one only knows in retrospect when they begin and end. The monetary policy backdrop holds the most promise as a practical guide. Although our determination of easy or tight policy turns on the modeled estimate of a concept and should not be looked to for absolute precision, it has provided a timely, reliable guide to value outperformance. We expect the relationship will persist because of the cushion provided by less demanding multiples. Earnings and multiples surge when policy is easy, lifting all boats. It is only when policy is tight, and the tide is going out, that the margin of safety offered by lower-priced stocks yields the greatest benefit. Per our estimate of the equilibrium fed funds rate, we are still firmly ensconced within Phase I of the policy rate cycle, and expect that we will remain there until sometime in the second half of 2019. We therefore expect that value, in Fama and French terms, will continue to underperform growth for another year. The clock is ticking for growth, though, as the expansion is in its latter stages and building inflation pressures will likely force the Fed to take a fairly hard line in this rate-hiking cycle. Once monetary policy turns restrictive, investors should hunt for value candidates using a range of valuation metrics, and combine them in a sector-neutral way, as we have via our Equity Trading Strategy service's model. Mark McClellan Senior Vice President The Bank Credit Analyst Doug Peta Senior Vice President U.S. Investment Strategy 1 Graham, Benjamin, The Intelligent Investor, Harper Collins: New York, 2005, p. 97. 2 Ibid, p. 15. 3 Ibid, p. 189. 4 Fama, Eugene F. and French, Kenneth R., "The Cross-Section of Expected Stock Market Returns," The Journal of Finance, Volume 47, Issue 2 (June 1992), pp. 427-465. 5 S&P currently brands its Growth and Value Indexes as S&P 500 Dow Jones Indexes, but Citigroup has the longest history of compiling S&P 500 Growth and Value Indexes, beginning in 1975, so we join the Citigroup S&P 500 style indexes to the Standard & Poor's series to obtain the maximum style-index history. We use the terms Citigroup and S&P interchangeably. 6 The Pure Value and Pure Growth indexes include only the top quartile of value and growth stocks, respectively, with no overlap between indexes, and are therefore better gauges of true style investing. 7 The Tech-versus-Financials cast of the indexes endures because all of the other sectors, ex-regulated Telecoms and Utilities, which account for too little market cap to make a difference, regularly move between the indexes as their fundamental fortunes, and investor appetites, wax and wane. The current Early Cyclical/Late Cyclical/Defensive profiles are not etched in stone and should be expected to shift, perhaps considerably, over time. 8 We created a second growth index by taking the top 30% of stocks ranked by earnings momentum. However, it made little difference to the results, so we will use the bottom 30% of stocks by value as our measure of "growth" for the purposes of this report, consistent with Fama/French methodology. 9 Please see The Bank Credit Analyst. September 2017, available on bca.bcaresearch.com 10 Please see the May 17, 2017 Global ETF Strategy Special Report, "Equity Factors And The Fed Funds Rate Cycle," available at getf.bcaresearch.com. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits remain potent enough to drown out scattered negative messages. Our Monetary Indicator remains at the low end of a multi-year range, suggesting that liquidity conditions have tightened. Our Composite Technical Indicator is in no-man's land, not far above the zero line that marks a sell signal, but coming close to issuing a buy signal by crossing above its 9-month moving average. Our Composite Sentiment Indicator is in a healthy position that suggests that the current level of investor optimism is sustainable. On the other hand, not one of our Willingness-to-Pay (WTP) Indicators is moving in the right direction. The U.S. version is still weak and slowly getting weaker; the European one has flat-lined; and our Japanese WTP extended its decline, albeit from a high level. Our Revealed Preference Indicator (RPI) for stocks continues to issue a sell signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, underlining the idea that caution is warranted. On balance, our indicators continue to suggest that the underlying supports of the U.S. equity bull market are eroding. Surging U.S. profits are papering over the cracks, and may still have some legs. Earnings surprises are at an all-time high, and the net revisions ratio remains elevated. The 10-year Treasury yield's march higher is due to run out of steam. Valuation (slightly cheap) and technicals (oversold by almost 2 standard deviations) imply that a countertrend pullback is not too far around the corner. Beyond a near-term correction, though, complacency about inflation and the Fed's ability to hike rates to at least the level of the FOMC voters' median projection points to looming capital losses. The dollar is quite expensive on a purchasing power parity basis, and its long-term outlook is not constructive, but policy and growth divergences with other major economies will likely keep the wind at its back in the near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Doug Peta Senior Vice President U.S. Investment Strategy

Special Report

Highlights The Global Golden Rule (GGR): The gap between market expectations of global central bank policy rates and realized interest rate outcomes is a reliable predictor of government bond returns. Thus, "getting the policymaker call right" is the key to outperformance for bond investors. Implied Government Bond Yields: Given the strong correlation between policy rate surprises and government bond yield changes, we can use the GGR to forecast yields one year from now based on our own assumptions of how many rate hikes (cuts) will be delivered versus what is discounted in money market yield curves. Total Return Forecasts: We can use implied government bond yield changes from the GGR to generate expected 12-month total returns for government bond indexes of different maturities, taking into account different rate hike assumptions for various central banks. Feature Chart 1Global Monetary Divergences? This month marked the ten-year anniversary of the 2008 Lehman Brothers default, which set off a worldwide financial crisis and a massive easing of global monetary policy. Extraordinary measures - zero (or negative) interest rates, large-scale asset purchases and dovish forward guidance from policymakers - were all successful in suppressing both global bond yields and volatility over time, helping the global economy slowly heal from the crisis. Now, a decade later, such hyper-easy monetary policies are no longer required given low unemployment rates and rising inflation in the major developed economies. That can be seen today with the Federal Reserve shifting to "quantitative tightening" (letting bonds run off its swollen balance sheet) alongside steady rate hikes, the European Central Bank (ECB) set to stop net new buying of euro area bonds at year-end, and the Bank of Japan (BoJ) dramatically slowing its pace of asset purchases. BCA's Central Bank Monitors, which assess the cyclical pressure on policymakers to tighten or ease monetary policy, have collectively been calling for interest rate increases since the start of 2017. Yet our Central Bank Monetary Barometer, which measures the percentage of central banks that have tightened policy over the previous three months, shows that only 1 in 5 banks have actually delivered rate hikes of late (Chart 1). Thus, the risks are tilted towards more countries moving away from highly accommodative monetary conditions given tightening labor markets and rising inflation pressures. This now-global shift towards policy normalization has major implications for global bond investing. The focus is now returning back to more traditional drivers of government bond returns, like changes in central bank policy rates. We recently shared a Special Report published by our colleagues at our sister BCA service, U.S. Bond Strategy, describing a methodology they dubbed "The Golden Rule of Bond Investing".1 That report introduced a numerical framework that translates actual changes in the U.S. fed funds rate relative to market expectations into return forecasts for U.S. Treasuries. The historical results convincingly showed that investors who "get the Fed right" by making correct bets on changes in the funds rate versus expectations were very likely to make the right call on the direction of Treasury yields. In this Special Report, we extend that Golden Rule analysis to government bonds in the other major developed markets (DM). Our conclusion is that utilizing a "Global Golden Rule" (GGR) framework that links bond returns to unexpected changes in policy rates can help bond investors correctly forecast changes in non-U.S. bond yields. The report is set up in two sections. First, we illustrate how the GGR works and how it empirically tends to generally succeed over time for different DM bond markets. In the second section, we make use of the GGR to generate expected return forecasts for non-U.S. government bonds for a variety of interest rate "surprise" scenarios. ECB Policy Rate Surprises Dovish surprises from the ECB do reliably coincide with positive German government bond excess returns versus cash (Chart 2A). Chart 2AECB Policy Rate Surprise & Yields I Chart 2BECB Policy Rate Surprise & Yields II The 12-month ECB policy rate surprise and the 12-month change in the Bloomberg Barclays German Treasury index yield displays a strong positive correlation (Chart 2B). The excess returns during periods of dovish surprises is 14.4% on average and are positive 85% of the time. Hawkish surprises on the other hand, coincide with negative average excess returns of -1.5% (Chart 2C). In terms of total return, the picture is roughly the same except that under hawkish surprises, the average total return you would expect is now positive, given that it factors in coupon income (Chart 2D). Chart 2CGermany: Government Bond Index Excess Return & ECB Policy Rate Surprises (2004 - Present) Chart 2DGermany: Government Bond Index Total Return & ECB Policy Rate Surprises (2004 - Present) Table 1Germany: 12-Month Government Bond Index Returns And Rate Surprises (2004 - Present) Looking ahead, the ECB should not deviate from its current dovish forward guidance of no interest rate hikes until at least the third quarter of 2019. That is somewhat consistent with the reading of the ECB monitor being almost equal to zero. Bank Of England (BoE) Policy Rate Surprises The GGR works well for the U.K. as can be seen in Chart 3A. Chart 3ABoE Policy Rate Surprise & Yields I Chart 3BBoE Policy Rate Surprise & Yields II The 12-month BoE policy rate surprise and the 12-month change in the Bloomberg Barclays U.K. Treasury index yield displays a strong positive correlation except for a major divergence in 1997-1998 (Chart 3B). Dovish surprises coincide with positive excess returns over cash 78% of the time and are on average equal to 6.2% over the full sample (Chart 3C and Chart 3D). As you would expect if the GGR applies, hawkish surprises coincide with negative excess returns. Chart 3CU.K.: Government Bond Index Excess Return & BoE Policy Rate Surprises (1993 - Present) Chart 3DU.K.: Government Bond Index Total Return & BoE Policy Rate Surprises (1993 - Present) Table 2U.K.: 12-Month Government Bond Index Returns And Rate Surprises (1993 - Present) Looking ahead, outcomes will be biased toward dovish surprises over the next six months given the uncertain outcome of the U.K.-E.U. Brexit negotiations. Against that backdrop, the BoE will remain accommodative despite inflationary pressures building up. Bank Of Japan (BoJ) Policy Rate Surprises The GGR does not seem to work when it comes to the Japanese bond market. This reflects the fact that both the markets and the Bank of Japan (BoJ) have understood that chronic low inflation has required no changes in BoJ policy rates (Chart 4A, second panel). Chart 4ABoJ Policy Rate Surprise & Yields I Chart 4BBoJ Policy Rate Surprise & Yields II While the 12-month BoJ policy rate surprise and the 12-month change in the Bloomberg Barclays Japan Treasury index yield displayed a strong positive correlation pre-1998, the correlation has broken down since then (Chart 4B). Negative excess returns over cash both coincide with dovish and hawkish surprises, on average over time. Further, dovish surprises coincide with positive excess returns only 45% of the time (Chart 4C and Chart 4D). Chart 4CJapan: Government Bond Index Excess Return & BoJ Policy Rate Surprises (1994 - Present) Chart 4DJapan: Government Bond Index Total Return & BoJ Policy Rate Surprises (1994 - Present) Table 3Japan: 12-Month Government Bond Index Returns And Rate Surprises (1994 - Present) Looking ahead, given that the BoJ will in all likelihood maintain its ultra-accommodative monetary policy stance in the near future, we do not expect the GGR to become more effective when applied to the Japanese bond market. Bank Of Canada (BoC) Policy Rate Surprises The GGR works relatively well for the Canadian bond market (Chart 5A). Chart 5ABoC Policy Rate Surprise & Yields I Chart 5BBoC Policy Rate Surprise & Yields II We observe a tight correlation between 12-month BoC policy rate surprises and the 12-month change in the Bloomberg Barclays Canada Treasury index yield, especially post-2010 (Chart 5B). Dovish surprises coincide with positive excess returns 81% of the time and 94% of the time if we look at total returns (Chart 5C and Chart 5D). Chart 5CCanada: Government Bond Index Excess Return & BoC Policy Rate Surprises (1993 - Present) Chart 5DCanada: Government Bond Index Total Return & BoC Policy Rate Surprises (1993 - Present) Table 4Canada: 12-Month Government Bond Index Returns And Rate Surprises (1993 - Present) Looking ahead, the BoC will most likely continue to follow the tightening path of the Federal Reserve, admittedly with a lag. However, accelerating inflation at a time when there is no spare capacity in the Canadian economy suggests that the BoC could deliver more rate hikes than are already priced for the next 12 months. As shown in Table 4, hawkish surprises from the BoC do coincide with negative monthly excess returns of -2.8%. Reserve Bank Of Australia (RBA) Policy Rate Surprises The GGR applies extremely well to the Australian bond market (Chart 6A). Chart 6ARBA Policy Rate Surprise & Yields I Chart 6BRBA Policy Rate Surprise & Yields II The 12-month RBA policy rate surprise and the 12-month change in the Bloomberg