Policy

Highlights U.S. Tax Cuts: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. Fed vs. ECB: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. We expect a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. U.S. Corporates vs. EM: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Feature Who's In Charge Here? Table 1A Rough Month For Risk Financial markets are sailing without a rudder at the moment. A clear risk-off flavor has swept over most risk assets, as can be seen in the returns seen so far in August in so many asset classes (Table 1). There have been a number of negative news events for investors to process, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to the North Korean tensions to last week's terror attack in Spain. On top of that, some of the major central banks have become a bit more wishy-washy in their guidance to the markets, even going as far as questioning their own understanding of the inflation process (does the Philips curve even work anymore?). Investors always prefer a clean narrative when it comes to the "big picture" macro backdrop. Right now, they are not getting that from political leaders and policymakers, especially in the U.S. (Chart of the Week). Trump's popularity rating is steadily declining, even now among Republican voters. This has raised concerns that any of his business-friendly policies tax cuts or initiatives to boost growth like infrastructure spending can be successfully enacted. At the same time, and perhaps for similar reasons, the gap between the market expectation and the Fed's projection for the funds rate is widening with only 24bps of hikes priced over the next year. This is driven largely by investors' persistent lack of belief that U.S. inflation will hit to the Fed's target in the next few years. Simply put, the market is saying that the Fed's current tightening cycle is essentially complete unless there is a turnaround in U.S. inflation and/or a sizeable fiscal stimulus enacted in D.C. On that latter point, we think it is critical to monitor measures of U.S. business confidence. The current cyclical upturn in global growth and corporate profits has certainly lifted optimism among business leaders. Yet it is clear that there was also a boost to business sentiment after the U.S. election (Chart 2) last November as it was believed that Trump's victory, and the likely policies that would follow, would be good for American companies. Right now, business optimism remains at strong levels whether looking at small business measures like the NFIB survey (top panel) or the big business series like the Conference Board CEO confidence index of the Duke University/CFO Magazine indicator for confidence among chief financial officers (middle panel). There has been a slight recent pullback from the post-election peak in all the business sentiment indicators, however, and any sign that Trump will have difficulty pushing his tax cuts through Congress could result in a bigger loss of confidence that could impact future hiring and capital spending activity. Our colleagues at BCA Geopolitical Strategy continue to believe that a tax reform package, including significant tax cuts, is still the most likely outcome. Congressional Republicans will not want to go into the 2018 U.S. mid-term elections "empty-handed". With Congress and the White House on the same page, focused by fears of losing seats next year, even an embattled and unpopular president should be able to get his tax cuts implemented. Any fiscal boost in the U.S. can only help to support the current global cyclical economic upturn. While growth indicators like our global PMI index have come off the highs a bit (Chart 3), the OECD's global leading economic indicator is still rising and pointing to rising real developed market bond yields (middle panel). In addition, the global data surprise index has bottomed out, leaving global bond yields exposed to any improvement in economic momentum (bottom panel). Chart of the WeekLosing Faith In##BR##Trump & The Fed Chart 2U.S. Businesses##BR##Are Still Confident Chart 3Global Bond Yields Are##BR##Vulnerable To Faster Growth The fiscal news flow out of D.C. is likely to remain volatile once Congress returns from its summer recess, particularly with regards to tax cut negotiations and the looming debt ceiling. Yet the big news that investors want to hear, regarding U.S. tax cuts, is more likely to be positive for growth and risk assets and negative for bond yields. Bottom Line: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. The Fed & ECB: Still Sticking To Their Script Chart 4Inflation Expectations Are##BR##Stable In The U.S. & Europe The markets continue to underestimate the likelihood of more Fed rate hikes in the next year. The odds of a hike in December now sit at only 32%, while essentially no hikes in 2018 are currently discounted. This is far too low, given the steady (if unspectacular) growth in the U.S. and tightening labor conditions. The market has clearly responded to the dip in realized U.S. inflation since March as a sign that the real fed funds rate is now close to equilibrium - a point that has also been suggested by some FOMC members - and that the Fed's inflation forecasts are hence unlikely to be realized. Yet measures of U.S. inflation expectations, both survey-based and market-based, have been fairly stable at levels consistent with the Fed's inflation target in recent months, even as headline U.S. inflation has slowed (Chart 4, 2nd panel).1 A similar dynamic is playing out in Europe. Both survey-based and market-based measures of inflation expectations have been stable at levels close to the ECB's inflation target of "just below" 2% on headline inflation (bottom panel), despite the dip in realized inflation. Stable inflation expectations are something that central bankers take very seriously as a sign that their monetary policies are seen as credible. If the recent dip in realized inflation also showed up as an equivalent decline in expected inflation, this would give policymakers in D.C. and Frankfurt second thoughts about making any policy changes in a less dovish/more hawkish direction. The latest readings on realized inflation in both the U.S. and Euro Area suggest some stabilization of the current downturn may be underway. Headline CPI inflation ticked higher from 1.6% to 1.7% in July, ending a streak of four consecutive months of deceleration since March. Core CPI inflation has been stable at 1.7% for three consecutive months up to July, after falling for four consecutive months from January. Data released last week for July inflation in Europe showed a similar dynamic, with core HICP inflation ticking up to 1.2%, the third consecutive month of faster year-over-year inflation. With growth on both sides of the Atlantic maintaining a steady, above-potential pace, amid stable inflation expectations and with realized inflation showing signs of bottoming out, we see both the Fed and the ECB sticking with their current messaging and forward guidance. That means one more rate hike this year by the Fed, most likely in December, following an announcement on beginning the process of reducing the Fed's balance sheet at the September FOMC meeting. After that, at least another 25-50bps of hikes in 2018 will be delivered, which is currently not discounted by the market. As for the ECB, expect a shift to a slower pace of asset purchases for 2018, to be announced at either the September or October monetary policy meetings. Chart 5Has The Euro Already Overshot? The Kansas City Fed's annual Jackson Hole conference, set to take place this weekend, is unlikely to produce any major surprises for investors. Both Fed Chair Janet Yellen and ECB President Mario Draghi will give speeches to an audience of their peers - other global central bankers. Much is being made of Draghi's speech, since he has not spoken at Jackson Hole since 2014 when he gave strong indications of the introduction of the ECB's asset purchase plan in 2015. After his speech at the ECB Forum in Portugal in late June of this year - also to an audience of central bankers - where he mentioned a "reflationary" impulse in Europe that could require some "adjustments" to the ECB's policy settings, investors will be on high alert for any indications that the ECB is about to announce a tapering of its asset purchases. The Account of the July ECB meeting released last week suggested some concern within the ECB Governing Council regarding the potential for an "overshoot" of the euro in response to any policy shift.2 Some are interpreting those comments as a sign that the ECB might be getting cold feet over making any changes to its asset purchase program given the 11% rise in the euro seen this year. However, we think that there was too much attention focused on the fears that a strong euro could derail any plans for an ECB taper, for two reasons: The ECB did note in the July Account that the rise in the euro was a reflection of both the relatively stronger growth seen in the Euro Area this year and the reduction in political risk premia after the French presidential elections in the spring. The Account also noted that the ECB was looking at the totality of its monetary policy measures - policy rates, forward guidance & asset purchases - when assessing its policy stance. This specific quote from the Account, shown with our emphasis on the key passages, highlights that the ECB thinks that a tapering of asset purchases, done on its own with no hikes in short-term interest rates, will still leave monetary policy at very accommodative settings: "...the point was made again that the overall degree of accommodation was determined by the combination of all the monetary policy measures implemented by the ECB, and that the Governing Council's assessment of progress regarding a sustained adjustment in the path of inflation should apply to the overall design and direction of the ECB's monetary policy stance as a whole, and not with reference to any particular instrument in isolation, such as the duration and pace of APP asset purchases." Investors should understandably be worried about the impact of the rising in the euro, which was one of the fastest rates of acceleration seen in the currency's history (Chart 5). Yet given that extreme in price momentum, the lack of support from higher short-term Euro Area interest rates, and with speculative positioning on the euro at very bullish levels, it is unlikely that much further gains in the currency can be expected. This is especially true for the euro versus the U.S. dollar if the Fed delivers additional rate hikes, as we expect. Unless there is decisive evidence that the latest rise in the euro was seriously dampening Euro Area economic growth or inflation, which is not currently visible in the data (bottom panel), then the ECB is still likely to downshift to a slower pace of asset purchases in 2018. Bottom Line: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. The Fed and ECB remain on course to shift to a less accommodative policy stance towards year-end. That means a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. Trim EM Debt Exposure Versus U.S. Investment Grade Corporates Emerging market (EM) debt has been one of the strongest performing asset classes so far in 2017. EM USD-denominated sovereign bonds have delivered a total return of 7.5%, while USD-denominated EM corporates have returned 8.7%, according to Bloomberg Barclays index data. These returns have handily surpassed the majority of all other major USD-denominated fixed income sectors. A robust pace of inflows into EM debt, a record $48.6 billion year-to-date to August 9th according to the Wall Street Journal, has helped drive EM debt spreads to tight levels (Chart 6).3 The outperformance of EM debt, both versus its own history and compared with other pro-risk fixed income classes like U.S. corporates, would be justified if EM economic growth was faster than that seen in developed markets. Yet that is not currently the case. An EM (excluding China) PMI Index put together by our colleagues at BCA Emerging Markets Strategy has shown a sharp deceleration of EM growth for most of 2017 (Chart 7, top panel). This stands in sharp contrast to the improving growth seen in both the U.S. and Europe. Chart 6EM Debt Looks##BR##Fully Valued Chart 7Stronger U.S. Growth Favors##BR##U.S. IG Vs EM Sovereigns... The gap between the U.S. and EM (ex China) PMIs has widened to the largest level since 2014. This PMI gap has been a good directional indicator for the spread between U.S. corporate bond spreads (both for Investment Grade and High-Yield) and EM debt spreads (bottom two panels). Right now, it appears that U.S. High-Yield looks fairly valued versus EM USD-denominated sovereign debt but U.S. Investment Grade spreads still look a bit too wide relative to EM sovereigns. A similar story can be told when comparing U.S. corporates to EM USD-denominated corporate debt (Chart 8). Arthur Budaghyan, BCA's Chief Emerging Market strategist, recently made a trade recommendation to go short EM sovereign and corporate debt versus U.S. Investment Grade corporate debt.4 His argument was based on the relatively expensive valuations on EM debt, coming at a time when the outlook for economic growth and corporate profits looks healthier in the U.S. We could not agree more - especially if the Fed begins to hike rates, as we expect, and the U.S. dollar begins to strengthen anew, potentially triggering outflows from EM. Arthur has also pointed out that the gap between the option-adjusted spread (OAS) on EM corporates and U.S. corporates (both Investment Grade and High-Yield) has been an excellent leading indicator of the total return differential between the asset classes (Chart 9). The current relationships show that there is upside potential for U.S. Investment Grade versus EM corporates over the next 12 months, but not for U.S. High-Yield versus EM. Chart 8...And Vs. EM Corporates Chart 9Downgrade EM Debt Vs U.S. IG Corporates Thus, this week, we are cutting our allocations to both EM sovereign and corporate debt in our model bond portfolio, and increasing our allocation to U.S. Investment Grade corporates (see page 12). While this does move us into an asset class with a longer duration, the increase in our overall portfolio duration from this shift is very small given the small weight of EM debt in our custom benchmark. More importantly, U.S. Investment Grade is less risky than EM corporates using the duration-times-spread metric - our preferred measure for spread product risk. Bottom Line: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. We see better value in U.S. higher-quality corporates vs. EM debt at current spread levels. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The inflation expectations data shown in Chart 4 is based off the U.S. Consumer Price Index (CPI) measure of inflation, while the Fed targets growth in the headline Personal Consumption Expenditure (PCE) deflator of 2%. The spread between the two measures have averaged around 50bps in recent years, which suggests that the current CPI-based inflation expectations around 2.5% are in line with the Fed's 2% PCE inflation target. 2 https://www.ecb.europa.eu/press/accounts/2017/html/ecb.mg170817.en.html 3 https://blogs.wsj.com/moneybeat/2017/08/17/emerging-market-bonds-attract-record-inflows/?mg=prod/accounts-wsj 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Focus Is On Profits", dated August 16th 2017, available at ems.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights The strong labor market may be holding down wage inflation. The strength in sales and EPS is broad-based and sustainable. July FOMC minutes highlight internal debate at the Fed over inflation. Financial stability is the Fed's Third Mandate. Feature Risk assets struggled again last week but Treasury yields held steady as investors reacted to President Trump's latest controversy, the FOMC minutes, another round of solid economic data for Q3 and the final few earnings reports of the Q2 reporting season. The July FOMC minutes highlighted the internal debate at the Fed about the Phillips curve and financial stability. Nonetheless, we expect the Fed to continue to tighten policy later this year. In this week's report, we examine a study by the San Francisco Fed that highlights the negative impact of a strong labor market on wages. Profit margins continued to expand in Q2 and the BCA EPS model projects a solid 2H performance, driven by both domestic and globally oriented firms. Strong Labor Market, Weak Wages The labor market continues to tighten measures of overall labor market slack suggest that wage inflation should accelerate soon. Still, slack remains in some segments of the labor market and that may be depressing overall wage growth. The overall quit rate (2.1%) is slightly below its all-time peak and 65% of the 11 industry groups have quit rates that are at or close to pre-global financial crisis level (Chart 1). Moreover, fill rates, the ratio of hires to job openings, for most industries are at record lows, and job openings in all but the wholesale trade, information, mining & logging and construction areas have surpassed prior peaks (Chart 2). The implication is that economy-wide, there are more jobs seekers than jobs, which will ultimately force businesses to offer higher salaries. Chart 1Labor Market Strength Is Widespread... Chart 2...With Only A Few Industries Lagging Behind Moreover, wage pressures are mounting, especially for full-time employees. A recent study1 published by the San Francisco Fed found that at 3.4%, the year-over-year change in median weekly earnings was still below the 2007 peak. However, wage gains for continuously employed full-time workers (4.8%) are in line with rates seen a decade ago (Chart 3). Overall wage gains continue to be suppressed by new entrants to the labor force. Growth rates of median weekly earnings for this group are down 1.4%, and have been negative since the overall labor market began to recover in early 2010. The counter-intuitive implication of the SF Fed study is that substantial gains in the labor market may be depressing average wage rates. As individuals learn about better prospects for employment, they choose to join the workforce, either as new entrants (from school) or as reentrants (those who left either voluntarily or involuntarily). These groups, according to the study, have suppressed median weekly earnings growth by between 1.5% and 2.0% (Chart 4). Chart 3Wage Inflation Dragged##BR##Down By New Entrants Chart 41.5% To 2% Drag On Wage Inflation##BR##Due To Compositional Shifts In Workforce In addition, as 10,000 higher paid baby boomers reach 65 years of age each day and leave the labor force, they are replaced by lower wage earners. Bottom Line: The labor market is even tighter