Policy

Highlights Monetary Policy: Investors should not place much importance on current estimates of NAIRU or the neutral fed funds rate. The Fed will continue to lift rates at a pace of 25 bps per quarter until the economic recovery is threatened, revising NAIRU and neutral rate estimates as necessary. Duration: The spillover from weak global growth into the U.S. will probably cause the Fed to pause its gradual rate hike cycle at some point next year. But with the market priced for only one rate hike in all of 2019, this risk is already in the price. Maintain below-benchmark portfolio duration on a 6-12 month investment horizon. Inflation: Recent rapid increases in year-over-year core inflation will moderate in the coming months, as base effects provide less of a tailwind. But the economic back-drop remains highly inflationary and we expect inflation's uptrend will continue. Investors should maintain an overweight allocation to TIPS versus nominal Treasuries, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Feature Fed Chairman Jerome Powell used his highly anticipated Jackson Hole address to reinforce the theme that has quickly become the hallmark of his tenure.1 Much like at the June FOMC press conference, the Chairman stressed the importance of incorporating uncertainty into the decision-making process.2 Specifically, the uncertainty surrounding real-time estimates of important macroeconomic variables such as the natural rate of unemployment (NAIRU) and the neutral (or equilibrium) fed funds rate. Chart 1The Fed's "Gradual" Rate Hike Cycle Uncertainty Surrounding NAIRU Considering the uncertainty surrounding NAIRU, the Chairman pointed to two specific time periods. The first being the "Great Inflation" of the 1960s and 1970s. In the late 1960s, real-time NAIRU estimates suggested that the unemployment rate was only slightly below its natural level, meaning that inflationary pressures were thought to be relatively muted (Chart 2). That expectation led policymakers to maintain an accommodative monetary policy that fueled the inflation of the 1970s. In Powell's view, the policy error was placing too much faith in real-time estimates of NAIRU, which with hindsight have been heavily revised (Chart 2, bottom panel). Chart 2Real-Time NAIRU Estimates Are Often A Poor Guidepost For Policymakers The second period Powell discusses is the late 1990s. This period is the opposite of the 1960s in the sense that real-time NAIRU estimates were eventually revised lower (Chart 2). At the time, labor markets were thought to be very tight. But former Fed Chairman Alan Greenspan downplayed real-time NAIRU estimates and kept monetary policy easier for longer than many would have liked. Powell argues that subsequent downward NAIRU revisions vindicated that decision. At present, the unemployment rate of 3.9% is considerably below the Fed's most recent median NAIRU estimate of 4.5% (Chart 3). Complete faith in that NAIRU estimate would suggest that the Fed should be aggressively tightening policy. But as in the 1990s, it is possible that current NAIRU estimates will eventually need to be revised down. Despite seemingly tight labor markets, year-over-year core PCE inflation has still not returned to the Fed's 2% target. This makes future downward NAIRU revisions currently appear more likely than future upward revisions. Chart 3Current Estimates Point To A Very Tight Labor Market Powell argues that the Fed's "gradual" tightening path - raising the fed funds rate 25 bps per quarter - is a way of splitting the difference. The process of lifting rates acknowledges the current NAIRU estimate, while the relatively slow pace hedges the risk that it turns out to be too high. Uncertainty Surrounding The Neutral Rate Chart 4Growth At Odds With The Yield Curve Other than NAIRU, policymakers must also deal with the concept of the neutral (or equilibrium) fed funds rate. This is the interest rate that will keep the economy growing at its potential, leading to neither inflationary nor deflationary pressures. At the moment, most FOMC participants think the longer-run neutral rate is somewhere between 2.75% and 3% (in nominal terms). If this is correct, it means that the Fed's current 25 bps per quarter rate hike pace will cause the funds rate to reach neutral by the middle of next year. This is illustrated by the shaded grey boxes in Chart 1. If we assume complete confidence in the current estimate of the neutral rate, it is obvious that unless inflation significantly overshoots the 2% target, the Fed should halt its tightening cycle next year when the funds rate hits neutral. In fact, some FOMC members are advocating for at least a pause. Dallas Fed President Robert Kaplan recently said that when the fed funds rate reaches the current estimate of neutral: I would be inclined to step back and assess the outlook for the economy and look at a range of other factors - including the levels and shape of the Treasury yield curve - before deciding what further actions, if any, might be appropriate.3 However, the importance Powell places on uncertainty makes us think that any such pause would be very brief, if it occurs at all. In a recent report we showed that while the slope of the yield curve is consistent with a monetary policy that is already close to neutral, economic indicators do not corroborate this message (Chart 4).4 Bottom Line: Investors should not place much importance on current estimates of NAIRU or the neutral fed funds rate. The Fed will continue to lift rates at a pace of 25 bps per quarter until the economic recovery is threatened, revising NAIRU and neutral rate estimates as necessary. Heading For A Slowdown? The catalyst that could actually derail the Fed's rate hike cycle would be a meaningful slowdown in U.S. economic growth. In this regard, we observed in a recent report that current weakness outside of the U.S. is likely to spill over.5 Since 1993, every time the Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed (Chart 5). Is there any reason to believe that this time might be different? One reason for optimism is that the Eurozone has been the main driver of the year-to-date slowdown in the Global Manufacturing PMI (Chart 6). This is encouraging because while Eurozone growth has certainly slowed, the PMI remains at a high level, well above the 50 boom/bust line. Further, recent data have shown some stabilization. The PMI is falling less rapidly than earlier in the year and broad money growth has picked up (Chart 7, top panel). However, weakness in China and emerging markets could easily swamp any positive impulse out of Europe. Though indicators of current economic activity in China appear in good shape, leading indicators and the imposition of tariffs point to weakness ahead (Chart 7, panel 2). Chinese policymakers have taken some steps to ease monetary conditions (Chart 7, bottom panel), but it remains unclear whether that will be sufficient to maintain current growth rates. Chart 5Global Growth Could Bring Down The U.S. Chart 6Weakness Due To Eurozone Chart 7The Biggest Risk Is From China Our assessment is that it is highly likely that weak global growth will eventually filter into the States. This will cause the Fed to pause its 25 bps per quarter tightening cycle at some point next year. However, applying Chairman Powell's uncertainty doctrine to our investment strategy, we must weigh this risk against what the market is already discounting. Chart 1 shows that the fed funds futures market is priced for a funds rate of 2.33% by the end of this year and 2.68% by the end of 2019. This means that the market is priced for only a single 25 bps rate hike in 2019, rather than the four we would expect in an environment of no economic hiccups. According to our golden rule of bond investing, we should be reluctant to adopt an above-benchmark portfolio duration stance unless we are confident that Fed rate hikes will come in below expectations over our investment horizon.6 Given that a significant growth slowdown would be required for the Fed to deliver only one hike in 2019, we think below-benchmark portfolio duration is still justified on a 6-12 month horizon. Bottom Line: The spillover from weak global growth into the U.S. will probably cause the Fed to pause its gradual rate hike cycle at some point next year. But with the market priced for only one rate hike in all of 2019, this risk is already in the price. Maintain below-benchmark portfolio duration on a 6-12 month investment horizon. Inflation Update An additional reason why any pause in the Fed's rate hike cycle could prove fleeting is that core inflation is very close to returning to the Fed's 2% target. Trailing 12-month core PCE inflation clocked in at 1.98% in July, while trailing 12-month trimmed mean PCE inflation was 1.99%. Rising inflation is likely the reason that long-dated TIPS breakeven inflation rates have remained stable in recent weeks, even as high-frequency global growth indicators have turned down (Chart 8). Looking ahead, the economic backdrop suggests that monthly inflation prints will continue to be strong. Our Pipeline Inflation Indicator remains elevated, despite the recent decline in commodity prices, and our PCE diffusion index shows that recent price increases have been broadly based (Chart 9). Chart 8Closing In On Target Chart 9Macro Environment Is Inflationary However, unless month-over-month inflation prints strengthen considerably, we should expect smaller increases in the year-over-year inflation rate going forward, as base effects provide less of a tailwind. To assess how much base effects influence year-over-year inflation rates we created our Core PCE Base Effects Indicator. We constructed the indicator using core PCE growth rates over horizons ranging from 1 to 11 months. We compare each growth rate to the growth rate over the next longest interval and increase the indicator's value by 1 each time a shorter-interval growth rate exceeds a longer-interval growth rate. In other words, we compare the 1-month growth rate in core PCE to the 2-month growth rate. If the 1-month growth rate is above the 2-month growth rate, we add 1 to our indicator. We then compare the 2-month growth rate to the 3-month growth rate, and so on. This gives us an indicator that ranges between 0 and 11. Chart 10 shows that when our Base Effects Indicator is elevated it usually means that year-over-year core PCE inflation will rise during the next six months, and vice-versa. We also observe that the cut-off point between positive and negative base effects is between 5 and 6. That is, when our indicator is at 6 or above, base effects bias the year-over-year core PCE inflation rate higher. Base effects tend to drag year-over-year inflation lower when our Indicator gives a reading of 5 or below. Chart 11 demonstrates the impact of base effects in more detail. The chart presents the median, first quartile and third quartile of 6-month changes in year-over-year core PCE inflation for each possible reading from our indicator. The median inflation change is positive for readings of 6 and above, and negative for readings of 5 and below. Chart 10Base Effects Now Less Of A Tailwind Chart 11The BCA Base Effects Indicator Tested (1960 - Present) In recent months, the reading from our Base Effects Indicator had been at 8, suggesting a very strong tailwind pushing the year-over-year growth rate in core PCE higher. But following last week's July PCE release our indicator fell to 6, suggesting only a mild positive impact from base effects going forward. Bottom Line: Recent rapid increases in year-over-year core inflation will moderate in the coming months, as base effects provide less of a tailwind. But the economic back-drop remains highly inflationary and we expect inflation's uptrend will continue. Investors should maintain an overweight allocation to TIPS versus nominal Treasuries, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 