Barclays Australia Treasury index yield displays the tightest correlation out of all the countries covered (Chart 6B). Dovish surprises coincide with positive excess returns 83% of the time and 96% of the time if we look at total returns (Chart 6C and Chart 6D). Turning to hawkish surprises, they reliably coincide with negative excess returns. Chart 6CAustralia: Government Bond Index Excess Return & RBA Policy Rate Surprises (1994 - Present) Chart 6DAustralia: Government Bond Index Total Return & RBA Policy Rate Surprises (1994 - Present) Table 5Australia: 12-Month Government Bond Index Returns And Rate Surprises (1994 - Present) As can be seen on the bottom panel of Chart 6A, the RBA Monitor has been rapidly falling since 2016 and now stands in the "easier monetary policy" required. However, the RBA will likely have to see a rise in unemployment or a decline in realized inflation before it considers cutting rates, which raises a risk of "hawkish" surprises if the market begins to price in rate cuts. Reserve Bank Of New Zealand (RBNZ) Policy Rate Surprises The GGR works fairly well for Nez Zealand (NZ) government bonds (Chart 7A). Chart 7ARBNZ Policy Rate Surprise & Yields I Chart 7BRBNZ Policy Rate Surprise & Yields II 12-month RBNZ policy rate surprises and the 12-month change in the Bloomberg Barclays NZ Treasury yield exhibit a decent correlation (Chart 7B). Unusually, NZ is the only bond market covered in this report where both dovish and hawkish surprises coincide with positive excess returns on average, although positive episodes are much less frequent for hawkish surprises than for dovish surprises; respectively 55% and 86% (Chart 7C and Chart 7D). Chart 7CNZ: Government Bond Index Excess Return & RBNZ Policy Rate Surprises (2000 - Present) Chart 7DNZ: Government Bond Index Total Return & RBNZ Policy Rate Surprises (2000 - Present) Table 6New Zealand: 12-Month Government Bond Index Returns And Rate Surprises (2000 - Present) Looking ahead, the RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will most likely stay flat until 2020 - an assessment that we agree with, so the odds are against any policy surprises over at least the next 6-12 months. Using The Global Golden Rule To Forecast Government Bond Returns The practical application of the GGR is that it can be used as a framework for generating expected changes in yields and calculating total return forecasts for global government bond indices. The strong correlation demonstrated in the previous section between the 12-month policy rate surprises and the 12-month change in the average yield from the government bond indexes allows us to translate our "assumed" policy rate surprise over the next 12 months into expected changes in yields along the curve. With these expected yield changes, we can simply generate expected total returns using the following formula: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(DY2) E(DY2) = 1-year trailing estimate of yield volatility It is important to note that we would not give too much importance to what this analysis yields for longer-dated bonds. As shown in the Appendices, once we move into longer government bond maturities, the correlation between the policy rate surprise and the change in yields declines or even becomes non-existent for some countries. This result should not be surprising, as longer-term yields are driven by other factors besides simply changes in interest rate expectations. Inflation expectations, government debt levels and demand from longer-term investors like pension funds all can have a more outsized influence on the path of longer-term bond yields relative to the shorter-end. That results in much more uncertainty when it comes to the total return forecasts for long-dated maturities calculated with this framework. Practically speaking, we are not encouraging our readers to blindly follow that yield and return expectations generated by the GGR, even for bond markets where it clearly seems to be working over time. Rather, the GGR can be integrated in a larger asset-allocation framework for a global fixed-income portfolio by providing one possible set of bond market outcomes. On a total return basis, the results presented below, interpreted alongside the readings on the BCA Central Bank monitors, suggest that investors should be underweight core Euro Area (Germany, France and Italy), Australia and New Zealand while remaining overweight the U.K. and Canada over the next twelve months. As for Japan, given the likelihood that BoJ will leave its policy rate flat, the results hint at a neutral allocation. Jeremie Peloso, Research Analyst jeremie@bcaresearch.com Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com. 2 Please see Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: Divergences Opening Up," dated September 19, 2018, available at gfis.bcaresearch.com. Global Golden Rule: Germany In light of the forward guidance ECB President Mario Draghi has been providing to the markets, it appears that the most likely scenario over the next 12 months is for the ECB to keep interest rates on hold. Based on the strong relationships between 12-month ECB policy rate surprises and 12-month changes in yields along the curve (Appendix A), a flat interest rate scenario would be bond bearish for German government bonds especially at the short end of the curve with the 1-year German yield expected to rise by 16bps (Table 7A). Table 7AGermany: Expected Changes In Bund Yields Over The Next 12 Months (BPs) Using the expected change in yields thus inferred by the policy rate surprise, the German government bond aggregate index is forecasted to return 0.45% over the next 12 months (Table 7B). Table 7BGermany: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: U.K. Markets are currently discounting only 21bps of rate hikes in the U.K. over the next year. Thus, even a scenario where the BoE delivers only a single 25bp rate hike would be bearish for U.K. Gilts, especially at the short-end of the curve. Applying the GGR, 1- and 3-year Gilt yields would be expected to rise by 20bps and 10bps respectively (Table 8A). Table 8AU.K.: Expected Changes In Gilt Yields Over The Next 12 Months (BPs) Interpolating these expected yield changes, the 1-3 year government bond index total return forecast would be 0.46%. On the other hand, if the BoE prefers to keep rates on hold given the uncertainty of the Brexit outcome, that same 1-3 year government bond index is forecasted to deliver 0.97% of total return over the next 12 months (Table 9B). This is our current base case scenario for Gilts. Table 8BU.K.: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Japan Despite many rumors to the contrary earlier this year, the base case view remains that the BoJ will not change its stance on monetary policy anytime soon. As such, the expected changes in JGB yields under a flat interest rate scenario over the next 12 months are close to zero at the short end of the curve and rather bond bullish at the longer end of the curve; for instance, the 30-year JGB yield would be expected to rally by 9bps (Table 9A). Table 9AJapan: Expected Changes In JGB Yields Over The Next 12 Months (BPs) In that most likely scenario, the Japanese government bond index is forecasted to deliver 0.83% of total return over the next 12 months. In the event that the BoJ surprises the markets by delivering one rate hike of 25bps, it would be bond bearish for JGBs and the total return forecasts for the government bond indices would be negative, regardless of the maturity (Table 9B). Table 9BJapan: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Canada Will the Bank of Canada follow the footsteps of the Fed? The markets certainly seem to think so, with more than three 25bps rate hikes priced in for next 12 months in the OIS curve. Table 10ACanada: Expected Changes In Government Bond Yields Over The Next 12 Months (BPs) That scenario would be outright bearish for Canadian government bonds, with 1- and 2-year yields rising by 16bps and 21bps, respectively (Table 10A). In terms of total returns, the GGR framework forecasts that with 75bps of rate hikes, the Canadian government bond aggregate index would deliver a positive return of 2.35% (Table 10B). This is because 75bps of hikes are currently discounted in the Canadian OIS curve, thus it would neither be a hawkish nor dovish surprise. Table 10BCanada: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Australia The RBA Monitor just dipped below the zero line, implying that easier monetary policy is required based on financial and economic data. Table 11A shows that a rate cut delivered by the RBA in the next 12 months would be bond bullish for Aussie yields, especially at the long end of the curve, where the 30-year Aussie bond yield would fall by 34bps. Table 11AAustralia: Expected Changes In Aussie Yields Over The Next 12 Months (BPs) Of all the interest rate scenarios presented in Table 11B, the two rate cut scenarios would return the highest total returns. For instance, the Australian government bond aggregate index would return 2.80% and 3.90% in the event of one and two 25bps rate hikes, respectively. Table 11BAustralia: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: New Zealand Our view is that the Reserve Bank of New Zealand will stay on hold for a while longer, which is broadly the same message conveyed by the RBNZ Monitor being positive, but very close to 0. With that in mind, a flat interest rate scenario appears to be bond bearish for the NZ bond yields, except for the longer end of the curve (Table 12A). Table 12ANew Zealand: Expected Changes In NZ Yields Over The Next 12 Months (BPs) Table 12BNew Zealand: Government Bond Index Total For New Zealand, the government bond aggregate bond index is the only index provided by Bloomberg Barclays, as opposed to the other countries in our analysis where different maturities are given. In the flat interest rate scenario, the total return forecast for the overall index would be of 2.53% over the next 12 months. Appendix A: Germany Chart 1Change In 1-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 2Change In 2-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 3Change In 3-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 4Change In 5-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 5Change In 7-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 6Change In 10-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 7Change In 30-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix B: France Chart 8Change In 1-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 9Change In 2-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 10Change In 3-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 11Change In 5-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 12Change In 7-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 13Change In 10-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 14Change In 30-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix C: Italy Chart 15Change In 1-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 16Change In 2-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 17Change In 3-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 18Change In 5-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 19Change In 7-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 20Change In 10-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 21Change In 30-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix D: U.K. Chart 22Change In 1-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 23Change In 2-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 24Change In 3-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 25Change In 5-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 26Change In 7-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 27Change In 10-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 28Change In 30-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Appendix E: Japan Chart 29Change In 1-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 30Change In 2-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 31Change In 3-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 32Change In 5-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 33Change In 7-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 34Change In 10-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 35Change In 30-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Appendix F: Canada Chart 36Change In 1-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 37Change In 2-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 38Change In 3-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 39Change In 5-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 40Change In 7-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 41Change In 10-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 42Change In 30-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Appendix G: Australia Chart 43Change In 1-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 44Change In 2-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 45Change In 3-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 46Change In 5-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 47Change In 7-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 48Change In 10-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Appendix H: New Zealand Chart 49Change In 1-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 50Change In 2-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 51Change In 3-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 52Change In 5-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 53Change In 7-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 54Change In 10-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise

Highlights The U.S. dollar is likely to correct further over the coming weeks. The CAD should benefit as it is cheap and oversold, and the inflationary back-drop warrants tighter monetary conditions. This will be a bear market rally, not the ultimate trough for the loonie. EUR/SEK should correct as the Riksbank will start tightening policy in December; a pause in the global growth slowdown should also give the cheap SEK a welcome boost. Cheap long-term valuations will not help the yen in the coming weeks; instead, falling Japanese inflation expectations and growing investor expectations of Chinese stimulus will weigh on the JPY. A better opportunity to buy the yen on its crosses will emerge later this year. EUR/CHF has upside over the coming months; the swissie needs additional global growth weakness to rally further. This is unlikely to happen for a few months. Feature Chart I-1DXY Correction Has Further To Run By the middle of the summer, the dollar had hit massively overbought levels, which left it vulnerable to any signs of stabilization in global growth, especially if some key U.S. activity gauges began to soften (Chart I-1). This is exactly what is transpiring. As we highlighted last week, BCA's Global LEI Diffusion Index is rebounding, EM and Japanese exports are stabilizing and U.S. core inflation and building permits have disappointed. This bifurcation in the data suggests the dollar has more room to correct, as neither our Capitulation Index nor our Intermediate-Term Technical Indicator have hit technically oversold levels. Last week we also argued that this correction in the dollar is likely to prove a temporary reprieve, but that in the interim the euro and the Australian dollar were well placed to experience significant rebounds.1 This week, we explore if the same case can be built for the Canadian dollar, the Swedish krona, the yen and the Swiss Franc. CAD: The Bank of Canada Will Proceed Cautiously The first half of 2018 has not been kind to the Canadian dollar. A rout in EM assets, signs of softening global growth and tough rhetoric from the White House on trade generally and NAFTA and Canada in particular have conspired to create fertile grounds for loonie-selling. Since the end of June, the CAD has managed to regain some composure, rallying by 3.3% against the USD. Essentially, much bad news has been embedded in this currency, which now trades at a significant discount to BCA's estimate of its short-term fair value (Chart I-2). Moreover, speculators, who had been aggressively buying the CAD at the end of 2017, now hold large short positions in the currency (Chart I-2, bottom panel). This combination is now resulting in a situation where any pause in the USD's strength is being mirrored in CAD strength. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Chart I-2No One Is Going Crazy For The Loonie Chart I-3Canada: Growth Picture Is Mixed The weakness in Canadian consumption partly reflects the underperformance of Canadian employment relative to the U.S. However, the slowdown in house prices has played a bigger role (Chart I-4). Canadian households are burdened by a debt load of 170% of disposable income. Now that mortgage rates are rising, Canadians are spending more than 14% of their disposable income servicing their debt, a burden last experienced in 2008 when mortgage rates were 220 basis points higher. Without the benefit of rapidly rising real estate assets, it is much more difficult for Canadian retail sales to grow at an 8.7% annual rate as they did three quarters ago. Despite these weaknesses, it is hard to justify that Canadian monetary conditions - as approximated by the slope of the yield curve, the level of real rates, and the trade-weighted CAD - should be as easy as they are today (Chart I-5). This is even truer when we take into account Canadian inflationary conditions. Chart I-4Canadian Consumers Have A Problem Chart I-5Canadian Monetary Conditons Are Very Easy The three inflation gauges targeted by the Bank of Canada stand between 1% and 3%, or at its objective. This means that the BoC's 1.5% policy rate is negative in real terms. Moreover, this inflationary pressure is unlikely to abate. The BoC estimates that the output gap has closed, and companies are running into growing capacity constraints (Chart I-6, top panel). Despite a correction last month, wages are in an uptrend, powered by growing and severe labor shortages (Chart I-6, bottom panel). Thanks to these conditions, we anticipate that the BoC will track the pace of rate increases by the Federal Reserve over the next 12 months. This is not very different from what is currently priced into Canadian money markets. Chart I-6Canadian Capacity Pressures Point To A Hawkish ##br##BoC Inflation Will Force The BoC's Hand If the BoC does not disappoint, the combination of a cheap and oversold CAD should help the loonie rally against the USD, so long as the current stabilization in global growth continues. A move toward USD/CAD 1.26 is likely. The biggest risk to this view is that trade negotiations between the U.S. and Canada deteriorate further. While we do not anticipate an imminent breakthrough in these negotiations, we do not see much scope for significant deterioration in the relationship either. The energy market could prove to be another positive for the loonie. Bob Ryan, who leads BCA's Commodity and Energy Strategy service, argues that the oil market is currently very tight and vulnerable to supply disruptions.2 Under these circumstances, the removal of Iranian exports, tensions in Iraq, declining Nigerian production and Venezuela's cascading implosion all risk causing a melt-up in oil prices by the first half of 2019. This could help the CAD as well, even if the Canadian oil benchmark remains at a large discount to Brent. Longer-term, the upside in the CAD is likely to be capped. There is only one rate hike priced into the U.S. OIS curve from June 2019 to December 2020. We expect the Fed to hike rates by more than that. Meanwhile, the emerging softness in the Canadian household sector suggests it will be much more difficult for the BoC to keep following the Fed higher over that period. The CAD is not cheap enough to compensate for these long-term headwinds (Chart I-7). Bottom Line: On a short-term basis, the Canadian dollar is cheap and oversold. While the Canadian consumer has begun to disappoint, the inflationary pressures present in Canada should keep the BoC on track to follow the Fed and push rates higher over the coming 12 months. The CAD should therefore benefit from any USD weakness, with USD/CAD moving toward 1.26. Once the short-term undervaluation and oversold conditions are corrected, USD/CAD should rebound toward 1.40. Chart I-7We Like The CAD For Now, But The Rally Has A Limited Shelf Life EUR/SEK Will Trade Heavy Any which way we cut it, the SEK is cheap. The trade-weighted krona is trading at its cheapest levels relative to BCA's long-term fair value since the Great Financial Crisis (Chart I-8). The SEK is not only trading at a 32% discount to its purchasing-power parity against the greenback, it is also trading at a 10% discount against its PPP relative to the euro. Chart I-8The SEK Is An Attractive Long-Term Buy... The SEK is not only cheap on a long-term basis, it is also cheap on a short-term basis. This is most evident against the euro. Currently the SEK trades at a 7% discount to the euro according to our short term fair value model based on real rate differentials, commodity prices and global risk aversion. Historically, this kind of discount in the SEK has been followed by a prompt rebound (Chart I-9). Are there any catalysts to convert this good value into good returns? We see many. First, as was the case in Canada, Sweden's Monetary Gauge has not been at such easy levels since the Great Financial Crisis (Chart I-10). Meanwhile, the economy is also experiencing rising capacity pressures. The OECD's estimate of the output gap stands at 0.7% of GDP, and inflationary pressures are building, as evidenced by the Riksbank's Capacity Utilization measure (Chart I-11). Chart I-9...And A Short-Term One As Well Chart I-10The Riksbank Is Too Easy Chart I-11Swedish Inflation Has Upside This set of circumstances suggests the Riksbank could start hiking rates as early as this coming December, well ahead of the European Central Bank. As a result, we project that Swedish real interest rates could rise further relative to the euro area. Historically, falling euro area / Swedish real interest rate spreads precede depreciations in EUR/SEK (Chart I-12). Chart I-12Real Rate Differentials Point To A Lower EUR/SEK Chart I-13Chinese Liquidity Injections Point To A Lower EUR/SEK The global context also points toward an imminent correction in EUR/SEK. The krona is much more pro-cyclical than the euro. This reflects the more volatile nature of the Swedish economy and the extraordinarily large role of trade in its GDP. EUR/SEK greatly benefited from the tightening in Chinese liquidity conditions, as evidenced by the widening between the 1-month and 1-week Chinese interbank rate (Chart I-13). EUR/SEK essentially sniffed out a slowdown in Chinese capex, a key source of ultimate demand for Swedish goods. However, now that the PBoC is injecting liquidity in the Chinese interbank system, EUR/SEK is likely to suffer. Moreover, the outperformance of Chinese infrastructure and real estate stocks in recent weeks also suggests the SEK could appreciate further against the EUR. The rally of risk assets on the day that U.S. President Donald Trump announced an additional 10% tariff on US$200 billion worth of Chinese exports further confirms that investors may be in the process of discounting additional stimulus out of China, which would further hurt EUR/SEK. To be clear, we have already noted that we do not anticipate the Chinese authorities to attempt to boost growth - we only expect them to limit the damage created by an intensifying trade war with the U.S. As a result, the positive impact of China on the krona should prove transitory. But for the time being, it could be enough to help correct the SEK's 7% discount to the euro. Since we anticipate the USD to continue to correct in the coming weeks, this also implies that USD/SEK possesses ample tactical downside. This negative EUR/SEK view is not without risks. The first comes from the fact that the Swedish current account surplus is now smaller than the euro area's, something not seen since the early 1990s. This is mitigated by the fact that Sweden's net international investment position is now 10% of GDP, while it used to be negative as recently as 2015. The euro area NIIP is still in negative territory. The second risk is that Swedish house prices have begun to contract in response to macroprudential measures. However, we believe that Sweden's inflationary backdrop is likely to dominate the Riksbank's reaction function. Bottom Line: The SEK is cheap against the dollar and the euro on both long-term and short-term metrics. As the Riksbank is set to lift rates in December, we expect EUR/SEK to decline significantly. Recent injections of liquidity by the PBoC and growing expectations among investors of Chinese stimulus could create additional downward impetus under both EUR/SEK and USD/SEK. This is a tactical view. We anticipate the reprieve in the global growth slowdown to be temporary. Once it resumes, the SEK will find it difficult to rally further. JPY: Down Now, Up Later Investors are well aware that the yen is one of the cheapest G10 currencies on a long-term basis. BCA's long-term fair value model shows that the real trade-weighted yen is trading at a 17% discount, close to its cheapest levels in 36 years. However, despite its prodigious long-term cheapness, the yen is not nearly as attractive when compared to its short-term determinants, which show a small premium in the price of the yen versus the dollar (Chart I-14). This means the direction of Japanese monetary policy and global growth will remain more important for the yen's price action over the coming months than its long-term cheapness. When it comes to growth, Japan is doing okay. We witnessed a decline in industrial production driven by foreign demand this summer, but domestic machinery orders are improving and export growth is finding a floor. Actually, BCA's real GDP model for Japan is suggesting that growth could re-accelerate significantly next quarter (Chart I-15). In our view, this improvement reflects the fact that business credit is once again growing after decades of hibernation. Chart I-14Is The JPY A Bargain? Long Term, Yes; Short Term, No! Chart I-15Japanese Growth Doing Just Fine However, we doubt this is enough to prompt any tightening in the Bank of Japan's policy. The most immediate problem facing the BoJ is that Japanese inflation expectations are in free fall (Chart I-16). Since the BoJ assigns the blame of low realized inflation on depressed inflation expectations, this aforementioned weakness, despite the yen's softness, guarantees that the BoJ will stay on the sidelines for much longer. After all, if any little shock can spur such a sharp impact on Japanese inflation expectations, despite an unemployment rate at 2.5% and an output gap at 0.8% of GDP, the BoJ has not anchored inflation expectations higher. Further reinforcing our bias that the BoJ is not set to tighten policy for many more quarters, the VAT is set to be increased to 10% in October 2019. The LDP leadership race is currently underway, and no one is mentioning postponing that hike. This suggests that significant fiscal tightening could emerge next year. The fact that the BoJ will continue to lag behind other global central banks forces us to be negative on the yen. However, could an external event push the yen higher, despite this absence of domestic support? A big downgrade in EM asset prices and global growth would do the trick. While we do think this is likely to happen over the next six to nine months, now does not appear to be the moment to implement such a bet. As we highlighted above, the deceleration in global growth seems to be pausing, and Chinese liquidity conditions have eased. Seven weeks ago, we introduced our China Play Index to track whether or not investors were discounting additional easing on the part of China.3 This indicator looks as if it is forming a base right now (Chart I-17), indicating that pro-growth plays could perform well over the coming weeks while countercyclical plays, like the yen, could perform poorly. Until this indicator begins a new down leg - something we anticipate for the backend of the year - the yen will remain under downward pressure against the dollar, the euro or the aussie. Chart I-16The BoJ's Problem Chart I-17Chinese Plays Are Stabilizing As a result, while we continue to expect more upside in the yen in the latter part of the year, for the time being we will remain on the sidelines as neither short-term valuations, monetary policy dynamics or the global growth environment point to an imminent rally in the yen. Bottom Line: The yen is an attractive long-term play as it displays prodigiously cheap long-term valuations. However, the short-term outlook is less favorable. The yen is not cheap enough based on our augmented interest rate differentials models, the BoJ will remain dovish for the foreseeable future, and an uptick in our China Play Index bodes poorly for countercyclical currencies like the yen. However, since we do expect that global growth will stabilize only on a temporary basis, we will look to