than the data suggests and the market's vigor may be understating wage inflation. Investors are mis-pricing the extent of rate hikes in 2017 and 2018. Bond yields are likely headed higher, but the stock market should take this in stride because of the favorable earnings backdrop. Corporate Profits Are Not Only A Weak Dollar Story EPS and sales growth in Q2 ran well ahead of consensus expectations as forecast in our July 3 preview. Moreover, the counter-trend rally in profit margins is still in place. So far, more than 90% of companies have reported results with 74% of companies beating consensus EPS projections, just above the long-term average of 70% (Chart 5). Furthermore, 69% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 6% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to ultimately re-assert itself, perhaps beginning early in 2018. Nonetheless, we saw another quarter of margin expansion in Q2. Average earnings growth (Q2 2017 versus Q2 2016) was strong at 12% with revenue growth at only 5%. The BCA Earnings model predicts EPS growth to hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 6). Measured this way, S&P 500 EPS growth in Q2 will be 18%, compared with 13% in Q1. Chart 5Positive Earnings Surprises Continued In Q2 Chart 6Strong EPS Growth Expected In 2H '17 Importantly, the strength in earnings and revenues is broadly based (Table 1). Earnings per share were higher in Q2 2017 versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Energy revenues surged by 16% in Q2 versus a year ago. Sales gains in technology (8%), materials (7%) and utilities (6%), are notable. Moreover, year-over-year sales gains in Q2 2017 in all but three sectors (telecom, consumer staples and consumer discretionary) ran ahead of nominal GDP (+3.7%) in the same period. Investors will turn their attention to earnings prospects in 2H 2017 and 2018 as the Q2 reporting season ends. Since the start of 2017, the trajectory of EPS estimates for 2017 and 2018 (not shown) has been encouraging. The forecast for 2017 is 11.6%, up from 11% at the outset of the Q2 reporting season and unchanged from the start of the year. Similarly, the 2018 estimate (10.9%) is little changed from estimates made in January 2017. In a typical year, earnings estimates tend to move lower as the year progresses. Like the financial markets, corporate managements have largely ignored President Trump during this earnings season. Trump's name was used only once in Q2 earnings calls held through August 11, down from 9 in Q1 calls and 32 in the Q4 2016 reporting season just after Trump took office (Chart 7). The single mention thus far matches the number of times that CEOs and CFOs cited Trump's name before last November's election. We are inclined to see fading concerns about government policy from the next Beige Book (due in early September) because Trump has managed to slow regulation2 during his first seven months in office, although uncertainty around the president's legislative agenda remains elevated. Table 1S&P 500: Q2 2017 Results* Chart 7Trump Fading As Topic On Earnings Calls BCA's case for improving profits in the second half of 2017 is supported by the August readings on the Empire State and Philadelphia Fed manufacturing indices, along with the June and July readings on industrial production (IP). IP has been a good proxy for sales of S&P 500 companies (Chart 8); a rollover in the 12-month change in IP would challenge BCA's constructive view towards earnings. However, strong readings on the ISM (July), the August Empire State and Philadelphia Fed indices suggest that IP should accelerate in the next six months. Moreover, the weaker dollar has boosted foreign demand for U.S. goods and services. The implication is that foreign demand (rather than domestic consumer or business spending) leads the U.S. manufacturing sector. Consistent with this perspective, the 3- and 12-month changes in the IP indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 9). Chart 8Favorable Backdrop For Earnings And Sales Continues Into Q3 Chart 9U.S. IP Growth Still Lagging##BR##Other Developed Markets... Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, the weaker dollar has allowed profit and sales gains of globally oriented firms to rebound and outpace those of domestically focused businesses. (Table 2 and Chart 10) Margins for U.S. focused companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but are higher than margins of domestic companies. Chart 10Global EPS, Sales Playing Catch Up To Domestic Table 2Q2 Earnings Breakdown Bottom Line: EPS growth will continue to accelerate through 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth (Chart 6). The solid performance of manufacturing at home and overseas sets the stage for EPS growth in firms with both U.S. and global outlooks. BCA's bullish profit story for 2017 is still intact, supporting an overweight stance towards stocks versus bonds. The Fed will not get in the way of the equity rally unless inflation suddenly surges in the coming months (which we do not expect). FOMC Debate Still Centers On Inflation The minutes from July's FOMC meeting indicates little progress on the debate over low inflation and the appropriate monetary policy response. It will require at least a modest rise in inflation to break the deadlock. Policymakers appear to be pleased with the state of economic growth, which has rebounded from a lackluster first quarter. They agree that the expansion will be strong enough that the labor market will continue to tighten. As highlighted in previous minutes, the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike, and how policy should adjust to changing financial conditions. A majority of policymakers seem willing to believe that this year's soft inflation readings are driven by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excessive risk-taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. Therefore, the hawks are anxious to resume tightening, despite the current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. If true, this would mean that the Phillips curve is very flat, or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. Some argued that the recent easing in financial conditions would add little to growth and thus, does not require tighter Fed policy. There was little movement toward capitulation by either camp evident in the minutes. Discussion of the Fed's balance sheet in the recent minutes reinforced that an announcement would likely occur in September, with tapering beginning shortly thereafter. "A number of participants" commented that financial conditions will be key to determining the pace of rate hikes. If the bond market and risk assets react negatively to balance sheet shrinkage, then it would be appropriate to slow rate increases to offset any economic repercussions. Given that only one rate gain is discounted in the money market curve over the next 12 months, it appears that investors are betting that balance sheet shrinkage will largely eliminate the need for higher short-term interest rates. Fed economists recently updated their quantitative assessments of FOMC minutes.3 The note provides a guide (Table 1 in the Fed paper) to the "quantitative words" used in the minutes (one, a couple, a few, etc.). We intend to comment on the findings of this paper in a future Weekly Report. An Update On The Fed's Third Mandate Financial stability remained a concern for Fed policymakers in July and that is why the hawks want to keep tightening even though inflation has not yet met the FOMC's target. BCA views "financial stability" as a third mandate4 for the central bank, along with low and stable inflation, and full employment. Financial stability was discussed at the July meeting by both Fed staff and voting FOMC members. Fed Chair Janet Yellen has elevated financial stability during her tenure, leading discussions or staff briefings in 20 of the 28 meetings she has presided over. Yellen will deliver a speech on financial stability on August 25 at the Fed's Jackson Hole conference. However, the Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in December 2013, but its next judgment (also moderate) was only in January 2016. Since then, Fed staff has provided an assessment of financial stability in 7 of the 13 subsequent meetings. FOMC participants have debated about financial stability at 4 of the 5 meetings this year, and 8 of the 11 since April 2016. As was the case at the June meeting, Fed staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance in July.5 This assessment has not changed since the Fed began to offer opinions on the health of the financial system at its September 2013 meeting. We conclude that the doves want inflation to rise closer to the 2% target before tightening again. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excessive risk-taking in markets according to some on the FOMC. Bottom Line: The FOMC minutes did not change our base case outlook: the FOMC will announce in September that it will begin to shrink the Fed's balance sheet. The next rate bump will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation will edge higher in the coming months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 http://www.frbsf.org/our-district/about/sf-fed-blog/wage-growth-good-news/?utm_source=frbsf-home-sffedblog-title&utm_medium=frbsf&utm_campaign=sffedblog 2 Please see U.S. Investment Strategy Weekly Report, "Still Waiting For Inflation,"August 14, 2017, available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 4 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017, available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/fomcminutes20170726.htm

Highlights Mantra 1 - Europe: First Among Equals - instils awareness that the euro area's long-term growth prospects and 'neutral' real interest rate are not meaningfully different to those in other developed economies. Mantra 2 - Mission Impossible: 2% Inflation - instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. Mantra 3 - Negative Skew: A Ticking Time-Bomb - instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. Feature The titles of three of our recent reports - Europe: First Among Equals,1 Mission Impossible: 2% Inflation,2 and Negative Skew: A Ticking Time-Bomb3 - can be regarded as mantras instilling awareness of major investment opportunities and threats. This week's report is a recap of the messages encapsulated within these three mantras. Mantra 1 - Europe: First Among Equals Mantra 1 instils awareness that long-term growth in the euro area, adjusted for population, is not meaningfully different to that in other developed economies (Chart of the Week). Through the past 20 years, the euro area has underperformed through multi-year periods encompassing around half the time; but it has outperformed through the multi-year periods encompassing the other half. Chart of the WeekThe Euro Area Is An Economic Equal Seen in this wider context, the euro area's 2008-14 phase of poor economic performance was not structural, it was cyclical - the impact of back to back recessions separated by an unusually short gap. And if the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends in the bond and currency markets have much further to run. Bond yield spreads closely follow relative real GDP per head (Chart I-2). As they must, given central banks' self-professed 'data-dependency'. Although nobody expects the ECB to hike interest rates any time soon, expectations for the long-term 'neutral' rate are correctly rising from overly-depressed levels. Hence, the yield spread between long-dated bonds in the euro area4 and the U.S. has compressed from -175 bps last year to -125 bps today. Still, to reach the mid-point of its long-term cycle, this yield spread must ultimately converge to around -40 bps. But why is the mid-cycle yield spread -40 bps? The simple answer is that, over this 20-year period, the euro area versus U.S. inflation differential has averaged -40bps (Chart I-3). In other words, the mid-cycle real yield spread is zero. Chart I-2Bond Yield Spreads Just Follow ##br##Relative GDP Per Head Chart I-3The Euro Area - U.S. Inflation Differential ##br##Has Averaged -40 Bps This leads to a very important empirical observation. The mid-cycle or 'neutral' real interest rates in the euro area and U.S. have been near-identical over the past 20 years. Bear in mind that the past 20 years captures a very wide spectrum of economic and financial backdrops: the launch of the euro, the dotcom bubble and bust, the U.S. subprime credit boom and financial crisis, the euro debt crisis, QE. If this disparate past is a reasonable representation of the disparate future, we should expect the neutral real interest rate in the euro area to remain broadly similar to that in the U.S. The implication is that the yield spread between long-dated bonds in the euro area and the U.S. can compress much more. On a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. And expect euro/dollar eventually to break through 1.30. Mantra 2 - Mission Impossible: 2% Inflation Mantra 2 instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. The crux of the matter is that the monetary system and inflation form a classic non-linear system. A defining feature of a non-linear system is that it can be very difficult, even impossible, to achieve an arbitrary point target output like '2%' (Chart I-4). Chart I-4Non-Linear: Inflation Flipped From One Mode To A Completely Different Mode In a linear system, if a small input produces a small output, then double the input will produce double the output and triple the input will produce triple the output. But in a non-linear system, double the input could produce no output, half the output, or ten times the output. To be clear, we have no doubt that a fiat monetary system makes it possible to generate rampant inflation, should policymakers be absolutely determined to create it. But central banks are now starting to ask. At what cost? And for what benefit? Central banks are realising that in the struggle to achieve 2% inflation, persistent ultra-accommodative policy endangers the healthy functioning of markets and poses a risk to financial stability. At the same time, the continued undershoot of 2% inflation is not such a terrible thing when the economy is growing well. Chart I-5Relative Interest Rate Expectations##br## Just Follow Relative GDP Per Head The latest to admit this is Kasumasa Iwata, a leading candidate to become the next governor of the Bank of Japan. With the demerits of extraordinary stimulus becoming clearer, the BoJ should slow purchases of government bonds and ETFs even though inflation is nowhere near its target, he said. This follows hot on the heels of respected and influential ECB Governing Council member, Ewald Nowotny, who recently asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." And in Sweden, even though inflation has just hit 2% for the first time in six years, the Riksbank has suggested (re)introducing a variation band of 1% either side of the target5 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve. Additionally, Riksbank Governor, Stefan Ingves, proposed that "central banks should also have the explicit responsibility for financial stability." The direction of travel is very clear. The most accommodative central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. These central banks are set to dial back accommodation. Hence, the multi-year phase of divergent monetary policies across developed economies is over. The new multi-year phase is re-convergence of monetary policy, and specifically the ECB and Riksbank versus the Fed (Chart I-5). Therefore, mantra 2 - Mission Impossible: 2% Inflation - reinforces the investment conclusions that stem from mantra 1 - Europe: First Among Equals. Mantra 3 - Negative Skew: A Ticking Time-Bomb Mantra 3 instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. When the equity market is advancing, its observed volatility is low. But this is just a property of so-called 'negative skew'. Up weeks tend to generate small and regular positive returns which means that advances tend to be gradual and gentle. And the longer and more established the advance becomes, the lower the observed volatility goes. Unfortunately, some investors and risk-control algorithms mistakenly use the observed volatility of an investment as a gauge of its riskiness. They incorrectly equate low observed volatility with a lower risk premium, which justifies an additional advance in the market. The additional advance then takes observed volatility even lower - which justifies a further market advance. And so on, in a self-reinforcing positive feedback. Eventually, the truth dawns. Equity market risk hasn't actually declined, but the equity risk premium - the excess prospective return that equities offer over bonds - has almost disappeared. And suddenly, the self-reinforcing feedback phase-shifts from positive to negative. The equity risk premium is the excess prospective return that equities offer over bonds, but a good working approximation is the difference between the equity index earnings yield and the bond yield. The concerning thing is that this measure of the equity risk premium is moving exactly in line with the equity market's observed volatility (Chart I-6), when it shouldn't. Admittedly, it is difficult to know when the time-bomb will go off. But the good news is that when observed volatility is very low - as it is now - options become very cheap. And a long index plus at-the-money put option becomes an excellent absolute return strategy.6 Chart I-6The Equity Risk Premium Is Tracking The##br## Equity Market's Observed Volatility Chart I-7Record Low Observed Volatility ##br##Doesn't Last For those that cannot buy options, record low observed volatility tends to signify a good time to raise a little bit of cash. This should be set aside for reinvestment in the equity market when observed volatility spikes (Chart I-7), as it always ultimately does. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3 2017 and available at eis.bcaresearch.com 2 Published on July 20 2017 and available at eis.bcaresearch.com 3 Published on July 27 2017 and available at eis.bcaresearch.com 4 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. 