3 https://www.bloomberg.com/news/articles/2018-08-21/fed-s-kaplan-inclined-to-reassess-rates-amid-yield-curve-angst 4 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights We decompose the fed funds rate cycle into four phases based on the interaction between the level of the fed funds rate and its direction to examine monetary policy's impact on equities. The policy backdrop matters for equity returns. All of the S&P 500's price gains over the last six decades have accrued while policy settings have been accommodative. From a policy perspective, equities have been in an extended sweet spot ever since the Fed began aggressively cutting rates to combat the crisis. We estimate that they will remain there for close to another year. The fed funds rate cycle is only one of the variables we consider when calibrating investment strategy. Its bullish message faces resistance from decelerating growth, full valuations, and trade tensions between China and the U.S. The net impact of the individual crosscurrents is subject to spirited debate within BCA. Feature You really can't fight the Fed. As longtime U.S. Investment Strategy readers know, the fed funds rate cycle has been a consistently robust predictor of the direction and magnitude of equity returns. Over nearly six decades, the S&P 500 has risen at a 10% annualized clip when policy is easy; it's scratched out just a percentage point a year when it's tight. Adjusted for inflation, the easy/tight performance disparity has been even wider. In this Special Report, we update and revise the full-scale analysis we first performed nearly five years ago. In this iteration, we evaluate performance for each phase of the cycle on the basis of chained aggregate returns, rather than in terms of means and medians. That tweak expands our sample size to 685 months from 60 cycle phases, and eliminates the individual phases' sensitivity to short-term outliers. We have also revised the demarcation of the cycle phases to correct for a flaw in our historical effective fed funds rate data feed.1 The Fed Funds Rate Cycle We decompose the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction, as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase 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 rate2 (shown as a dashed line in Chart 1 and Chart 2). Chart 1It's Easiest To Be Easy Chart 2The Fed Funds Rate Cycle 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, and the subsequent adjustment period when the Fed remains on hold at the cycle trough in an effort to kick start an economic recovery. What Is The Equilibrium Fed Funds Rate? The equilibrium fed funds rate is the policy rate that neither encourages nor discourages economic activity. That is a simple enough idea, but we note that the equilibrium rate is just a concept. No one can put a blood pressure cuff around the economy's arm, or stick a thermometer in its mouth, to determine the rate objectively and precisely. Our equilibrium rate, which uses potential GDP growth to adjust a smoothed and filtered long-run series of the actual fed funds rate, is simply the modeled estimate of a concept. Why Bother Pursuing Such Elusive Quarry? 70 years ago, BCA sprang from our founder's insight that investors might be able to intuit a good deal about the future direction of the economy and financial markets by studying the flow of credit through the banking system. The Bank Credit Analyst owes its name and existence to the proposition that money flows matter. Tracking monetary conditions is in our DNA, and the fed funds rate is the foremost input into standard monetary conditions models. The empirical record suggests that the monetary backdrop holds such powerful sway over financial markets that tracking the equilibrium rate's relationship to the actual fed funds rate is worthwhile even if our ability to pin it down in real time is limited. Stocks And The Fed Funds Rate Cycle History convincingly demonstrates that the monetary backdrop matters, and that the level of rates (accommodative or restrictive) exerts far more influence on equity returns than their direction (higher or lower). Table 1 presents annualized price returns for the S&P 500 by fed funds cycle phase for the nearly 60 years covered by our equilibrium fed funds rate estimate. When policy is easy, as in Phases I and IV, the S&P has appreciated at a 10% annual rate; when it's tight, as in Phases II and III, it's barely advanced. Table 2 adjusts the nominal returns for inflation, making the easy/tight policy divide even starker - in real terms, the S&P 500 has lost considerable ground when the fed funds rate has exceeded our estimate of equilibrium. Table 1Tight Policy Is Hazardous To Stocks' Health, ... Table 2... Especially In Real Terms, ... Estimated Earnings And Forward Multiples Although overall equity returns are a function of the level of rates, their underlying components - earnings growth and the multiple investors are willing to pay for future earnings - are more sensitive to rates' direction. Earnings estimates are directly related to rate moves - they rise more when rates rise than they do when rates fall (Table 3). The direct relationship follows from the countercyclical nature of monetary policy. If the Fed is cutting rates, it must anticipate a softer growth environment in which estimates should be revised lower, whereas if it's hiking them, it must foresee such robust growth that it fears the economy could overheat. Table 3... But Earnings Thrive When The Fed Hikes Multiples are inversely related to the direction of rates; they contract in the aggregate when rates rise, and expand when they fall (Table 4). Although multiples are constrained by their mean-reverting properties, their movement around the mean adheres to a tidal pattern: ebbing when the Fed's trying to rein in the economy with rate hikes (and future earnings are subject to an increasing discount factor), and rising when it's trying to give it a boost (and the discount factor is falling). Multiples' action vis-à-vis the rate cycle suggests that they are forward-looking - moving in accordance with the Fed's intentions - while estimates are backward-looking, primarily extrapolating from actual results. In terms of S&P 500 returns, estimates' and multiples' tendency to counter one another when policy is tight has maintained the overall easy/tight dynamic over the four decades covered by forward earnings data (Table 5). Table 4Stocks De-Rate When Rates Rise, ##br##And Re-Rate When They Fall Table 5A Rising Tide Lifts All Boats, But Easy Phases Still Lead The Way Why Does The Fed Funds Rate Cycle Work? For all of its import, monetary policy is a blunt instrument that works with indeterminate lags. Its shortcomings heavily influence the way the Fed deploys it, and impose a predictable pattern on its economic and market impacts. In this analysis we focus on the Fed's inability to make targeted, precise adjustments; its uncertainty over when its effects will take hold; and its mandate's explicit focus on managing inflation, a lagging indicator. All of these factors come into play when the Fed embarks on a rate-hiking campaign, kicking off a new iteration of the policy rate cycle. New rate cycles begin from the previous cycle's trough level, when the Fed's primary concern is to avoid revisiting the adversity that inspired accommodation. It does not want to induce a double-dip by being too aggressive, especially when inflation readings are tame (Table 6). The Fed does not begin Phase I, or proceed very far with it, until it is all but certain that the economy can withstand higher rates. It therefore predictably embarks upon Phase I with a bias to err on the side of being too easy. Table 6Has The Tail Been Wagging The Dog? This bias gives the economy a chance to build up momentum in Phase I, consonant with a cycle peak in earnings growth (Chart 3, third panel). In markets, that momentum helps to feed meaningful excess returns in spread product,3 and sizable outperformance among late-cyclical equity sectors at home and abroad,4 as well as outsized returns in the S&P 500. Left unchecked, the momentum could promote higher inflation. Inflation can move stealthily because of its lagging nature, and the Fed is often compelled to intervene forcefully to counter it. Chart 3Monetary Policy Matters, A Lot Forceful intervention brings about Phase II of the cycle, when economic activity may still be expanding at a good clip, as indicated by double-digit earnings growth. Wielding a blunt instrument that works with a lag, however, the Fed is at risk of going too far, and Phase II hikes often induce a recession. Investors begin to sniff out the looming downturn and de-rate equities. By the time the Fed backs off and initiates a new easing campaign (Phase III), earnings growth has stalled out and measured inflation is peaking (Chart 3, bottom panel). Equities mark time (Chart 3, first and second panels) and spread product generates negative excess returns until, with the recession plainly evident and measured inflation sliding, there is nothing stopping the Fed from full-on accommodation (Phase IV), and it maintains market-friendly settings until the economy begins to look too strong, and the Fed intervenes to hold it back (Phase II). This stylized example focused on the Fed and markets, but monetary policy impacts all aspects of the real economy. Consumer demand for homes and other durable goods that have to be financed, along with businesses' appetite for investment, are keenly sensitive to monetary conditions. There is a powerful self-reinforcing dynamic that joins corporate earnings, business expansion and hiring, and consumption. The links between equity performance and the fed funds rate cycle are real and lasting. Investment Implications In its current setting, the fed funds rate cycle is issuing a risk-friendly signal. Even if it were our only guide to asset allocation and investment strategy, however, we would need to heed a couple of caveats before rushing out to overweight equities and other risk assets. First of all, estimates of the equilibrium fed funds rate are notoriously imprecise - equilibrium is a concept that can only be observed after the fact. Secondly, there is no guarantee that asset returns in this iteration of the fed funds rate cycle will continue to hew closely to the historical record. Following 10-plus years of accommodation, equity valuations are at fairly demanding levels. We continue to have a constructive view of the business, market and policy cycles, but the current environment carries significant risks. Activity is broadly decelerating outside of the U.S., public-market valuations are full nearly everywhere around the world, and the unsettled trade picture has the potential to upend financial markets. BCA is closely monitoring China to see whether or not it will provide monetary or fiscal stimulus that might help mitigate the forces threatening to undermine global trade and the economies that rely upon it. We remain on hold, recommending a benchmark equity allocation, while underweighting bonds and overweighting cash, in line with the house view. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 A bug in our third-party provider's conversion of daily effective fed funds rate data into monthly data slightly skewed our previous phase definitions. 2 Potential GDP growth is the key input to our model estimating the equilibrium policy rate level. 3 Please see the May 27, 2014 U.S. Investment Strategy Special Report, "Bonds and the Fed Funds Rate Cycle." Available at usis.bcaresearch.com. 4 Please see the July 3, 2017 Global ETF Strategy Model Portfolios Review, "Overhauling the U.S. Equity Exposures," and the May 11, 2018 Global Alpha Sector Strategy Special Report, "Global Equity Sectors and the Fed Funds Rate Cycle."Available at getf.bcaresearch.com and gss.bcaresearch.com.