open some long yen bets later this fall. Close Short EUR/CHF Trade Last March, we argued that EUR/CHF had more cyclical upside, but that bouts of volatility in global markets would cause periods of weaknesses in the cross.4 Based on this insight, we proceeded to sell EUR/CHF on April 6 as we worried that markets were set to price in a period of weakness in global growth.5 We closed this trade in August, but EUR/CHF kept falling. Now, is EUR/CHF more likely to rally or selloff in the coming quarter? We think a rebound is in the cards. First, the franc is once again highly valued, based on the Swiss National Bank's assessment. It is true that the SNB has not intervened to limit the franc's upside recently, but the CHF's strength is likely to short-circuit the increase in inflation that could have justified betting on the Swissie moving higher (Chart I-18). Ultimately, there is limited domestic inflationary pressures in Switzerland. Moreover, since the import penetration of goods and services in Switzerland is the highest of all the G10, imported deflation will soon be felt. Further, as Swiss labor costs remain very high internationally, the large improvement in full-time jobs witnessed this year is likely to peter off as Swiss businesses work to maintain their competitiveness. Second, the franc received an additional fillip this year as the breakup risk premium in Europe surged (Chart I-19). Every time investors perceive that the probability of a disintegration of the euro rises, they end up pouring money into stable Switzerland. Marko Papic, BCA's Geopolitical Strategy expert, believes that the euro break-up risk will continue to be a red herring in the coming few years. Investors will therefore price out this risk, pulling money out of Switzerland where interest rates remain 30 basis points below the euro area, and boosting EUR/CHF in the process. Chart I-18The Swissie's Strength Will Be Deflationary Chart I-19If A Euro Break-Up Is A Red Herring... Finally, if a temporary stabilization in global growth will hurt the yen, it will also hurt the Swiss franc. As a result, the stabilization in the China Play Index should support EUR/CHF. While we expect EUR/CHF to rally over the coming months, we worry that any such rebound will prove temporary. The current expansion in Chinese stimulus is only a passing phenomenon, and not one powerful enough to put a durable bottom under global growth and EM assets. Hence, while EUR/CHF could easily rally to 1.15, any such rebound should be faded. This move, if followed by a deterioration in our China Play Index, should be used to re-open EUR/CHF shorts. Bottom Line: The Swiss franc remains in a cyclical bear market, punctuated by occasional rallies against the euro when global growth sentiment sours. We just experienced such a rally in the Swissie, but it is ending as the deflationary impact of the CHF's rally will soon be felt. Moreover, the breakup risk premium in the euro is currently too large, and the pricing-in of slowing global growth is likely to take a breather. As a result, EUR/CHF is likely rally over the coming months. We will look to bet again on a CHF rally once the reprieve in global growth ends. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergence Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Retail sales and retail sales ex autos yearly growth underperformed expectations, coming in at 0.1% and 0.3% respectively. Capacity utilization and building permits also surprised to the downside, coming in at 78.1% and 1.229 million respectively. However, Housing starts and the Michigan Consumer Sentiment Index surprised positively, coming in at 9.2% and 100.8 respectively. DXY has fallen by nearly 1% this week. Overall, we continue to be bullish on the dollar on a cyclical basis, as inflationary pressures inside the U.S. will force the Fed to hike more than the market expects. That being said, the slowdown in the dollar's momentum, the growing Chinese stimulus, and accumulating signs of stabilizing global economic activity are likely to further weigh on the dollar on a more immediate basis. We will monitor these factors closely in order to gauge whether or not this pullback will remain a garden-variety correction or something more serious. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been positive: Labor costs growth outperformed expectations, coming in at 2.2%. Moreover, construction output yearly growth also surprised positively, coming in at 2.6%. Finally, both core and headline inflation came in line with expectations, at 1% and 2% respectively. EUR/USD has rallied by 1.1% this week We are bearish on the cyclical outlook for the euro, given that core inflation measures are continue to be too weak for the ECB to meaningfully change their dovish monetary policy stance. However, the current tactical rebound is likely to continue, as the weakness in the euro this year has eased financial conditions, which could lead to a temporary boon for the economy. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Industrial production yearly growth surprised negatively, coming in at 2.2%. Moreover, capacity utilization also underperformed expectations, coming in at -0.6%. Finally, both export and import yearly growth outperformed expectations, coming in at 6.6% and 15.4% respectively. USD/JPY has been relatively flat this week. We are bearish on the yen on a structural basis, given that the economy continues to suffer from strong deflationary forces, which will force the Bank of Japan to keep their ultra-easy monetary policy. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: The retail price index yearly growth surprised to the upside, coming in at 3.5%. Moreover, both core and headline inflation outperformed expectations, coming in at 2.1% and 2.7% respectively. Finally, the DCLG House Price Index also surprised positively, coming in at 3.1%. GBP/USD has rallied by roughly 1.5% this week. The GBP's vol is likely to increase further going foirward, as very little political risks is priced into it. A practical strategy will be to lean against large weekly moves, both on the upside and downside. This strategy should be particularly profitable versus the euro. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: The participation rate surprised to the upside, coming in at 65.7%. Moreover, the total change in employment also outperformed expectations, coming in at 44 thousand. Finally, the house price index yearly growth also surprised positively, coming in at -0.6%. AUD/USD has risen by roughly 1.8% this week. We continue to be cyclically bearish on the Australian dollar, as the deleveraging campaign in China will weigh on demand for industrial metals, Australia's main export. Moreover, the AUD will also have downside against the CAD, as oil should continue to hold up relative to other commodities thanks to supply cuts from OPEC. That being said, the AUD's recent rebound is likely to continue on a short-term basis. Hence, investors already shorting the Aussie should consider buying hedges. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied nearly 1.9% this week. We are negative on the New Zealand dollar on a structural basis due to the measures taken by the Ardern government, which include reducing immigration, and adopting_a dual mandate for the RBNZ. Both of these measures will weigh on the real neutral rate, which means that the RBNZ will have to hold rates lower than otherwise. However, on a more tactical basis, this cross could rally, thanks to the temporary stimulus by the Chinese authorities which will help risk assets. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Manufacturing shipments monthly growth outperformed expectations, coming in at 0.9%. However, capacity utilization surprised to the downside, coming in at 85.5%. Finally, the new house price index yearly growth was in line with expectations, coming in at 0.5% USD/CAD has depreciated by 1% this week. We remain bullish on the CAD among the dollar bloc currencies, given that inflationary pressures continue to be strong in Canada. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has rallied by 0.5% this week. We continue to be bullish on this cross on a cyclical basis, as the Swiss economy is still too fragile for the SNB to remove its ultra-dovish monetary stance. Moreover, the recent appreciation in the franc that has taken place over the last four months should be very negative for inflation, as Switzerland is the country with the most imports as a percentage of demand in the G10, and thus the country with the most sensitive inflation to currency movements. Finally, on a tactical basis we are also bullish on this cross, as the recent easing of monetary policy by Chinese authorities should be weigh on safe heaven assets like the franc. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Yesterday, Norges Bank increased rates for the first time since 2011, yet the NOK was flat against a weak USD, and fell against the euro and the Swedish krona, suggesting that the hike was well anticipated by market participants. Despite this price action, USD/NOK has depreciated by 1.2% this week. We are positive on the NOK against other non-oil commodity currencies, as oil should outperform base metals in the current environment. After all, OPEC supply cuts and geopolitical risk in the Middle East should provide a boon for oil prices. On the other hand, while temporary easing is likely, the Chinese deleveraging campaign will continue once the Chinese economy has stabilized. Finally, the positive NIIP, and positive current account of the NOK should give it an additional advantage against the rest of the commodity currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Headline inflation underperformed expectations, coming in at 2%. Moreover, the unemployment rate increased from 6% in July to 6.1% on the August reading. USD/SEK has depreciated by almost 2.8% this week. We expect the Riksbank to begin tightening policy in December, as Swedish inflationary pressures remain strong. Moreover, the recent stimulus from the PBoC should put additional downward pressure on EUR/SEK, given the krona's more pro-cyclical profile than the euro. Finally, valuations also support the SEK, as the krona is cheap according to multiple measures. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. The message now conveyed by the Monitors is that divergences between the cyclical pressures faced by the individual central banks are growing larger. This is occurring within some countries, where the growth and inflation indicators are trending in opposite directions. This is also visible across countries, with not every Monitor calling for rate hikes - a significant shift from the coordinated backdrop seen in 2017 (Chart of the Week). Chart of the WeekFrom Convergence To Divergence In The BCA Central Bank Monitors The combined message from the Monitors is that the slower pace of global growth seen in 2018 has not been enough put a serious dent in inflation pressures stemming from a dearth of spare capacity in most major countries. Perhaps that changes if a full-blown U.S.-China trade war develops, or if the tensions in emerging markets spill over more broadly into global financial conditions, but that remains to be seen. Add it all up, and a below-benchmark stance on overall global duration exposure remains appropriate. Feature An Overview Of The BCA Central Bank Monitors Chart 2CB Monitor Divergence = Bond Yield Divergence The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Our current recommended country allocation for global government bonds reflects the trends seen in the Central Bank Monitors - underweighting countries were the Monitors are most elevated (the U.S., Canada) in favor of regions where the Monitors are lower (Australia, Japan, euro area, New Zealand). In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the Monitors plotted against the relative returns for each country versus the overall Bloomberg Barclays Global Treasury index (shown inversely in the charts so that a rising line means underperformance versus the benchmark index). Fed Monitor: Still On A Gradual Rate Hike Path Our Fed Monitor remains in the "tight money required" zone, signalling that the cyclical backdrop justifies additional Fed rate hikes (Chart 3A). Resilient U.S. growth, a dearth of spare capacity and an acceleration of both wage growth and core inflation are all consistent with a U.S. economy starting to overheat and requiring tighter monetary policy (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BU.S. Inflation On The Rise The growth and inflation components of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published back in April. Most notably, the inflation component has blasted through the zero line to the highest level since 2008 (Chart 3C). The financial conditions component has retreated from very elevated (i.e. growth-supportive) levels, mostly due to the stronger U.S. dollar but also because of wider corporate credit spreads seen since the start of 2018. Importantly, the financial conditions component has not tightened enough to offset the impact on the Monitor from faster growth and inflation. Chart 3CAll Fed Monitor Components Now Above Zero Recent comments from senior Fed officials (Chair Jay Powell and Governor Lael Brainard) have indicated that the Fed is less confident in its own estimates of the full-employment NAIRU or the appropriate neutral level of the funds rate. Our read on this is that the Fed will instead continue to raise the funds rate at a gradual 25bp per quarter pace until there are signs that U.S. monetary policy has become tight (i.e. an inverted yield curve, wider credit spreads, softer U.S. economic data). Until then, the message sent by the Fed Monitor is to remain underweight U.S. Treasuries with below-benchmark duration, as market pricing of expectations for both the funds rate and inflation remain too low (Chart 3D). Chart 3DU.S. Treasury Underperformance Will Continue - Stay Underweight BoE Monitor: Brexit Uncertainty Trumps Inflation Pressures The BoE Monitor remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has kept monetary policy at highly accommodative levels, only raising the base rate 50bps over the past year. The BoE Monetary Policy Committee remains torn between signs that inflation risks are tilted to the upside and the downside risks to U.K. growth from an uncertain Brexit outcome. The U.K. unemployment rate is well below NAIRU with an output gap that is now estimated to be closed (Chart 4B). Yet realized inflation has peaked, with core inflation drifting back below 2%. Wages are finally starting to grow in real terms, which the BoE cites as an important factor underpinning consumer spending, but the pace remains modest. Chart 4AU.K.: BoE Monitor Chart 4BNo Spare Capacity, Yet Has Inflation Peaked? Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator have recently reaccelerated (Chart 4C). Yet U.K. leading economic indicators continue to decline and dampened business confidence measures reflect the heightened uncertainty over the future relationship between the U.K. and the European Union. Chart 4CBoth Growth & Inflation Components Are Boosting The BoE Monitor The performance of U.K. Gilts has diverged from the Monitor since the 2016 Brexit vote (Chart 4D), as the BoE has been more worried about Brexit than inflation and has stayed accommodative. Stay overweight U.K. Gilts within global government bond portfolios, even with the more bearish signal implied by our BoE Monitor, given the weakening trend in leading economic indicators and persistent Brexit uncertainty. Chart 4DBrexit Uncertainty Preventing More BoE Hikes - Stay Overweight Gilts ECB Monitor: No Pressure To Hike Rates Quickly Post-QE Our European Central Bank (ECB) Monitor has fallen sharply since we last published this Chartbook back in April, and it now sits below the zero line (Chart 5A). The growth deceleration in the first half of the year from the rapid pace seen in 2017 is the main reason for this move, as inflation pressures have not subsided (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEuro Area At Full Capacity ECB President Mario Draghi noted last week that the plan remains in place to end the net new buying phase of the ECB's Asset Purchase Program at the end of 2018. Policymakers' have grown more confident that their inflation forecasts will be met as most measures of euro area wage growth (and headline inflation) have accelerated to 2% over the past year. It remains to be seen if those expectations are too optimistic, as the growth component of our ECB Monitor remains well below the zero line, while the inflation component is no longer rising (Chart 5C). Chart 5CGrowth Component Dragging Down The ECB Monitor For now, we recommend a neutral stance on core euro area government bonds with an underweight posture on Peripheral sovereign debt as a way to manage these conflicting trends. The overall performance of euro area bonds versus global benchmarks has followed the pace of the ECB's bond-buying since 2015, and not the pressures suggested by our ECB Monitor (Chart 5D), suggesting a bearish stance as the bond buying ends. Yet from a more bullish perspective, the mixed message on growth and lack of immediate pressures on core inflation (still at 1%) imply that the ECB will not deviate from its current dovish forward guidance of no interest rate hikes until at least September 2019. Chart 5DECB Will Not Hike Rates Quickly After QE Ends - Stay Neutral Core European Bonds BoJ Monitor: Too Soon To Consider Policy Changes Our Bank of Japan (BoJ) Monitor has stayed just barely in the "tighter money required" zone since last October, due mostly to growing inflation pressures (Chart 6A). Yet with the Japanese labor market now as tight as it has been in decades, headline and core CPI inflation are only at 0.9% and 0.3% respectively, well below the BoJ's 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Chart 6BInflation Pressures Slowly Building In Japan Japanese firms appear to finally be reacting to the tightness of the labor market, however, as wage growth has accelerated in recent months. The pick-up in wages has helped boost inflation expectations, both of which are part of the inflation component of the BoJ Monitor that is now at the highest level since 2008 (Chart 6C). However, the growth component just rolled over and now sits at the zero line, as the Japanese economy has lost some momentum. Chart 6CInflation Boosting BoJ Monitor We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings - especially compared to the rest of the developed markets - until there is much higher realized inflation in Japan. JGBs have indeed been outperforming over the past year, even with the less dovish signal sent by the BoJ Monitor (Chart 6D). Yet the absolute level of the Monitor remains around zero, suggesting that no policy changes should be expected. That means no upward adjustment of the BoJ's 0% yield target on 10-year JGBs or major further reductions in the annual pace of BoJ JGB buying (even though the central bank is hitting capacity constraints as it now owns close to ½ of all outstanding JGBs). Chart 6DBoJ In No Hurry To Turn Hawkish - Stay Overweight JGBs BoC Monitor: Rate Hikes - More To Come The Bank of Canada (BoC) Monitor has stayed in "tighter money required" since the beginning of 2017 and is now well above the zero line (Chart 7A). The BoC has been following our BoC Monitor, hiking rates by a cumulative 100bps since July 2017. Chart 7ACanada: BoC Monitor Chart 7BAn Overheating Canadian Economy? The BoC has been responding to the growing inflation pressure in Canada. There is no evidence that spare economic capacity exists, while realized inflation is near the upper bound of BoC's target range of 1-3% (Chart 7B). There is a growing divergence between the growth and inflation subcomponents of the BoC Monitor, with the latter decelerating over the past several months. That was due to a combination of slowing Chinese import demand and the imposition of trade tariffs on Canada by the Trump administration (Chart 7C). Yet the domestic economy remains in good shape, with the overall indicator from the BoC's Business Outlook Survey at the highest level since 2010. Chart 7CInflation Component Boosting BoC Monitor We continue to recommend an underweight stance on Canadian government bonds, as the relative performance has broadly followed the path of the BoC Monitor over the past three years (Chart 7D). The BoC tends to follow the policy actions of the Fed with a short lag, thus our bearishness on Canadian government bonds is related to our more hawkish views on the Fed. Yet the surge in Canadian inflation, at a time when the economy has no spare capacity, suggests that there are good domestic reasons to expect more rate hikes from the BoC over the next year than what is currently discounted by markets. Chart 7DBoC Not Done Yet - Stay Underweight Canadian Bonds RBA Monitor: Easier Policy Needed The Reserve Bank of Australia (RBA) monitor has rapidly fallen below the zero line for the first time since 2016, and now indicates that easier monetary policy is required (Chart 8A). This stands out from the more stable trajectory of the rest of the BCA Central Bank Monitors. Unlike most other developed countries, there is still excess capacity in the Australian economy. Australia's output gap has not closed while the current unemployment rate is just at the OECD's NAIRU estimate of 5.3%. Headline and core inflation are at the low end of the RBA's 2-3% target and struggling to gain much upward momentum (Chart 8B). Chart 8AAustralia: RBA Monitor Chart 8BMinimal Inflation Pressure In Australia While both the growth and inflation components of the RBA Monitor have fallen, the biggest decline has come from the inflation side (Chart 8C). The sluggishness of Australia's economy is due to the slow growth of consumer spending and a big deceleration in exports related to softer Chinese demand. On inflation, excess labor market slack, with an underemployment rate close to 8.5%, is the main factor explaining soft wage growth and overall sluggish inflation. Chart 8CInflation Component Weighing On RBA Monitor Our highest conviction country allocation call this year has been to overweight Australian Government bonds, and we see no need to change that given the bullish signal from our RBA Monitor (Chart 8D). It would likely take a rise in unemployment, a renewed decline in realized inflation or a big external shock for the RBA to actually cut rates as our Monitor suggests, but the signal is still bullish for Australian debt on a relative basis. Chart 8DRBA A Long Way From A Hike - Stay Overweight Australian Government Bonds RBNZ Monitor: Policy On Hold For A While Longer The Reserve Bank of New Zealand (RBNZ) Monitor is currently just above the zero line, indicating that tighter monetary policy is required (although just barely) (Chart 9A). This is consistent with the mixed messages in the New Zealand economic data. For example, there is no spare capacity in the economy according to estimates of the output and employment gaps, yet both headline and core inflation have decelerated to the lower end of the RBNZ's 1-3% target band (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor Chart 9BNo Spare Capacity In NZ, But No Inflation Either Looking at the components of the RBNZ Monitor, the growth factors have continued to plunge whereas the inflation factors have been increasing (from below zero) since the start of 2018 (Chart 9C). New Zealand's economic growth has slowed because of softer consumer spending and weaker housing activity, the latter of which is related to lower net immigration. Yet business confidence is falling, both the manufacturing and services PMIs have also declined, and export growth has cooled thanks to weaker growth from China and Australia. Meanwhile, the uptick in the inflation components has not yet translated into any broader improvement in realized inflation that would cause the RBNZ to take a more hawkish turn. Chart 9CConflicting Trends Within The RBNZ Monitor We continue to recommend an overweight stance on New Zealand Government Bonds, in line with the bullish signal sent by our RBNZ Monitor (Chart 9D). The RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will stay unchanged until 2020, and it will take some time before there is evidence that the recent hook down in inflation is nothing more than a temporary blip. Chart 9DRBNZ To Remain On Hold - Stay Long New Zealand Bonds Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Two key issues will remain important drivers of global financial markets in the coming quarters: the direction of the dollar and Chinese policy stimulus. Policy and growth divergences will remain tailwinds for the dollar and there is little the Trump Administration can do to reverse the upward trend. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon. Expect more EM fireworks. EM market turmoil could pause the Fed's tightening campaign, but this would require evidence that the U.S. economy and/or financial markets are being negatively affected. Chinese stimulus is a risk to our base-case outlook. A growth impulse might keep the RMB from weakening further, boost commodity prices and support EM exports. However, we believe that Chinese stimulus will not be a 'game changer', and might even cause more problems if the authorities push the RMB lower. The U.S. economy and financial system are less exposed to emerging markets than in the Eurozone. An excellent profit backdrop also provides U.S. risk assets with a strong tailwind. Nonetheless, the U.S. is not immune to EM woes. Poor valuation implies a meaningful correction in U.S. risk assets on any flight-to-quality event. Stay cautious on asset allocation. Fed Chair Powell is willing to wait for the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Evidence of labor market overheating is accumulating. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. We believe that investors are underestimating the upside in U.S. inflation risks over the medium term. We recommend below-benchmark duration, although government bonds would temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Japanese corporate profits have been stellar, but that will soon change. EPS growth is likely to soften in the Eurozone too. Favor the U.S. market in unhedged terms. Feature There are numerous key issues on the investment landscape, but two stand out at the moment because they both have wide-ranging global implications: (1) Will the U.S. dollar continue to appreciate; and (2) Will Chinese policymakers place structural reform on the back burner and 'go for growth' in the near term? The latest U.S. economic and profit data provide a strong tailwind for American risk assets. Nonetheless, the mighty U.S. dollar is casting a dark shadow over the heavily-indebted emerging market economies, sparking comparisons with the late 1990s. Could Turkey be the start of a 'domino' effect, similar to Thailand's plunge into financial crisis in 1997 that eventually spread to Brazil and Russia, and finally contributed to the demise of Long-Term Capital Management in the fall of 1998? On the global growth front, the story has not changed much from our assessment last month. Growth is solid, but slowing, in part due to a deceleration in developed-economy capital spending. The global expansion has become less synchronized and relative growth dynamics are pointing to more upside for the greenback (Chart I-1). Chart I-1Cyclical Divergence Is Still Dollar Bullish As in the late 1990s, the Fed is likely to ignore turbulence in EM financial markets and will continue on its tightening path until it begins to affect the U.S. economy or asset prices. The path of least resistance for the dollar is up until something breaks. A major policy impulse from China could alter the feedback loop between the strengthening dollar and EM asset prices. A growth pickup would lift China's imports and commodity prices, both of which would support emerging market economies and asset prices. There is plenty of uncertainty regarding the size of the recently-announced Chinese stimulus measures, but our take is that they are likely to underwhelm because a major growth push would undermine the authorities' structural initiatives. The implication is that the global backdrop will remain unfriendly to emerging market assets at a time when they are more vulnerable than the consensus believes. The risk of a financial accident is escalating. The good news is that the U.S. earnings picture remains excellent, which precludes us from being underweight on risk assets. Nonetheless, investors should have no more than a benchmark allocation to equities and corporate bonds in the major advanced economies. We are upgrading government bonds to neutral at the expense of cash on a tactical basis, to reflect the rising possibility of a global flight-to-quality. The First Domino Turkey has had all the hallmarks of a crisis for a long while. Erdogan's slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. The central bank has been forced to provide large injections of liquidity into the banking system, despite double-digit inflation readings. The country suffers from a classic "twin deficit" problem. Turkish private sector external debt stands at 40% of GDP, of which 13% of GDP is