5 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 6 For more details of the absolute return strategy, please see the European Investment Strategy Special Report titled "Negative Skew: A Ticking Time-Bomb", dated July 27, 2017 and available at eis.bcaresearch.com Fractal Trading Model Long USD/CAD successfully hit its 2.5% profit target and is now closed. This week's new trade is to short MSCI Turkey versus the Eurostoxx600 with a profit target and symmetric stop-loss set at 5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights Geopolitical tensions will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a major military conflict or escalating trade wars with significant economic damages, the impact on both the broader growth outlook and financial markets should be limited. President Trump's recent decision to probe China's IPR practices is his first direct trade measure against China, and therefore is of important symbolic significance, but the near term impact should be limited. There is enough common ground for the two sides to avoid direct confrontation. We expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Short KRW/JPY as a hedge against geopolitical risk in The Korean Peninsula. There is an economic case for the trade, even without geopolitical considerations. Feature The Chinese economy is experiencing a summer lull, as most recent growth figures have disappointed, albeit slightly. Exports, production, investment and retail sales have all decelerated, underscoring that growth momentum is softening across the board. Investors have largely shrugged off the weaker-than-expected numbers, a sign that the market is not overly concerned about a major relapse down the road. We share investors' optimism, as discussed in some recent reports,1 but are watchful for signs of market complacency.2 After the most recent rally, multiples of Chinese equities are no longer exceptionally cheap by historical norms, even though they are still a lot cheaper compared with most other major global and EM bourses. We will discuss Chinese equity valuations in greater detail in the coming weeks. Geopolitical risks have dominated Greater China markets of late. The escalation of tensions surrounding North Korea briefly took their toll in the past week. On Monday, U.S. President Donald Trump authorized U.S. Trade Representative Robert Lighthizer to determine whether to launch an investigation into China's alleged theft of intellectual property. Overall, both events underscore rising geopolitical tensions globally, particularly around China. So long as the situation does not degenerate into a major military conflict or an escalating trade war that causes major economic damage, the tensions should not have a material impact on the outlook for the Chinese and global economy, as well as financial markets. A short position on the Korean won versus the Japanese yen offers a low-risk hedge against a sudden escalation of geopolitical tensions in the region. Intellectual Property Investigation: The Knowns And Unknowns It is unclear at the moment whether Trump is simply using the investigation as a bargaining chip to seek concessions/cooperation from China, or to start a trade war with lose-lose outcomes. The situation needs to be closely monitored and assessed continuously. For now, a few observations are in order: This is the first direct trade measure by the Trump administration against China, and therefore is of important symbolic significance, but the near-term impact should be limited. President Trump has only authorized his administration to determine whether or not to formally investigate Chinese policies and practices. It may take a year to finalize the decision, and even longer to begin negotiations and discussions with Chinese officials for solutions and remedies. Previous similar investigations against Chinese products resulted in bilateral agreements rather than all-out confrontations. Trump's decision is based on Section 301 of the Trade Act of 1974, which allows the president to unilaterally impose tariffs or other trade restrictions to protect U.S. industries from "unfair trade practices" of foreign countries. This was a popular trade tool in the 1980s and was used to impose tariffs against certain Japanese and Korean products, but has been rarely used in the past decade. In 2010 the Obama administration also accepted a petition under Section 301 to investigate China's state support for clean-energy exports, particularly solar panels and wind turbines, and the Chinese government later promised to limit some of these practices through bilateral negotiations. The World Trade Organization (WTO) has ruled that taking any such actions against other member countries without first securing approval under WTO rules is, in of itself, a violation of the WTO Agreement, and can be challenged under the WTO framework. In fact, section 301 investigations have not resulted in any trade sanctions since the WTO was set up in 1995. Table 1Top Challenges Doing Business In China More importantly, we see common ground enabling the U.S. and China to work together to improve China's Intellectual Property Rights, or IPR practices. From the U.S.'s perspective, while Trump's blunt accusations on China's trade policies are not completely justified and will not solve the massive trade imbalances between the two countries, his challenge on China's IPR infringement has legitimate ground, and resonates well within the broader American business community. American companies doing business in China have long listed intellectual property rights infringement and protectionism as top challenges, especially among industrial and resources businesses (Table 1). In other words, Trump's complaints on China's IPR practices reflects corporate America's rational voice rather than a sensational rant. China's own practices are also in conflict with its intentions to build a more open and market-friendly policy environment. Indeed, China has also been making notable progress to enhance IPR protections. In September 2015, in his state visit to the U.S., President Xi promised to limit the scope of national security reviews on investment, refrain from cyber-enabled IP theft, and uphold WTO agreements regarding market access for information and communications technology (ICT) products. China's deficits in IP royalty fees has increased sharply in recent years, while America's royalties surpluses have been expanding (Chart 1). Furthermore, 90% of American firms doing business in China believe that China's IPR enforcement has improved over the last five years, according to American Chamber Of Commerce In China (AmCham China) surveys.3 In short, there is certainly room for further improvement in China's IPR practices, and the broad direction fits with Trump's expectations, creating common ground for the two sides to avoid direct confrontation. We expect China's IPR practices will continue to converge towards international standards going forward. Chart 2 shows Chinese patent applications have exploded in recent years. As the country's technology continues to advance and local businesses are growing more aware of the value of intellectual property, China will develop a keen interest to safeguard its own IPRs. We are hopeful that Trump's investigation will provide a catalyst for further improvement in Chinese IPR practices, rather than derail broader bilateral trade. Chart 1China's Widening Deficits In IPR Royalty Chart 2China's Exploding Patent Applications ##br##Will Demand Stricter IPR Protections North Korea Tensions, And Short KRW/JPY As A Crisis Hedge The escalation of geopolitical tensions surrounding North Korea briefly took a toll on global and Greater China markets in the past week. The situation remains highly fluid, and the stakes are exceedingly high - both of which will put investors on edge in the weeks and months ahead. Our Geopolitical team in their latest assessment concludes that the U.S. is not likely to preemptively attack North Korea. However, the U.S. has an interest in signaling that it may conduct precisely such an attack, and brinkmanship could last for a long time.4 As far as China is concerned, there is genuine interest among the Chinese leadership to de-escalate tensions on the Korean Peninsula, but there is no easy solution. On one hand, it is absolutely against the country's best interests to collapse the North Korea regime. Such an outcome could see a surge of refugees to its densely populated and economically struggling Northeast region. Moreover, it could also potentially lead to a strong and unified Korea at the Chinese border that is a military ally to the United States. On the other hand, Beijing also feels that it has fallen victim to North Korea's nuclear ambitions, and has become growingly frustrated by its escalating provocations. China also fears that North Korea's nuclear program could encourage countries in the region, particularly Japan, to develop their own nuclear arsenals, which would be viewed as strategically threatening to China's national security. For now, we expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Already, China has supported the United Nations Security Council in imposing new sanctions on North Korea last week. Early this week, the Commerce Ministry announced a ban on imports of iron ore, iron, lead and coal from North Korea. These actions may have contributed to the softened tones from North Korea since, but it remains to be seen whether the impact will be long-lasting. The upshot is that the shared interests between China and the U.S. on various major global issues mean that the risk of an escalating trade war between the two countries should remain under control. For investors, bouts of geopolitical tension will likely bid up traditional safe-haven assets such as gold and the Swiss franc going forward. Another way to play the geopolitical risk is to short the Korean won (KRW) and long the Japanese yen (JPY). The KRW will obviously suffer devastating losses in even mild military skirmishes between the U.S. and North Korea, while the JPY may benefit from any "risk-off" unwinding of the yen carry trade. More importantly, economic fundamentals are not supportive of a stronger KRW, especially against the JPY, which means the downside risk in shorting the KRW/JPY is quite low, even without geopolitical considerations. Chart 3The Won Is Expensive Against The Yen The KRW is expensive against the JPY, based on a purchasing power parity (PPP) assessment (Chart 3). The 30% rally of KRW/JPY since 2012 has pushed it to an over two-sigma overshoot above its PPP fair value. Historically the won has rarely been sustainable at such elevated levels. Korea's economic outlook remains uninspiring. Capacity utilization has continued to decline, pricing power is weak, money growth is decelerating and real retail sales growth has stalled (Chart 4). Exports have been the bright spot in the overall growth picture, recovering strongly from last year's slump, but it is unrealistic to expect the export sector to continue to accelerate if growth numbers in China downshift. Softening exports will further weigh on Korea's growth outlook. In contrast, the latest growth numbers confirm that the Japanese economy has improved notably (Chart 5). Real GDP expanded by 1% in the second quarter compared with the previous three months, significantly beating expectations. While it remains to be seen whether Japan is able to maintain its regained momentum going forward, its growth gap with Korea has narrowed considerably of late, which will also lend support to the yen against its Korean counterpart. Chart 4Korea Growth Is Set To Moderate Chart 5Japan And Korea: Growth Gap Has Narrowed The bottom line is that geopolitical tensions in the Korean Peninsula will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a significant military conflict that causes major economic damage, the geopolitical skirmishes should not have a material impact on both the broader growth outlook and financial markets. Investors may consider shorting the KRW/JPY as a hedge for geopolitical risks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, and "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: What Could Go Wrong?" dated August 3, 2017, available at cis.bcaresearch.com. 3 AmCham In China 2016 White Paper 4 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. With U.S. equity valuations stretched, prolonged uncertainty in Northeast Asia may be a catalyst for a pullback. The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lags that of consumer prices. Feature Safe haven assets caught a bid last week while risk assets sold off as investors weighed geopolitical tensions in Northeast Asia and more uncertainty over fiscal policy in Washington. Last week's U.S. economic data highlighted the disconnect between a tighter labor market and a lack of wage pressures. Meanwhile, the data suggest that growth outside the U.S. is accelerating. Nonetheless, history shows that investors should be patient while waiting for an upturn in inflation. Next Up: Tax Cuts The GOP will deliver on tax cuts this year despite disarray at the White House and an incompetent Congress, but fiscal stimulus may fail to live up to its hype. Furthermore, a fiscal lift from infrastructure spending is unlikely anytime soon. Republicans need a win ahead of the 2018 mid-term elections and they have already laid the groundwork for tax reform via the budget reconciliation process. Moreover, cutting taxes is easier to justify politically than removing an entitlement program (i.e. Obamacare). Tax rates probably will not be lowered by as much as originally promised because conservative Republicans in the House will demand "revenue offsets" to pay for tax cuts. Internal GOP battles over how to fund tax cuts could spill over into some tension regarding raising the debt ceiling. However, it is in neither political party's interests to create another "fiscal cliff" out of thin air. The GOP needs Democratic votes to pass this legislation in the Senate and the Democratic leadership has indicated it is willing to support it. At what price? House Minority leader Nancy Pelosi and Senate Minority leader Chuck Schumer may link the debt ceiling and spending bill to tax reform, and push for the tax cuts to extend to the middle class and to be revenue neutral. There is a chance that both parties will agree to temporarily eliminate the debt ceiling, perhaps beyond the 2018 mid-term elections. In any event, we expect a last minute resolution to both the U.S. debt ceiling and the potential government shutdown in September. Thus, there should be no lasting impact on financial markets from the debt ceiling debate. Turning to government regulation, the NFIB survey shows that small businesses are pleased with the Trump administration's attack on red tape. President Trump has made progress on slowing regulation and is on track to enact one-tenth the amount of economically significant regulation1 passed by the Obama administration (Chart 1). By this metric, Trump is even more frugal than Reagan. Trump and the GOP-held Congress have rolled back Obama-era rules and delayed others. Still, regulatory change is slow to impact the economy and it may take years for the regulatory rollback to provide any meaningful lift to growth. Accordingly, the "Trump Put"2 is still in place. U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively (Chart 2). Chart 1Trump Has Had Success In Slowing Regulation Chart 2The Trump Put Bottom Line: Trump will not be impeached until after the 2018 mid-term election, and only then if the Democrats manage to take control of the House. The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. The intensifying Mueller investigation and White House incompetence will only fuel the "Trump Put", which has been positive for U.S. equities, neutral for Treasuries, and bad for the dollar, all else equal. A significant uptick in inflation could overwhelm the "Trump Put" and spark a dollar rally. As such, investors should focus on inflation prospects rather than on White House politics. Fire And Fury Investors are on high alert and with the Q2 earnings season over, may look beyond the positive news on corporate profits for direction. Our colleagues in the BCA Geopolitical Strategy service have long maintained that Northeast Asia is ripe for economic/political risk.3 The underlying driver of uncertainty on the Korean Peninsula is the Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the U.S. and its allies. The immediate consequence is mounting friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea, are all heating up. North Korea's regime is highly unpredictable as evidenced by events in the past few weeks. In that sense, it is more significant than the other "proxy battles" between the U.S. and China. In essence, North Korea is no longer merely an object of satire. A new round of negotiations over North Korea's nuclear and missile programs is about to begin. The potential for a military conflict is high unless diplomacy succeeds in convincing North Korea to freeze its weapons programs. The events on the Korean peninsula are unfolding as we expected they would. North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty, but not a regime change. The U.S. has forsworn regime change as an intention and China has recommitted to new sanctions. South Korea is pro-engagement. Moreover, we are seeing the U.S. establish a credible military as part of the "arc of diplomacy," comparable to U.S.-Iran relations 2010-15. Bottom Line: We do not expect a pre-emptive strike by the U.S. on North Korea, as the constraints to conflict are extremely high and not all diplomatic options have been exhausted. Nonetheless, with U.S. equity valuations stretched, prolonged uncertainty in the region may be a catalyst for a pullback. A Rosy Global Picture The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Global real GDP estimates continue to move higher, a welcome departure from years past when estimates slid relentlessly lower (Chart 3). Since the start of 2017, global GDP estimates for this year have increased from 2.8% to 3%, while 2018 forecasts have accelerated from 2.7% to 2.9%. This upward trajectory has occurred despite a recalibration by many major central banks away from accommodative policies. Aggressive central bank actions or escalating tensions in Northeast Asia, or both, may halt the improving growth forecasts. Falling oil prices would also challenge a quickening of global growth, but our view is that oil prices will move higher in the coming months.4 Chart 3Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global leading indicators are on the upswing (Chart 4). The BCA Global Leading Indicator Index (excluding the U.S.) in July 2017 was the strongest since 2010 when it slowed after a sharp rebound from the global financial crisis. The increase in growth still has room to run. Admittedly, the LEI's diffusion index has dipped below 50%. It would be a warning sign for global growth if the diffusion index does not soon turn up. Nominal global GDP growth is speeding up, boosted by improving consumer and business confidence, rising capital spending and declining policy uncertainty (Chart 5). The global economic surprise index is also climbing, which provides additional support. Investors may be concerned that the global PMIs have peaked (Chart 6), but they remain at levels consistent with above-trend GDP growth and we see no reason why they should drop below 50. Chart 4LEIs Pointing Higher Chart 5Supports For Global Growth In Place Chart 6Global Economic Activity Brightening Industrial production (IP) overseas is expanding nearly twice as fast as in the U.S. (Chart 5). This suggests that U.S. economic activity will be pulled up by foreign demand. A stronger dollar (as much as a 10% appreciation in the next year) may dampen U.S. exports and earnings, but this will be more a problem for 2018 than 2017. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both U.S. economic growth and profits of U.S. firms with significant business abroad. Solid foreign demand will help the economy hit the Fed's GDP target and also support additional, but gradual, tightening by the central bank. Stay overweight U.S. equities and remain short duration. Waiting For Wages Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Both primary and secondary indicators point to a tighter U.S. labor market. The July jobs report (released in early August) was yet another sign that the slack in the jobs market is vanishing.5 Data released last week on job openings (JOLTS) and the National Federation of Independent Business (NFIB) further supported this trend, and indicated that the labor market may tighten even more. Job openings rose to a new all-time high along with BCA's quit rate less layoffs indicator (Chart 7). The hire rate remained at a cycle peak. The NFIB data was equally impressive, with hiring plans and job openings surging in July. Small businesses are also finding it increasingly difficult to find quality labor. (Chart 7, panel 4) The strength in the labor market has not yet translated into accelerating wages, but patience is required. The July NFIB survey noted that "while a tight job market may point to higher wages and rising consumer spending down the road, which is also good for small businesses, the current expansion efforts by small business owners are being choked by their difficulties in hiring and keeping workers." The NFIB's compensation plans (Chart 7) provided quantitative support for the group's qualitative assessment. However, the latest readings on labor compensation from the Q2 productivity report, the tepid July average hourly earnings data and the Atlanta Fed wage tracker suggest that the labor market is still not tight enough to generate much wage pressure (Chart 8). Chart 7Widespread Evidence That##BR##Labor Market Is Tightening Chart 8Not Much Wage##BR##Pressure Yet Inflation And Long-Expansion Dynamics That said, wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lag that of consumer prices. In previous research we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart 9 compares the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart 9). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Inflation pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed slowly. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat. The result was an extended late-cycle phase that was very rewarding for equity investors because the economy and earnings continued to grow. Of course, inflation eventually did turn higher, signaling the beginning of the end for the expansion and equity bull phase. In Chart 10, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth gave no warning that an inflation upturn was imminent. Indeed, wages were a lagging indicator of consumer price inflation. Chart 9Labor Market, Inflation And Stocks##BR##In The Long 80's & 90's Expansions Chart 10In The 80's & 90's Wage Growth##BR##Gave No Early Warning On On Inflation Market commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. Chart 11Leading Indicators Of Inflation##BR##In "Slow Burn" Recoveries This is not to say that we should totally disregard wage information. But it does suggest that we must keep an eye on a wider set of data. Indicators that provided some leading information for inflation in the previous two long cycles are shown in Chart 11. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart 11 because it does not have enough history. All of these indicators have moved higher over the past 18 months, after bottoming at extremely low levels in 2015 and early 2016. However, they have all pulled back to some extent in recent months. This year's pipeline inflation "soft patch" continued into July, according to last week's release of the Producer Price Index. The easing in cost pressures at the producer level has been broadly based (i.e. one cannot blame special factors). These indicators suggest that consumer price inflation, according to either the CPI or the PCE, will struggle to rise in the next few months. The July CPI report revealed another tepid 0.1% monthly rise in the core price index, while the year-over-year rate remained at 1.7%. Rising prices for health care goods and services were offset by price declines for new and used cars. The diffusion index for the CPI moved up to the zero line in July, indicating that disinflation was a little less broadly based in the month. Bottom Line: Our base case is that core PCE inflation edges higher in the coming months, which will be enough for the FOMC to justify a rate hike in December. We also expect that inflation will be high enough in 2018 for the Fed to hike rates by more than is discounted in the bond market. Nonetheless, the warning signs of an inflation upturn are mixed at best. It would flatter our stocks-over-bonds recommendation if we are wrong on the inflation outlook, but our short duration stance would not be profitable in this case. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Office of Information and Regulatory Affairs (OIRA) of Office of Management and Budget (OMB): https://www.reginfo.gov/public/do/eAgendaMain and https://www.reginfo.gov/public/do/eoCountsSearchInit?action=init 2 Please see Geopolitical Strategy Weekly Report, "How Long Can The Trump Put Last" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Weekly Report, "North Korea: Beyond Satire, dated April 18, 2017, available at gps.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "KSA's Tactics Advance OPEC' 2.0's Agenda," dated August 10, 2017, available at ces.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Stay The Course" dated August 7, 2017, available at usis.bcaresearch.com.

Highlights The rise in the yen sparked by the verbal confrontation between the U.S. and North Korea is creating an opportunity to buy USD/JPY. The DXY is set to stabilize and may even rebound, removing a key support for the yen. The U.S. economy is showing signs of strength, and the bond market is expensive, a backup in yields is likely. Rising U.S. bond yields should be poisonous for the yen Until higher bond yields cause an acute selloff in risks assets, an opportunity to buy USD/JPY is in place for investors. Feature After benefiting from the U.S. dollar's generalized weakness, the yen has received a renewed fillip thanks to the rising tensions between North Korea and the U.S. If the U.S. were indeed to unleash "fire and fury" on North Korea, safe-haven currencies like the yen or Swiss franc would obviously shine. While the verbal saber-rattling will inevitably continue, our colleagues Marko Papic and Matt Gertken - head and Asia specialist respectively of our Geopolitical Strategy service - expect neither the U.S. nor North Korea to go to war. Historically, North Korea has behaved rationally, and it only wants to use the nuclear deterrent as a bargaining chip. Meanwhile, the U.S does not want to invest the time, energy, and money required to enact a regime change in that country. Additionally, China is already imposing sanctions on Pyongyang, and Moon Jae-in, South Korea's new president, wants to appease its northern neighbor. With cooler heads ultimately likely to prevail, will the yen rally peter off, or should investors position themselves for additional USD/JPY weakness? We are inclined to buy USD/JPY at current levels. DXY: Little Downside, Potential Upside Most of the weakness in USD/JPY since July 10 has been a reflection of the 3.7% decline in the DXY between that time and August 2nd. However, the dollar downside is now quite limited and could even reverse, at least temporarily. The dollar is currently trading at its deepest discount since 2010 to our augmented interest rate parity model, based on real interest rate differentials - both at the long and short-end of the curve - as well as global credit spreads and commodity prices (Chart I-1). Crucially, the euro, which accounts for 58% of the dollar index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart I-2). Confirming these valuations, investors have now fully purged their long bets on the USD, and are most net-long the euro since 2013. Chart I-1DXY Is Cheap... Chart I-2...But The Euro Is Not Valuations are only an indication of relative upside and downside; the macro economy dictates the directionality. While U.S. financial conditions have eased this year, they have tightened in Europe, resulting in the biggest brake on euro area growth relative to the U.S. in more than two years (Chart I-3). This is why euro area stocks have eradicated their 2017 outperformance against the S&P 500, why PMIs across Europe have begun disappointing, and why the euro area economic surprise index has rolled over - especially when compared to that of the U.S. The improvement in U.S. economic activity generated by easing financial conditions also has implications for the dollar. As Chart I-4 illustrates, the gap between the U.S. ISM manufacturing index and global PMIs has historically led the DXY by six months or so. This gap currently points to a sharp appreciation in the dollar. Chart I-3Easing Versus Tightening FCI Chart I-4PMIs Point To USD Rally If the dollar were indeed to stop falling, let alone appreciate, this would represent a hurdle for the yen to overcome, especially as the outlook for U.S. bond yields is pointing up. Bottom Line: Before North Korea grabbed the headlines, the USD/JPY selloff was powered by a weakening dollar. However, the dollar has limited downside from here. It is trading at a discount to intermediate-term models, while macroeconomic momentum is moving away from the euro area and toward the U.S. - a key consequence of the tightening in European financial conditions vis-à-vis the U.S. Additionally, the strong outperformance of the U.S. ISM relative to the rest of the world highlights that the dollar may even be on the cusp of experiencing significant upside. The Key To A Falling Yen: Treasury Yields Upside An end to the fall in the USD is important to end the downside in USD/JPY. However, rising Treasury yields are the necessary ingredient to actually see a rally in this pair. We are optimistic that U.S. bond yields can rise from current levels. The U.S. job market remains very strong. The JOLTS data this week was unequivocal on that subject. Not only are there now 6.2 million job openings in the U.S., but the ratio of unemployed to openings has hit its lowest level since the BLS began publishing the data, suggesting there is now a limited supply of labor relative to demand. Additionally, the number of unfilled jobs is nearly 30% greater than it was at its 2007 peak, pointing to an increasingly tighter labor market. We could therefore see an acceleration in wage growth going into the remainder of this business cycle, even if structural factors like the "gig-economy", the increasing role of robotics, or even the now-maligned "Amazon" effect limit how high wage growth ultimately rises. The Philips curve, when estimated using the employment cost index and the level of non-employment among prime-age workers, still holds (Chart I-5). Thus, a tight labor market in conjunction with continued job-creation north of 100,000 a month should put upward pressure on wages. Even when it comes to average hourly earnings, glimmers of hope are emerging. Our diffusion index of hourly wages based on the industries covered by the BLS cratered when wage growth slowed over the past year. However, it has hit historical lows and is beginning to rebound - a sign that average hourly earnings should also reaccelerate (Chart I-6). Chart I-5The Philips Curve Still Works Chart I-6Even AHE Are Set To Re-Accelerate The job market is not the only source of optimism, as U.S. capex should continue to be accretive to growth. Despite vanishing hopes of aggressive deregulation, the NFIB small business survey picked up this month. Even more importantly, various capex intention surveys as well as the CEO confidence index point to continued expansion of corporate investment (Chart I-7). Healthy profit growth is providing both the necessary signal and the source of funds to engage in this capex. This will continue to lift the economy. This is essential to our bond and our yen views, as it points to higher U.S. inflation. In itself, economic activity is not enough to generate higher prices. However, when this happens as aggregate capacity utilization in the economy is becoming tight, inflation emerges. As Chart I-8 shows, today, our composite capacity utilization indicator - based on both labor market conditions and the traditional capacity utilization measure published by the Federal Reserve - is in "no-slack" territory, a condition historically marked by bouts of inflation. Chart I-7U.S. Capex To Boost Growth Further Chart I-8No Slack Plus Growth Equals Inflation The recent increase to a three-year high in the "Reported Price Changes" component of the NFIB survey corroborates this picture, also pointing to an acceleration in core inflation (Chart I-9). But to us, the most telling sign that inflation will soon re-emerge is the behavior of the U.S. velocity of money. For the past 20 years, changes in velocity - as measured by the ratio of nominal GDP to the money of zero maturity - have lead gyrations in core inflation, reflecting increasing transaction demand for money. Today, the increase in velocity over the past nine months points to a rebound in core inflation by year-end (Chart I-10). Chart I-9The Pricing Behavior Of Small Businesses ##br##Points To An Inflation Pick Up Chart I-10Reaching Escape ##br##Velocity Expecting higher inflation is not the same thing as expecting higher interest rates and bond yields. However, we believe this time, higher inflation will result in higher yields. First, the Fed wants to push interest rates higher. Fed Chairwoman Janet Yellen and her acolytes have been very clear about this, with the "dot plot" anticipating rates to rise to 2.9% by the end of 2019. While the Fed's preference and reality can be at odds, this is currently not the case. Our Fed monitor continues to be in the "tighter-policy-needed" zone. While it is undeniable that it is doing so by only a small margin, higher inflation - as we expect - would only push this indicator higher. Moreover, the diffusion index of the components of the Fed monitor is already pointing toward an improvement in this policy gauge (Chart I-11). Chart I-11The Fed Monitor Will Pick Up Second, the Fed may have increased rates, and the spread between U.S. policy rates and the rest of the world may have widened, but the dollar has weakened this year. This counterintuitive result highlights that the Fed's effort has had little impact in tightening liquidity conditions. In fact, as we have mentioned, because of the lower dollar and higher asset prices, financial conditions have eased, suggesting liquidity remains plentiful. As such, like in 1987 or 1994, this is only likely to re-invigorate the Fed in its confidence that it can hike rates further, as liquidity conditions remain massively accommodative. Third, beyond the Fed's reaction function, what also matters are investors' expectations. At the time of writing, investors only expect 45 basis points of rate hikes over the upcoming 24 months, which is a reasonable expectation only if inflation does not move back toward the Fed's 2% target. However, our work clearly points toward higher inflation by year end. In a fight between the Fed's "dot plot" and the OIS curve, right now, we would take the side of the Fed. Fourth, it is not just 2-year interest rate expectations that seems mispriced, based on our view on U.S. growth, inflation, and the Fed. U.S. Treasury yields are also trading at a 36 basis points discount to the fair-value model developed by our U.S. Bond Strategy sister service (Chart I-12). Continued good news on the job front and an uptick in inflation would likely do great harm to Treasury holders. Finally, the oversold extreme experienced by the U.S. bond market in the wake of the Trump victory has been purged. While we are not at an oversold extreme, our Composite Technical Indicator never punched much into overbought territory during the Fed tightening cycle from 2004 to 2006 (Chart I-13). Moreover, with no more stale shorts, an upswing in U.S. economic and inflation surprises should help put upward pressure on U.S. bond yields. Confirming the intuition laid out above, the copper-to-gold ratio, a measure of growth expectations relative to reflation, has now broken out - despite the North Korean risks. In the past, such a development signaled higher yields (Chart I-14). With this in mind, let's turn to the yen itself. Chart I-12U.S. Bonds Are##br## Too Expensive Chart I-13Stale Shorts Have Been Purged, ##br##But Overbought Conditions Are Unlikely Chart I-14Where The Copper-To-Gold Ratio Goes, ##br## So Do Bond Yields Bottom Line: The U.S. economy looks healthy. The labor market is strong, and capex continues to offer upside. Because capacity utilization is tight and money velocity is accelerating, inflation should begin surprising to the upside through the remainder of 2017. With the market pricing barely two more hikes over the course of the next 24 months and U.S. bonds trading richly, such an economic backdrop should result in higher U.S. bond yields. Yen At Risk, Even If Volatility Rises JGB yields have historically displayed a low beta to global bond yields. As a result, when global bond yields rise, the yen tends to weaken. USD/JPY is particularly sensitive to yield upswings driven by actions in the Treasury market. This contention is even truer now than it has been. The Bank of Japan is targeting a fixed yield curve slope and does not want to see JGB yields rise much above 10 basis points. With the paucity of inflation experienced by Japan - core-core inflation is in a downtrend, ticking in at zero, courtesy of tightening financial conditions on the back of a stronger yen - this policy remains firmly in place. Emerging signs of weakness in Japan highlight that the BoJ is likely to remain wedded to this policy, even as Shinzo Abe's popularity hits a low for his current premiership. The recent fall in the leading indicator diffusion index suggests that industrial production - which has been a bright spot - is likely to roll over in the coming months (Chart I-15). This means the improvement in capacity utilization will end, entrenching already strong deflationary pressures in Japan. This only reinforces the easing bias of the BoJ, and truncates any downside for Japanese bond prices. Chart I-15The Coming Japanese IP Slowdown In short, while JGB yields might still experience some downside when global yields fall, they will continue to capture none of the potential upside. This makes the yen even more vulnerable to higher Treasury yields than it was before. Hence, based on our view on U.S. inflation and yields, USD/JPY is an attractive buy at current levels. But what if the rise in U.S. bond yields causes a correction in risk assets, especially EM ones? Again, monetary policy differences and the trend in yields will dominate. As Chart I-16 illustrates, USD/JPY has a much stronger correlation with dynamics in the bond markets than it has with EM equity prices. Chart I-16Yen: More Like Bonds Than Anything Else Chart I-17USD/JPY Falls Only When EM Selloffs Are So Acute That They Cause Bond Rallies Moreover, as the experience of the past three years illustrates, only once EM selloffs become particularly acute does USD/JPY weaken (Chart I-17). Essentially, the EM selloff has to be so severe that it threatens the Fed's ability to tighten policy, and therefore causes U.S. bond yields to fall. It is very possible that a rise in Treasury yields will ultimately generate this outcome, but in the meantime the rise in U.S. bond yields should create a tradeable opportunity to buy USD/JPY. Bottom Line: With Japan still in the thralls of deflation and the BoJ committed to fight it, JGB yields have minimal upside. Therefore, higher Treasury yields are likely to do what they do best: cause USD/JPY to rally. This might ultimately lead to a selloff in EM stocks, but in the meanwhile, a playable USD/JPY rally is likely to emerge. Thus, we are opening a long USD/JPY trade this week. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. labor market continues to strengthen, with the JOLTS Survey's Job Openings and Hires both ticking up. The NFIB Survey also shows signs of strength as the Business Optimism Index steadied at lofty levels, coming in at 105.2. Unit labor costs disappointed, but this supports U.S. equities. Nonfarm productivity also outperformed, pointing to improving living standards. U.S. data has turned around, with data surprises improving relative to the euro area. These dynamics are likely to prompt a resumption of the greenback's bull market. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data has been mixed: German current account underperformed, with both exports and imports contracting on a monthly rate, and underperforming expectations. The trade balance, however, outperformed; German industrial production failed to meet expectations, even contracting on a monthly basis; Italian industrial production outperformed both on a monthly and yearly rate, but remains well below capacity European data has begun to show the pain inflicted by tightening financial conditions. Relative to the U.S., the economic surprise index has rolled over. If this trend continues, EUR/USD will struggle to appreciate more this year, and may even weaken if U.S. inflation can improve. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been negative in Japan: Labor cash earnings yearly growth went from 0.6% in May to a contraction of 0.4% in June, underperforming expectations. Machinery orders yearly growth fell down sharply, contracting at a 5.2% rate and underperforming expectations. The Japanese economy continues to show signs of weakness, which means that the Bank of Japan will not let 10-year JGB yields rise above 10 basis points. In an environment of rising U.S. bond yields this will cause the yen to fall. However the question remains: Could a selloff in EM prompted by a rising dollar help the yen? This should not be the case, at least for now, as the yen is much more correlated with U.S. bond yields than it is with EM stock prices. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: BRC like-for-like retail sales yearly growth came in at 0.9%, outperforming expectations. However, the RICS Hosing Price Balance - a crucial bellweather for the British economy - came in at 1%, dramatically underperforming expectations. Also, the trade balance underperformed expectations, falling to a 12 billion pounds deficit for the month of June as exports sagged. As we mentioned on our previous report, we expect the pound to suffer in the short term, as the high inflation produced by the fall in the pound following the Brexit vote is starting to weigh on consumers. Furthermore, house prices are also suffering, and could soon dip into negative territory. All of these factors will keep the BoE off its hawkish rhetoric for longer than priced by the markets. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD gains are reversing as the U.S. dollar rebounds from a crucial support level. This has also occurred due to mixed Chinese and Australian data: Chinese trade balance beat expectations, however, both exports and imports underperformed; Chinese inflation underperformed expectations; Australian Westpac Consumer Confidence fell to -1.2% from 0.4% in August; This is largely in line with our view that the rally in AUD was would only create a better shorting opportunity. Underlying structural and fundamental issues will remain a headwind for the AUD for the remainder of the year. Iron ore inventories in China are also at an all-time high, which paints a dim picture for Australian mining and exports going forward. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Wednesday, the RBNZ left their Official Cash Rate unchanged at 1.75%. Overall, the bank signaled that it will continue its accommodative monetary policy for "a considerable period of time". Furthermore the RBNZ's outlook for inflation, specifically tradables inflation, remains weak. Finally, the bank also showed concern for the rise in the kiwi, stating that "A lower New Zealand Dollar is needed to increase tradables inflation and help deliver more balanced growth". Overall, we continue to be positive on the kiwi against the AUD. While the outlook for tradable-goods inflation might be poor, this is a variable determined by the global industrial cycle.. Being a metal producer, Australia is much more exposed to these dynamics than New Zealand, a food producer. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data continues to look positive for Canada: Housing Starts increased by 222,300, beating expectations; Building permits also increased at a monthly pace of 2.5%, also beating expectations. CAD has experienced some downside as the stretched long positioning that emerged in the wake of the BoC's newfound hawkishness are being corrected. While we expect the CAD to outperform other commodity currencies, based on rate differentials and oil outperformance, USD/CAD should is likely to trend higher as U.S. inflation bottoms. EUR/CAD should trend lower by the end of this year as euro positioning reverts. As a mirror image, CAD/SEK may appreciate based on the same dynamics. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Last week we highlighted the possibility of a correction in EUR/CHF, given that it had reached highly overbought levels. This prediction turned out to be accurate, as EUR/CHF fell by almost 2% this week, as tensions between North Korea and the United States continue to escalate. Meanwhile on the economic front, Switzerland continues to show a tepid recovery: Headline inflation went from 0.2% in June to 0.3% in July, just in line with expectations. The unemployment rate continues to be very low at 3.2%, also coming in according to expectations. Inflation, house prices and various economic indicators are all ticking up, however, the economic recovery is still too weak to cause a major shift in monetary policy. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone has fallen this week against the U.S. dollar, even as oil prices have remained relatively flat. This highlights a key theme we have mentioned before: USD/NOK is more sensitive to rate differentials than it is to oil prices. We expect these rate differentials to continue to widen, as the Norwegian economy remains weak, and inflation will likely remain below the Norges Bank target in the coming years. On the other hand, U.S. yields are set to rise, as a tight labor market will eventually lift wages higher and thus increase rate expectations. Meanwhile EUR/NOK, which is much more sensitive to oil prices than USD/NOK, will keep going down, as inventory drawdowns caused by the OPEC cuts should continue pushing up Brent prices. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data in Sweden was mixed: New Orders Manufacturing yearly growth fell from 7.3% to 4.4%. Industrial production yearly growth increased from 7.5% in May to 8.5% in June, outperforming expectations. The Swedish economy continues to exhibit signs of strong inflationary pressures. Overall we continue to be bullish on the krona, particularly against the euro, as the exit of Stefan Ingves at the end of this year should give way for a more hawkish governor, who would respond to the strength in the economy with a more hawkish stance. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017Xx Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Chart I-4BWidening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Mueller investigation is part of the "Trump Put;" General White House disarray and congressional incompetence combine to produce Goldilocks conditions for U.S. equities; Mexico's frontrunner in the upcoming elections, Andres Manuel Lopez Obrador, is no Chavez; Malaysian political risks are overstated, the ruling Barisan Nasional has pushed through painful reforms; With economic growth stabilizing, cheap valuations, and overstated political risks, Malaysia could be an intriguing investment opportunity. Feature This week, we turn to two emerging markets: Mexico and Malaysia. Our approach to EMs is to look for opportunities where politics may emerge as the alpha amidst appealing valuations. We rely on our sister strategy, BCA's Emerging Market Strategy, for fundamental analysis, to which we then add our political research. We find it striking that these two EMs are the very two that stood to suffer the most should U.S. Congress have passed a border adjustment tax (Chart 1). Not only have the Republicans forsworn the border tax, but these countries will benefit from other trends, as we explain below. Before we dive into Malaysia and Mexico, however, a short note on the latest developments in the White House is in order. Clients from St. Louis, Missouri to Auckland, New Zealand are asking us the same question this summer: when does the Mueller investigation become a headwind for the SPX? Chart 1Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes The "Trump Put" Continues Our answer is that Special Counsel Robert Mueller's investigation may already be a tailwind to the U.S. equity market. The investigation, along with general White House disarray and congressional incompetence, makes up the ongoing "Trump Put."1 The American political imbroglio has combined with decent earnings and steady global growth to produce Goldilocks conditions for U.S. equities, while simultaneously weakening the USD and supporting Treasuries. The political fulcrum upon which all these assets turn is the failure of the Trump administration to deliver its promised fiscal stimulus (Chart 2). Tax reform, which was supposed to be the main vehicle of such stimulus, is increasingly looking like it will fail to live up to its hype. We still think it will pass, for three broad reasons: Chart 2Handcuffed Trump The Most Likely Scenario Trump's low popularity remains an albatross around the neck of GOP candidates in the November 2018 elections, with potentially ominous results. Our simple "line-of-best-fit" model between a Republican president's approval rating and the GOP's midterm performance produces a 38-seat loss in the upcoming election (Chart 3). Republicans need a legislative win and need it fast. The House has laid the groundwork for tax reform, passing the FY2018 budget resolution with reconciliation instructions focused on tax legislation. This means that the Obamacare replace and repeal effort has until October 1 to be resolved.2 Investors are conflating replacing and repealing Obamacare with tax reform. The former is an entitlement program, the latter a more popular measure that Republicans have always tried to move through Congress. It is very rare for U.S. policymakers to successfully reduce or remove an entitlement program. Cutting, even reforming, taxes is easier to justify politically. Chart 3The Clock Is Ticking For The GOP On Tax Reform Although we still maintain that tax reform, or mere tax cuts, will happen, they are unlikely to be as stimulative as originally advertised. Corporate and household tax rates are unlikely to be lowered by as much as originally touted. That is because Republicans in the House will demand "revenue offsets" to accomplish rate reduction, yet they have already lost key offsets like Obamacare repeal and the border adjustment tax.3#fn_3 The White House could change all that by using its considerable political capital among conservative grassroots voters and the bully pulpit to get fiscally conservative Republicans in the House to move a stimulative tax reform through Congress. But, as we noted two weeks ago, factional fighting in the White House and an ineffective chief of staff are considerable hurdles.4 A few days after we published that report, President Trump replaced Reince Priebus with retired General and Homeland Security Secretary John Kelly. While Kelly is likely to introduce some discipline into the White House, we doubt he will make the executive more effective in cajoling House Representatives to toe the administration's line on tax reform. This is because Kelly adds no legislative experience to a White House that is already quite low on it by recent historical standards (Chart 4). Chart 4Trump Administration Is On The Low End Of Congressional Experience Additionally, the Trump Administration continues to drag its feet on presidential appointments, hurting the effectiveness of the executive. Only 220 appointments had been sent to the Senate by July 19, compared to the average 309 during the same time period by the previous four presidents (Chart 5). The Senate is very slow in confirming the candidates, perhaps because of their unorthodox backgrounds and resumes. The average time to confirm a Trump nominee is 45 days, which is astonishing given that the Senate is controlled by Republicans. Chart 5The Trump Administration Is Dragging Its Feet On Appointments In addition to the ineffectiveness of the White House, investors fret that the ongoing Mueller investigation, which has just impaneled a grand jury, could undercut the rally in risk assets. By summoning a grand jury Mueller can subpoena documents and obtain testimony of witnesses under oath. Doing so will accelerate the investigation and perhaps take it down new avenues. For example, the Kenneth Starr investigation initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky. Impeachment proceedings ensued. That said, we are sticking with our conclusion from May that investors should look through any risk of impeachment or indictment for President Trump, at least as long as Republicans hold the House of Representatives (i.e., at least until the midterms in 2018).5 In particular, there are three main reasons to fade any near-term equity market volatility: President Mike Pence - Under both impeachment rules and the 25th amendment, the U.S. president would be replaced by the vice president. Vice President Pence's approval rating largely tracks that of President Trump and is in the 40% area, but investors should note that he once stood at nearly 60% during the campaign (Chart 6). As such, the worst-case scenario for investors in the event of a post-midterm impeachment is that Trump is replaced by Pence, an orthodox Republican, and that Pence has to deal with a split Congress. And that is not bad! It would grind reforms to a halt, but at least tax reform would be out of the way by then. Midterm Election - If the Trump White House becomes engulfed in scandal, Republicans in the House will fear losing their majority. Yes, the partisan drawing of electoral districts - "gerrymandering" - has reduced the number of competitive U.S. House districts from 164 in 1998 to 72 in 2016 (Chart 7). But the Democrats managed to win the House in 2006 and the Republicans managed to take it back in 2010, so there is no reason the roles cannot be reversed yet again. However, this is not a risk, it is an opportunity. It will motivate the GOP in Congress to lock in tax and health care reform well ahead of the midterm elections. Counter-Revolution - With Trump embattled and facing impeachment, the market may let out a sigh of relief because it would mark a clear defeat of populist politics in the U.S. Much as with electoral outcomes in Europe, investors may want to cheer the defeat of an unorthodox, anti-establishment movement in the U.S. As such, we would push against any "Russia scandal"-induced volatility in the U.S. markets, at least until the midterm election. We think the market would digest the volatility and realize that Trump's impeachment, were it to occur after midterm elections, would not arrest the Republican agenda before the midterms. After all, the GOP has waited over 15 years to make Bush-era tax cuts permanent and the opportunity to do so may evaporate within the next 12 months. In addition, given the performance of high tax-rate S&P 500 equities (Chart 8), investors appear to have already discounted the failure of meaningful tax reform in the market. This means that the "Trump Put" is in full effect: investors are bidding up risk assets not because they expect something to happen (tax reform, fiscal stimulus, financial deregulation, etc.), but because they expect nothing to happen (no fiscal stimulus, no fast Fed rate hikes, no onerous regulation for businesses, etc.). Chart 6Could Be Worse ##br##Than Pence Chart 7Gerrymandering Reduces##br## Competitive House Seats Chart 8Investors No Longer##br## Expect Tax Reform What about the long term? A scandal-ridden White House, escalating leaks against the administration, and a mounting bureaucratic revolt against the executive cannot be good for the U.S., can they? The news flow out of Washington increasingly looks like news from Ankara, Brasilia, or Pretoria. There are two diametrically opposed directions the U.S. can take. The first is deepening polarization and policy gridlock that leads to President Trump being replaced by an even greater bout of populism in 2020 or 2024. We described this scenario recently in a pessimistic note about the coming social unrest in America.6 The alternative is that Democrats and Republicans in Congress (particularly the Senate), representing the country's elites, decide to work together on legislation. Both parties recently united to pass veto-proof sanctions on Russia with a 98-2 vote that has bound the executive to future review by Congress. And some green shoots of bipartisanship appeared over the past two weeks on tax reform and even on health care. It is too soon to say which path American policymakers will take. Investors may have to wait until after the midterm election for genuine cooperation. But it would be very positive for the U.S. economy and prospects of reform if genuine bipartisanship emerged as a reaction to the incompetence, scandal, nationalism, and populism of the White House. Bottom Line: The intensifying Mueller investigation and ongoing White House incompetence will only further fuel the "Trump Put." This is positive for U.S. equities, neutral for bonds, and bad for the dollar, ceteris paribus. A significant pickup in inflation could overwhelm the "Trump Put" and cause the dollar to rally. As such, investors should focus on inflation prospects more than politics in the White House. What If Mexico Builds A Wall First? For every action, there is an equal and opposite reaction. The election of President Donald Trump, an unabashed nationalist who campaigned on an anti-immigrant platform, is spurring the campaign of Andres Manuel Lopez Obrador, also known as AMLO, in the upcoming July 1, 2018 elections in Mexico. Obrador has been a left-wing firebrand of Mexican politics for years. He was the Head of Government of Mexico City (essentially the city's mayor) from 2000 to 2005 and contested a close election against Felipe Calderon in 2006, which he narrowly lost. He lost the 2012 election by a much wider margin, but still came second to current president Enrique Pena Nieto of the Institutional Revolutionary Party (PRI). Obrador's election campaign calls for a confrontational attitude towards President Trump, the renegotiation of NAFTA, an increase to farm subsidies, and limitations on foreign investment in Mexico. He has said that he would reverse the opening of the energy sector to foreign investment through a referendum, but that he is in favor of public-private partnerships in the sector. That said, his left-wing firebrand persona is more PR than substance. In 2012, for example, he also campaigned on cutting government expenditure and ending monopolies - not exactly Chavista credentials. Nonetheless, he quit the left-leaning Party of the Democratic Revolution (PRD) to form a more left-wing movement. Obrador's new party, the National Regeneration Movement (MORENA), did well in the 2015 midterms and is currently leading in the polls ahead of the 2018 election (Chart 9). MORENA also did well in the State of Mexico, a PRI stronghold and Nieto's home state, in the June 4 election. The ruling PRI held the state for 90 years and is accused of election-rigging in order to, only narrowly, defeat an unknown MORENA candidate this year. Chart 9MORENA Has Lead In The Polls Given that the election is a year away, it is too soon to make a forecast. Nonetheless, it is clear that Obrador is the frontrunner for the presidency. There are three reasons why his election may be an over-hyped risk: The Congress: For much of Mexico's twentieth century history, the president was essentially a dictator due to the one-party rule of PRI. In the twenty-first century, however, Congress has become plural, forcing the president to cooperate with the body or see his reforms stalled. Given recent elections (Chart 10), it is highly unlikely that Obrador would have a congressional majority behind him, thus forcing him to temper his policies. Chart 10Mexico's Rising Political Plurality The PAN-PRD Alliance: An unlikely alliance of the conservative National Action Party (PAN) and the center-left PRD has emerged as a reaction to the rise of MORENA in the polls. (These two parties have a history of cooperating against PRI presidents.) The two parties come from completely opposite ideological spectrums, but successfully joined forces in several state elections in 2016. It is unlikely that the two parties will unify sufficiently to field a single candidate - they failed to do so in the June 4 State of Mexico elections - but they may get enough votes to form a plurality in Congress. Mexicans do not lean left: Unlike most of Latin America, Mexico is a conservative country. Most Mexicans either think of themselves as centrist or lean right (Chart 11). While our data stops in 2015, the historical trend is clear: Mexico is a right-leaning country. As such, it is highly unlikely that AMLO will be able to manipulate the country's democratic institutions - which have been strengthened over the past twenty years - to turn Mexico into Venezuela. Chart 11Mexicans Lean Right We would therefore fade any politically induced volatility in Mexican assets. Next year, investors should prepare to "sell the rumor and buy the news" (you read that right), as Mexican election fever grips the markets. Given current macroeconomic fundamentals, an entry point in Mexican assets may develop if they sell off ahead of the election - but they are not a buy at the moment. BCA's Emerging Market Strategy has pointed out in a recent report that:7 Inflation is well above the central bank's target and is broad based (Chart 12). Notably, wage growth is elevated (Chart 13). Given meager productivity growth, unit labor costs - calculated as wage-per-hour divided by productivity (output-per-hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will, in turn, prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Chart 12Inflation is Above Target Chart 13Wage Inflation Is High Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail a further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart 14). This will weigh on corporate profits and share prices. Even though non-oil exports and manufacturing output are accelerating (Chart 15), non-oil exports - which make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. That said, the positive for Mexico is that the Mexican peso remains cheap (Chart 16) and may rally against other EM currencies. Our EM strategists suggest that investors should overweight MXN versus ZAR and BRL. Chart 14Domestic Demand to Buckle Chart 15Exports are Robust Chart 16Peso is Cheap If EM currencies depreciate or oil prices drop, it would be difficult to see MXN rally against the USD. However, MXN should outperform other currencies, especially given that political risks in Mexico are far lower than they are in Brazil and South Africa. Bottom Line: The Mexican markets may get AMLO-fever in 2018. Obrador is a clear frontrunner in the election to be held a year from now. However, AMLO will face off against constitutional, political, and societal constraints. As such, we would fade any politically induced risks in Mexican markets. Go strategically long MXN versus BRL and ZAR and look for an entry point into Mexican risk assets over the next 12 months. Malaysia: Hold Your Nose And Buy We have been broadly bearish on Malaysia since August 2015, but the upcoming elections - due by August 2018, but we expect to occur sooner rather than later - are likely to cause the markets to re-price Malaysian assets (Chart 17). The country's fundamentals are not rosy, and it remains vulnerable to a slowdown in China, a drop in commodities prices, and bad loans. Nevertheless, its underperformance is late, and this fact, combined with the political outlook, suggests that it will outperform for a while. Malaysia is in the midst of a long saga of party polarization that began amid the Asian Financial Crisis, when Prime Minister Mahathir Mohamad ousted his ambitious deputy, Anwar Ibrahim. Both men hailed from the dominant party of the country's ethnic Malay majority: the United Malay National Organization (UMNO), which is the center of Barisan Nasional (BN). The BN is a multi-ethnic coalition that has held power in one form or another since independence in 1957. Anwar went on to lead the reformasi (reform) movement, creating an opposition coalition of strange bedfellows: his own urban Malay People's Justice Party (PKR), the ethnic Chinese DAP, and the Islamist PAS. In the 2008 general elections, the opposition shocked the BN, depriving it of a two-thirds super-majority for the first time since 1969. In the 2013 general elections, the opposition won the popular vote, though BN retained control of parliament due to inherent advantages in the electoral system (Chart 18). Hence the past two elections, particularly the last one in 2013, have shaken the political system to the core. Since the 2013 shock, the opposition has had its sights set on the 2018 election, and a series of blows to the Najib government have given cause for hope. First, exports and commodity prices plunged from 2014 to 2016, damaging the economy and giving the opposition a grand opportunity to attack the administration (Chart 19). Second, Najib was personally implicated in a massive scandal involving 1MDB, a sovereign wealth fund that Najib helped create and from which he allegedly embezzled $700 million (!). Street protests emerged in 2015 and suddenly Najib faced a revolt from the old guard within his own party (including Mahathir himself). Chart 17Malaysian Underperformance Is Late Chart 18Opposition Threatens UMNO's Dominance Chart 19Commodities Should Help Malaysian Exports The problem for the opposition, however, is timing. The 2008 election occurred before the worst of the global financial crisis had been felt; the 2013 election occurred before the full impact of the commodity bust; and now the ruling coalition's fortunes are recovering in time for the upcoming election - which, of course, the prime minister schedules to his advantage. Thus, the opposition once again faces an uphill battle in this election cycle: The Malaysian economy has beaten expectations, growing by 5.6% in the first quarter of 2017, the fastest rate in two years. This was driven mainly by exports and the manufacturing sector (Chart 20). Money supply growth is strong while the credit impulse has bottomed and is approaching positive territory (Chart 21). The 1MDB scandal has mostly dissipated. Najib publicly confessed that the $700 million found in his personal account was a donation from a foreign government, and Saudi Arabian authorities confirmed this, prompting Najib to return the money. Malaysia's attorney general, anti-corruption commission, and central bank have all cleared Najib of wrongdoing, and his popular support has recovered from the fever pitch of the scandal in 2015-16, as demonstrated by the net-gain for BN in by-elections since 2013, and the fact that the BN saw its share of seats rise from 27% to 37% in the 2016 Sarawak State Assembly elections. This state's local elections have tended to foreshadow national elections, and it has the largest representation of any state in the national parliament (31/222). The opposition is split. Najib has courted the Islamist opposition party, PAS, peeling it away from the opposition coalition. Without PAS, the opposition falls from 89 seats in parliament to 71 seats, which is 41 shy of a majority. Even in the best case scenario for the opposition in the upcoming election, in which the opposition holds all seats from 2013 and Bersatu gains all of UMNO's seats in Kedah and Johor, the opposition would still fall 16 seats shy of a majority. Chart 20Growth Is Strong Chart 21Credit Cycle Is Picking Up Bottom Line: Our baseline case holds that Najib and BN will retain control of the government in the upcoming election on the back of the fading scandal, economic recovery, and a shrewd practice of dividing political enemies. What Does A Najib Win Mean? Is a Najib/BN victory positive for Malaysian risk assets? We think so, at least relative to other EMs. While Malaysia would benefit in the long run from breaking the BN's monopoly over parliament, the immediate consequence of an opposition victory would be confusion as the various opposition parties have widely divergent interests ... and zero governing experience. On the other hand, Najib's government has undertaken some significant reforms, expanded infrastructure, and improved government finances, making his corrupt and pseudo-authoritarian government not as market unfriendly as one might expect: As a result of weak commodities, cuts in subsidies, and the introduction of a goods and services tax (GST) and a tourism tax, Malaysia's fiscal deficit has improved from 5.5% in 2013, when Najib took office, to 3.1% today (Chart 22). The government is on a path to close the deficit by the end of the decade. The GST has allowed the government to reduce its dependency on oil revenues. Non-tax revenues, which include oil royalties, have decreased from 35% in 2010 to only 20% of total revenue, while indirect taxes (which include GST) have increased from 17% to 28% of revenue (Chart 23, top three panels). There are plans to increase the goods covered by the GST in the near future. The government has cut subsidies in fuel and cooking gas, taking advantage of low oil prices. The government had also eliminated subsidies in cooking oil and sugar. Subsidies as a percent of total expenditures have declined from almost 20% in 2014 to only 9% today (Chart 23, bottom panel). The government has expanded infrastructure, completing a mass rail transit extension in Kuala Lumpur, connecting the two East Malaysian states of Sabah and Sarawak via a 2,000 km highway, and attracting Chinese investment from the One Belt One Road program. The latter entails China building an East Coast Rail Link to connect the west and east coasts. Upon completion, this link will enable shippers to circumvent the port of Singapore and reach the South China Sea in a shorter time period. Chart 22Austerity Works Chart 23Tax Reforms Paid Off One perceived drawback of Najib's government is that in order to stay in power, he has had to court the Islamist PAS party, as mentioned above, specifically by allowing it to promote aspects of shariah law in the country's parliament. However, Malaysia is not at risk of being swept away by an imaginary rising tide of Islamic extremism. The country is very diverse, and Malay Muslims make up only a little more than half of the population. Malaysians are highly religious, but they are also highly tolerant, as they have lived among other races and religions since independence (Chart 24). Moreover, Islam is regulated and bureaucratized in Malaysia, which discourages the emergence of charismatic, anti-establishment religious leaders and the development of extremist movements. Finally, the government has an absolute need to win votes both in the Borneo states of Sabah and Sarawak, which have sizable Christian and non-Malay populations (adding up to more than half), and in the population centers of Kuala Lumpur and Penang. This means that it is not likely to allow PAS (or other Islamist movements) to go too far. Chart 24Malaysians Are Tolerant Bottom Line: Najib's government is corrupt and has authoritarian leanings, but has improved its management of the economy and public finances, and is not getting out of control with Islamism or populism. We would not expect a sustained market sell off in the face of a BN victory in upcoming polls. By contrast, if the opposition coalition wins a majority, it offers the long-term promise of a more inclusive and competitive political system that would be good for Malaysia, but would bring greater policy uncertainty in the short term. The opposition would likely have a low probability of achieving major reforms, as the BN party-state conglomerate would fight tooth and nail against it. A positive knee-jerk market response to an opposition win - on the expectation that "regime change" raises the probability of pro-market reforms - would likely be ephemeral. Investment Conclusion A key internal risk to the Malaysian economy stems from the country's fairly sizable debt, which may eventually become unsustainable. Yet at the moment, household and government debt are both rolling over even as growth is improving (Chart 25). A key external risk stems from China. Chinese politics are likely to shift from a tailwind for Chinese growth - fiscal stimulus and the need for stability ahead of the National Party Congress - to a headwind, as stimulus subsides and reforms are rebooted in 2018.8 We do not expect China's investment in Malaysia to fall sharply, since it is tied to a broad, long-term, strategic plan; nor do we see Malaysia as overexposed to Chinese imports or tourism. Nevertheless, Malaysia would suffer to some extent, and it is indirectly vulnerable as Malaysian exports to ASEAN and tourists from ASEAN are significant, and ASEAN would suffer from a Chinese slowdown. In short, China is a risk, albeit not as direct or major as one might think. The Malaysian ringgit has already become the best-performing currency this year. Yet this recent appreciation has not come near to reversing the currency's roughly 20% depreciation since 2014. A cheap currency, combined with robust external demand, should be a tailwind for Malaysian exports and the broader economy (Chart 26). Moreover, the rising price of key Malaysian exports like energy and palm oil should be positive for Malaysian equities (Chart 27). Chart 25Debt Is High, But Is Rolling Over Chart 26Cheap Currency Is A Tailwind For Exports Chart 27Commodities Support Equity Prices At the same time, valuations are attractive. Malaysian equities have underperformed the EM universe and its ASEAN peers since 2013 (see Chart 17 above). Malaysian equities have lost considerable value relative to their EM peers, and are trading at a discount relative to ASEAN peers. Compared to historical valuations, Malaysian equities are also trading at a discount (Chart 28 A and B). Chart 28aMalaysia Is Cheap Compared To Peers... Chart 28b...And Its Historical Valuation Bottom Line: The likely start of a new credit cycle, improving government finances, a persistently cheap currency, and the likelihood of an acceptable policy status quo should put a tailwind behind Malaysian risk assets. We recommend going long Malaysian equities relative to their EM peers. Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst Emerging Markets Strategy stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?," dated February 8, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 7 Please see BCA Emerging Market Strategy Weekly Report, "The Case For A Major Top In EM," dated July 12, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com.

Highlights U.S. Treasuries: The downturn in U.S. inflation looks to be stabilizing, while the U.S. economy continues to churn along at an above-potential growth pace. Treasury yields are now at risk of a repricing of both inflation expectations and Fed rate hike probabilities. Treasury-Bund Spread: The "leadership" of the global bond market is likely to switch back to the U.S. from Europe in the next few months, which will lead to an underperformance of Treasuries. We are entering a new Tactical Overlay trade this week, shorting 10-year U.S. Treasuries versus 10-year German Bunds. Central Bank Balance Sheets: Central banks with large amounts of maturing bonds on their balance sheets, like the Fed and the Bank of Japan, have had no choice but to signal a slower pace of future bond buying. The ECB is in a similar boat, as its holdings of German debt approach issuer limits in the ECB portfolio. A slower pace of ECB bond buying is certain in 2018, to the detriment of European government bond market performance. Chart 1UST Yields Have Some##br## Catching Up To Do Feature Is the surprising 2017 downdraft in U.S. inflation starting to bottom out? The latest set of readings on growth in prices and wages provides some evidence that the decline may be over. Core PCE inflation rose on a year-over-year basis in June for the first time since January. In July, Average Hourly Earnings had the largest monthly increase since October of last year (Chart 1). With oil prices up 16% off the mid-June lows, and the trade-weighted U.S. dollar down nearly 5% over the same period, the stars are aligned for a pickup in U.S. inflation in the coming months. A sustained rebound in realized inflation would be the catalyst for a renewed rise in U.S. Treasury yields, particularly with U.S. economic data starting to show more upside surprises. With the market only priced for 28bps of Fed rate hikes over the next twelve months, Treasuries are exposed to any improvement in U.S. growth and inflation. Treasuries are certainly due for a bit of catchup to the moves in global bond yields seen over the past couple of months. Rate hike expectations have ratcheted higher in a number of countries that have left policy rates at very low levels as growth has accelerated, such as Canada, the U.K. and Sweden (bottom panel). This has put mild upward pressure on government bond yields in those markets. Yields in the Euro Area have also been rising, not because of rate hike expectations but rather a growing belief that the European Central Bank (ECB) will soon begin paring back the pace of its asset purchases. Reduced central bank buying by the Fed, ECB and the Bank of Japan (BoJ) remains a major threat to the global bond market. It will likely take higher yields to entice other investors to absorb the supply of global duration risk currently taken down by central banks. This is a longer-term factor that will place a gently rising floor underneath global bond yields. In the meantime, the path of least resistance for bond yields in the next 6-12 months remains upward as expectations for U.S. inflation and Fed rate hikes shift higher. The Fed Will Soon Be Back In Play Chart 2Low Unemployment, ##br##But With A Low Equilibrium Rate The July U.S. employment report released last week showed continued strength in hiring activity. The headline number of +209k jobs created was above expectations, bringing the 2017 monthly average up to +184k which is almost identical to the +187k average seen in 2016. The headline U-3 unemployment rate dipped back to a cyclical low of 4.3%, in line with the lows of the previous two business cycles (Chart 2). The broader U-6 measure was unchanged at 8.6% - within hailing distance of the low seen during the last business cycle (8.0% in 2007). Yet despite the historically low levels of unemployment, wage inflation is still only holding steady and not yet accelerating. The annual growth rate of Average Hourly Earnings remains stuck around 2.5%, while other measures like the Employment Cost Index are also showing little upward momentum. Yet as long as wage growth is not decelerating, the Fed is likely to remain confident that inflation should eventually drift back up to the central bank's 2% target IF the economy grows in line with its forecasts and additional spare capacity in labor markets is absorbed. The Fed has been openly debating the appropriate level of the real funds rate in recent weeks. Measures such as the Laubach-Williams "R-star" have been cited as evidence that the Fed may be getting very close to a neutral funds rate. However, this is only true if realized inflation stays at current levels. If inflation begins to reaccelerate, additional interest rate increases would be needed to restore the real Fed funds rate back even to current levels. More increases would be needed to get the real funds rate back to even just the current R-star estimate of -0.2%. A level of the real funds rate above R-star could even be necessary if realized inflation was above the Fed's target, as occurred in the late-1990s and mid-2000s when the U.S. Employment/Population ratio climbed higher alongside a steadily growing economy (bottom panel). For now, however, we see the Fed as remaining in a wait-and-see mode, holding off on any additional rate hikes until higher inflation begins to manifest itself in the actual data. In the meantime, market expectations for U.S. inflation are already starting to drift higher. The 10-year TIPS breakeven is at 1.80%, up +13bps since June 16th. The model for breakevens developed by our sister publication, U.S. Bond Strategy, based on financial market variables has also increased by 6bps to 1.82% over the same period, suggesting that current breakevens are now essentially at fair value. (Chart 3). While breakevens remain well below the 2.5% level that we deem to be consistent with the Fed's inflation mandate, this shift in the direction of expectations is critical given the current low level of Treasury yields.1 Chart 3A Weaker USD Should Soon##br## Boost Growth & Inflation The sharp decline in financial market volatility seen across risk assets over the past few months can largely be traced back to that pullback in realized U.S. inflation since February. Interest rate volatility has collapsed alongside the drop in inflation, as investors have priced in a less hawkish Fed outlook. This also triggered a bout of U.S. dollar weakness that has helped boost demand for assets that typically suffer during periods of U.S. dollar strength, like Emerging Market equities and credit. If inflation begins to soon perk up again, as we expect, then Fed rate hikes will come back into play and both bond volatility and the U.S. dollar will increase, providing a challenge to the current stable return profiles for both equities and corporate credit. We still see the Fed only slowly nudging the funds rate up towards equilibrium levels over the next year, unless inflation rises at a much faster rate than both the Fed and markets expect. Coming at a time when the U.S. economy will continue to churn along at a steady above-potential pace, risk assets can continue to outperform Treasuries even with some appreciation of the U.S. dollar, although with a higher level of market volatility. We still see a December rate hike as the most likely next move on rates by the Fed, with an announcement on reducing the Fed's balance sheet, which has been well-telegraphed, likely in September. This sequence will give the Fed time to assess developments in inflation while still incrementally "normalizing" its monetary policy by beginning to reduce the reinvestment of maturing bonds in its portfolio. A shift to more hawkish Fed expectations would open up the potential for a tactical widening of the spread between U.S. Treasuries and German Bunds. The current spread is too low relative to differentials at the short ends of the respective yield curves, and is holding at the rising trendline that began in 2014 (Chart 4, top panel). At the same time, the gap between the Citigroup economic data surprise indices for the U.S. and Euro Area is starting to widen in a direction that should trigger a wider Treasury-Bund spread (middle panel) - especially given the large net long positions still seen in Treasury bond futures (bottom panel). A tactical widening of the Treasury-Bund spread is not inconsistent with our views on the ECB (Chart 5). We still expect some additional upward pressure on Euro Area bond yields as the ECB announces a tapering of its asset purchases at next month's monetary policy meeting. However, there has already been a considerable adjustment higher in European yields since ECB President Mario Draghi's relatively hawkish Portugal speech in June - one that was not matched by U.S. Treasuries. The next move in "leadership" for global bonds will come from a return of U.S. inflation and Fed hawkishness, not from Europe. Chart 4Higher Volatility On The Horizon? Chart 5Position For A Tactically Wider UST-Bund Spread On the back of this, we are opening up a new trade in our Tactical Overlay portfolio this week, going short 10-year U.S. Treasuries vs 10-year German Bunds. Bottom Line: The downturn in U.S. inflation looks to be stabilizing, while the U.S. economy continues to churn along at an above-potential growth pace. Treasury yields are now at risk of a repricing of both inflation expectations and Fed rate hike probabilities. The "leadership" of the global bond market is likely to switch back to the U.S. from Europe in the next few months, which will lead to underperformance of Treasuries. Thus, we are entering a new Tactical Overlay trade this week, shorting 10-year U.S. Treasuries versus 10-year German Bunds. The State Of The "QE5" The current coordinated cyclical upturn in global growth, combined with booming equity and credit markets, is forcing central bankers to contemplate shifting to a less dovish monetary policy stance. Only the Fed and the Bank of Canada have actually raised interest rates since the oil-driven deflation scare of 2014/15. Yet policymakers in regions that have undertaken asset purchase programs - the U.S., Euro Area, the U.K., Japan and Sweden which we will call the "QE5"- also must consider policy moves that will impact the future size, and composition, of central bank balance sheets. The sums involved are enormous and will have major implications for financial markets. In Table 1, we present data first published in the 2017 BIS Annual Report published in late June (that we have since updated ourselves), showing the details of the QE5's balance sheets.2 A few numbers stand out from the table: Table 1The State Of The "QES" Central Bank Balance Sheets The Fed owns 13% of U.S. general government debt, with an average maturity of 8.0 years; 43% of the holdings mature within two years The BoJ owns 40% of Japanese general government debt, with an average maturity of 6.9 years; 49% of the holdings mature within two years The Bank of England owns 25% of U.K. general government debt, with an average maturity of 12.0 years; 20% of the holdings mature within two years The Riksbank owns 15% of Swedish general government debt, with an average maturity of 5.0 years; 37% of the holdings mature within two years The ECB owns 17% of Euro Area general government debt, with an average maturity of 8.0 years; the specific maturity structure is not publically known, however, as the ECB does not provide the same level of detail on its bond holdings as the other QE5 central banks. It is clear from the data that the Fed essentially has little choice but to begin the process of letting bonds run off its balance sheet, given that nearly half of its holdings will mature by 2019. With the U.S. economy at full employment, there is little need for the Fed to continue sending an unnecessarily dovish message by rolling over its bond holdings and maintaining such a large balance sheet. Similar arguments can be made for the Bank of England and the Riksbank, with both the U.K. and Sweden at full employment and a large share of bond holdings set to mature within two years. Chart 6BoJ Will Peg JGB Yields And Hope ##br##For A Weaker Yen Japan is a unique case, as always. With the economy still struggling to avoid deflation, even with an unemployment rate below 3%, the BoJ must maintain a hyper-easy monetary policy to keep the yen weak enough to generate some imported inflation (Chart 6). Yet the sheer size of its balance sheet, and its bond holdings, makes it increasingly difficult to roll over all of its maturing debt without severely impairing liquidity in the JGB market. Thus, it is no surprise that the BoJ has chosen to shift to a "yield curve" target that aims to peg the benchmark 10-year JGB yield at 0% - a policy which, presumably, would entail only buying bonds when there is upward pressure on yields from growth and inflation. The BoJ has already "tapered" to an annualized rate of bond buying of 70 trillion yen in 2017 - below the central bank's official 80 trillion yen per year target - and even slower amounts of buying could occur in the next couple of years as the maturing bonds in the BoJ's portfolio are not fully replaced. Which brings us to the ECB. The current economic expansion has been impressive in its scope and breadth, with even perpetual laggards like Italy enjoying a solid cyclical upturn. Although inflation remains below the ECB's 2% target, core inflation has clearly bottomed out and is even slowly accelerating in some countries, like Germany and Spain (Chart 7). The central bank has been sending out signals that an adjustment in its monetary policy settings will likely be needed soon. The markets have interpreted this as a sign that the ECB will announce a tapering of its asset purchases in 2018. The ECB has to be a little surprised, and perhaps nervous, over the market reaction to this shift in its communication with the markets. Longer-term bond yields rose sharply, with the benchmark 10-year German Bund more than doubling in a matter of weeks in late June and early July. The central bank has been clear in stating that no change in short-term interest rates is imminent, and there has been very little movement in shorter maturity bond yields. Yet the euro has appreciated 5% since Mario Draghi's Portugal speech on June 26th, following the rise in long-term bond yields rather than the typical short-rate moves that guide currency fluctuations (Chart 8). Chart 7The Case For A Less Accommodative ECB Chart 8Could A Stronger Euro Delay The Taper? The surge in the euro has largely been due to capital inflows by global investors chasing the improving growth in the Euro Area, combined with some short covering of the large short positioning on the currency from earlier this year. Without the support of actual interest rate hikes that more sustainable boost the attractiveness of the currency, additional gains in the euro may be hard to come by - especially if the Fed soon shifts back to a more hawkish stance, as we discussed earlier in this report. As long as the rising euro does not materially impact broader Euro Area financial conditions through falling equity prices or wider corporate credit spreads, the ECB can continue on a path towards signaling a slower pace of asset purchases next year. They essentially have no choice on that front, given the approaching constraints on its bond buying program. The ECB has set internal rules that its asset purchases must: a) be allocated across the Euro Area countries according to the weights of the ECB "Capital Key"; and b) not result in the ECB owning more than 33% of any single countries stock of government debt. Following the first rule means buying far more German and French debt than Spanish or Austrian debt. Yet if they continue to follow the first rule, the second rule will be violated for some countries, most notably Germany. In Chart 9, we show the share of government bonds owned by the ECB for Germany, France, Italy and Spain. We also show projections for the ownership shares based on four scenarios for the pace of ECB asset purchases in 2018. If the ECB was to maintain the current €60bn/month rate of buying, then the 33% threshold for Germany would be breached next year (the green dotted line in the top panel) and the limit would almost be reached for Spain (the green dotted line in the bottom panel). Given these projections, it is perhaps no surprise that the ECB is sending signals about a taper even with inflation still south of the 2% ECB target. The ECB has already starting altering the composition of its monthly asset purchases, buying a lower share of German bonds between April and June, while buying a larger share of French and Italian bonds in excess of the Capital Key limits (Chart 10). To continue to do this would invite potential political criticism of the ECB's policies from Germany and other "hard money" countries in the Euro Area that do not wish to subsidize the high deficit governments. Chart 9ECB Holdings Of German Debt ##br##Approaching Limits Chart 10This Is Politically Unsustainable For that reason, we consider it to be very unlikely that the ECB will maintain the same level of bond purchases next year, but while also moving away from the Capital Key as the weighting scheme. The single country issuer limit could be raised from 33%, but this is also not a sustainable solution as it would potentially create the same problems faced by the other QE5 countries where the central bank ends up absorbing increasing shares of new government bond issuance, impairing market liquidity. We see the ECB as having no choice but to reduce the pace of asset purchases next year. We expect a true taper announcement next month that sets a date when the pace of buying goes to zero. The most "dovish" decision we can envision is a reduction in the pace of buying to €40bn/month that is maintained for all of 2018. This would be an identical move to the decision made last December, but even this would result in the ECB coming very close to the 33% issuer limit for Germany (the black dotted line in the top panel of Chart 9). Net-net, we see the ECB buying fewer Euro Area government bonds in 2018, no matter what. This will continue to put a rising floor underneath bond yields, with risks of bigger increases if inflation begins to accelerate in line with the ECB's projections. Bottom Line: Central banks with large amounts of maturing bonds on their balance sheets, like the Fed and the Bank of Japan, have had no choice but to signal a slower pace of future bond buying. The ECB is a similar boat, as its holdings of German debt approach issuer limits in the ECB portfolio. A slower pace of ECB bond buying is certain in 2018, to the detriment of European government bond market performance. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The Fed targets a growth rate of 2% on the headline Personal Consumption Expenditure (PCE) deflator, but the inflation rate reference in TIPS pricing is the growth of the headline Consumer Price Index (CPI). Given that the spread between headline PCE and headline CPI inflation has averaged around 50bps in recent years, a CPI inflation rate of 2.5% would be consistent with the Fed's stated inflation target. 2 http://www.bis.org/publ/arpdf/ar2017e4.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights July jobs report friendly for risk assets. Q2 earnings and July ISM confirm bullish profit environment. The Fed acknowledges softer inflation, but remains determined to tighten policy. 1H economic growth is just enough for the Fed. Housing weakness in Q2 is not a concern. Feature Chart 1Labor Market Conditions Favor Risk Assets The July jobs report suggests that the environment of solid economic growth and still muted wage pressures remains in place, a positive backdrop for equity markets. The report showed that the economy added 209,000 jobs in July, well above the consensus forecast of 178,000. Prior months were also revised higher by 2,000 pushing the 3-month moving average up to 195,000 jobs per month. Monthly job gains thus far in 2017 are nearly identical to the 187,000 jobs per month averaged in 2016. Despite an uptick in the participation rate to 62.9% from 62.8%, the unemployment rate dipped by 0.1% to 4.3%. At two decimal points, the dip in the jobless rate was from 4.36% to 4.35%. Although the monthly increase ticked up to 0.3%, the annual increase in average hourly earnings was flat at 2.5% for the fourth consecutive month (Chart 1). Nonetheless, the reacceleration in the 3-month change in average hourly earnings from 1.9% in January 2017 to 2.8% in July supports the Fed's view on inflation. Bottom Line: The July employment report paints a fairly stable picture of the U.S. economy. Job gains are continuing at a pace consistent with the 2% GDP growth rate of recent years. Meanwhile, wage gains remain modest and consistent with muted inflation. We still expect the Fed to announce the process of running down its balance sheet at the September FOMC meeting. The next rate hike will likely come at the December FOMC meeting, if inflation rebounds in the second half of the year. Steady growth, low inflation and a gentle Fed should continue to underpin U.S. risk assets. Q2 Earnings Update: Margin Expansion In Place EPS and sales growth in Q2 are running well ahead of consensus expectations as forecasted in our July 3 preview. Moreover, the counter trend rally in profit margins is still in place. More than 80% of companies have reported results so far with 73% of companies beating consensus EPS projections, just above the long-term average of 70% (Chart 2). Furthermore, 68% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 6% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to ultimately re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, over the nearer term, results thus far imply that Q2 will see another quarter of margin expansion. Average earnings growth (Q2 2017 versus Q2 2016) is strong at 12% with revenue growth at just 5%. The BCA Earnings model predicts EPS growth to hit roughly 24% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 3). Measured on this basis, S&P 500 EPS growth in Q2 would be 20%, compared with 13% in Q1. Chart 2Positive Earnings Surprises Continue Chart 3Strong EPS Growth Ahead Importantly, the strength in earnings and revenues is broadly based (Table 1). Earnings per share are higher in Q2 2017 versus Q2 2016 in all 11 sectors. Results are particularly strong in energy, technology and financials. Energy revenues surged by 15.7% in Q2 versus a year ago. Sales gains in technology (8.2%), materials (7.2%) and utilities (5.7%) are notable. Since the start of 2017, the trajectory of EPS estimates for 2017 and 2018 (Chart 4) has been encouraging. The forecast for 2017 is 12%, up from 11% at the outset of the Q2 reporting season and unchanged from the start of the year. The 2018 estimate (11%) is also little changed from estimates made in January 2017. In a typical year, earnings estimates tend to move lower as the year progresses. Table 1S&P 500:##BR##Q2 2017 Results* Chart 4Stability In '17 & '18 EPS##BR##Estimates Supports U.S. Equities BCA's U.S. Equity Strategy service noted1 that the lagged effect from a softening U.S. dollar will also likely underpin EPS in the back half of the year. We are surprised that mentions of the greenback are absent from Q2 conference calls; the domestic market appears front of mind for both investors and management teams. We are inclined to see fading concerns about the dollar from the next Beige Book (due in early September) as evidence in favor of our colleagues' view. The July reading of the ISM manufacturing Index supports our case for accelerating profits in the second half of 2017. From the perspective of risks to our stance, industrial production (IP) has historically been a good proxy for sales of S&P 500 companies (Chart 5); and a rollover in the 12-month change in IP would challenge our constructive view towards earnings. However, strong readings on the ISM, which tracks IP, suggest that IP should accelerate in the next six months (Chart 5, panel 1). Chart 5Favorable Macro Backdrop For Earnings And Sales At 56.3 in July, the ISM has rebounded from its recent low of 47.9 in 2015, but ticked down from the 57.8 reading in June. For many investors, the risk is that the index has peaked and will soon roll over. While a decline is certainly possible given that the index is already elevated, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 6). Moreover, the new export orders component of the ISM has also surged. The implication is that foreign demand (rather than domestic consumer or business spending) is leading the U.S. manufacturing sector. Consistent with this perspective, the 3- and 12-month changes in the industrial production indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 7). Chart 6IP Poised To Accelerate##BR##And Support EPS Growth Chart 7U.S. IP Growth Still##BR##Other Developed Markets Bottom Line: EPS growth will continue to accelerate through the end of 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth. The elevated level of ISM sets the stage for EPS growth to gather momentum in the second half of 2017. Firm readings on ISM indicate that our bullish profit story for 2017 is still intact, supporting an overweight stance towards stocks versus bonds. Fed Still On Track The July FOMC statement supports our view that the Fed will announce plans to shrink its balance sheet at the September FOMC meeting and hold off until December for the next rate hike. Policymakers upgraded their views of the labor market and downgraded their assessments of inflation. The reference to job gains moderating was dropped; instead, the Fed noted that employment growth has been robust. On inflation, the Fed stated that it is "running below" 2%, as opposed to "somewhat below" 2% in the June statement. These are only small tweaks and do not suggest any deviation from the Fed's plan to raise rates one more time this year as per its latest "dot plot" published in June. We still see the next rate hike in December if inflation begins to turn higher and shows signs of heading towards the 2% target. While the Fed is on the sidelines regarding rate hikes until the final meeting of 2017, it is creeping closer to begin shrinking its balance sheet. The July FOMC statement announced that the balance sheet normalization process will begin "relatively soon." The Fed had previously stated that the process would commence "this year." We view this shift in language as a signal that the balance sheet announcement will be made at the September meeting. Hesitation on tapering by the ECB, persistently weak readings on U.S. inflation or a tightening of U.S. financial conditions, would also give the Fed reason to reassess its plan. Bottom Line: Slight variations in the FOMC's statement indicate that rates are on hold at least until December. This will give the Fed time to determine whether inflation is moving back to its target and to assess the market impact of shrinking its balance sheet. 1H GDP: Just Enough U.S. GDP grew by 2.6% in Q2, following a revised 1.2% advance in Q1 (Chart 8). Given the potential distortions to the quarterly data from residual seasonality issues, an average of the first two quarters gives a better reading on the underlying trend in the economy. In the first half of this year, growth averaged 1.9%. On a year-over-year basis, the economy grew by 2.1%, and while that is only in line with the Fed's 2.1% forecast for 2017, it is above the central bank's view of 1.8% GDP growth in the "longer run." In addition, the NY Fed's Nowcast for Q3 is 2.0% and the Atlanta Fed's GDP now reading for Q3 is 3.7%. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time.2 Quarterly GDP has averaged 2.2% since the current expansion started in the second half of 2009. Chart 8GDP Growth Remains Below Average, But Above Fed's Long Run Target Looking beyond the quarterly fluctuations, the U.S. economy has been relatively stable at about 2% growth for nearly 10 years. This advance has been sufficient to lower unemployment, with trend GDP growth slowing due to weak productivity gains and demographics. However, the expansion has not yet led to a material acceleration in wage growth or inflation. Inflation, a lagging indicator, warrants more attention from investors. BCA's Global Investment Strategy,3 team recently argued that both cyclical and structural forces will boost inflation in the next year and far into the next decade. In making this assessment, it was noted that inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended. The implication is that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. This also suggests that the central bank already may be behind the curve on raising rates. The implication for investors is to stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Bottom Line: Despite historically weak readings on economic growth, the U.S. economy is advancing quickly enough to reduce slack and ultimately, push up inflation. We agree with the Fed that gradual increases will forestall more aggressive hikes later in the cycle. Strong Housing Sector Dips In Q2 We expect housing to continue to add to GDP growth in 2017 and beyond. Housing - as measured by residential fixed investment - subtracted 0.27% from GDP growth in Q2 2017. However, since early 2011, the sector has contributed to growth in 20 of 25 quarters. Moreover, the Q2 decline appears to be a one off, with all of the weakness coming in "other structures," which measures broker commissions, manufactured housing and home improvement. The more economically sensitive single-family sector added 0.31% to GDP in Q2. There are few signs of the severe imbalances in housing and housing-related debt that sparked the 2007-2009 global financial crisis. Chart 9 shows that housing investment is running behind other long "slow burn" recoveries.4 These recoveries lasted well beyond the point at which the economy hit full employment, and inflationary pressures were also slower to emerge. The housing sector's lag is not surprising given the bloated inventory of vacant, unsold and foreclosed homes that needed to be absorbed in the early part of this recovery. Chart 10 shows the overhang has disappeared. Moreover, recent anecdotal reports suggest that the limited supply of homes in areas where people want to live is hurting sales. Chart 9We Are In A "Slow Burn" Expansion Chart 10Solid Housing Fundamentals In Place Other positive factors for housing include: A rise in FICO scores, which indicates that more renters now qualify for loans and could move from a rental unit to a single family house. We highlighted this factor in a recent Special Report on housing.5 Housing affordability: although off its all-time high, it remains favorable and the cost of owning remains cheap relative to renting. The rate of home ownership is now well below its long-term average (Chart 10, panel 2). If the pre-Lehman bubble in the homeownership rate has been unwound, it removes a headwind for construction activity because renting favors multi-family construction that produces less GDP per unit compared with single-family homes. The supply of foreclosed homes on the market is almost nil. While this may not directly impact home construction and GDP directly, it supports higher home prices. Lending standards have not eased much in this cycle, and accordingly, have not been a net plus for the housing market. Nonetheless, more selective mortgage lending by banks in this cycle stands in sharp contrast to the lax lending in the last cycle, with the net result being better credit quality for bank mortgage portfolios and less systemic risk in the banking sector. This is an area the Fed is paying close attention to in this cycle.6 That said, with lending standards tight, there is room for them to loosen and provide an additional boost to housing in the future. Household formation is still recovering from a period in which young adults stayed home with their parents for longer than normal for economic reasons. Although mild by historical standards, the tightening labor market and cyclical rebound in disposable incomes have allowed millennials to move out of their parents' basements, which has boosted housing demand (Chart 11). Chart 12 estimates the remaining pent up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the remaining gap implies an extra 540,000 housing units. The equilibrium number of housing starts needed to cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' occurs during the next two years, adding another 250,000 units per year, then total demand could be 1.6 to 1.7 million in each of the next two years. This compares with the July housing starts level of 1.2 million. If starts rise smoothly from today's level to 1.7 million at the end of 2018, then the housing sector will contribute about 0.25 percentage points and 0.52 percentage point to real GDP growth in 2017 and 2018, respectively (Chart 13). Chart 11Household Formation##BR##Following Incomes Higher Chart 12A Catch Up In Housing Construction##BR##Will Occur If This Gap Narrows Chart 13Housing Catch Up##BR##Will Boost GDP Growth The implication for the economy is that this already-aged expansion phase could persist for a couple of more years as long as it is not hit by an adverse shock and inflationary pressures remain muted, which would allow the Fed to proceed slowly. Bottom Line: Housing starts remain well below the equilibrium level implied by underlying household formation and a "catch up" phase could stoke the current "slow burn" expansion in the coming years. Residential investment will continue to add to GDP growth in 2017 and beyond, and keep economic growth on track to hit the Fed's modest target. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see U.S. Equity Strategy Weekly Report "Growth Trumps Liquidity", dated July 31, 2017, available at uses.bcarearch.com. 2 Please see U.S. Investment Strategy Weekly Report "Waiting For The Turn", dated June 26, 2017, available at usis.bcarearch.com. 3 Please see Global Investment Strategy Weekly Report "A Secular Bottom In Inflation", dated July 28, 2017, available at gis.bcarearch.com. 4 Please see The Bank Credit Analyst Monthly Report, dated November 24, 2016, available at bca.bcarearch.com. 5 Please see U.S. Investment Strategy Special Report "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcarearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017, available at usis.bcaresearch.com.