Highlights We remain bullish on the dollar, but no longer think that being long the greenback is the "slam-dunk" trade that it was earlier this year. A reacceleration in growth outside the U.S. and an overly dovish Fed represent the biggest risks to our constructive dollar view. China is likely to stimulate its economy, but concerns about high debt levels and malinvestment will limit the scale of any fiscal/credit stimulus. Letting the RMB slide may prove to be the preferable option. Worries about debt sustainability in Italy and EM contagion to European banks will constrain credit growth in the euro area, thus keeping the ECB in a highly dovish mode. For the time being, we favor developed market stocks over their EM peers. At the sector level, we would overweight defensives relative to deep cyclicals. U.S. stocks will outperform European stocks in dollar terms, although the performance is likely to be much more balanced in local-currency terms. The longer-term path for Treasury yields is to the upside. Nevertheless, a stronger dollar, coupled with safe-haven flows into the Treasury market, could temporarily push the 10-year yield down to 2.5% over the next few months. Feature The Dollar At A Crossroads After surging by 10% between February 1st and August 15th, the broad trade-weighted dollar has fallen by 0.9% over the past two weeks. Despite the latest setback, the greenback is still 23.2% above its 2014 lows and only 2.8% below its December 28, 2016 high (Chart 1). BCA continues to maintain a bullish view on the dollar. However, given recent market action, it is useful to stress-test our thesis in order to explore what could go wrong with it. As we discuss below, a key risk to the dollar is that global growth reaccelerates, with the U.S. once again going from leader to laggard in the global growth horserace. Global Growth And The Dollar The dollar tends to strengthen when global growth is deteriorating. Since the U.S. is a "low-beta" economy dominated by services rather than manufacturing and primary industries, an environment in which the global economy is slowing is usually one where the U.S. is outperforming the rest of the world. Chart 2 shows that there is a strong correlation between the value of the trade-weighted dollar and the difference between The Conference Board's U.S. Leading Economic Indicator (LEI) and the non-U.S. LEI. The gap between the U.S. and the non-U.S. LEI is still quite large. However, it has started to shrink recently, reflecting both a dip in the U.S. LEI as well as a small improvement in the non-U.S. LEI. The implication is that the U.S. economy is outshining the rest of the world, but the magnitude of outperformance has begun to narrow. Looking forward, the fate of the dollar will hinge on whether growth in the rest of the world can catch up with the United States. By definition, this can happen either if U.S. growth falls or non-U.S. growth rises. We examine each possibility in turn. Chart 1Despite Recent Pullback, ##br##The Dollar Is Still Close To Its 2016 High Chart 2The U.S. Economy Is Still Outperforming The Rest Of The World, But The Gap Is Starting To Narrow U.S. Growth: As Good As It Gets? The second quarter was probably the high watermark for U.S. growth for the rest of this cycle. Real GDP expanded by 4.2%, more than double most estimates of trend growth. The deceleration in payroll growth in July, a string of weak housing data releases, and the drop in the national ISM surveys alongside declines in a number of regional surveys such as the Philly Fed PMI, all point to a somewhat softer third quarter GDP growth reading. How worried should dollar bulls be? We see three reasons to downplay the negative impact on the dollar from the recent string of softer economic data. While the U.S. economy has slowed, it is still quite strong. The Bloomberg consensus forecast suggests that real GDP will increase by 3% in Q3. The Atlanta Fed's GDPNow model predicts 4.1% growth, while the New York Fed's Nowcast anticipates a more modest growth rate of 2%. The underlying drivers of aggregate demand remain supportive. U.S. financial conditions have loosened recently, thanks mainly to narrower credit spreads and higher equity prices (Chart 3). The effects of fiscal stimulus have also yet to make their way fully through the economy, especially with respect to government spending. The consumer is in great shape. The unemployment rate is near a 20-year low and the savings rate stands at a comfortable 6.7%, well above the level that the current ratio of household net worth-to-disposable income would predict (Chart 4). The housing vacancy rate is close to all-time lows, which limits the downside risk both to home prices and construction activity (Chart 5). Chart 3U.S. Financial Conditions Have Eased Recently Chart 4The Savings Rate Has Room To Fall Some of the apparent slowdown in U.S. growth appears to be due to intensifying supply-side constraints rather than faltering demand (Chart 6). This is important because slower growth resulting from weaker demand should, in principle, cause the Fed to moderate the pace of rate hikes, whereas slower growth resulting from an overheated economy should prompt the Fed to accelerate the pace of rate hikes. The latter is much better for the dollar than the former. Chart 5Low Housing Inventories Will ##br##Support Home Prices And Construction Chart 6U.S. Economy Is Hitting Supply-Side ##br##Constraints The Fed's Fate Is In The Stars What is true in principle, however, does not always match what happens in practice. In his Jackson Hole address, Jay Powell invoked a Draghi-esque phrase when saying that the FOMC would "do whatever it takes" to keep inflation expectations from becoming unmoored.1 Nevertheless, he also said that "there does not seem to be an elevated risk of overheating" at the moment. This is a curious statement considering the abundant evidence that U.S. firms are struggling to find qualified workers. To his credit, Powell stressed the inherent difficulty of "navigating by the stars," that is, of setting monetary policy based on highly imprecise estimates of the natural rate of unemployment, u*, and the neutral real rate of interest, r*. What he did not say is that the Fed's current estimates of these "stars" stand at record lows, which introduces a dovish bias into monetary policy should these estimates prove to be too low. Our baseline view is that the Federal Reserve will raise rates more than the market is currently discounting. We also doubt the Fed will succumb to President Trump's pressure to keep rates low or to accommodate any effort by the Treasury to intervene in the foreign exchange market with the aim of driving down the value of the dollar. That said, the risk to this view is that the Fed reacts too slowly to rising inflation. This could cause real rates to drift lower, with adverse consequences for the dollar. The China Policy Wildcard The discussion above suggests that the dollar would suffer either if U.S. growth slows significantly or if the Fed falls too far behind the curve in normalizing monetary policy. An additional risk to the dollar is that growth outside the U.S. picks up. This would suck capital away from the U.S. and into the rest of the world, with adverse consequences for the greenback. At present, the biggest question mark around the global growth outlook concerns China. The Chinese economy has struggled of late, with trade tensions adding to the misery (Chart 7). The stock market is down in the dumps. On-shore corporate yields for low-quality borrowers continue to rise. Industrial production, retail sales, and fixed asset investment all disappointed in July, following a further drop in the PMIs. The economic surprise index remains in negative territory. Only the housing market is showing renewed vigour, with both starts and sales rebounding (Chart 8). Chart 7China: Some Signs Of A Struggling Economy... Chart 8...With Housing Being The Main Exception The central bank has responded by easing liquidity. Interbank rates fell from a peak of 5.9% in late 2017 to 2.9% today. The authorities have also instructed local governments to expedite their spending plans, while ordering state-owned banks to expand lending to the export sector and for infrastructure-related projects. Fiscal/credit stimulus of the sort the authorities engaged in both 2009 and 2015 carries significant risks, however. Debt levels have reached stratospheric levels and concerns about excess capacity and malinvestment abound. We suspect these facts will cause policymakers to be more guarded than they would otherwise be. What's Next For The RMB? Letting the RMB weaken offers an alternative way to stimulate the economy - and one, crucially, that does not require piling on evermore debt. In contrast to more roads and bridges, a cheaper Chinese currency would not be welcome news for the rest of the world. A weaker RMB makes it more difficult for other economies to compete against China. A weaker currency also increases the costs to Chinese firms of importing raw materials, thus putting downward pressure on commodity prices. Despite efforts by emerging markets to diversify their economies, EM earnings remain highly correlated with industrial metals prices (Chart 9). Despite the presence of capital controls, the USD/CNY exchange rate has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 10). The differential has dropped from close to 300 basis points at the beginning of this year to less than 100 basis points today. Given that prospect of further Fed rate hikes, the only way the Chinese authorities will be able to keep the interest rate differential from falling even more is by tightening monetary policy themselves. This could slow credit growth and thus weaken the economy. The failure to raise rates, however, would probably cause the RMB to fall further. Both outcomes would be problematic for the rest of the world. Chart 9EM Earnings Are Correlated ##br##With Industrial Metal Prices Chart 10USD/CNY Tracks China-U.S. ##br##Interest Rate Differentials Our bet is that the authorities will ultimately choose to keep domestic monetary conditions fairly easy - leading to a weaker RMB - but will use administrative controls to prevent credit growth from accelerating too rapidly. That said, we would not rule out the possibility that the authorities succeed in stimulating the economy in a way that precludes further currency weakness. If this stimulus coincides with a thawing in trade tensions, it could lead to a burst in optimism about China specifically, and global growth in general. Such an outcome would hurt the dollar. The Euro Area: Keeping The Recovery On Track 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. The election of a populist government in Italy renewed concerns about debt sustainability in the euro area's third largest economy. The 10-year yield reached a four-year high of 3.2% this week. It is now 150 basis points above its April 2018 lows (Chart 11). The resulting tightening in Italian financial conditions will continue to weigh on growth in the months ahead. Bank credit remains the lifeblood of the euro area economy. Chart 12 shows that the 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to move closely with GDP growth. Euro area credit began to moderate this year even before the Italian imbroglio and worries about the exposure of European banks to vulnerable emerging markets came on the scene. It will be difficult for euro area GDP growth to accelerate unless credit