short-term, the highest among EM countries. Erdogan wants economic growth at all costs, but has done little in terms of the structural reforms necessary to lift the country's growth potential. The Lira has lost almost 26% of its value versus the dollar since August 1 and Turkish spreads have blown out. It appears that a lot of bad news has been discounted, but our EM strategists do not see this as a buying opportunity. One risk is that Erdogan imposes capital controls next. Our emerging market team's long held caution on EM is rooted in concern for failing fundamentals.1 They emphasize that Turkey was the catalyst, not the main cause, for the broader financial stress observed across EM assets in August. BCA has highlighted for some time that EM debt is a ticking time bomb. Chart I-2 shows that EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports. Chart I-3 highlights the most vulnerable EM economies in terms of the foreign currency funding requirement, and the foreign debt-servicing obligation relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart I-2Debt Makes EM Vulnerable Chart I-3EM Debt Exposure In all previous major EM selloffs, any decoupling between different EM regions proved to be unsustainable. And it certainly does not help that the Fed remains on its tightening path; EM equities usually fall when U.S. financial conditions tighten (Chart I-4). The combination of a strong dollar and weak RMB is a deadly combination for highly-indebted emerging market economies. Chart I-4EM Highly Sensitive To U.S. Financial Conditions... Investors should expect contagion to intensify. China To The Rescue? Some investors are hoping that China will 'save the day' by providing a major dose of policy stimulus, as it did in 2015, the last time that EM was close to a tipping point. We doubt China will be able to play the same stabilizing role. The Chinese authorities are committed to their long-term structural goals. They have been trying to reorient the economy toward consumption and away from investment and exports, as well as undertake other reforms to reduce financial risk, pollution, poverty and corruption. China kept policy on the tight side until recently, which resulted in a gradual growth slowdown. The Li Keqiang index (LKI) is a good coincident indicator for economic growth (Chart I-5). This index has ticked up in recent months, along with imports, but this likely reflects industrial activity designed to fill foreign orders before the new U.S. tariffs take effect. Our LKI model, based on money and credit, points to further economic weakness ahead. Chart I-5China: Watch Credit And Fiscal Impulse The escalation of the trade war with the U.S. is forcing the Chinese authorities to provide some short-term policy stimulus in order to pre-empt any resulting economic damage. A flurry of policy announcements over the past month has given investors the impression that Beijing has cranked up the policy dial, including cuts to short-term interest rates, a decrease in reserve requirements, liquidity provision to the banking system, and promises of various forms of fiscal stimulus. Chinese stimulus has historically been positive for commodity prices and EM assets. However, we are less sanguine this time. First, the authorities are not abandoning structural reforms, which means that the associated growth headwinds will not disappear. Second, our China experts believe that Chinese policy is only turning moderately reflationary; this is not the 'big bang' that followed the Great Recession in the late 2000s, or the same level of stimulus provided following the 2015-16 global manufacturing downturn. There will no doubt be some fiscal stimulus, but we do not expect a major expansion in bank credit to the private sector because of the government's crackdown on shadow banking, excessive leverage and growing non-performing loans. The change in the policy stance amounts to 'taking the foot off the brake' rather than pressing firmly on the accelerator.2 Third, and perhaps most importantly, the authorities may rely even more on the currency lever to do the heavy lifting if the economy continues to slow and/or the tariff war escalates further. This would be negative for commodity demand because a weaker RMB will make commodities dearer for Chinese producers. Metals prices are particularly at risk. China's competitors will also feel the sting of a cheaper RMB. It will be critical to watch the Chinese money and credit data in the coming months to gauge whether our view on the policy stimulus is correct. We will also be watching the combined credit and fiscal impulse which, at the moment, points to continued weakening in import growth in the near term (Chart I-5, bottom panel). Slower EM growth and/or more financial market turbulence is likely to take a larger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks (Chart I-6). Notably, Spanish banks - BBVA in particular - has sizable exposure to Turkey. Meanwhile, Italian assets have come under pressure as the rift between the European Commission and the new populist government widens and Italian banks become increasingly wary of financing their government. Chart I-6DM Bank Exposure To EM European growth will therefore likely continue to trail that of the U.S. Our base case does not see euro area growth falling below a trend pace in the coming quarters, but relative growth momentum and the ongoing policy divergence will favor the dollar over the euro. FOMC: No Urgency The key message from the latest FOMC Minutes and Chairman Powell's Jackson Hole speech is that policymakers are sticking with the "gradual" approach to tightening, despite the late-cycle acceleration in economic growth. The blowout second-quarter GDP report supports the view that fiscal stimulus is stoking the economy at a time when there is little slack. Evidence that the labor market is overheating is not simply anecdotal anymore. In past cycles, an acceleration in growth at a time when inflation is already at target and unemployment is below estimates of full employment would have sparked aggressive Fed action. But the Minutes and Powell's speech revealed no sense of urgency. Powell made the case that the Fed must proceed carefully in an environment where there is much uncertainty about the level of the neutral policy rate, the natural rate of unemployment and the slope of the Phillips curve. Moreover, long-term inflation expectations are still hovering below a level that is consistent with meeting the 2% target over the medium term. Some FOMC policymakers believe that this fact justifies taking chances with an inflation overshoot in the coming quarters. Another reason for the FOMC to proceed cautiously is the wage picture, which is confusing even to economic experts because the official measures paint a mixed picture (Chart I-7). The Employment Cost Index for private sector workers continues to march higher. However, growth in compensation per hour, average hourly earnings (AHE) and unit labor costs have all eased a little this year. The Atlanta Fed Wage Tracker, one of the cleanest measures of wages, reveals an even more significant pullback. The softening in wage growth has been fairly widespread across age cohorts, educational attainment and regions, according to the Atlanta Fed data (Chart I-8). Part-time workers appear to be the only segment that has bucked the trend. It is not clear why workers in the 16-24 age group, as well as those with bachelor's degrees (of any age), have seen the most pronounced softening in wage growth this year. Chart I-7Mixed U.S. Wage Data Chart I-8U.S. Wage Slowdown Broadly-Based Which measure is telling the correct story: the ECI or the Atlanta Wage Tracker? Both are a relatively clean measure of wages and it is difficult to tell based on the relative merits of each index alone. Nonetheless, there is little doubt that the labor market is now very tight by historical standards. Small business owners' compensation plans remained near record levels in July, while concerns about the "quality of labor" have never been higher (Chart I-9). Chart I-10 shows that the ratio of the level of job openings to unemployed workers has surpassed the pre-recession level in all but one sector according to the Jolts survey. Indeed, in most cases this ratio is well above the previous peak. Unemployment is now below the estimated level of full-employment in more than 80% of U.S. states. Chart I-9U.S. Labor Shortage Is Growing Chart I-10JOLTS Signals Very Tight Jobs Market No Evidence Of U.S. Overheating? Labor shortages first appeared for skilled workers, helping to explain why highly-skilled workers have enjoyed the fastest wage gains in recent years. But this year's Fed Beige Books have noted that many businesses are now having trouble finding low- and middle-skilled workers, as listed in Table I-1. These industries roughly line up with the ones that reveal above-average growth in average hourly earnings, and with the ones where labor market tightness is the most acute according to the Jolts survey (second and third columns in the table). The shortages appear to be broadly based, ranging from truck transportation to financial services, manufacturing and construction. This makes it all the more curious that Chairman Powell finds that there is no evidence of overheating in the labor market. The evidence seems pretty conclusive to us and it even features in the Fed's own Beige Book. Keep in mind that inflation is not always the 'cost push' type, beginning in the labor market and traveling to consumer prices. Sometimes inflation can begin in the market for goods and services, and then affect wage demands. U.S. consumer price inflation appears to be headed higher based on the New York Fed's Underlying Inflation Gauge (Chart I-11). Our CPI diffusion index shows that inflation is accelerating in a majority of categories. Other measures of underlying inflation, such as the Sticky Price Index, the Trimmed Mean, and the Median inflation rate are all in a solid uptrend. Dollar strength this year will eventually put downward pressure on core goods inflation, but that will take some time; non-energy goods inflation is more likely to rise in the near term as it catches up to the previous acceleration in imported goods prices (Chart I-11, bottom panel). Table I-1Labor 'Shortages' Identified In The Beige Book Chart I-11U.S. Underlying Inflation Is Rising U.S. Inflation To Surprise On Upside We believe that the market is underestimating the risk of a meaningful inflation overshoot over the medium term. Investors still do not believe that the Fed will be able to consistently meet the 2% target over the long-term, based on CPI swaps and TIPS breakeven rates. BCA's Chief Global Strategist, Peter Berezin, penned a two-part Special Report in August on the potential for upside inflation surprises over the coming years.3 First, increasing political pressure on the major central banks is worrying. Second, policymakers are coming around to the idea that there may be an exploitable trade-off between higher inflation and lower unemployment. This was a mistake last made in the inflationary 1970s. Finally, the pressure to keep monetary policy accommodative until the "whites of the eyes" of inflation are visible will remain strong. Bonds are in for some trouble if we are correct on the inflation outlook. We recommend that investors with a 6-12 month investor horizon remain short in duration and overweight TIPS versus conventional Treasurys. That said, we cannot rule out a flight-to-quality episode at some point, possibly reflecting trade tensions and/or EM turmoil, which would send Treasury yields temporarily lower. The Fed may be forced to place rate hikes on hold if financial conditions tighten too quickly. No Margin Peak Yet In The U.S.... The S&P 500 was unfazed by the turmoil in emerging markets and the re-widening in Italian bond spreads in August, likely because of continuing good news on the profit front. Corporate earnings remained in a sweet spot in the second quarter. Nominal GDP grew by a whopping 5.4% from a year ago, helping to boost the top line for the corporate sector. The lagged effect of previous dollar depreciation is still flattering earnings, although this only accounts for about two percentage points according to our model (Chart I-12). Meanwhile, equity buybacks have kicked into overdrive (Chart I-13). Chart I-12U.S. Dollar Impact On EPS Growth Chart I-13U.S. Equity Buyback In Overdrive Margins continued their impressive ascent in the second quarter to well above the pre-Lehman peak (Chart I-14). A lot of the increase is related to the tax cuts; EBITDA margins are still substantially below the 2007 peak according to the S&P data. It is disconcerting that all of the surge in S&P 500 margins is due to the Tech sector (Chart I-14, bottom panel). Excluding Tech, S&P after-tax margins have simply moved sideways since 2010. Looking ahead, the tailwind from previous dollar depreciation will shift to a headwind by mid-2019. Chart I-12 shows that the contribution from changes in the dollar to EPS growth will shift from a positive two percentage points to a drag of 1½ percentage points if the dollar is flat from today's level in broad trade-weighted terms. If the dollar rises by another 5% this year, then next year's drag on EPS growth will reach three percentage points. Moreover, the impact of the tax cuts on after-tax profits will fade next year. Wage pressures are building and this should eventually squeeze profit margins. That said, a margin peak does not appear to be imminent. Last month we introduced some macro indicators for profit margins (Chart I-15). Most appeared to be rolling over a month ago, but they have all since ticked up. Chart I-14Tech And Taxes Driving Profit Margins Chart I-15U.S. Margin Indicators Have Turned Up The bottom line is that we continue to expect a mean reversion in U.S. profit margins in the coming years, but this is not a risk for at least the rest of 2018. ...But Profit Outlook Darkening In Japan Second quarter earnings season was also a good one for Japanese companies. Twelve-month forward earnings estimates have been in a steep incline and margins have been rising (Chart I-16). Despite this, the Nikkei has only managed to move sideways this year in local currency terms. Concerns over trade and global growth have perhaps weighed on Japanese stock performance. Company profits have a high beta with respect to global growth. Things are looking shaky on the domestic front too. Domestic demand growth is decelerating, consistent with a weakening Economy Watcher's Survey. Some of the weakness may be related to poor weather, but the LEI suggests that this trend will continue in