growth revives. In the absence of faster credit growth, the ECB will have little choice but to remain firmly in dovish mode. Chart 11Italian Populism Meets The Bond Market Chart 12Euro Area Credit Growth Has Flatlined The best-case scenario for the common currency is that EM stresses subside, and the Italian government reaches a friendly agreement with the European Commission over next year's budget. The thawing in Brexit negotiations would also help. We are skeptical that any of these three things will happen, but if one or a number of them did occur, this would benefit the euro at the expense of the dollar. Investment Conclusions We are not as bullish on the dollar as we were earlier this year. Sentiment towards the greenback has clearly improved (Chart 13). The narrative about a "synchronized global growth recovery" that was all the rage last year has also given way to a more sober appreciation of the problems facing emerging markets. In short, markets have moved a long way towards our view of the world. Still, we are not ready to abandon our strong dollar view. Chinese stimulus or not, the structural challenges facing emerging markets - high debt levels, poor productivity growth - will not go away. The same goes for Europe and its litany of political and economic travails. Even if the dollar did manage to weaken again, this would constitute an unwelcome easing in U.S. financial conditions at a time when the Fed wants to tighten financial conditions in order to keep the economy from overheating. From this perspective, a weaker dollar just means that the Fed would need to hike rates even more than it otherwise would. Since more rate hikes will buttress the dollar, the extent to which the dollar can weaken is self-limiting. In short, interest rate differentials between the U.S. and its trading partners should continue to favor the greenback. Assuming the dollar does strengthen from here, emerging markets will be the main casualties. While EM assets have cheapened considerably, Chart 14 shows that neither EM equities, credit, nor currencies are at levels that have marked past bottoms. Global investors should continue to favor developed market stocks over their EM peers. At the equity sector level, investors should overweight defensives over deep cyclicals. Regionally, this posture implies that U.S. stocks will outperform European stocks in dollar terms, although the performance is likely to be much more balanced in local-currency terms. Chart 13Investors Have Turned More Bullish On The Dollar Chart 14EM Assets Are Not Very Cheap As we recently discussed in a two-part Special Report,2 the longer-term path for Treasury yields is to the upside. Nevertheless, a broad-based appreciation in the value of the dollar, coupled with safe-haven flows into the Treasury market, could temporarily push the 10-year yield down to 2.5% over the next few months. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Jerome H. Powell, "Monetary Policy in a Changing Economy," Speech at "Changing Market Structure and Implications for Monetary Policy," a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 24, 2018. 2 Please see Global Investment Strategy Special Reports, "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018; "1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The U.S. Treasury has authority to intervene unilaterally in foreign exchange markets. However, conditions for effective interventions to weaken the dollar exist neither within nor outside the U.S. For the time being, central banks in Europe, Japan, and China will not cooperate with the U.S. to depreciate the dollar. The Federal Reserve will effectively team up with the U.S. Treasury to depreciate the greenback only if economic conditions in the U.S. warrant a weaker currency. This is not currently the case. In this context, the dollar will continue to appreciate, but its rally will be accompanied by substantially higher volatility as the U.S. administration aggressively "talks down" the dollar. To capitalize on this theme, traders should consider going long dollar volatility. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM. Feature Chart I-1U.S. Core Inflation Will Rise Further Economics and politics are set for a major clash in foreign exchange markets. Economic fundamentals and crosscurrents worldwide herald U.S. dollar appreciation. Yet, U.S. President Donald Trump wholeheartedly opposes any dollar strength. The higher the greenback rises, the more forceful Trump's jawboning about the exchange rate and interest rates will become. If the dollar does not halt its advance and overshoots, the odds are material that at a certain point the U.S. Treasury will initiate currency market interventions itself. It would do so by selling dollars and buying foreign assets. What will be the outcome of this battle between economics and politics in financial markets? The conclusion of this report is that for government-led currency market interventions to be effective in reversing the dollar's uptrend, the U.S. administration will have to convince the Federal Reserve to cease rate hikes and balance sheet contraction. Without the Fed recalibrating policy to be more consistent with a weaker dollar, the U.S. Treasury may not succeed in weakening the greenback on a sustainable basis. Given core consumer price inflation in the U.S. will likely surprise to the upside (Chart I-1), the Fed will not be willing to halt its tightening campaign. Hence, it will take time for the U.S. administration to wrestle and convince the Fed to accommodate currency interventions in efforts to weaken the greenback. In the meantime, the dollar will likely continue its volatile ascent. The Dollar Will Rally If Left To Market Forces Based on economic fundamentals, the path of least resistance for the greenback is up - for now. U.S. growth and inflation warrant higher interest rates, and the Fed is willing to continue moving short rates higher. In contrast, the unfolding EM/China slowdown is not only negative for their own respective currencies but is also harmful for commodities currencies in the advanced economies. Besides, the German and Japanese economies are much more vulnerable to a slowdown in EM/China than the U.S. (Chart I-2). Consistently, Chart I-3 illustrates that outperformance by the equal-weighted U.S. stock index versus its global peers in local currency terms - a measure of relative domestic demand - still points to a stronger U.S. dollar. On the whole, the growth and interest rate differentials between the U.S. and the rest of the world will likely continue to move in favor of the former and extend the dollar rally. Chart I-2Germany and Japan Are Much More Exposed ##br##To EM/China Than To The U.S. Chart I-3Relative Share Prices Point ##br##To A Firmer Dollar The dollar is typically a counter-cyclical currency. It depreciates when global trade is improving and appreciates when the global business cycle is slowing (the dollar is shown inverted on this chart) (Chart I-4). Odds are that global trade will continue to decelerate due to the slowdown in EM/China and trade protectionism - even if U.S. domestic demand growth remains robust. Furthermore, U.S. trade protectionism is positive for the dollar. The basis is that exporters to the U.S. could opt for weaker currencies to offset the negative impact of tariffs on their local currency revenues. Financial markets are often self-regulating, and they move to rebalance the global economy and amend economic excesses. A stronger dollar is the right medicine for the global economy for now. A firmer dollar is required to rebalance growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. In addition, a stronger greenback will compel unraveling of excesses within the developing economies. While it will cause growth retrenchment and will be painful for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. U.S. dollar liquidity is tightening, supporting the greenback (the latter is shown inverted on this chart) (Chart I-5). Continued shrinkage of the Fed's balance sheet entails tighter U.S. dollar liquidity going forward. With respect to currency market technicals, the broad trade-weighted U.S. dollar is not yet overbought, and trader sentiment on the U.S. currency is not extremely bullish (Chart I-6). Hence, conditions for an ultimate cyclical top in the dollar do not yet exist. Chart I-4The Global Business Cycle and The Dollar Chart I-5Upside Risks To The Dollar Chart I-6The Dollar: Market Technicals Finally, the U.S. dollar is not expensive. Our favored currency valuation measure - the real effective exchange rate-based on unit labor costs - currently suggests that the greenback is only slightly above its fair value (Chart I-7). This measure is superior to the real effective exchange rate based on consumer and producer prices because it considers both wages and productivity. Ultimately, competitiveness is not a function of wages (or prices) but wages adjusted for productivity.1 Besides, labor costs typically constitute the largest share of business costs. Hence, the unit labor cost-based real effective exchange rate is the best measure of currency competitiveness. This currency valuation yardstick does not corroborate the widely circulating narrative in the investment community that the U.S. currency is very expensive. The greenback is also not expensive according to the real broad trade-weighted dollar index. The latter is only slightly above its historical mean, and well below its previous highs (Chart I-8). Chart I-7AThe Dollar Is Not Expensive Chart I-7BThese Currencies Are Expensive Chart I-8Trade-Weighted Dollar in Real Terms To be sure, we are not implying the dollar is cheap. It is not. Rather, our point is that the greenback is not yet expensive. When valuations are not extreme, they usually do not prevent a rally or selloff. Odds are that the dollar could become more expensive in this cycle before topping out. Bottom Line: Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The Main Risk To The Dollar Is Trump Chart I-9U.S. Monetary Conditions Are ##br##About To Become Tight Will the U.S. administration invoke the "nuclear" option - currency market interventions - to eclipse the dollar's fundamentals and reverse the greenback's rally? President Trump fiercely opposes a stronger dollar. He prefers a structurally weaker currency to bring back manufacturing jobs to the U.S. Besides, from a cyclical perspective, President Trump has been explicit that higher U.S. interest rates and a stronger dollar are negating his economic stimulus. Trump's worry is that tightening monetary conditions, if they persist, will depress growth by late 2019 when the next presidential election season begins in earnest (Chart I-9). President Trump is a genuine economic populist and is ready to cross boundaries that many presidents refused to. This leaves us little doubt that the U.S. administration will escalate its calls both for a weaker currency and a halt in Fed tightening. The U.S. Treasury is in charge of foreign exchange policy, and it can intervene in currency markets. The Fed can, but is not obliged by law, to supplement the Treasury's interventions in foreign exchange markets. In theory, the U.S. Treasury has a special fund (the Exchange Stabilization Fund) and could opt for unilateral currency market interventions even if the Fed does not cooperate. In such a case, a pertinent question is: What are the essential conditions for currency interventions to succeed in reversing the dollar's uptrend? Conditions For Effective Currency Interventions There have been two major interventions conducted by the U.S. authorities to depreciate the dollar: the 1971 Smithsonian Agreement and the 1985 Plaza Accord. BCA's Geopolitical Strategy service has discussed the political and trade backdrops of these interventions in past reports, and we will not detail them here.2 There was also the Louvre Accord in 1987, but it was aimed at propping up the U.S. dollar, not weakening it. All of these interventions were successful and achieved their objective (Chart I-10). We list below the stipulations that secured the success of these interventions and examine whether conditions for effective interventions are present today. Chart I-10The Smithsonian And Plaza Accords Were Successful Currency interventions accompanied by congruent monetary and fiscal policies tend to be more successful. The previous currency interventions conducted by the U.S. Treasury would not have been successful without the Fed simultaneously adjusting monetary policy. Not only did the Fed join the U.S. Treasury's efforts to depreciate the greenback following the Smithsonian Agreement and the Plaza Accord, but it also altered its monetary policy stance - it pursued a policy of lower-than-otherwise called for real interest rates. Academic literature on this issue is straightforward. Bordo (2010) contends the following about the efficacy of currency interventions: "If intervention were to have anything other than a fleeting, hit-or-miss effect on exchange rates, monetary policy had to support it ... Most of the movements in exchange rates over the Plaza and Louvre period seem attributable to policy changes, not intervention."3 Given current economic conditions in the U.S. economy - a very tight labor market and the prospect of higher inflation - the Fed is unlikely to easily agree to altering its current policy stance to accommodate the Treasury's preferred exchange rate policy. Academic literature finds that sterilized interventions are less effective than non-sterilized ones.4 For the Fed not to sterilize currency interventions aimed at weakening the dollar, it would need to allow commercial banks' reserves to rise. This would conflict with its current explicit objective of reducing commercial banks' reserves and shrinking its balance sheet (Chart I-11). Chart I-11U.S. Banks' Reserves and The Dollar Hence, the bar is presently very high for the Fed to agree to non-sterilized currency interventions to weaken the dollar, as it would go against its current policy objective of tightening and shrinking its balance sheet. Going on the Treasury's leash would substantially damage the Fed's creditability. Bilateral currency interventions are much more effective in achieving the desired objective than unilateral ones. Hence, for interventions to succeed it is critical to involve counterparts in other countries. Back in the 1970s and 1980s, the U.S. used its hegemonic leadership over Europe and Japan as well as tariffs (in 1971) and the threat of tariffs (1980s) to force its allies to agree to bilateral interventions to weaken the dollar. However, it is difficult to envision either Europe or Japan agreeing to allowing their respective currencies to strengthen a lot at this time. First, both Europe and Japan are actively fighting latent deflationary forces at home. Given the high-beta, export-dependent nature of both economies, a strong currency would negatively impact growth. Geopolitically speaking, Europe is not as dependent on the U.S. today as it was at the height of the Cold War. Russia is a "poor man's" Soviet Union, with the combined defense budget of the EU economies dwarfing its own. Besides, in the 1970s and 1980s, the U.S. was "the only market in town." Crossing American policymakers upped the threat of being evicted from the most lucrative global middle class consumer market. This is no longer the case with the rise of emerging markets, China and the common European market. Prominently, Trump's main objective is to depreciate the dollar versus the Chinese RMB. Yet, there is no chance that in the foreseeable future China will agree with the U.S. to engineer considerable yuan appreciation against the dollar. In fact, Beijing has been actively using CNY depreciation to offset the impact of tariffs imposed on its exports by the Trump administration. Chart I-12China: Exchange Rate and Interest Rate##br## Differential Are Correlated Notably, this week there was an article published by China's Xinhua news agency referring to the "... Plaza Accord, in which Tokyo agreed to strengthen the currency against the dollar, as cause of the country's economic woes. ... Rapid and steep yen appreciation and Japan's domestic policy mistakes eventually brought about the nation's "lost decade."5 Chinese policymakers have carefully studied and internalized Japan's mistakes in the late 1980s and early 1990s. The mainland will not accept a considerably stronger yuan at times when deleveraging remains an important policy objective - and the latter is bound to weigh on domestic demand. Amid deleveraging, China requires a weaker - not stronger - currency to mitigate deflationary pressures in the economy. For interventions to be effective, foreign counterparts need to also agree to adjust their monetary and fiscal policy stances to be in sync with exchange rate policy. Presently, both the European Central Bank and the Bank of Japan are still conducting QE and expanding their balance sheets. These policies are compatible with weaker - not stronger - currencies. It is highly unlikely these central banks will abruptly reverse their current policies to accommodate President Trump's economic preferences. With time, if the U.S. dollar overshoots on the strong side and the euro and yen plunge substantially, it is probable that the ECB and BoJ will become willing to support the U.S. administration's efforts to depreciate the dollar. However, conditions for bilateral interventions do not exist at the moment. As to China, policymakers are unlikely to push local rates higher to promote a major currency rally. Chart I-12 illustrates the tradeoff between the exchange rate and interest rates in China might be weak but exist - the CNY/USD rate broadly correlates with the China-U.S. interest rate differential. The PBoC may not be able to appreciate the yuan without tolerating higher money market rates. Yet China's corporate debt burden is enormous, and requires low - not high - borrowing costs to smooth the deleveraging process. Bottom Line: Conditions for effective foreign exchange market interventions do not presently exist in the U.S. For the time being, neither the Fed nor central banks in Europe, Japan and China will cooperate with the U.S. Treasury to depreciate the dollar. Can The U.S. Intervene In CNY/USD Market? Chart I-13Trade-Weighted RMB And Dollar Move Together The U.S. can intervene in the euro, yen and other currency markets, but the focus of President Trump is the dollar's exchange rate with the Chinese yuan. Provided China has capital controls, its government decides which foreign institutions/organizations can buy local currency and assets, and how much. It is highly unlikely the Chinese government will grant permission to the U.S. authorities to freely operate in the RMB market. In short, China will not allow the Fed and other U.S. institutions to act on behalf of the government and push around the exchange rate. The ongoing trade confrontation between the U.S. and China has not produced any agreement. There is, at this time, zero chance that China will agree to appreciate its currency considerably under U.S. pressure. In fact, our geopolitical strategy team still expects the Trump administration to impose tariffs on the announced $200 billion of Chinese imports at some point in September. While the ultimate figure may be smaller than $200 billion, the point remains that the trade war between the U.S. and China continues to heat up, not cool off. The only feasible option for the U.S. authorities is to devalue the dollar against the European and Japanese currencies, triggering a broad-based selloff in the dollar. In this scenario, the RMB might appreciate versus the greenback, but only moderately. The CNY/USD rate is tightly controlled by the PBoC, and the yuan typically depreciates (appreciates) in trade-weighted terms when the greenback weakens (strengthens), respectively (Chart I-13). Consequently, U.S. intervention in currency markets that does not directly embrace the yuan will likely lead to a weaker trade-weighted RMB and make China even more competitive versus other nations. In fact, such an effort would be welcomed by Chinese policymakers, as it would stabilize and even lift the yuan versus the dollar (fostering financial stability in China), but allow the renminbi to depreciate in trade-weighted terms (boosting China's overall trade competitiveness). Bottom Line: There is currently no effective way for the U.S. to intervene and achieve material RMB appreciation in trade-weighted terms. Investment Conclusions Chart I-14Go Long U.S. Dollar Volatility The global macro landscape warrants a continued dollar rally. Yet the U.S. administration will use frequent verbal attacks to halt the greenback's ascent. President Trump is likely to continue to publically oppose the Fed and its interest rate policy. At some point, potentially in the near future, his criticism could become a full-on assault. In this context, the U.S. currency will continue to appreciate, but its rally will be accompanied by large dips, i.e., substantially higher volatility. To capitalize on this theme, traders should consider going long dollar volatility (Chart I-14). The trajectory of the U.S. dollar is critical for many financial markets in general and EM in particular. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM in absolute terms and underweighting EM versus DM for stocks, credit and currencies. BCA's Emerging Markets Strategy continues to recommend shorting a basket of the following EM currencies versus the U.S. dollar: the Brazilian real, the South African rand, the Chilean peso, the Malaysian ringgit and the Indonesian rupiah. Potential dynamics that would persuade the Fed to arrest its tightening campaign include escalating EM turmoil that spills into U.S. financial markets. An intensifying EM selloff is our baseline view, and the dollar will spike materially in this scenario. Only after this occurs will the Fed likely contemplate halting its tightening, and only then will the dollar peter out. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Unit labor cost = (wage per person per hour) / (productivity per person per hour). 2 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, and "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available at gps.bcaresearch.com. 3 Bordo, M. et al (2010), "U.S. Foreign-Exchange-Market Intervention during the Volcker-Greenspan", NBER Working Paper, September 2010 4 Bordo, M., Humpage, O. & Schwartz, A. (2011), "U.S. Monetary-Policy Evolution and U.S. Intervention", Federal Reserve Bank of Cleveland, Working Paper, October 2011 5 South China Morning Post: Chinese state media cites Japan's 'lost decade' when warning of risks of giving in to US demands; https://www.scmp.com/news/china/diplomacy-defence/article/2160196/chinese-state-media-cites-japans-lost-decade-when Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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.

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

Highlights "When you come to a fork in the road, take it." - Yogi Berra The last time we invoked the great American philosopher Yogi Berra was in September 2015. Back then, the oil market was at a critical juncture, as the market-share war initiated by OPEC in November 2014 approached its dénouement.1 The signal feature of the oil market in September 2015 was a massive 1.5mm b/d oversupply that was rapidly filling storage globally. We noted this surplus "... either will be cleared gradually or convulsively. ... (H)igh-cost supply either will exit the market rationally ... or via sharp lurches toward cash-breakeven costs, as global inventories fill on the back of slowing demand in an oversupplied market. Either way, markets will balance." In the event, prices lurched sharply into the left tail of the distribution toward cash-breakevens, with Brent approaching $25/bbl in 1Q16 (vs. more than $100/bbl in mid-2014). Oil's at a critical juncture again. Only this time, prices are poised to push higher into the right tail of the distribution, ahead of the likely loss of 2mm b/d or more of exports on the back of U.S.-imposed sanctions against Iran, and the all-but-certain collapse of Venezuela's economy. In our modelling, these events - along with constrained U.S. shale oil output due to pipeline bottlenecks in the Permian basin, and still-strong demand assumptions - could send prices above $120/bbl.2 This is not a foregone conclusion, however. Downside risks to global oil demand - largely from tariffs and non-tariff barriers to trade, and the Fed's monetary policy - are building. In this Special Report, we expand our examination of downside risks to oil prices arising from divergent monetary policies at systematically important central banks, particularly their impacts on currency markets, which we began last week. Feature Chart of the WeekOil Prices And USD TWIB Share##BR##Long-Term Trend, Equilibrium We strongly believe Fed policy will, once again, become a key variable in the evolution of oil prices, mostly via the FX markets. As a result, our regular monthly oil price forecast will be complemented by an additional component: our U.S. trade-weighted dollar (USD TWIB) forecast. In the current market, this is a downside scenario not a revised expectation. The FX simulation we describe below for prices hugs the lower boundary of the 95-percent confidence interval we use to situate our scenarios within. This will allow us to judge our expectation against market-cleared expectations. Our thesis that the USD's appreciation earlier this year would have a moderate effect on the evolution of oil prices - i.e., that supply-demand fundamentals would dominate this evolution - has been spot-on so far in 2018.3 This is largely due to OPEC 2.0's remarkable production discipline, and strong demand, particularly out of EM economies, which caused global inventories to draw, and kept the forward curves for Brent and WTI backwardated. 4 However, with the U.S. economy powering ahead - growing at a 3.1% rate in 1H18 - and, per our House view, the Fed continuing to lean into its rates-normalization policy, the USD will rise ~ 5% over the next year.5 We have shown in the past how important the USD can be for oil prices. Our oil financial model uses the USD as its main explanatory variable, and shows these variables are cointegrated in the long run - i.e. they share a common long-term trend and are in an equilibrium relationship (Chart of the Week). Consequently, forecasting the U.S. dollar is crucial step in our oil-price forecasting process. The Fed And Oil Prices As the Iran sanctions approach, OPEC 2.0 has indicated - not in a particularly clear manner - that it will be increasing production. While it appears the producer coalition will raise output slower than it previously led the market to believe, it is raising output.6 In addition, the U.S. Strategic Petroleum Reserve (SPR) also will be releasing 11mm barrels of oil over the October - November period. This short-term measure will help keep gasoline prices down going into the U.S. mid-term elections. While OPEC 2.0 calibrates the output required to offset the Iran-Venezuela supply-side risks, demand growth is being threatened by tariff and non-tariff barriers to trade, and the Fed's monetary policy.7 Between tariffs and U.S. monetary policy, we believe Fed policy trumps U.S. trade policy ... at least for now. Fed Policy Trumps Tariffs A lot of ink has been spilled on the Sino - U.S. trade war, but so far, the actual damage done to the $17 trillion global trading markets is trivial (Chart 2). Of course, this could quickly change if the U.S. and China step up their tit-for-tat tariffs and both plunge into an all-out trade war. Fed policy is neither trivial nor local: It is a global macro variable, largely because it impacts the U.S. dollar directly. This is important for EM economies, especially as it pertains to trade. We have shown EM imports and exports are exquisitely sensitive to the USD TWIB.8 This makes the USD TWIB particularly important to commodity markets, since most of the world's traded commodities are priced in USD and EM demand dominates global demand. When the Fed is tightening, the dollar appreciates, and commodities priced in USD become more costly ex-U.S. at the margin. This lowers demand for goods priced in USD. In addition, a stronger USD lowers the cost of production ex-U.S., which, again, at the margin, incentivizes supply growth, since commodity producers effectively arbitrage their local currency weakness by selling their output for USD. This supply-side effect is tempered somewhat by the degree to which commodity producers ex-U.S. are exposed to dollar strength in their input markets. For example, if a producer's production inputs are priced in USD - e.g., drilling services - its margins suffer, and output increases are constrained or nullified. The Fed is the only systematically important central bank we follow - the others being the ECB, BoJ and PBoC - implementing and executing an interest-rate normalization policy. This has supported USD strength against the systematically important currencies we follow, as well (Chart 3). Chart 2Tariffs Are A Less Threat To Global Growth ... Chart 3Important Central Banks Keeping Policies Accommodative The IMF is encouraging the ECB to maintain its accommodative policy, and the BoJ also is keeping its policy relatively loose.9 The BoJ is keeping policy on hold for now, and is guiding to no rate hikes until 2020. Our colleagues in BCA's FX and Fixed Income desks expect the BoJ to continue with its Yield Curve Control Strategy for the remainder of the year, and most of next year. The absence of monetary tightening will keep Japanese yields lower than other major central banks. The PBoC appears to have moved toward a more accommodative mode, in the wake of the Sino - U.S. trade war. We believe the PBoC will remain accommodative in terms of official lending rates to avoid too-fast a deceleration of the economy, largely because of high private debt levels.10 EM Trade Volumes And Oil Prices Against a largely accommodative backdrop ex-U.S., the USD TWIB appreciated ~5% y/y, while the JP Morgan Emerging Markets FX index dropped ~11% (Chart 4). In the wake of USD TWIB strength, EM trade volumes have held up reasonably well; but growth rates have been under pressure particularly in Central and Eastern Europe (Chart 5, bottom panel). This is being offset by a turn-around in the Middle East and Africa (third panel). Chart 4Fed Policy Drives USD Strength Chart 5EM Trade Slowing, But Still Holding Up Assuming the Fed maintains its existing course re policy-rate normalization, our Fed-policy models indicate the USD TWIB will continue to strengthen (Chart 6).11 On the flip side of that, EM currencies will continue to weaken (Chart 7). This will keep pressure on EM trade volumes, particularly the important import volumes. Over the next year, we expect continued slowing in trade volumes, although, on average, we still expect y/y growth (Chart 8). While growth is slowing in EM trade, the levels of trade will remain high, unless a full-blown global trade war erupts that literally forces trade to contract. Chart 6Fed Policy Will Propel USD TWIB Higher... Chart 7... And Keep EM Currencies Weaker Chart 8Downward Trend In EM Trade Will Continue As USD Strengthens ... Strong USD, Weak EM Trade := Bearish Fed policy will strengthen the USD TWIB and weaken EM trade. These factors will tend to pull crude oil prices down, in and of themselves (Chart 9). We do not think these factors will dominate the evolution of crude oil prices over the next six months, however. That said, the current environment forces us to adapt our modelling procedure in order to account for the possible re-emergence of the USD as a key driver of oil prices. Going forward, our regular monthly oil price forecast will be complemented by our U.S. trade weighted dollar forecast.12 We will be rolling out our new oil-price forecasting models next month, when we update our supply-demand balances and price forecasts. For the immediate future, we continue to believe upside price risk dominates the oil market: The approaching U.S. sanctions against Iran and the all-but-certain collapse of Venezuela's economy could remove as much as 2mm b/d of exports from oil markets by next year, if not sooner. This would constitute an oil-price shock, pushing prices into the right tail of the price distribution, consistent with the modelling we've done for the past several months (Chart 10). Chart 9... Adding A Bearish Factor To##BR##The Evolution Of Brent, WTI Prices Chart 10Upside Risks##BR##Still Dominate We reiterate our conclusion from last week, however, that an oil-supply shock, coupled with slower EM trade growth ultimately will produce strong deflationary impulses. If markets avoid an oil supply shock, and if the Fed maintains its rates-normalization policy while the rest of the world's systemically important central banks remain accommodative, pressure will build on EM trade - and incomes - that reduces commodity demand, in line with lower aggregate demand from the EM economies. In either event, the Fed's rates-normalization policy most likely will have to turn accommodative to counter this. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see our Special Report entitled "Oil Volatility To Stay Higher Longer," published September 17, 2015. It is available at ces.bcaresearch.com. 2 We have written at length regarding this possible price evolution. Please see, e.g., BCA's Commodity & Energy Strategy Weekly Reports from August 16 and August 2, 2018, entitled "OPEC 2.0 Sailing Close To The Wind," and "Calm Before The Storm In Oil Markets." Both are available at ces.bcaresearch.com. 3 For more details, please see Commodity & Energy Strategy Weekly Report published February 8, 2018, "OPEC 2.0 Vs. The Fed." It is available at ces.bcaresearch.com. 4 OPEC 2.0 is the name we coined for the producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. 5 In Jackson Hole last week, Fed Chair Jerome Powell gave a strong endorsement of the Fed's rates-normalization. Please see "Fed Chair Powell: further rate hikes best way to protect recovery," published by reuters.com August 24, 2018. 6 On a 4Q19 vs 4Q18 basis, we expect global oil supply to increase just over 1mm b/d, and for demand to rise 1.8mm b/d, leaving the market in a physical deficit in 2H18 and 2019. We expect Brent to average $70/bbl in 2H18 and $80/bbl in 2019. Please see our updated balances estimates and price forecasts in "OPEC 2.0 Sailing Close To The Wind," published August 16, 2018, by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 Our $80/bbl forecast for Brent crude next year - and the physical deficit we expect - implicitly assumes OPEC 2.0 either wants to keep the market relatively tight, which will force inventories to draw and backwardate the forward curves, or that it is pushing up against the limits of the production it can readily bring to market. 8 We most recently discussed this in our Commodity & Energy Strategy Weekly Report published August 23, 2018, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk." It is available at ces.bcaresearch.com. 9 Please see Abdih, Yasser, Li Lin, and Anne-Charlotte Paret (2018), "Understanding Euro Area Inflation Dynamics: Why So Low for So Long?" published by the IMF this month. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "An R-Star Is Born," dated August 7, 2018, and Foreign Exchange Strategy Weekly Report, "Rhetoric Is Not Always Policy", dated July 27, 2018, available at gfis.bcaresearch.com and fes.bcaresearch.com. 11 We have a suite of models we use to forecast the USD TWIB, many of which use proxies for the Fed's Congressionally mandated policy goals - i.e., maximum employment, stable prices and moderate long-term interest rates. We use cointegrating regressions to estimate these policy-driven models. The R2 coefficients of determination for the models are clustered around 0.95. The out-of-sample results are strong; we use a weighted-average of the five forecasts based on root-mean-square errors to come up with our USD TWIB forecast. We presented our policy-variables USD TWIB models in last week's Commodity & Energy Strategy Weekly Report. Please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk." It is available at ces.bcaresearch.com. 12 With the introduction of these financial and macro variables, our oil price forecast will be a weighted average of our core Fundamental model and the new Financial model - i.e. the final forecast will look like [aFundamental+(1-a)Financial]. The weights - a and (1-a) - are time-varying, and will reflect our Bayesian probabilities for the relative importance of each model's contribution to price action every month. These weights are crucial. We allow them to vary in order to capture periods in which our analysis tells us we should expect the USD effect to be muted by idiosyncratic supply, demand or inventory dynamics. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Since 2010, China's private sector has accounted for the majority of the country's increase in the debt-to-GDP ratio, most of which has been on the balance sheets of state-owned enterprises (SOEs) and the household sector. While policymakers achieved their goal of maintaining aggregate demand in the decade following the global financial crisis, the financial condition of SOEs has been greatly sacrificed as a result. An analysis of SOE return on equity highlights a sharp decline in return on assets, which has occurred due to both declining profit margins and a falling asset turnover ratio. Even worse, a comparison of adjusted SOE ROA to borrowing costs suggests that the marginal operating gain from debt has become negative. This has profound implications for policymakers, as it suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. We can envision a modest releveraging scenario over the coming 12-18 months, but even that scenario is not consistent with a surge in investment-driven economic activity. Policymakers face a clear choice between growth and leveraging, and our bet is that they will choose just enough of the latter to prevent the former from decelerating significantly. This implies that the typical beneficiaries of Chinese reflation are not likely to outperform global risk assets, and that China's contribution to global growth is not set to rise sharply. However, over the coming 6-12 months, we acknowledge that domestic stocks are significantly oversold, and we are watching closely for an opportunity to time a reversal. Feature Global investors have paid considerable attention to China over the past month, focusing on the likely stimulative response of policymakers to an upcoming, tariff-induced export shock. We recently presented our view of the likely character and magnitude of upcoming Chinese stimulus in a two-part joint special report with our geopolitical team,1 and concluded that an acceleration in fiscal spending was far more likely than a sharp pickup in credit growth. In this report, we further examine the constraints facing Chinese policymakers and again conclude that they are likely to remain committed to preventing a significant releveraging of the economy. The financial condition of Chinese state-owned enterprises features prominently in our argument, and we highlight how the damage caused by China's post-2008 "business model" is a serious roadblock to further credit excesses. Whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, Chinese policymakers now appear to understand that they face a trade-off between growth and leveraging. While we agree that economic stability will always remain the paramount objective of policymakers and a major policy mistake is not likely in the cards, reflationary efforts are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth. This means that there is both limited downside and upside to Chinese economic activity, implying that expectations of a material, credit-driven reacceleration in growth are not likely to be met. A Brief Review Of Chinese Private Sector Debt Chart 1A Now Familiar Concern After several years of intense concern about China's elevated debt, Chart 1 should be familiar to most investors. It highlights the significant rise in Chinese credit to the non-financial sector (i.e. total credit to governments, households, and non-financial corporations) based on data from the Bank for International Settlements (BIS), most of which has occurred in the private sector (non-financial firms and households). But Charts 2-4 presents a different breakdown of credit to the non-financial sector, based on IMF data, that includes a separation of corporate debt into private and state-owned enterprises (SOEs). The data shown in Charts 2-4 covers the 2010-2016 period; for reference, private non-financial sector debt continued to rise relative to GDP in 2017, in large part due to households (see Table A1 in Appendix 1 for the most recent IMF estimate of China's non-financial sector debt, absent the breakdown in corporate debt by ownership that the fund previously provided). Chart 2 presents the IMF's version of the rise in total non-financial debt (akin to Chart 1 from the BIS), and Charts 3 and 4 attribute the rise in debt to different sectors. Chart 3 shows that the increase in private sector debt accounts for 70% of the increase in leverage since 2010, and Chart 4 shows that the rise in SOE debt has accounted for nearly half of the rise in private sector debt. Within the private sector, household leverage has also risen substantially, accounting for roughly 40% of the rise from 2010-2016. Non-SOE corporates accounted for only 12% of the total rise in private leverage, the smallest of all sectors. Chart 2Another Perspective On Chinese Leveraging, With A Breakdown Of Corporate Debt By Ownership   Chart 3The Private Sector Has Accounted For ##br##Most Of Chinese Leveraging... Chart 4...Due Mostly To State-Owned ##br##Enterprises And Households     When considering the potential economic impact of a sharp rise in leverage, BCA's view is that the focus should usually be on the increase in private sector debt rather than government debt. Public sector deleveraging is fundamentally a political choice in countries that have control over their own monetary policy, and simply will not occur in China over the coming year given the headwinds facing the economy. Given this, Chart 4 suggests that to understand any constraints facing policymakers from excessive leverage, investors should primarily devote their attention towards China's SOEs. China's State-Owned Enterprises: The Sacrifice Of Profitability For Stability Chart 5Within SOEs, Industrial And Construction Firms ##br##Account For Half Of The Increase In Debt When assessing the risk of a potential private sector debt crisis in China, many investors have a sanguine view. The common refrain is that Chinese corporations, particularly state-owned enterprises, will be bailed out by the government if debt problems arise. Ultimately, we agree with this view, although we would note that the market pressure required to force the government to act could be quite severe. Still, there is a more pressing concern for investors: an analysis of the financial condition of China's state-owned enterprises suggests that the country may have reached the limit of how much SOEs can be further leveraged by policymakers in an attempt to rescue the economy, without significantly increasing the ultimate cost to the public. Our sense is that the campaign to control debt growth over the past two years reflects this economic reality, suggesting that the motivation behind the campaign will not be easily abandoned. Chart 2 showed that non-financial SOE debt-to-GDP rose by 20 percentage points from 2010-2016, a change in the stock of debt of roughly RMB33 trillion. Chart 5 shows that roughly half of this amount can be accounted for by the change in liabilities of state-owned industrial and construction enterprises over the same period. To the extent that they broadly reflect the condition of all non-financial SOEs, the availability of income statement and balance sheet data for these two industries allows us to make some inferences about the debt sustainability of China's state-owned firms.   Table 1 presents a breakdown of return on equity (ROE) for state-owned/state-holding companies in these industries, using the DuPont approach. Several points are noteworthy: Industrial & construction SOEs are highly leveraged entities, with an assets to equity ratio of 2.7. This explains the substantial difference between return on equity, which has been decently high, and a low single-digit return on assets (ROA). From 2010-2016, the ROE for industrial & construction SOEs fell from 14% to 8%, entirely because of a substantial decline in ROA. The decline in ROA occurred because of a roughly equal combination of declining profit margins and a falling asset turnover ratio. Based on the DuPont approach to expressing leverage,2 SOEs in the industrial and construction industries increased their leverage only very modestly during the period. But when leverage is expressed as liabilities relative to net income, a considerably more relevant measure when considering the potential to service debt, leverage nearly doubled. Table 1A Meaningful Decline In SOE Efficiency And Profitability We presented Chart 6 in our last weekly report of 2017,3 and used it to represent a stylized timeline of China's economic history over the past 15 years. The chart describes how China's extremely rapid growth phase from 2002-2008 was followed by the global financial crisis and a normal, counter-cyclical rise in the debt-to-GDP ratio from 2008 to 2010. Chart 6A Stylized Timeline Of China's Recent Economic History However, amidst the Great Recession, it became clear that China's export-enabled catchup growth phase was durably over, and policymakers were faced with a hard choice. They could either replace exports with debt-fueled domestic demand as a growth driver in order to buy time to transition to a services-led economy (the "reflate" path), or allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity (the "stagnate" path). The picture that emerges from the combination of this narrative and our analysis of the evolution of SOE financial health is straightforward, but sobering. State-owned enterprises, already highly indebted at the onset of the global economic recovery, were levered even further in order to pursue the "reflate" path described above. While policymakers achieved their goal of maintaining aggregate demand, the consequence of their choice is that both the profitability and efficiency of SOEs have declined significantly. Avoiding An SOE Debt Trap A significant deterioration in SOE efficiency against the backdrop of a sharp rise in leverage speaks to the existence of capital misallocation, i.e. investment that has been funded by debt but cannot produce sufficient income to repay the debt. This suggests that SOEs are likely to have a bad debt problem at some point that will need to be resolved with government support. But in our view, the decline in profitability is a more immediate problem for policymakers, because it does not appear that SOEs can be leveraged any further without pushing them dangerously towards a self-reinforcing debt trap. Chart 7 illustrates why. The chart shows SOE ROA adjusted for interest expenses (a proxy for EBIT/Assets) versus a market-based proxy for SOE borrowing rates.4 Adjusted ROA fell below borrowing rates in 2013, suggesting that some of the observed decline in SOE profitability has occurred because the marginal operating gain from debt for Chinese state-owned enterprises has become negative. If so, this has profound implications for Chinese policymakers. Chart 8 illustrates how the process of perpetually leveraging an entity with a negative marginal operating gain from new borrowing eventually leads to a debt trap. An initial increase in debt causes interest costs to rise and profits to fall, as the return on new assets fails to exceed the interest rate on the debt used to acquire the assets. The process repeats itself as the entity is directed to leverage further, although management may choose to raise the entity's debt in this situation regardless of policy objectives (e.g. to cover a working capital deficit) if they mistakenly believe that the decline in ROA below debt costs is temporary. In addition, the existence of a negative marginal gain from new borrowing for a significant portion of the private sector would imply that China's natural rate of interest may have fallen. Chart 9 shows some evidence in support of this notion: the rise in the weighted average lending rate since late-2016 was relatively minor compared with levels that have prevailed over the past decade, and yet it is clear that it succeeded in materially slowing the investment-driven sectors of China's economy. This suggests that further leveraging of SOEs could tighten the shackles on the PBOC in terms of its ability to meaningfully raise interest rates, potentially fueling credit excesses in other sectors of the economy Chart 7SOEs Now Appear To Have A Negative ##br##Financial Gain From Debt Chart 8A Stylized Example Of ##br## Debt Trap Dynamics Chart 9Has SOE Leveraging Caused China's ##br##Natural Rate Of Interest To Fall?         In short, the financial condition of China's state-owned enterprises appears to represent a proximate constraint preventing policymakers from responding to economic weakness with a significant acceleration in credit growth. It is not just that SOEs are highly levered and there is "a lot of debt in the system"; material further leveraging of these entities risks deteriorating what is already very poor profitability, which may push SOEs into an outright debt trap. That would precipitate a crisis and necessitate a bailout from the government, the cost of which will increase directly in line with the amount of additional debt taken. We agree that economic stability will always remain the paramount objective of policymakers, and we fully expect a policy response to address the upcoming export shock from the U.S. But whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, our analysis of China's state-owned enterprises suggests that Chinese policymakers now seem to understand that they face a trade-off between growth and leveraging. This implies that current reflationary efforts from policymakers are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth. Envisioning Modest Releveraging Chart 10Modest Releveraging Is Ok, As Long As ##br##Its Pace Continues To Slow What is a carefully calibrated credit response likely to look like, and what does it mean for private sector debt growth? As noted above, my colleague Matt Gertken addressed this question by presenting three scenarios in part 1 of the recent joint special report with our geopolitical team.5 His base-case view, to which he assigned 70% odds, implied that there would be a very modest reacceleration in total social financing (on the order of 1% or so). In this report we take a second approach to estimating the potential magnitude of a modest reacceleration scenario using the BIS private sector credit data, primarily to incorporate different growth rates for the corporate and household sectors. Using the BIS data, Chart 10 shows the growth rate in Chinese total private sector debt, nominal GDP, and the difference between the two. The significant leveraging period from 2010-2016 is evidenced by the persistently positive gap between credit and GDP growth (it was only briefly negative in 2011).   But the chart also shows that there has been a downtrend in the gap since 2013, with 2017 representing a major overshoot (to the downside). Given that the trend shown in Chart 10 points downward and reflects policy efforts to control debt growth, we could envision Chinese policymakers tolerating some acceleration in credit growth relative to GDP, as long as it does not materially overshoot the trendline to the upside. Using this framework as a guide, we can calculate what modest releveraging might mean for corporate sector debt, assuming the following: Chinese policymakers, through a combination of fiscal spending and modest releveraging, succeed in stabilizing nominal GDP growth at current levels. Policymakers tolerate total non-financial private sector credit growth that is 4% in excess of nominal GDP growth. Household credit growth remains well in excess of GDP growth, in-line with its average of the past 5 years. Given the significant leveraging of the household sector and the recent uptick in home sales, this appears to be a reasonable assumption barring a major crackdown on the property market by Chinese officials. Chart 11 presents the result of these assumptions, which shows non-financial corporation credit growth accelerating to roughly 12% by the end of 2019. At first blush, the chart appears to show a meaningful acceleration, as the annual change in year-over-year credit growth based on this measure would meet or exceed that of the past two credit cycles. But there are two important caveats for investors: Even as depicted in Chart 11, non-financial corporate credit growth would still be extremely weak relative to its recent history. At the end of 2019, the chart shows that corporate credit growth would be almost two percentage points lower than its weakest point in 2015. Chart 11 illustrates a scenario where the level of credit to the total private non-financial sector grows by RMB36 trillion by the end of 2019. Chart 12 shows that when compared to our estimate of the stock of adjusted total social financing, this rise barely even registers as an acceleration. Chart 11A Rebound, But Weak Relative To History Chart 12Barely Even Registers As An Acceleration In Adjusted TSF In short, while the degree of acceleration in credit growth as implied in our scenario varies depending on the definition of credit employed, the bottom line for investors is that a modest releveraging scenario is not consistent with a surge in investment-driven economic activity. Policymakers face a clear choice between growth and leveraging, and our bet is that they will choose just enough of the latter to prevent the former from decelerating significantly. This cautious, contingent attitude towards an acceleration in private sector credit growth would be in marked contrast to previous episodes of reflation, suggesting that investors who are following China's "old stimulus rulebook" are likely to be disappointed. Implications For Investment Strategy Chart 13No Signs Yet Of A Heavy, Credit-Based Response There are two clear implications of our analysis for investment strategy. First, in ironic reference to Reinhart & Rogoff's book that coined the term, "this time" is likely to be different for China because policymakers seem resolute in their intention to prevent a financial crisis (as opposed to the term having been used in the past by those who have ended up contributing to one). Our analysis shows that the debt burden for state-owned enterprises is already extreme, and that further, material, forced leveraging of the sector risks a possible debt trap. This implies that the typical beneficiaries of Chinese reflation are not likely to outperform global risk assets, and that China's contribution to global growth is not set to rise sharply. For now, our BCA China Play Index and the relative performance of infrastructure stocks seem to support our conclusion (Chart 13). Second, if this time is not different, i.e. if policymakers allow a significant further releveraging of the private sector, either intentionally or by accident, investors should recognize that the longer-term outlook for China may darken considerably if the country is not capable of quickly shifting away from its old growth model over the next few years. Unfortunately for officials in China, the reality of economics is that positive NPV projects for SOEs to invest in cannot simply be willed into existence. The significant decline in profitability and asset turnover that we have observed in state-owned enterprises since 2010 speaks to the poor use of credit, and policymaker reliance on the traditional methods of stimulus is likely to achieve the country's short-term goals at the expense of making the already large debt problem (and the cost of the eventual bailout by the public sector) much worse. This would raise both the political and economic risks facing the country, at a time when a U.S. and/or global recession appears likely within the next 2-3 years. As a final point, despite our caution against over-optimism concerning China's stimulative response, we acknowledge that policymakers are likely to succeed in preventing a significant deceleration in their economy over the coming 6-12 months. Given how materially Chinese stock prices have declined, it remains a debate whether a mere stabilization of economic activity at a modest pace will be enough for domestic or investable equities to meaningfully rally in absolute or relative terms. For now, we have highlighted that the relative selloff in domestic stocks appears to be quite late, particularly in common currency terms, and we are watching closely for an opportunity to time a reversal.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Appendix 1 Appendix A-1Chinese Non-Financial Sector Debt 1 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018 available at cis.bcaresearch.com 2 The DuPont approach breaks down return on equity into the product of profit margins (profits / revenue), asset turnover (revenue / assets), and financial leverage (assets / equity). 3 Pease see China Investment Strategy Weekly Report "Legacies Of 2017", dated December 21, 2017, available at cis.bcaresearch.com 4 We use the yield-to-maturity of the ChinaBond Corporate Bond Index as our proxy for the interest rate paid by state-owned firms, given that the index includes bonds issued by central and local government SOEs. Importantly, our proxy is closely aligned with the weighted average bank loan borrowing rate paid by SOEs from 2014-2016, as per a 2017 report from the China Academy of Fiscal Science ("Cost reduction: 2017 survey and analysis", August 28, 2017). 5 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018 available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing. Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017. Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes. Feature Dear Client, This week, we are sending you a Special Report written by Ryan Swift, Chief Strategist of our sister publication, U.S. Bond Strategy. The report introduces an intriguing framework that directly links market expectations of changes in short-term interest rates to bond market returns for both U.S. Treasuries and U.S. spread product. We will extend the analysis to non-U.S. bond markets in a future Special Report to be published in late September. I trust you will find this report to be interesting and insightful. Best Regards, Rob Robis It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't. While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise. During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing. In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product. Testing The Golden Rule's Performance Chart 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash. Chart 1The Golden Rule's Track Record If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case. Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1). Chart 2Treasury Index Excess Return &##BR##Fed Funds Rate Surprises (1990 - Present) Chart 3Treasury Index Price Return &##BR##Fed Funds Rate Surprises (1990 - Present) Table 112-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present) Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise. Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order. The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step. Learning From Failures While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components: Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns. The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises. This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession. Chart 4When The Golden Rule Doesn't Work The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year. The 2017 Episode Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower. At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike. Chart 5The 2017 Example The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year. Forecasting Total Returns One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index. Chart 6Market Has Underestimated##BR##The Fed In Recent Years First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher. We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps. With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(DY2) E(DY2) = 1-year trailing estimate of yield volatility In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.59% for the Treasury Master Index. Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.36%. Table 2Treasury Index Total Return Forecasts Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors. Spread Product Total Return Forecasts With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten. Table 3Spread Product Total Return Forecasts For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.79%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix A Chart 7Change In 1-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 8Change In 2-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 9Change In 3-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 10Change In 5-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 11Change In 7-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 12Change In 10-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 13Change In 30-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Appendix B Chart 14Corporate Bond Spread Scenarios Chart 15Government-Related Spread Scenarios Chart 16Structured Product Spread Scenarios