the coming quarters (Chart I-17, bottom panel). Chart I-16Japan: Trailing Earnings Are Solid... Chart I-17...But Profit Margins Will Narrow Chart I-17 presents some of the variables that have helped to explain historical trends in Japanese EPS. Industrial production growth, a good proxy for top line growth, is decelerating. Nominal GDP growth has fallen to just 1.1% year-over-year, at a time when total labor compensation has surged by more than 4%. The difference between these two, a proxy for profit margins, has therefore plunged. Previous shifts in the yen have not had a large impact on EPS growth over the past year and we do not expect that to change much in 2019. On a positive note, Japanese stocks are attractively valued now that the 12-month forward P/E ratio has fallen below 13 (Chart I-16, bottom panel). It is also constructive that the Bank of Japan is the only central bank that is not backing away from monetary stimulus. The recent widening of the trading band for the 10-year JGB yield was a technical change meant to give the central bank more flexibility, not a signal that policymakers are planning to change tack. Nonetheless, we believe that earnings growth and margins will disappoint market expectations over the next year. The story is much the same for the Eurozone. Both trailing and forward profit margins have been in a strong uptrend. Twelve-month forward EPS growth has been holding at a solid 9%. Nonetheless, the data that feed into our Eurozone profit model point to some softening ahead, including industrial production and the difference between nominal GDP and the aggregate wage bill (not shown). The Eurozone's credit impulse turned negative even before concerns about EM and Italian politics exploded onto the scene. Thus, home-grown profit generation is likely to moderate along with foreign-sourced earnings. For the moment, the BCA House View remains at benchmark on Japanese and Eurozone stocks in currency-hedged terms. In unhedged terms, we prefer the U.S. market to these other bourses because of our bullish dollar bias. Investment Conclusions: Two key issues will remain important drivers of global financial markets in the coming months and quarters: the direction of the dollar and Chinese policy stimulus. We believe that the U.S. dollar has additional upside potential due to growth and policy divergences. There is some speculation in the financial community that President Trump might resort to currency intervention. However, any intervention would be sterilized by the Fed. The only way to shift currencies on a sustained basis would be to organize a coordinated change in monetary or fiscal policies among the U.S. and its main trading partners. This is highly unlikely. Thus, the path of least resistance is up for the U.S. dollar. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon because high debt levels make these economies vulnerable to any weakness in global growth, commodity prices or global liquidity conditions. EM financial market turmoil could cause the Fed tightening campaign to go on hold, but this would require evidence that the former is negatively affecting the U.S. economy and/or financial markets. In other words, we need to see some pain before the Fed blinks. Chinese stimulus is a risk to our base-case EM outlook. Policy stimulus might keep the RMB from weakening further, boost commodity prices and support EM exports. This would not change the EM debt situation, but would at least give emerging economies a temporary reprieve. Careful analysis suggests that Chinese stimulus will not be a 'game changer', and might even cause problems if the authorities push the RMB lower. But it will be critical to monitor the next couple of money and credit reports. The U.S. economy and financial system are less exposed to further EM turmoil than in the Eurozone. But as the LTCM event demonstrated in 1998, the U.S. is not immune. Moreover, U.S. equity prices are more expensive than they were during previous EM selloffs that have occurred since the Great Recession. This could mean a larger equity re-rating on any flight-to-quality. This is not to say that we expect a bear market in DM risk assets to get underway in the near future. A U.S./global recession before 2020 is unlikely. Nonetheless, the risk of a meaningful correction is elevated enough that caution is warranted, especially at a time when all risk assets appear expensive. Chart I-18 updates our valuation measures for some major asset classes. All appear to be expensive, especially U.S. equities, raw materials and gold. EM sovereigns and equities are at the cheaper end of the spectrum, but are still not cheap in absolute terms even after the recent selloff. Chart I-18Major Asset Valuation Comparison Treasurys rallied briefly after Chairman Powell signaled that he is not willing to accelerate the pace of rate hikes in light of the U.S. economy's growth acceleration. He is willing to wait until he sees the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. Over the medium term, we believe that investors are underestimating the upside in U.S. inflation risks. We recommend below-benchmark duration, although bonds may temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Finally, as we go to press, the U.S. is trying to force Canada to sign on to the U.S./Mexico 'agreement in principal' by August 31. A framework deal with Canada would likely leave many tough issues unresolved. There is also a chance that Canada misses the deadline and that the existing trilateral deal will not survive. It is technically possible that Canada's refusal to join the U.S.-Mexico bilateral deal will delay its ratification well into next year. In the meantime, Trump could raise the stakes for Canada by boosting tariffs on Canadian autos and/or by suspending NAFTA altogether. As a result, we decided to go ahead and publish our Special Report on U.S. equity sector implications if NAFTA is not ratified and tariffs rise to WTO levels. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst August 30, 2018 Next Report: September 27, 2018 1 Please see BCA Emerging Market Strategy Weekly Report "What's Really Driving The EM Selloff?"dated June 28, 2018, available on ems.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report "China is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available on cis.bcaresearch.com 3 Please see BCA Global Investment Strategy Special Reports: "1970s-Style Inflation: Could It Happen Again? Parts I and II," dated August 10 and 24, 2018, available on gis.bcaresearch.com II. What If NAFTA Is Not A Done Deal? U.S. Equity Implications This Special Report examines the impact of a NAFTA cancelation on 21 level-three GICs industries. While the latest news on the NAFTA renegotiation with Mexico is positive as we go to press, there is still a non-negligible risk that the existing trilateral deal will not survive. The U.S.-Mexico bilateral deal is an "agreement in principle" and will take time to ratify. Meanwhile, a framework deal with Canada would leave many thorny issues to be resolved. President Trump can still revert to his tough tactics on Canada ahead of the U.S. mid-term elections. If the President does not gain major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base. The probability of Trump triggering Article 2205 and threatening to walk away from the suspended U.S.-Canada free trade agreement is still not trivial, despite the deal with Mexico. By itself, the cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved (especially Autos). We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and input cost exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. While the latest news on the renegotiation of the North American Free Trade Agreement (NAFTA) is positive as we go to press, there is still a non-negligible risk that President Trump could revert to his tough tactics ahead of the U.S. mid-term elections.1 Even if Canada signs on to a framework deal, a lot of thorny details will have to be worked out. A presidential proclamation triggering Article 2205 of the NAFTA agreement (as opposed to tweeting that the U.S. will withdraw) would initiate a six-month "exit" period. Trump could use this deadline, and the threat of canceling the underlying U.S.-Canada FTA, to put pressure on Canada (if not Mexico) to concede to U.S. demands, just as he could revoke his exit announcement anytime within the six-month period. While some market volatility would ensue upon any exit announcement, even a total withdrawal at the end of the six months would have a limited macro-economic impact as long as the U.S. continued to respect its WTO commitments and lifted tariffs only to Most Favored Nation (MFN) levels. Nonetheless, a modest tariff hike is not assured given the Administration's "America First" policy, its looming threat of Section 232 tariffs on auto imports, its warnings against the WTO itself, and the steep tariffs it has already imposed on Canada, including a 20% tariff on softwood lumber and the 300% tariff on Bombardier CSeries jets. Moreover, even a small rise in tariffs to MFN levels would have a significant negative impact on industries that are heavily integrated across borders. Our first report on the evolving U.S. trade situation analyzed the implications of the U.S.-China trade war for the 24 level two U.S. GICs equity sectors. This Special Report examines the impact of a NAFTA cancelation on 21 level three GICs industries (finer detail is required since NAFTA covers mostly goods industries). We find that there are no "winners" among the U.S. equity sectors because the negative impact would outweigh any positive effects. The hardest hit U.S. industries would be Autos, Metals & Mining, Food Products, Beverages, and Textiles and Apparel, but many others are heavily exposed to a failure of the free trade agreement. Out Of Time President Trump is seeking a new NAFTA deal ahead of the U.S. midterms in November. While this timing may yet prove too ambitious, the U.S. has made progress in recent bilateral negotiations with Mexico, raising the potential that Trump will be able to tout a new NAFTA framework deal by November 6. Yet, investors should be prepared for additional volatility. There are technical issues with the bilateral U.S.-Mexico deal that could delay ratification in Congress until mid-2019. The new Mexican Congress must ratify the deal by December 1 if outgoing President Enrique Peña Nieto is to sign off. Otherwise, the incoming Mexican President Andrés Manuel López Obrador may still want to revise any deal he signs, prolonging the process. Meanwhile, it would be surprising if the Canadians signed onto a U.S.-Mexico deal they had no part in negotiating without insisting on any adjustments.2 The important point is that President Trump's economic and legal constraints on withdrawing from NAFTA have fallen even further with the Mexican deal. If Trump does not get major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base, as a gray area of "continuing talks" will not inspire voters. This could mean imposing the threatened auto tariffs or threatening to cancel the existing trade agreements with Canada. Thus, the risk of Trump triggering Article 2205 is still not trivial. A bilateral Mexican trade deal is not the same as NAFTA. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act. Some provisions of NAFTA under this act may continue, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. The potential saving grace for trade with Canada was that the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989, was incorporated into NAFTA. The U.S. and Canada agreed to suspend CUSFTA's operation when NAFTA was created, but the suspension only lasts as long as NAFTA is in effect. However, Trump may walk away from both CUSFTA and NAFTA in the same proclamation. In that event, WTO rules for preferential trade would require the U.S. and Canada to raise tariffs on trade with each other to Most Favored Nation (MFN) levels. These tariff levels are shown in Charts II-1A and II-1B. The Charts also show the maximum tariff that could potentially be applied under WTO rules. The latter are much higher than the MFN levels, underscoring that the situation could get really ugly if a full trade war scenario somehow still emerged among these three trading partners. Chart II-1AU.S.: MFN Tariff Rates By GICS Industry (2017) Chart II-1BMexico & Canada: MFN Tariff Rates By GICS Industry (2017) Current tariffs are set at zero for virtually all of these GICs industries, which means that the MFN levels also indicate how much tariffs will rise at a minimum if NAFTA is cancelled. Tariffs would rise the most for Automobiles, Textiles & Apparel, and Food Products (especially agricultural products), and Beverages. U.S. tariffs under the WTO are not significantly higher than NAFTA's rates; the average MFN tariff in 2016 was 3½%, which compares to 4.1% for the average Canadian MFN tariff. Would MFN Tariffs Be Painful? An increase in tariff rates of 3-4 percentage points may seem like small potatoes. Nonetheless, even this could have an outsized impact on some industries because tariffs are levied on trade flows, not on production. A substantial amount of trade today is in intermediate goods due to well-integrated supply chains. Charts II-2A and II-2B present a measure of integration. Exports and imports are quite large relative to total production in some industries. The most integrated U.S. GICs sectors include Automobiles & Components, Materials, Capital Goods and Electrical & Optical Equipment. Higher tariffs would slam those intermediate goods that cross the border multiple times at different stages of production. For example, studies of particular automobile models have found that "parts and components may cross the NAFTA countries' borders as many as eight times before being installed in a final assembly in one of the three partner countries."3 Tariffs would apply each time these parts cross the border if NAFTA fails. Chart II-2AU.S./Canada Supply Chain Integration Chart II-2BU.S./Mexico Supply Chain Integration Appendix Tables II-1 to II-4 show bilateral trade by product between the U.S. and Canada, and the U.S. and Mexico. In 2017, the U.S. imported almost $300b in goods from Canada, and exported $282b to that country, resulting in a small U.S. bilateral trade deficit. The bilateral deficit with Mexico is larger, with $314b in U.S. imports and $243b in exports. The largest trade categories include motor vehicles, machinery, and petroleum products. Telecom equipment and food products also rank highly. As mentioned above, the impact of rising tariffs is outsized to the extent that a substantial portion of trade in North America is in intermediate goods. Box II-1 reviews the five main channels through which rising tariffs can affect U.S. industry. Box II-1 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: (1) The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of import tariffs via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines). NAFTA also eliminated many non-tariff barriers, especially in service industries. Cancelling the agreement could thus see a return of these barriers to trade; (2) Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs. There would also be a loss of economies-of-scale and comparative advantage to the extent that firms are no longer able to use an "optimal" supply network that crosses borders, further raising the cost of doing business; (3) Foreign Direct Investment: Some U.S. imports emanate from U.S. multinationals' subsidiaries outside the U.S., or by foreign OEM suppliers for U.S. firms. NAFTA eliminated many national barriers to FDI, expanded basic protections for companies' FDI in other member nations, and established a dispute-settlement procedure. The Canadian and Mexican authorities could make life more difficult for those U.S. firms that have undertaken significant FDI in retaliation for NAFTA's cancellation; (4) Macro Effect: The end of NAFTA, especially if it were to lead to a trade war that results in tariffs in excess of the MFN levels, would take a toll on North American trade and reduce GDP growth across the three countries. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. The macro effect would probably not be large to the extent that tariffs only rise to MFN levels; (5) Currency Effect: To the extent that a trade war pushes up the dollar relative to the Canadian dollar and Mexican peso, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given that tariffs would rise for all three countries. Chart II-3 is a scatter chart of GICs industries that compares the average MFN tariff on U.S. imports to the average MFN tariff on Canadian and Mexican imports from the U.S. A U.S. industry may benefit if it garners significant import protection but does not face a higher tariff on its exports to the other two countries. Unfortunately, there are no industries that fall into the north-west portion of the chart. The opposite corner, signifying low import protection but high tariffs on exports, includes Beverages, Household Durables, Household Products, Personal Products and Machinery. Chart II-3Import And Export Tariffs Faced By U.S. GICS Industries Model-Based Approach The C.D. Howe Institute has employed a general equilibrium model to estimate the impact of a NAFTA failure at the industrial level.4 The model is able to capture the impact on trade conducted through foreign affiliates. The study captures the direct implications of higher tariffs, but also includes a negative shock to business investment that would stem from heightened uncertainty about the future of market access for cross-border trade. It also takes into consideration non-tariff barriers affecting services. Table II-1Impact Of NAFTA Cancellation By Industry As with most studies of this type, the Howe report finds that the level of GDP falls by a relatively small amount relative to the baseline in all three countries - i.e. there are no winners if NAFTA goes down. Moreover, the U.S. is not even able to reduce its external deficit. While the trade barriers trim U.S. imports from NAFTA parties by $60b, exports to Canada and Mexico fall by $62b. At the industry level, the model sums the impacts of the NAFTA shock on imports, exports and domestic market share to arrive at the estimated change in total shipments (Table II-1). It is possible that an industry will enjoy a boost to total shipments if a larger domestic market share outweighs the damage to exports. However, the vast majority of U.S. industries would suffer a decline in total shipments according to this study, because the estimated gain in domestic market share is simply not large enough. Beef, Pork & Poultry and Dairy would see a 1-2% drop in total shipments relative to the baseline forecast. Next on the list are textiles & apparel, food products and automotive products. Even some service industries suffer a small decline in business, due to indirect income effects. Foreign-Sourced Revenue And Input Cost Approach Another way to approach this issue is to identify the U.S. industries that garner the largest proportion of total revenues from Mexico and Canada. Unfortunately, few companies provide much country detail on where their foreign revenues are derived. Many simply split U.S. and non-U.S. revenues, or North American and non-North American revenues. Table II-2 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the industry by market cap (in some cases the proportion that is generated outside of North America was used as a proxy for foreign- sourced revenues). While this approach is not perfect, it does provide a good indication of how exposed a U.S. industry is to Canada and Mexico. This is because any company that has "gone global" will very likely be doing substantial business in these two countries. Table II-2Foreign Revenue Exposure At the top of the list are the Metals & Mining, Personal Products, and Auto Component industries. Between 62% and 81% of revenues in these three industries is derived from foreign sources. Following that is Household Durables, Leisure Products, Chemicals and Tobacco. Indeed, all of the level three GICs industries we are analyzing are moderately-to-highly globally-oriented, with the sole exception of Construction Materials. Table II-3Import Tariff Exposure U.S. companies are also exposed to U.S. tariffs that boost the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A then sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that would be affected by a rise in tariffs to MFN levels. We then allocated the industries contained in the input/output tables to the 21 GICs level 3 industries we are considering, in order to obtain an import exposure ranking in S&P industry space (Table II-3). All 21 industries are significantly vulnerable to rising input costs, which is not surprising given that we are focusing on the manufacturing-based GICs industries and NAFTA focused on trade in goods. The vast majority of the industries could face a cost increase on 50% or more of their intermediate inputs to the production process. The Automobile industry is at the top of the list, with 72% of its intermediate inputs potentially affected by the shift up in tariffs (Automobile Components is down the list, at 56%). Containers & Packaging, Oil & Gas, Aerospace & Defense, Textiles and Food Products are also highly exposed to tariff increases. The automobile industry is a special case because of the safeguards built into NAFTA regarding rules-of-origin and the associated tracing list. The U.S. is seeking significant changes in both in order to tilt the playing field toward U.S. production, but this could severely undermine the intricate supply chain linking the three countries. Box II-2 provides more details. Box II-2 Automotive Production In NAFTA; Update Required We are focused on two key aspects to the renegotiation of the NAFTA rules that could have far reaching implications for automakers and the auto component maker supply base: the tracing list and country of origin rules. Regarding the first of these, the Trump administration has a legitimate gripe when it comes to automotive production. A tracing list was written in the early-1990's to define automotive components such that the rules of origin (ROO) could be easily met; anything not on the list is deemed originating in North America. As anyone who has driven a vehicle of early-1990's vintage and one of late-2010's vintage can attest, high tech components (largely not included on the tracing list) have grown exponentially as a percentage of the cost of the vehicle and, at least with respect to electronic and display components, are sourced mostly from overseas. Updating the tracing list would force auto makers to source a significantly greater amount of components domestically, almost certainly raising the cost of the vehicle and either hurting margins or hurting competitiveness through higher prices. The current NAFTA ROO require that 62.5% of the content of a vehicle must be sourced in North America, with no distinction between any of the member nations. The result of this legislation has been the creation of a highly integrated supply base that sees components move back and forth across borders through each stage of the manufacturing process. Early proposals from the Trump administration for a NAFTA rework included a country of origin provision for as much as 50% U.S. content. Such a provision would certainly cause a massive disruption in the automotive supply chain with components manufacturers forced to relocate or automakers electing to source overseas and pay the 2.5% MFN tariff on exports within North America. Either scenario presents a headwind to the tightly woven auto components base, underscoring BCA's U.S. Equity Strategy's underweight recommendation on the sector. The recently announced bilateral trade deal with Mexico raises the ROO content requirements to 75% from the 62.5% contemplated under NAFTA but, importantly, no country of origin provisions appear in the new deal. Still, given how quickly this is evolving, a final NAFTA deal could be significantly different. Chart II-4 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries in the north-east corner of the diagram are the most exposed to NAFTA failure. The problem is that there are so many in this region that it is difficult to choose the top two or three, although Metals & Mining stands out from the rest. It is easier to identify the industries that face less risk in relative terms: Pharmaceuticals, Construction Materials, Health Care & Supplies, Leisure Products and, perhaps, Machinery. The rest rank highly in terms of both foreign revenue exposure and import tariff exposure. Chart II-4Foreign Revenue And Import Tariff Exposure Conclusions: By itself, a total cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved. The negative impact on GDP growth would likely be worse for Canada (and Mexico if its bilateral somehow fell through), but U.S. exporters would see some loss of business. We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and import tariff exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. As we go to press, rapid developments are taking place in the NAFTA negotiations. The U.S. and Mexico have completed a bilateral agreement in principle and a Canadian team is looking into whether to sign onto the agreement by a U.S.-imposed August 31 deadline. This deadline would enable the current U.S. Congress to proceed to ratification before turning over its seats in January, though it is not a hard deadline. It is possible that the negotiations will conclude this week and the crisis will be averted. But the lack of constraints on President Trump's trade authority gives reason for pause. If Canada demurs, Trump could move to raise the cost through auto tariffs or announcements that he intends to withdraw from existing U.S.-Canada agreements in advance of November 6. While Mexico has now tentatively secured bilaterals with both countries through the new U.S. deal and the Trans-Pacific Partnership (which includes Canada), it still stands to suffer if a trilateral agreement is not in place. Moreover it is technically possible that Canada's refusal to join the U.S.-Mexico bilateral could delay the latter's ratification well into next year. Therefore, we treat Mexico the same as Canada in our analysis, despite the fact that Mexican assets stand to benefit in relative terms from having a floor put under them by the Trump Administration's more constructive posture and this week's framework deal. If Trump does not pursue a hard line with Canada, then it will be an important sign that he is adjusting his trade policy to contain the degree of confrontation with the developed nations and allies and instead focus squarely on China, where we expect trade risks to increase in the coming months. Mark McClellan Senior Vice President The Bank Credit Analyst Matt Gertken Associate Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy APPENDIX TABLE II-1 U.S. Imports From Canada (2017) APPENDIX TABLE II-2 U.S. Exports To Canada (2017) APPENDIX TABLE II-3 U.S. Imports From Mexico (2017) APPENDIX TABLE II-4 U.S. Exports To Mexico (2017) 1 Please see BCA Geopolitical Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28, 2018, and Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com 2 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com 3 Working Together: Economic Ties Between the United States and Mexico. Christopher E. Wilson, November 2011. 4 The NAFTA Renegotiation: What if the U.S. Walks Away? The C.D. Howe Institute Working Paper. November 2017. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits have been so strong recently as to dominate any negative market forces. Our Monetary Indicator is hovering at a low level by historical standards, suggesting that liquidity conditions have tightened. It is constructive that our Composite Technical Indicator has hooked up, narrowly avoiding a technical break below the zero line. It is also positive that our Composite Sentiment Indicator is rising, but not yet to a level that would signal trouble for stocks from a contrary perspective. However, our U.S. Willingness-to-Pay (WTP) indicator continues to erode, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Moreover, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in August. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Our indicators thus suggest that the underlying health of the U.S. equity bull market is fraying at the edges. Nonetheless, robust U.S. profits figures have sparked a euphoric late-cycle blow-off phase. The net revisions ratio is still in positive territory, and the net earnings surprises index has surged to an all-time high. Not much has changed on the U.S. Treasury front. The 10-year bond is slightly on the cheap side according to our model, and oversold conditions have not yet been worked off. This month's Overview section discusses the potential for upside inflation surprises in the U.S. that will place the FOMC "behind the curve". The term premium and long-term inflation expectations are still too low. This year's dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but economic and policy divergences vis-à-vis the U.S. and the other major economies suggests that the dollar is likely to continue moving higher in the near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst