Protectionism/Competitive devaluation

Highlights The direct impact of recently proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. In isolation, this development is not very relevant for investment strategy. However, the lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Feature The looming threat of U.S. protectionism came into full force over the past week, as President Trump stated that sweeping tariffs on all U.S. imports of steel and aluminum would soon be formalized. The tariff situation continues to evolve as we go to press, but the facts as they currently stand are the following: The proposed tariffs would be 25% on steel, and 10% on aluminum imports No exceptions are planned for any country, although statements from U.S. leadership on Monday suggested that Canada and Mexico may be exempt if NAFTA is renegotiated in the U.S.' favor Key European Union leaders threatened to retaliate against the U.S.' proposed tariffs, and the U.S. threatened to counter-retaliate China has taken a more cautious stance on the issue of retaliation, and is strongly seeking to negotiate with the Trump administration Minimal Direct Impact The developments over the past week raise two questions about China's economy that matter for investment strategy: What is the direct impact of the tariffs on China's exports likely to be? What is the implication for global growth? On the first question, the answer is fairly clear that the direct impact is likely to be small. The proposed tariffs do not disproportionately target China, and Chinese exports of steel and aluminum to the U.S. account for less than 0.2% of total exports (Chart 1). Exports of these products to all countries as a share of total exports is still quite small (panel 2). The second question is much more difficult to answer, and it has wide implications for both the Chinese economy and for investment strategy. When approaching the question, it is first important to note that the threat to the global economy from the imposition of the proposed tariffs comes from the potential for a series of retaliations from major trading partners, not the tariffs themselves. U.S. imports of steel and aluminum make up less than 1% of global goods exports, and Chart 2 presents a long-term history of average U.S. tariff rates along with our estimate of the impact of the U.S.' proposal. While the imposition of the announced tariffs would certainly change the trend that has been in place for some time, the rise is not very significant. Critically, even after the tariffs are imposed, U.S. tariffs rates will still be fractional when compared with those that prevailed during the early-1930s, when the Smoot-Hawley Tariff Act materially exacerbated the Great Depression. Chart 1Chinese Steel And Aluminum Exports##br## Are Not Significant Chinese Steel And Aluminum Exports Are Not Significant Chinese Steel And Aluminum Exports Are Not Significant Chart 2We're A Long, Long Way Away##br## From Smoot-Hawley We're A Long, Long Way Away From Smoot-Hawley We're A Long, Long Way Away From Smoot-Hawley China's cautious stance towards retaliation is, at first blush, an encouraging development, but it may not be as hopeful of a sign as it seems. First, despite a general feeling among investors that China was the intended target of the U.S.' proposed tariffs, a global tariff on steel and aluminum is likely to disproportionately affect developed countries rather than China. It is therefore not surprising that China has signaled a somewhat conciliatory stance. In our view, the likelihood of Chinese retaliation is considerably higher if further tariffs are announced on goods that make up a larger share of their exports. In addition, as we noted above, the European Union has already highlighted some U.S. goods that may be subject to higher retaliatory tariffs in response to the news (which already elicited a threat of counter-retaliation from the U.S.), and both Canada and Mexico have also threatened retaliation if they are not granted an exemption from the proposed tariffs. In our view, these threats should be treated seriously, especially after revisiting the lessons of one of the most famous experiments in game theory. Bottom Line: The direct impact of proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. Retaliation Risk And The Prisoner's Dilemma The dynamics of trade renegotiations can be examined, at least conceptually, through the lens of game theory. It is difficult to model these dynamics precisely because of the complexity of the relationship between trade and potential growth, but it is worth revisiting the lessons learned by the repeated playing of Prisoner's Dilemma, one of the most well-known examples of the application of game theory. To summarize, the Prisoner's Dilemma scenario describes two criminals who have been arrested, and whose statement to the authorities affects the manner in which punishment (if any) is distributed between the two of them. The standard payoff structure of the game is set up such that one prisoner is able to largely avoid punishment if (s)he accuses the other of the crime and the other prisoner remains silent, but that both prisoners receive a punishment if they both accuse each other that is greater than the punishment received if they both remain silent (Table 1). Given that tariffs and other forms of trade protectionism can only durably succeed at improving net domestic economic outcomes if they do not result in retaliation, from the perspective of trade renegotiation, accusing the other player in the game of Prisoner's Dilemma is tantamount to restricting trade, and remaining silent is equivalent to allowing existing trade relationships to persist. Table1In The Prisoner's Dilemma, It's Better To Return Defection With Defection China And The Risk Of Escalation China And The Risk Of Escalation The success of strategies employed in repeated games of Prisoner's Dilemma was studied most famously by Robert Axelrod in 1980.1 The winning strategy (in both of Axelrod's tournaments) was "Tit for Tat", which follows two very simple rules: cooperate initially, and thereafter copy the other player's decision in the previous round. This strategy has three attributes that Axelrod showed to be highly successful when playing repeated games of Prisoner's Dilemma: niceness (not being the first player to accuse/defect/renege), being provocable (responding to defections with in-kind retaliation), and forgiveness (not allowing one-time defections to impact future choices beyond a one-time retaliation). Chart 3 illustrates the performance of the "Tit for Tat" strategy in the first Axelrod tournament, along with the average scores of several other strategies. The most important lesson from both tournaments is summarized nicely in the chart: the average score of a series of "nice" strategies was considerably higher than those that were not nice. But Chart 4 also highlights that niceness is only a relatively successful strategy because of its ability to produce an optimal outcome with other nice strategies: all strategies, nice or not, tend to generate poor outcomes when played against strategies that are not nice. This is because the payoff structure of Prisoner's Dilemma is such that, compared with defection, co-operation makes a player worse off if their opponent defects. Chart 3In Repeated Games Of Prisoner's Dilemma,##br## "Nice" Strategies Pay Off... China And The Risk Of Escalation China And The Risk Of Escalation Chart 4...But Only Because They Do Well Against ##br##Other "Nice" Strategies China And The Risk Of Escalation China And The Risk Of Escalation In the context of global trade, this can be seen as the likelihood of outsized job losses (or the lack of job gains in a protected industry) from a failure to retaliate. The key point for investors is that the most basic lesson of the Prisoner's Dilemma suggests that market participants should be legitimately concerned about retaliation from the U.S.' trade partners (and subsequent counter-retaliation) if it continues to pursue a protectionist agenda, because it can be a rational response for an individual country even if it leads to poor outcomes for everyone involved. In addition, three assumptions of the Prisoner's Dilemma game are not valid in the real world (or the current environment), which in two of these cases further increases the risk of an iterative exchange of retaliation: Chart 5The U.S. Has A Trade Deficit ##br##With Many Trading Partners The U.S. Has A Trade Deficit With Many Trading Partners The U.S. Has A Trade Deficit With Many Trading Partners In terms of the payoffs associated with the game, Prisoner's Dilemma assumes an equal starting position (of zero "points") on both sides, which is not the case in the current environment. The U.S. has a sizeable trade deficit with the world (Chart 5), and several important trading partners with the U.S. (especially China) maintain significant non-tariffs barriers to trade. Regardless of whether this inequity has been caused by an unfair trading relationship, in the parlance of Axelrod's tournaments, this implies that the U.S. strategy is likely to be not nice due to the perception on the part of the Trump administration of an unequal starting position. The implication is that the odds of an escalation of the imposition of relatively small tariffs into a full-blown trade war are higher than would normally be the case. Prisoner's Dilemma has clear and symmetric payoffs, which is also not the case in the current environment. The Trump administration apparently feels that the payoff to the U.S. of certain trade restrictions is a net positive even assuming retaliation, which raises the possibility of a negative outcome for the global economy. Worryingly, in our view the chances are high that calculations of the net benefit of any trade restriction are being done on a political basis, rather than an economic one. Prisoner's Dilemma assumes that the participants are unable to communicate, which is a limitation that does not exist in a real-world trade negotiation scenario. This lowers the probability that the U.S. and its major trading partners will engage in a spiraling tit-for-tat trade war relative to what the game of Prisoner's Dilemma would imply, even if the recently announced tariffs on steel and aluminum stand and major partners do retaliate. Bottom Line: The lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. No Help From The Domestic Economy A protectionist agenda from the U.S. is also coming at an inconvenient time for Chinese policymakers, even if they were not blindsided by the move. Policymakers already have to contend with managing the impact of renewed reforms on economy's financial and industrial sectors, and the potential addition of the external sector to this list of problems needing attention is unwelcome. While a cooling of the economy was an inevitable result from the government's deleveraging campaign and shadow banking crackdown, Table 2 highlights how broadly leading economic indicators have decelerated. The table presents recent data points for several series that we identified in November Special Report as having leading properties for the Chinese business cycle,2 as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, how long this has been the case. Table 2No Convincing Signs Of An Impending Upturn In China's Economy China And The Risk Of Escalation China And The Risk Of Escalation Among the components of the BCA Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang index), all six series are in a downtrend and 5 out of these 6 fell in January (the growth in M2 was the exception). A similar story is borne out in the housing price data, with a variety of diffusion indexes having also fallen in January.3 The Caixin Manufacturing PMI remains the one bright spot, having recently risen above its 12-month moving average and having risen in January, in stark contrast to the official PMI (which fell a full point). But as Chart 6 highlights, following the last four episodes when the Caixin PMI exceeded the official PMI by this magnitude, the subsequent trend in the average of the two was down in every case. The implication is that the outlier nature of the current Caixin PMI shown in Table 2 is just that, and not a heralding a major upturn in China's economy. Chart 6The Caixin PMI Is Probably The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal Bottom Line: Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Conclusions For Investment Strategy Chart 7 illustrates the decision tree for Chinese stocks that we presented in our first report of the year. While there has been a modest further deterioration in the industrial sector, the pace of the decline is still consistent with the controlled slowdown scenario that we outlined in an October Weekly Report.4 As such, the recent softness in the data is not significant enough to cause us to change our recommended investment strategy. The key change over the past week has been the threat posed by U.S. protectionism to the global economy, which is the very first question to answer in our decision tree. The now high-beta nature of the Chinese stock market underscores that U.S. protectionism can significantly (negatively) impact the relative performance of Chinese equities if it destabilizes the global stock market, even if Chinese exports were to emerge from the exchange relatively unscathed. For now, we judge the likelihood of a full-blown tit-for-tat trade war to be a risk, and thus not a probable event. For now, market participants seem to agree: U.S. and global equities rebounded earlier this week in response to a feeling that the negative repercussions for global growth are likely to be minimal. Nonetheless, this is a risk that needs to be monitored closely, and to facilitate this our Geopolitical Strategy service has highlighted the following three bellwethers that they will be watching in order to judge the likelihood of a major escalation:5 Chart 7The Chinese Equity "Decision Tree" China And The Risk Of Escalation China And The Risk Of Escalation Tariff exceptions for allies: Given the national security basis for the steel and aluminum tariffs, it is likely that exceptions will be made for allies such as Canada and Europe. If yes, then the measure is unlikely to be part of a truly "America First" mercantilist strategy and is instead a veiled swipe at China to satisfy Trump's base ahead of the midterm elections NAFTA: Our geopolitical team has argued that the probability of NAFTA abrogation is around 50%.6 If the administration continues the negotiations in light of tariff announcements, however, it suggests that the revealed preference of the White House is less protectionist than it appears. Chinese intellectual property (IP) theft: The Trump administration is investigating Chinese technology transfer and IP theft under Section 301 of the Trade Act of 1974. If China is found to have acted unfairly, penalties would likely include a combination of tariffs and restrictions on Chinese investment in the U.S. This might include an indemnity for cumulative losses from past violations, which would be rare, if not unprecedented, and which China would reject outright. This could produce across-the-board tariffs of a sort that the U.S. has not imposed since the Nixon shock. Chart 8China Is Outperforming Global In Ex-Tech Terms China Is Outperforming Global In Ex-Tech Terms China Is Outperforming Global In Ex-Tech Terms In the meantime, Chart 8 highlights that investable Chinese ex-technology stocks (proxied by the MSCI China Index ex-technology) remain in an uptrend versus their global peers, which underscores that investors should have a high threshold for reducing exposure to China. This underscores that investors should have a high threshold for reducing exposure to China. While the ongoing slowdown in China's economy is likely to cause earnings growth to decelerate over the coming year, the continued likelihood of decently positive earnings growth coupled with a sizeable valuation discount relative to global signals that Chinese ex-tech stocks are remain attractive on a risk/reward basis. Investors should stay overweight. Bottom Line: Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "Effective Choice in the Prisoner's Dilemma" and "More Effective Choice in the Prisoner's Dilemma" by Robert Axelrod, The Journal of Conflict Resolution, Vol. 24 Nos.1 and 3, March and September 1980. 2 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of The Chinese Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 3 However, as discussed in our February 8 Weekly Report, we are keeping an eye on residential floor space sold given its history of leading China's housing market cycles. 4 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War", dated March 6, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto Populism", dated November 10, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Trump faces few constraints to further protectionism. His tariff announcement confirms our constraints-based methodology. Previous examples of U.S. protectionism show that the end game was not trade war, but USD depreciation. Key bellwethers for further protectionism are: waivers for allies, NAFTA, and China. The USD's global reserve currency status is at risk over the long run due to geopolitical multipolarity. Stay long defense stocks; short China-exposed S&P500 versus domestic-oriented companies; short EM assets. Feature "The import duty delights me..." - President Richard Nixon, August 2, 1971 (Oval Office Tapes) "Trade wars are good and easy to win." - President Donald Trump, March 2, 2018 The market has proven to be a terrible geopolitical analyst. It lost faith in Trump's overtly stated populism quickly into his presidency: What did the market do when Congress failed to pass repeal/replace of Obamacare? It immediately reduced the odds that the Republican-held Congress would get tax cuts or anything else done. What did the market do when Trump presented an austere "skinny budget," a budget that is normally ignored when any other president announces it? It immediately faded the odds of more deficit spending. What did the market do when Trump had a pleasant first meeting with Chinese President Xi Jinping at the Mar-a-Lago resort?1 It faded the odds of a trade war. It is becoming increasingly clear that the market has no framework for analyzing politics. It got the profligate tax cuts, extraordinary fiscal stimulus, and now Trump's protectionism wrong. In this Client Note, we explain how we got the odds of a trade war right, why market repricing is instructive, and how investors should position themselves for the coming volatility. Constraints Versus Preferences The mantra of BCA's Geopolitical Strategy is that preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. When making our forecasts, we focus on the constraints that bind policymakers and we ignore their preferences. President Trump did not announce that he would impose a 25% tariff on all imported steel and a 10% tariff on all imported aluminum because he was "unglued" or "angry" any more than World War One started because a Serb nationalist shot an Austrian archduke! He did so because he can. President Trump faces scant political, constitutional, and economic constraints when it comes to pursuing protectionist policies. Hence we have warned our clients to prepare for higher odds of trade wars and protectionism since the moment he was elected.2 There are three broad reasons why we have expected trade protectionism to re-emerge as a headline risk in 2018:3 Chart 1America Belongs To The Anti-Globalization Bloc Market Reprices Odds Of A Global Trade War Market Reprices Odds Of A Global Trade War Overstated political constraints: President Trump's base is anti-trade. We would argue that all Americans are far more protectionist than our clients wish to admit (Chart 1). Higher prices of Chinese made T-shirts and aluminum beer cans will not deter his supporters, nor will economic and market effects (short of a recession) change his voters' minds before the 2020 election. After all, President Trump was fully transparent during his presidential campaign when he promised a 45%-across-the-board tariff on Chinese imports and condemned NAFTA as a "disaster." It was this rhetoric that allowed him to outperform his opinion polls in the Midwest (Chart 2). Overstated constitutional constraints: The U.S. Congress has punted its responsibility for trade to the executive branch via several legislative acts over the decades. Most relevant at this juncture are: The Trade Expansion Act Of 1962: Allows the president to impose tariffs or quotas to offset any adverse impact of trade on national security;4 The Trade Act Of 1974: Allows the president to impose tariffs or quotas in order to deal with a serious U.S. balance of payments deficit or the unjust trade practices of another state; The International Emergency Economic Powers Act Of 1977: Allows the president to regulate all commerce and freeze all foreign assets in the case of a National Emergency.5 Overstated geopolitical constraints: Investors have continuously discounted the probability of Sino-American tensions, or even open conflict. Our clients know that we have been alarmists on this issue since 2012.6 In fact, it has been a key theme of BCA's Geopolitical Strategy that geopolitical risk is rotating to East Asia and that the constraints to U.S.-China conflict are falling as the symbiosis between the two economies fades (Chart 3). Chart 2Protectionism Boosted Trump In The Rust Belt Protectionism Boosted Trump In The Rust Belt Protectionism Boosted Trump In The Rust Belt Chart 3U.S.-China Symbiosis Has Died U.S.-China Symbiosis Has Died U.S.-China Symbiosis Has Died Bottom Line: If constraints to trade protectionism were considerable, Trump would not have the ability to surprise the markets with bellicose rhetoric on a whim. BCA's Geopolitical Strategy cannot predict individual triggers for events. But our framework allows us to elucidate the constraint context in which policymakers operate. On protectionism, Trump operates in a poorly constrained context. This is why we have been alarmist on trade since day one. Another Reason To Worry: Trump Is Not Unique The U.S. has a relatively recent tradition of bellicose protectionist rhetoric - under Presidents Richard Nixon, Ronald Reagan, and even at times George W. Bush and Barack Obama - perhaps due to the fact that it is the least globally exposed advanced economy (Chart 4). It is difficult to retaliate against the "consumer of last resort," which gives Washington D.C. considerable leeway in bullying global trade partners. Chart 4The U.S. Is Least Exposed To Trade The U.S. Is Least Exposed To Trade The U.S. Is Least Exposed To Trade President Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."7 Less understood, but very much part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. Also like Trump, he staffed his cabinet with trade hawks. Most notable amongst these was the Treasury Secretary John Connally, who wanted not only to close America's trade deficit but also to reduce U.S. military presence in Europe and Japan.8 Again, just like today, the economists in Nixon's cabinet opposed the surcharge, fearing retaliation from trade partners, while the politicians favored brinkmanship.9 We know from taped conversations of the Nixon White House that he and his advisors worried that the import surcharge could strengthen the dollar. But they decided to impose it anyway because of political expediency - Connally stressed that "it's more understandable to the American people to put on a border tax." They also saw it as a negotiating tactic. The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately forced other currencies to appreciate, mostly the deutschmark and yen. This is unsurprising given Germany's and Japan's total subservience to the U.S. in the early 1970s. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt transatlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, which included increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. Summing up the episode, then Undersecretary of the Treasury, Paul Volcker, remarked that: The conclusion reached by some that the United States shrugged off responsibilities for the dollar and for leadership in preserving an open world order does seem to me a misinterpretation of the facts ... The devaluation itself was the strongest argument we had to repel protectionism. The operating premise throughout was that a necessary realignment of exchange rates and other measures consistent with more open trade and open capital markets could accomplish the necessary balance-of-payments adjustment.10 Volcker's point was that the devaluation of the USD ultimately staved off protectionism. But he also reveals that the U.S. was close to abandoning its role as global defender and consumer of last resort due to domestic economic pressures. What does the 1971 "Nixon shock" teach us? FX depreciation obviates the need for protectionism: In both the case of the "Nixon shocks" and Reagan's 1985 "Plaza Accords," the rest of the world accommodated the U.S. and avoided a global trade war by allowing the USD to depreciate; Politics trumps economics: President Nixon ignored the advice about the economic effects of protectionism and used the import surcharge as a negotiating strategy - a successful negotiating strategy, we should add; Americans are not globalists: Not only is the U.S. economy largely insulated from the rest of the world, but Americans are not unequivocally pro-trade. Nixon was never hurt politically by the surcharge, and it even proved widely popular with the public. President Trump has come under withering criticism for using tariffs in 2018. However, his predecessors did so successfully as part of wider negotiations without ending global trade, all the while remaining popular with the public. The only question the history leaves unanswered is why Trump hasn't used tariffs sooner! What if the rest of the world does not play ball this time around? Two keystone themes of BCA's Geopolitical Strategy suggest that this time may be different: Apex of Globalization: The U.S. could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization and deeper access to U.S. markets. In 2018, however, this promise has been muted, with global trade as percent of GDP having peaked (Chart 5) and trade growth continuing to trail global GDP growth (Chart 6). America's trade partners may be far less willing to give in to U.S. protectionist threats in a world where the global trade pie is growing at a much slower pace. Multipolarity: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. still guarantees European defense, and thus could see some concessions from its ally, its geopolitical relationship with China is practically hostile. And, at the end of the day, it is Chinese trade policies that have had an adverse effect on U.S. manufacturing, not European. Chart 5Globalization Has Reached Its Apex Globalization Has Reached Its Apex Globalization Has Reached Its Apex Chart 6Trade Growth Trails Output Growth Trade Growth Trails Output Growth Trade Growth Trails Output Growth If this time is different, American policymakers will be left with only one lever: FX devaluation. Our current view that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation picks up. But what if Jay Powell, untested and facing political pressure from the White House, decides to respond to higher nominal GDP growth by hiking rates more slowly? Bottom Line: History teaches us that Trump's bellicose rhetoric is not unique to recent American presidents, let alone to world leaders. Previous times that the U.S. has threatened serious protectionism against trade partners the effect was USD depreciation, not trade wars. In addition, global trade boomed after each U.S. threat of protectionism, it was not derailed. What Matters (And What Does Not)? According to our calculation, Trump's suggested steel and aluminum tariffs would, in the most liberal estimate, impact just 0.3%-0.8% of global trade.11 As such, the proposed tariffs are insignificant from a macro perspective. They would also ostensibly have a much greater impact on U.S. allies, with China and Russia impacted only on aluminum (Chart 7). That said, the market is looking beyond the announced measures as it quickly reprices the greater risk of a global trade war that it ignored for the past 18 months. This, however, does not mean that the probability of a global trade war is high, just that the market was caught unaware due to complacency. We suggest three bellwethers for investors. If all three of these lean towards mercantilism, then the probability of global trade war is indeed high. Exceptions for allies: Given the national security basis for the steel and aluminum tariffs, it is likely that exceptions will be made for U.S. allies Canada and Europe. If yes, then the measure is unlikely to be part of a truly "America First" mercantilist strategy and is instead a veiled swipe at China and a political one-off to satisfy Trump's base ahead of the midterm elections; NAFTA: We have argued that the probability of NAFTA abrogation is around 50%, much higher than what the market is currently pricing in, for similar reasons as those outlined in this report.12 In short, we do not see any constraints - neither legal-constitutional nor political nor economic - preventing President Trump from ending the deal. If the administration continues the negotiations in light of tariff announcements, however, it suggests that the revealed preference of the White House is far less protectionist. It would also suggest that any Trump tariffs are really about China (Chart 8). China intellectual property (IP) theft: The Trump administration is investigating Chinese technology transfer and IP theft under Section 301 of the Trade Act of 1974. If China is found to have acted unfairly, penalties would likely include a combination of tariffs and restrictions on Chinese investment in the U.S.13 This might include an indemnity for cumulative losses from past violations, which would be rare, if not unprecedented, and which China would reject outright. Trump's rhetoric - and China's verifiably severe violations on IP - could produce across-the-board tariffs of a sort that the U.S. has not imposed since the Nixon shock. That would be a game changer in Sino-American tensions. Such a tariff could come to be remembered as the moment the Second Cold War began. Chart 7U.S. Allies Are Most Exposed Market Reprices Odds Of A Global Trade War Market Reprices Odds Of A Global Trade War Chart 8China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs Bottom Line: We would largely discount individual cases of tariffs that target specific goods, depending on the magnitude. These are largely within the realm of the expected and accepted. Trump's proposal would at most affect 0.8% of total global trade and that is assuming that no exemptions are made for allies. The real game changers would be if the U.S. began to think of "national security" in a narrow sense, no longer exempting geopolitical allies from an aggressive trade policy. A combination of both mercantilism and isolationism would imperil the transatlantic alliance and thus the American anchor in Eurasia. The loss of that alliance and that anchor, if pursued to its logical conclusion, would usher in the collapse of America's global hegemony.14 We would watch carefully whether the U.S. goes after China with broad, across-the-board tariffs. An all-out trade assault on China by the U.S. would avoid a global trade war, but would likely usher in a new Cold War, as China's internal stability would be threatened. Investment Implications Our forecast that Trump's protectionism would become investment-relevant in 2018 has come true. Now comes the hard part of forecasting how it plays out. It is tempting to simply replay the 1971 and 1985 episodes. After all, the U.S. is as closed of an economy today as it was then, largely immune to protectionist retaliation from the rest of the world. However, the U.S. economy is a third smaller as a percentage of global GDP than in both those episodes (Chart 9). And its geopolitical relevance to Europe is waning, whereas China remains a potent rival that may not "play ball." In fact, Chinese policymakers may be forced to accept a trade war in order to blame the painful effects of structural reforms on the Trump administration.15 Chart 9The U.S. Is Not As Dominant As It Was The U.S. Is Not As Dominant As It Was The U.S. Is Not As Dominant As It Was Before we assign high probability to any particular investment recommendation based on a higher probability of trade wars, we want to see how the NAFTA negotiations play out, whether the U.S. hits geopolitical allies with tariffs, and how the China IP case plays out. Nonetheless, the following three trades appear cogent even without such evidence: Long defense stocks: Our highest conviction investment call on the theme of "Apex of Globalization" is to go long defense stocks.16 We have recommended a vanilla trade to articulate this view, long S&P 500 aerospace and defense / short MSCI ACW, up 14.56% since initiation in December 2016. For a higher risk, higher reward strategy, we would suggest investors go long a basket of U.K., German, French, Italian, and Japanese major defense companies. In a world where the U.S. ceases to be a defender of last resort, countries will look to diversify their security portfolio away from America, and that will mean demand for non-U.S. military exports. Short U.S.-China plays: Investors should go long the most domestically-focused U.S. sectors - financials and telecoms17 - and go short our index of China-exposed S&P 500 companies. We were stopped out of this trade in March 2017 and again in September 2017, as we bet too early that the market would reprice the probability of a trade war. Short EM: Emerging markets have the most to lose in a potential trade war, especially amid higher U.S. bond yields. However, not all emerging markets are equally exposed. For example, India is largely insulated. A long India / short Brazil equity market position should reap returns in a de-globalized world (and BCA's Emerging Markets Strategy would endorse this trade based on macroeconomic factors). What about the U.S. dollar? Import tariffs ought to be bullish for the greenback, given that they lead to higher domestic policy rates as inflationary pressures rise (and not just passing ones). However, as the previous two examples of U.S. protectionism teach us, the U.S. uses threats of tariffs so that it can get a cheaper USD. From Washington's perspective, both accomplish the same thing. Intriguingly, the U.S. dollar has sold off on the most recent news of protectionism. Or are they already pricing in the likely conclusion of the current impasse (dollar falls) based on historical precedent? Or could it be a more ominous sign that the greenback's days as the global reserve currency are numbered? If the U.S. abandons its twin roles as the world's defender and consumer of last resort, then foreigners may decide that they should no longer reflexively store their wealth in U.S. assets. Think this is all merely geopolitical hogwash? Think again. Chart 10, courtesy of our colleague Mathieu Savary (BCA's chief FX strategist), is probably the best geopolitical chart we have ever published. It illustrates how the U.S. can manage to have a positive net international income despite a deeply negative net international investment position (NIIP). How is this possible? Because foreigners are willing to hold onto U.S. assets (U.S. Treasuries) for largely geopolitical reasons. It is too early to tell if this paradigm shift in global finance is underway. In the short term, Trump's rhetoric is likely to face the same constraints as Nixon's surcharge: geopolitical alliances will force him to carve out exemptions and focus on China. And if a trade war envelopes U.S. and China - rather than the world - we would bet that the U.S. dollar would rally, given that it would remain the safe-haven currency. Remain long DXY for now. Chart 10Exorbitant Privilege Market Reprices Odds Of A Global Trade War Market Reprices Odds Of A Global Trade War Chart 11Multipolarity Undermined The Pound Sterling Market Reprices Odds Of A Global Trade War Market Reprices Odds Of A Global Trade War But our view is that - over the long term - a multipolar world entails a multipolar currency regime. Such a development may come faster than most of us think. For example, the U.K. pound lost nearly a quarter of demand as the global reserve currency between just 1899 and 1913 (Chart 11).18 Financial markets move faster today. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 And served him chocolate cake that was this big. 2 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Reports, "Political Risks Are Understated In 2018," dated April 12, 2017, and "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017. 4 The Supreme Court is unlikely to counter U.S. executive action undertaken on the grounds of national security. 5 Such as perhaps the ongoing "American carnage"? 6 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Sino-American Conflict: More Likely Thank You Think," dated October 4, 2013, available at gps.bcaresearch.com. 7 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Berry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 8 Treasury Secretary John Connally makes Commerce Secretary Wilbur Ross look like a "globalist." Connally was famous for quipping that "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 9 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." In fact, the decision to impose the surcharge was made at a secret Camp David meeting on August 13, 1971 at a meeting to which officials from the State Department and the National Security Council were not even invited. 10 Paul A. Volcker, "The Political Economy of the Dollar," Federal Reserve Bank of New York Quarterly Review 1-12 (1978-79), quoted in Irwin (2013) (see footnote 7). 11 The sum of U.S. nominal imports by end-use category with steel and aluminum as part of the description was about US$56 billion in 2017, or roughly 0.32% of global goods exports according to the IMF's Direction of Trade statistics. An alternative and more liberal estimate using UNCTAD data and including a broader range of U.S. metals imports ("iron and steel," all "nonferrous metals," and all "manufactures of metal") yields 0.77%, or about $127 billion out of $16.5 trillion worth of total global imports. The former is more likely than the latter. The executive order raising the tariffs has not yet been issued so details are not known. 12 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto Populism," dated November 17, 2017, available at gps.bcaresearch.com. 13 President Trump, when commenting on the potential U.S. action, has described the coming punishment as "We're talking about big damages. We're talking about numbers that you haven't even thought about." 14 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "How To Profit From De-Globalization," dated December 9, 2016, and "Trump, Day One: Let The Trade War Begin," available at gps.bcaresearch.com. 17 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks," dated March 5, 2018, available at uses.bcaresearch.com. 18 Please see Barry Eichengreen, et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org.

Highlights We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a material correction. Our tactical view on gold is neutral, but the risk in gold prices will remain skewed to the upside this year. Are tariffs on aluminum and steel the start of a trade spat or a trade war? Feature Fears of a trade war and a hawkish tone from Fed Chair Jay Powell at his first Humphrey Hawkins testimony to Congress pushed the U.S. equity market lower last week. The ten-year Treasury yield barely budged however, buffeted by a more hawkish Fed on one side and a trade-induced slowdown in global growth on the other. The dollar was modestly higher last week, but oil and gold prices moved lower. The S&P 500's 4% loss in February was the worst single month since October 2016 and worst February since 2009. Both investment-grade and high-yield credit spreads widened last week, and have yet to return to their late January lows. Moreover, at 22, the VIX remained elevated relative to start of the year, consistent with our view that markets have entered a more volatile, late-cycle phase. With the 2.8% run-up in the S&P 500 since the February 8 low, investors are less concerned that the early February pullback in risk assets was a signal that the equity bull market is over and a recession is right around the corner. Nonetheless, some clients with a more strategic outlook are considering paring back risk now. Others want to know how to protect gains while still participating in the bullish tone for the market BCA expects in the next 12 months. Our Yield and Protector portfolios might provide a way for investors to protect against the downside while still participating in the S&P 500. Preparing For A Pullback BCA recommends investors stay overweight on equities and U.S. spread product, but expects that positions should be moved to neutral later this year and then to underweight sometime in 2019.1 Long-term investors should already consider paring back their exposures to both asset classes given that valuations are stretched. We have periodically recommended that a variety of investments be added as portfolio "insurance" to help guard against a material correction in equities. We recently highlighted two forms of insurance: our Yield and Protector Portfolios. We introduced the Yield Portfolio in October 20142 and first discussed the Protector Portfolio in October 2015.3 This week, we revisit the issue by comparing both portfolios with a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. The Yield Portfolio (YP) emphasizes "high quality carry", along with some protection via TIPS (25% of the Portfolio), if inflation begins to surprise on the upside after investors are conditioned to expect only deflation shocks. The YP performs well in an environment of slow nominal growth, no recession and gradual interest-rate hikes. On the other hand, the Protector Portfolio (PP) is designed to provide insulation against both deflationary (gold and trade-weighted dollar) and inflationary (TIPS) tail risks. Therefore, the PP may underperform risk assets for a time if tail risks keep receding. Still, it has done well during the equity rally and conservative investors should consider adopting it. As discussed in the section below, our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. Charts 1, 2, and 3 show a breakdown of the relative performance of S&P 500 defensives along with our Yield and Protector Portfolios. Panels 2 and 3 of Charts 1, 2 and 3 present the rolling one-year beta and alpha of each strategy versus the S&P 500. Alpha is presented as the difference between the actual year-over-year excess return of the portfolio (versus short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is also referred to as "Jensen's alpha." Chart 1S&P 500 Defensives##BR##A Modestly Low Beta Option S&P 500 Defensives A Modestly Low Beta Option S&P 500 Defensives A Modestly Low Beta Option Chart 2A Lower Beta##BR##Than Defensives A Lower Beta Than Defensives A Lower Beta Than Defensives Chart 3A Beta Near Zero,##BR##And Positive Alpha A Beta Near Zero, And Positive Alpha A Beta Near Zero, And Positive Alpha Based on the historical beta of the three portfolios versus the S&P 500, defensive stocks are the most correlated with the overall equity market. Our PP had a negative correlation to the broad market until earlier this year, when it turned slightly positive. BCA's YP is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 1). Note that our protector portfolio is composed entirely of non-equity assets. Table 1A Breakdown Of Three##BR##Portfolio Insurance Options A Golden Opportunity? A Golden Opportunity? After accounting for their lower betas, all three portfolios have outperformed the S&P in risk-adjusted terms since the onset of the global economic recovery. However, the three portfolios have experienced a relative decline versus the S&P 500 since Trump's election. This has occurred due to passive rather than active underperformance. In other words, they have underperformed because they failed to keep up with the S&P 500 rather than because of losses in absolute terms. We draw two important conclusions from Charts 1, 2 and 3 for U.S. multi-asset investors. First, the lower beta of our YP and PP compared with S&P defensives means that the former represent a better insurance against a sell-off in the equity market rather than the latter. Secondly, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets in the past few years. However, since late 2017 when investors began to significantly upgrade the prospects for global growth and U.S. corporate profits, all three portfolios struggled to outperform the S&P 500 on a risk-adjusted basis. BCA's forecast implies that these portfolios may continue to struggle in the next year or so. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. Our analysis suggests that clients who anticipate the need for portfolio insurance in the coming year should back our YP and PP over a defensive-sector allocation. We would likely extend this recommendation to all clients if there is any material progression towards the sell-off triggers identified in the Bank Credit Analyst's February 2018 publication.4 Bottom Line: Investors seeking protection against a potential equity market sell-off should look to our Yield and Protector Portfolios over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. Gold Bugged Our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. The yellow metal is supported by increasing inflation and inflation expectations, heightened geopolitical risks and greater volatility in equity markets.5 However, the higher inflation and inflation expectations will be countered by Fed rate hikes, which will boost the U.S. dollar and lift real rates in our base case. Strategically, we expect that gold will provide a good hedge against any downturn in equities when the bull market turns bear in 2H19. Chart 4 shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel initiated in early 2012 (Chart 5). There has been a significant gap between the model value and the actual price of gold for the past four years. The real price of gold remains elevated, although inflation has been well contained. Chart 4Model Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Chart 5Testing Top End Of A Downward Channel Testing Top End Of A Downward Channel Testing Top End Of A Downward Channel However, the macro environment BCA envisions for 2018 is also supportive for gold (Table 2). Gold tends to perform well when oil prices rise and as the 2/10 Treasury curve steepens. Moreover, gold prices tend to go up when the U.S. economy benefits from fiscal thrust and tax cuts. Furthermore, the soundings on the February ISM manufacturing index support higher gold prices. When the headline index is above 60 as it was in February (60.8), gold climbs by an average of 31%. Even 12 months after ISM is above 60, gold returns are over 20%. The elevated level of ISM new orders (64.2) and price (74.2) indices in February also suggest solid increases for gold. Finally, gold prices climb in the late stages of an economic expansion, such as the current one that began in 2009.6 Even so, our 6 to 12-month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year-end, which will be sufficient to keep the Fed on track this year as it continues to shrink its balance sheet and boost rates four times. Thus, there is no pressing need to hold gold as a hedge against inflation in the next year. Nonetheless, for those investors too concerned about a pullback that turns into a correction or a bear market, we note that gold has a 33% weight in our Protector Portfolio. Table 2Favorable Macro Backdrop For Gold A Golden Opportunity? A Golden Opportunity? Chart 6BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, it may have a better value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. Moreover, our macro backdrop forecast for the next 12 months supports higher gold prices. Keep gold as a strategic portfolio hedge. Trade Off BCA's Geopolitical Strategy team has long argued that two sources of geopolitical risk this year are China's trade surplus and Trump's position on trade relations with China, Canada and Mexico. Specifically, the view is that weak poll numbers may lead Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. However, our geopolitical analysts also point out that investors should not confuse a trade spat with a trade war. There are very few legal or constitutional constraints on Trump over trade issues (Table 3). It will be his decision whether to adopt sweeping tariffs (trade war) as opposed to a more targeted approach (trade spat). Clearly, the former is more disruptive and raises more uncertainty, so this is the key distinction to keep in mind. Presidents Nixon, Reagan, Bush (II) and Obama all imposed temporary tariffs on items (including steel and aluminum, and including by citing national security concerns) without triggering a trade war. Late last week, Trump indicated that he would announce tariffs on steel and aluminum this week. He implied that he would go for a broad-based approach of penalizing all steel and aluminum imports, which points toward the more aggressive approach. But the details (whether he exempts U.S. allies and partners or narrows the scope of goods) will not be certain until he issues his official proclamation. Table 3Trump Faces Few Constraints On Trade A Golden Opportunity? A Golden Opportunity? Steel and aluminum get the headlines, but account for only a small share of U.S. trade and GDP7 (Chart 7). BCA is more concerned about the Administration's stance on more deeper issues, like the WTO, NAFTA, or (in China's case) intellectual property and state-owned enterprises.8 The issues here are harder to quantify, have few precedents, and have more structural and ideological issues which are at stake. The U.S. has a massive trade surplus in services and in intellectual property,9 so a prolonged disruption would pose a serious threat to the U.S. economy, at least in the short term. Trump's decision on intellectual property trade with China is due on August 12, but could occur earlier. BCA's stance on U.S.-China relations is bearish in the long run.10 We place high odds on an eventual trade war, but the timing is a tougher call. Investors should not view China's proportional retaliation on an item-by-item basis as the start of a trade war. BCA's view is that China's leadership will try to offer reforms and investment opportunities to pacify Trump. However, there is a risk either that China offers no reforms (in which case Xi Jinping's rampant Communism exacerbates trade conflicts) or that Trump may introduce broad sweeping measures that give China no choice but to respond in kind, leading to a trade war. Our Geopolitical Strategy service notes that the probability of Trump abrogating NAFTA is as high as 50%. The seventh round of NAFTA talks concludes this week; an eighth round is scheduled for late March. Negotiations could drag on right to the Mexican election on July 1, but if they are not looking more optimistic by this spring then the risk of the U.S. (or Mexico) walking away will rise. The U.S. economy has been largely unaffected by NAFTA and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico (Chart 8). Chart 7Steel And Aluminum In Perspective Steel And Aluminum In Perspective Steel And Aluminum In Perspective Chart 8U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Bottom Line: Elevated trade tensions with China,11 Canada and Mexico are near-term risks to global growth. From now through April could be a decisive time for the Trump Administration with China and NAFTA. We are bearish on U.S.-China relations in the long term. If Trump abandons NAFTA, the implications for the U.S. economy would be muted, although U.S. inflation may push higher. Such a decision would also send a clear signal to other key U.S. allies. However, if Trump stands by NAFTA, then it signals that he has sided with the establishment on trade. This would be bullish for risk assets and would lower geopolitical risk premia. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," published February 23, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Ice Storm", published October 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Tenuous Relief Rally", published on October 12, 2015. Available at usis.bcaresearch.com. 4 Please see BCA Research's Bank Credit Analyst Monthly Report, February 2018. Available at bca.bcaresearch.com. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Gold Still Shines Despite Threat Of Higher Inflation", published February 1, 2018. Available at ces.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View", published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Global Aluminum Deficit Set To Ease", published March 1, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Weekly Report, "America Is Roaring Back", published January 31, 2018. Available at gps.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?", published June 5, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", published January 18, 2017. Available at gps.bcaresearch.com. 11 Please see BCA Research's Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China", published February 28, 2018. Available at gps.bcaresearch.com.

Highlights China's new exchange rate regime has significantly weakened the link between the U.S. dollar and the broad RMB trend, at the expense of a stronger (negative) relationship between CNY/USD and the dollar. Our metrics to gauge the impact of broad RMB movements on exports suggest that the recent rise is not yet a threat to China's economy. A further 5% depreciation in the U.S. dollar would cause a meaningful further increase, but not one large enough for our metrics to flash a warning sign. Several factors argue against the probability of an August 2015-style CNY/USD devaluation. Even if the PBOC were to do so, global investors would likely react very differently than they did in 2015, given the underlying strength of the global economy. Stay overweight Chinese investable stocks over the cyclical investment horizon, despite a likely dollar-driven retracement in CNY/USD over the coming months. Feature Chart 1A Sharp Rise In CNY/USD A Sharp Rise In CNY/USD A Sharp Rise In CNY/USD The Chinese Renminbi (RMB) has risen over 4% versus the U.S. dollar since mid-December, and global investors have begun to take notice (Chart 1). The sharp acceleration in the RMB has raised several questions in the minds of market participants: What is the likely economic impact of the rise, and how does this fit into the view that China's ongoing growth slowdown is likely to be benign and controlled? How will policymakers respond to the strength in the exchange rate? Is there a risk of a 2015-style depreciation that would roil global financial markets? In this week's report we offer our perspective on these issues, and provide investors with forecasts for the RMB assuming a 5% appreciation or depreciation of the U.S. dollar versus major currencies over the coming 6-12 months. While it is true that the broad RMB trend has risen non-trivially over the past year, we conclude that is too early to view this rise as a threat to the export sector. This supports our view of a benign, controlled economic slowdown in China, as well as a cyclical overweight stance towards Chinese equities. Putting Recent Exchange Rate Movements In Context In order to answer the questions noted above, it is important to examine recent exchange rate movements in the context of China's ongoing efforts to internationalize the RMB, as they have had a substantial impact on the relationship between the RMB and the U.S. dollar over the past few years. Beijing has been taking steps for years to promote the global use of the RMB, but these efforts came into sharp focus on August 11-12, 2015, when the PBOC devalued the currency versus the U.S. dollar (Chart 2). In addition to the devaluation, the PBOC changed the way that the daily fixing rate would be set, in a fashion that increased the sensitivity of the rate to market forces. The PBOC made these changes at the time that they did for two specific reasons: The IMF was in the process of deciding whether to include the RMB in the SDR basket, after having stated that a more market-based RMB rate was a precondition for inclusion. The policy to link the RMB to the U.S. dollar was causing significant appreciation of the former during a period of enormous dollar strength. Given the decision to alter the fixing rate mechanism, the PBOC decided to devalue the exchange rate by a modest amount in one, bundled policy change. The important point for investors is that the market turmoil that followed the August 2015 changes to the exchange rate overshadowed a much more consequential announcement on December 11, 2015 that precipitated a shift in the link between the RMB and the US dollar (USD) towards multiple currencies.1 At first blush, the "decision" made by the PBOC in December was trivial: they announced that the China Foreign Exchange Trade System (CFETS) would publish an index for the RMB measured against a basket of foreign currencies. But the implication of the announcement was that the PBOC was shifting its focus from managing CNY/USD to managing the value of the RMB versus the currencies of many trading partners. Essentially, December 2015 marked the beginning of a new exchange rate policy in China. The effect of this new policy change can clearly be seen in the relationship between CNY/USD and the trade-weighted RMB versus the U.S. dollar (Chart 3). The chart highlights that the beta of J.P. Morgan's nominal trade-weighted RMB versus the Bloomberg U.S. Dollar Spot Index was strongly positive prior to 2016, whereas the beta of CNY/USD to the Dollar Index was weak. Following the PBOC's policy shift, these relationships traded places: the beta between CNY/USD and the dollar became much more negative, whereas the strength of the U.S. dollar / trade-weighted RMB link weakened considerably. Chart 2The August 2015 Deval Significantly##br## Impacted Global Markets The August 2015 Deval Significantly Impacted Global Markets The August 2015 Deval Significantly Impacted Global Markets Chart 3A New Exchange Rate Regime Began##br## In December 2015 A New Exchange Rate Regime Began In December 2015 A New Exchange Rate Regime Began In December 2015 Bottom Line: China's new exchange rate regime has significantly weakened the link between the U.S. dollar and the broad RMB trend, at the expense of a stronger (negative) relationship between CNY/USD and the broad dollar trend. The Economic Implications Of China's New Exchange Rate Policy Chart 4The Recent Rise In CNY/USD ##br##Has Been Dollar-Driven The Recent Rise In CNY/USD Has Been Dollar-Driven The Recent Rise In CNY/USD Has Been Dollar-Driven Given our discussion above, the recent strength of the CNY/USD exchange rate should not be surprising: Chart 4 highlights that its sharp rise is largely the mirror image of recent U.S. dollar weakness. Panel 2 illustrates another way of observing this effect; EUR/USD typically trades inversely to the broad dollar trend, and CNY/EUR has been little changed over the past six months. The key questions for investors are 1) how to assess what impact the broad RMB appreciation over the past year will have on Chinese export growth, and 2) what future dollar movements might imply for the broad RMB trend. We use two metrics to gauge the likely impact of broad exchange rate movements on export growth: a fair value assessment (Chart 5), and the rise of an export-weighted RMB index relative to its high and low points over the past few years, when the exchange rate was clearly negatively and positively contributing to monetary conditions (Chart 6). The charts highlight that the real effective RMB is currently cheap, and that a nominal export-weighted index is only marginally above the median value since 2015. Neither of these measures implies that the rise in the RMB has reached levels that would be restrictive for exports. Chart 7 shows that the annual growth rate of our export-weighted RMB index has been predicted quite well by that of the dollar index and the CNY/USD exchange rate over the past two years. Based on this regression, Chart 8 presents what is likely to occur to our export-weighted RMB index in a 5% appreciation & depreciation scenario. The chart shows that the impact of a 5% appreciation (which we expect) will be muted, whereas a 5% depreciation in the dollar would cause a meaningful further rise in the export-weighted RMB. Still, it would not be enough to push the index to a new high, nor would it cause the real effective RMB shown in Chart 5 to rise into expensive territory. Bottom Line: Our metrics to gauge the impact of broad RMB movements on exports suggest that the recent rise is not yet a threat to the export sector. A further 5% depreciation in the U.S. dollar would cause a meaningful further increase, but not one large enough for our metrics to flash a warning sign. Chart 5The RMB Is Cheap In REER Terms The RMB Is Cheap In REER Terms The RMB Is Cheap In REER Terms Chart 6Rising, But Not Yet Near Previous Highs Rising, But Not Yet Near Previous Highs Rising, But Not Yet Near Previous Highs Chart 7The Dollar and CNY/USD Explain ##br##The Broad RMB Trend The Dollar and CNY/USD Explain The Broad RMB Trend The Dollar and CNY/USD Explain The Broad RMB Trend Chart 8Further Dollar Depreciation Would Bite, ##br##But Not Disastrously So Further Dollar Depreciation Would Bite, But Not Disastrously So Further Dollar Depreciation Would Bite, But Not Disastrously So August 2015, Redux? Given that the PBOC's devaluation of the RMB in August 2015 roiled global financial markets, it seems natural to ask whether the Chinese central bank could cause another shock by again depreciating the CNY/USD exchange rate. In our view, the answer is no. First, there are several reasons why the PBOC is unlikely to intervene to limit a rise in CNY/USD barring material further strength: Trade frictions with the U.S. remain, and a stronger CNY/USD could reduce the likelihood that the Trump administration will levy across-the-board tariffs on Chinese imports The PBOC recently reduced the influence of the "counter-cyclical factor" that was included in the CNY/USD midpoint formula. Since the factor was introduced to lessen the impact of market forces on the yuan's reference rate, the PBOC would likely have refrained from making any changes to it if they were unduly worried about the upward impact of recent dollar declines on CNY/USD If the PBOC becomes uncomfortable with the extent of the RMB rise in trade or export-weighted terms, it could aim to lower the yuan versus other key trading partners, including the euro area. As noted above, CNY/EUR has recently remained flat during the euro's sharp recent upleg versus the dollar. We noted that the RMB is now cheap in real effective terms (Chart 5), unlike in August 2015 when the deviation from fair value was the highest that it had been since mid-2000. Chart 92015 Vs Today: A Completely Different ##br##Global Economic Backdrop 2015 Vs Today: A Completely Different Global Economic Backdrop 2015 Vs Today: A Completely Different Global Economic Backdrop Second, even if the PBOC were to depreciate the CNY/USD exchange rate over the coming months, we doubt that investors would react in the same way as they did to the initial devaluation. As we reviewed in a Weekly Report last October,2 the global economy was suffering from a synchronized slowdown, and the surprise decision caused global investors to speculate heavily that additional devaluations were likely. The current condition of the global economy is clearly quite different than that which prevailed in the summer of 2015. Global PMIs are the most synchronized that they have been since the earliest phase of the economic cycle (Chart 9), which suggests that a significant slowdown is not imminent. Even if the pace of growth becomes narrower or slows modestly, it is difficult to envision the same kind of panicked response absent a separate and highly impactful accompanying shock. Bottom Line: Several factors argue against the probability of an August 2015-style CNY/USD devaluation. Even if the PBOC were to do so, global investors would likely react very differently than they did in 2015, given the underlying strength of the global economy. Investment Strategy Implications Chart 10Export Impact Of The RMB Appreciation##br## Is Non-Trivial, But Manageable Export Impact Of The RMB Appreciation Is Non-Trivial, But Manageable Export Impact Of The RMB Appreciation Is Non-Trivial, But Manageable Over a 6-12 month time horizon, there are two investment strategy implications of our above discussion. First, our analysis suggests that investors should focus on the broad RMB trend rather than the CNY/USD exchange rate when determining the likely impact of currency fluctuations on China's growth picture. It is true that an export-weighted RMB index has risen by a greater amount over the past year than a typical trade-weighted RMB (or the CFETS RMB index) would suggest (Chart 10), but for now it is too early to conclude that this represents a threat to the export sector. This conclusion is consistent with our view that China's ongoing economic slowdown will be benign, and controlled in nature. Second, given the tight (negative) link between CNY/USD and the U.S. dollar, and our view that USD is more likely to appreciate than depreciate over the coming months, it is true that the US$ relative performance of Chinese equities may be somewhat negatively impacted by a retracement in CNY/USD. But as we noted when presenting our "decision tree" for Chinese stocks at the beginning of the year,3 the cyclical condition of China's business cycle is the dominant factor that investors should consider when judging the appropriate allocation to Chinese equities. As such, our focus on China's exchange rate remains on how it impacts the growth outlook, and our judgement on this question continues to support a favorable stance towards the equity market. Bottom Line: Stay overweight Chinese investable stocks over the cyclical investment horizon, despite a likely dollar-driven retracement in CNY/USD over the coming months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 http://www.pbc.gov.cn/english/130721/2988680/index.html 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Decision Tree For Chinese Stocks", dated January 4, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The U.S.'s twin deficits do not explain the drop in the USD; Global growth is the biggest factor for the USD, and growth depends on China's economic reforms; The U.S. is turning more hawkish on China trade despite Beijing's reform-induced vulnerability; U.S. and Chinese political dynamics suggest upside risks in the former and downside in the latter; Go long DXY. Feature American policymakers scrambled to walk back Treasury Secretary Steven Mnuchin's "weak dollar" comments last week. Investors were left to wonder why Mnuchin broke with the long-held official position of favoring a strong dollar. Was it a "shot across the bow" of China, warning Beijing that the U.S. would engage in currency manipulation if it was not given concessions on trade? Or was it an admission that the U.S. would run large "twin deficits" - a budget deficit and a current account deficit - going forward? We don't have a good explanation for what Mnuchin said in Davos.1 But we can say with some conviction that the "twin deficit" explanation, which has been brought up in almost every client conversation so far this year, is wrong. Chart 1Twin Deficits: Why The Panic? Twin Deficits: Why The Panic? Twin Deficits: Why The Panic? Chart 2Because The Narrative Is Scary Because The Narrative Is Scary Because The Narrative Is Scary First, who says that the U.S. is about to widen its twin deficit (Chart 1)? The concern arises periodically in the marketplace but is often grossly off the mark in predicting the path of deficits or the dollar (Chart 2). We expect the budget deficit to hold steady in 2018, if not contract. Why? Because the fiscal deficit almost always contracts in the eight quarters before a recession, barring, in some cases, one or two quarters just before the recession hits (Chart 3). Unless investors have a high-conviction view that a recession is afoot in the next two quarters, they should ignore the dire predictions about the U.S. budget deficit. Chart 3The Deficit Is Not A Problem... Yet The Deficit Is Not A Problem... Yet The Deficit Is Not A Problem... Yet Chart 4Bond Market Not Sniffing Out Any Twin Deficit Crisis Bond Market Not Sniffing Out Any Twin Deficit Crisis Bond Market Not Sniffing Out Any Twin Deficit Crisis If the risk to the U.S. economy is to the upside, as we believe due to the tax cuts and unleashing of animal spirits, then deficits will come down regardless of additional tax or spending policy.2 In the long term, yes, the budget deficit will almost certainly expand due to entitlement spending, the impact of automatic stabilizers during a recession, and the loss of revenue from tax cuts. But long-term deficit concerns are the purview of the bond market, not currency traders. So what is the bond market telling us? Chart 4 shows that the yield curve tends to steepen as the twin deficit widens; both tend to occur during and after recessions. Today, however, the curve continues to flatten. Another fixed-income market indicator that tends to track budget deficits is the 30-year swap spread, which falls during recessions as budget deficits expand. But today the swap spread is not falling, it is increasing and doing so at the fastest pace since the 2008 recession (Chart 5). This may be a sign of resurgent animal spirits as banks throw caution - and concerns over Obama-era overregulation - to the wind. Credit demand is rising in the economy, which should increase both the velocity of money and growth. Concerns over the widening fiscal deficit are not being reflected in this indicator. Finally, our currency strategist, Mathieu Savary, has pointed out that a widening twin deficit only impacts developed economies' currencies about 50% of the time over 12 month periods. In other words, expansion of the twin deficit predicts currency moves about as well as flipping a coin. What really matters is how central banks respond to the causes and economic effects of the twin deficits. Protectionism, on the other hand, ought to be bullish for the dollar.3 As such, a potential trade war between China and the U.S. should not be the reason for the dollar's deepening doldrums. And while we are generally open to alarmism on trade protectionism - due to the fact that President Trump has few constitutional or political constraints holding him back on this issue - there is still not enough evidence to say whether the Trump administration will impose across-the-board tariffs on China. (See next section.) Could dollar weakness, conversely, be the result of a Plaza Accord 2.0 orchestrated between Chinese and American policymakers to depreciate the greenback in order to avert the need for protectionist policies? We doubt it. First, the U.S. and China economic dialogue has faltered. Second, the dollar would not have declined following the Plaza Accord had the Fed not aggressively cut rates from 1984 to 1985 by 423 basis points (Chart 6). And the Fed is obviously not cutting rates today, it is hiking them. Chart 5No Sign Of Deficit Here No Sign Of Deficit Here No Sign Of Deficit Here Chart 6The Fed Is More Important Than Politics... The Fed Is More Important Than Politics... The Fed Is More Important Than Politics... So, what matters for the U.S. dollar? Higher domestic inflation would matter as it would incentivize the Fed to tighten more than the market expects. Even here, however, recent history warrants caution on this view. Between 2004 and 2006, the Fed tightened 440 basis points and yet the dollar declined 11% from the start of the tightening cycle to its end (Chart 7). This is because the rest of the world's growth outpaced U.S. growth, particularly that of emerging markets, which grew at an annual 19%. We therefore come full circle to the single biggest issue on our forecasting horizon: Chinese policy. China is the most important variable for the U.S. dollar at the moment as it can single-handedly tip the global growth balance back towards the U.S., given its expected contribution to global growth (Chart 8). Chart 7...But Not More Important Than Global Growth ...But Not More Important Than Global Growth ...But Not More Important Than Global Growth Chart 8China Really Matters For Global Growth "America Is Roaring Back!" (But Why Is King Dollar Whispering?) "America Is Roaring Back!" (But Why Is King Dollar Whispering?) Our view is that Chinese policymakers are acting as an accelerant to BCA's House View that the Chinese economy will experience a benign slowdown. Risks are skewed towards the downside. We recently dedicated our monthly Crow's Nest Webcast solely to this issue and we highly encourage our clients to listen to it on replay.4 In today's weekly, we briefly assess where our Chinese view stands and then turn to U.S. politics. News Flash: Chimerica Has Been Dead Since 2012 Two critical aspects of our China view are coming together. The first is U.S. policy, which is becoming more aggressive after a year in which Trump showed restraint for the sake of North Korean negotiations.5 The second is China's renewed focus on domestic economic reforms.6 The "symbiotic" relationship between the U.S. and China is in decay, as we have argued since 2012.7 As China's economy grows, so grows its capacity for challenging the United States in the strategic sphere (Chart 9). Meanwhile the two economies have diverged markedly since U.S. households began to deleverage in 2008 (Chart 10). Chart 9China's Capabilities Are Growing China's Capabilities Are Growing China's Capabilities Are Growing Chart 10China No Longer Addicted To U.S. Demand China No Longer Addicted To U.S. Demand China No Longer Addicted To U.S. Demand The mainstream media is about to become more attuned to this reality now that the Trump administration has published a series of high-level reports declaring that U.S. strategy toward China is changing. Here are a few choice quotations: "China is a strategic competitor using predatory economics to intimidate its neighbors while militarizing features in the South China Sea." (Department of Defense, National Defense Strategy, 2018) "Long-term strategic competitions with China and Russia are the principal priorities for the Department." (Department of Defense, National Defense Strategy, 2018) "[High-level bilateral dialogues] largely have been unsuccessful - not because of failures by U.S. policymakers, but because Chinese policymakers were not interested in moving toward a true market economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States also will take all other steps necessary to rein in harmful state-led, mercantilist policies and practices pursued by China, even when they do not fall squarely within WTO disciplines." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States ... is seeking fundamental changes to China's trade regime, including the overarching industrial policies that have continued to dominate China's state-led economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "China and Russia want to shape a world antithetical to U.S. values and interests. China seeks to displace the United States in the Indo-Pacific region, expand the reaches of its state-driven economic model, and reorder the region in its favor." (President Trump, National Security Strategy of the United States of America, 2017) We expect to find echoes of this tough rhetoric in Trump's State of the Union Address on January 30, which will air as we go to press. Already commentators have declared that the U.S. is entering a "post-engagement" phase in the U.S.-China relationship.8 The U.S. and China will continue to engage. What is important is the Trump administration's shift toward more aggressive economic statecraft. Trump's view, made amply clear on the campaign trail, and now officially U.S. policy, holds that China is a mercantilist as well as a revisionist power and that it has initiated a trade war against the U.S. Thus the real policy change lies not in naming China a "strategic competitor" antithetical to U.S. values, but in declaring that normal "WTO consistent" remedies are no longer sufficient and the U.S. will have to resort to "all other steps necessary." The question is whether the U.S., in adopting unilateral measures, will pursue trade remedies on an item-by-item basis, as it has done so far, or break out of the mold and levy broader tariffs to try to achieve "fundamental changes" as quoted above. Trump's recent tariffs on solar panels and washing machines adhered closely to U.S. institutional procedures and penalized U.S. ally South Korea as well as China: if this is the trajectory that the U.S. intends to take, then markets can breathe a sigh of relief.9 The basic trade data show that the U.S. has continued to expand imports from China despite past incidents of presidents slapping on tariffs (Chart 11). Chart 11China And U.S.: Ships Passing In The Night China And U.S.: Ships Passing In The Night China And U.S.: Ships Passing In The Night However, the U.S. is likely to draw a harder line than that. The same data also show that the U.S. is not gaining much access to the Chinese market over time, while China has greatly diminished its exposure both to exports and to U.S. trade as a whole. Furthermore, the Trump administration is accusing China of trying to gain superior technology from the U.S. in a way that jeopardizes its security and sovereignty in the pursuit of a better strategic position. This is said to include coercion and corruption of U.S. firms in China, favoring the manufacturing sector by squeezing out competition, preferring domestic-sourced goods over foreign goods, and jeopardizing U.S. companies' intellectual property and network security. The key grievances are forced technology transfer, the "Made in China 2025" industrial strategy, "indigenous innovation" rules, and the new Cyber-Security Law.10 A test case for the U.S.'s harder line will be the ongoing investigation into China's intellectual property theft, which is due by August but is expected to elicit action by Trump sooner. Trump has a range of actions he can take either within or without the WTO. Going outside the WTO would give him greater flexibility, for instance, to impose a "fine," as he called it, for the cumulative "big damages" of China's intellectual property theft - but it would also enable China to claim that the U.S. itself is violating WTO trade rules.11 How will China respond to this turn in U.S. policy? It will continue to focus on rebooting its economic reforms. Reform is both necessary for its own interests, as we have outlined in the past, and expedient in that it enables China to try to deflect and delay U.S. pressure.12 This is not to say that China will not retaliate to particular U.S. moves, but simply that it will prefer to minimize conflict unless and until the Trump administration demonstrates via broad and sweeping trade measures that Beijing has no choice but to engage in open trade war. China's recent declarations that it will accelerate economic reforms aimed at trade and investment openness - particularly in financial services but also more generally - are geared toward allaying Washington. Xi Jinping's right-hand economist, Liu He, who is a key figure, made this clear at the World Economic Forum in Davos, where he said that China's reform and opening up this year would "exceed international expectations." Politburo Standing Committee member Wang Yang made a similar point late last year, saying that the "Made in China 2025" program would not discriminate against foreign or private firms.13 Simultaneously, leading technocrats are calling attention to China's vulnerability as it attempts delicate financial reforms. Guo Shuqing of the China Banking Regulatory Commission has warned of "black swan" or "gray rhino" events as he continues with his financial regulatory crackdown, and he has been echoed by the vice-secretary general of the National Development and Reform Commission.14 These statements are prudent - as it is always risky for highly leveraged countries to tinker with financial tightening - and useful because Beijing wants to warn the U.S. against pushing too hard since it is both "making progress" and vulnerable to instability. We certainly expect the reforms to have a significant, adverse impact on China's economic growth this year. In the latest developments, the policy crackdown is spreading to local governments, where fiscal tightening could ensue (Chart 12). Local governments lack stable sources of revenue, have large hidden debts, face an intensifying debt repayment schedule over the next three years, and have recently begun to cancel infrastructure projects under central government scrutiny (in Inner Mongolia, Gansu, and other provinces, and reportedly even in Xi's favored province of Zhejiang). Furthermore, the reforms have involved a crackdown on shadow lending that has sent non-bank credit into a steep decline (Chart 13). While some market estimates suggest that bank loans could grow by 13%-15% in 2018, such estimates cut against the policy grain. Assuming that non-bank credit does not grow any faster in 2018 than it did in 2017 (9.7%), China can afford to let new bank loans grow at 9.7% and still keep its total social financing (TSF) at its five-year annual average growth rate of 14.5%. Policymakers will not be able to soften their line easily, as several key players are newly appointed and must establish their credibility from the outset. Chart 12Local Government Finances Under Scrutiny Local Government Finances Under Scrutiny Local Government Finances Under Scrutiny Chart 13Shadow Bank Crackdown To Weigh On Credit Growth Shadow Bank Crackdown To Weigh On Credit Growth Shadow Bank Crackdown To Weigh On Credit Growth Our view is that Trump will harden the line despite China's promises both of deeper internal reforms and greater opening up. But the timing is impossible to predict. The real fireworks may be reserved until closer to the U.S. midterm election, as campaigning heats up in the fall. That would be the time for Trump to try to rally his voters by means of a clash of economic nationalisms with China. Beyond the top U.S. grievances cited above, we would highlight the U.S. approach toward China's state-owned enterprises (SOEs). Preferential policies for SOEs are a structural issue that the U.S. is now criticizing. At the party congress in October, President Xi Jinping pledged not only to reform the SOEs but also to make them bigger and stronger. Hence there is a potential collision course. The precise implementation of China's reforms could determine whether the U.S. pursues the issue further. China's State-Owned Assets Supervision and Administration Commission has so far reaffirmed Xi's comments at the party congress but, in keeping with the subtlety of Xi's policies, has also suggested there may be room to intensify reforms. The combination of Trump's economic policies, and China's intensifying reforms, will result in the U.S. economy outperforming expectations relative to China while U.S. corporations will outperform their Chinese counterparts (Chart 14). China will experience higher volatility, both in general and in relation to the U.S., and Chinese companies that suffer from reforms will underperform U.S. companies that benefit most from tax cuts (Chart 15). This is ironic given the popular narrative that the U.S. is suffering from chaotic democratic politics while China's centralized authoritarian model reigns triumphant. Of course, we do think Xi has key capabilities to drive reforms further in his second term than in his first, so these U.S.-China divergences will continue for the next 6-to-12 months at least. China's slowdown and increase in equity volatility should create a policy response: more fiscal spending and credit expansion. The comparison of relative U.S. and Chinese credit impulses suggests that China extends more credit as relative volatility rises (Chart 16). Our view, however, is that China's credit impulse will continue disappointing this year as Beijing prioritizes reform over growth. The credit numbers in January are the next data set to watch, in addition to the aforementioned local government spending. Investors should brace for more uncertainty as the Lunar New Year approaches (Feb. 16). Chart 14U.S. Earnings Surprise Relative To China U.S. Earnings Surprise Relative To China U.S. Earnings Surprise Relative To China Chart 15Xi Adds Volatility Relative To Trump Bump Xi Adds Volatility Relative To Trump Bump Xi Adds Volatility Relative To Trump Bump Chart 16China's Credit Impulse Disappoints China's Credit Impulse Disappoints China's Credit Impulse Disappoints Bottom Line: The Trump administration has issued an ultimatum of sorts on trade. Yet China claims to be redoubling its efforts at reforming and opening up its economy - party to deflect the pressure. We are almost certain that Trump will take further punitive actions, but it is too soon to say when or if he will engage in sweeping measures that threaten to destabilize China and thus initiate a trade war. The political context heading into the U.S. midterm vote will be crucial. Is America Having A Macron Moment? It is unfortunate when one's forecast is challenged only weeks after it is conceived. But that appears to be happening to our view, articulated in late December, that investors should expect no significant legislation to come out of Congress following the passage of the tax cuts.15 Bad news for our forecast is perhaps good news for U.S. policy initiatives and the overall quality of U.S. governance. President Trump has softened his stance on immigration, stating that he would be willing to grant citizenship to roughly 1.8 million "Dreamers" - young adults who came to the U.S. as illegal immigrants.16 Clearing the immigration hurdle would mean that Congress can focus on passing a budget for FY2018 that would see both defense and discretionary spending levels significantly raised. It would also relegate the never-ending saga of the debt ceiling to the dustbin, at least for the duration of this political cycle. Trump also followed up his immigration proposal by sketching a $1.7 trillion infrastructure investment plan (albeit a vague one). Chart 17Bipartisanship = Steeper Bull Market? Bipartisanship = Steeper Bull Market? Bipartisanship = Steeper Bull Market? Could we be approaching a "Macron moment" in U.S. politics? A moment when the "silent majority" rises up and sends a message to politicians that it has had enough of polarizing extremes? Previous such moments have included President Reagan's collaboration with congressional Democrats and President Clinton's with Republicans, which underpinned that glorious stock market run between August 12, 1982 and March 24, 2000 (Chart 17). Both presidents passed significant economic and social reforms during that time. Chart 18Peak Partisanship? Peak Partisanship? Peak Partisanship? Chart 19Independents On The Rise Independents On The Rise Independents On The Rise Yes, polarization remains at extreme levels (Chart 18), but that could also mean that it is reaching its natural limits. Rather than dwell on the high levels of polarization, which are baked into the "expectations cake," we would point out that the percentage of Americans who identify as independents is now fast approaching the combined total who identify as either Republican or Democrat (Chart 19). Ominously for Republicans - who hold both the House and the Senate - midterm electoral sweeps have almost always occurred along with the share of independents crossing the 40% mark (Table 1). Table 1Sweep Elections Coincide With High Independent Affiliation "America Is Roaring Back!" (But Why Is King Dollar Whispering?) "America Is Roaring Back!" (But Why Is King Dollar Whispering?) Meanwhile, President Trump's conciliatory tone on immigration was met with howls of protest from conservative activists. This is despite the fact that his proposal essentially exchanges leniency for Dreamers for considerably tougher immigration laws in general, which would align the U.S. with its developed market peers.17 Conservative activists are, however, massively out of step with the rest of America. Polls show that immigration is not high on the list of priorities for most Americans, and that most Americans continue to believe both that immigration is a positive and that immigration intake should remain at current levels (Chart 20). Chart 20Americans Are Neither Anti-Immigrant Nor All That Concerned About Immigration "America Is Roaring Back!" (But Why Is King Dollar Whispering?) "America Is Roaring Back!" (But Why Is King Dollar Whispering?) Our gut call that President Trump was itching to move to the political middle appears to be correct.18 Whether this becomes investment relevant will ultimately depend on whether the Democrats reciprocate. If Democrats go by data, they will. The government shutdown imbroglio has cost them a double-digit lead in the generic congressional ballot (Chart 21). As a political strategy, the shutdown was a miserable failure. Furthermore, the 2016 election stands as clear evidence that "outrage" does not work. Clinton picked up almost a million more voters in California than President Obama yet failed to beat his performance where it mattered: the Midwest. If Democrats continue to run on a "resistance" platform in order to satisfy their activist base, they will fail to win the House. Chart 21Government Shutdown An 'Own Goal' For Dems Government Shutdown An 'Own Goal' For Dems Government Shutdown An 'Own Goal' For Dems Ironically, the best strategy for Democrats ahead of the midterm election is to cooperate with Trump. The swelling ranks of independent voters will reward them if they do so. That same strategy, however, will paradoxically boost Trump's chances in 2020. Bottom Line: The market is, of course, ideologically nihilist. But a move to the middle - which benefits everyone involved except House Republicans - would be positive for stocks and the economy. Key bellwethers going forward are how Democrats react to Trump's immigration proposal and whether Trump moves to the middle on trade deals, starting with NAFTA, whose sixth round of negotiations just ended inconclusively (although not negatively) in Montreal. Investment Implications From the perspective of global asset allocation, the most important issue today is Chinese economic and regulatory policy. Yes, U.S. inflation is important, but whether it moves the dollar - and therefore commodities and EM assets - will depend on the pace of the current Chinese slowdown. China is therefore the most "diagnostic variable" in 2018. If our House View that inflation is coming back in the U.S. is right and our Geopolitical Strategy view that risks to growth in China are to the downside is also right, then investors should go long the U.S. dollar and underweight EM and EM-leveraged assets. If, on the other hand, we are wrong, then investors should load up with EM risk assets to the hilt right now. It is that simple. For what it is worth, we are putting our moderate-conviction view to the test and opening a long DXY trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 But on a completely unrelated note we would like to remind our clients that, over the past 24 months, Mr. Mnuchin was the executive producer of How to Be Single, Midnight Special, Batman v. Superman: Dawn of Justice, Keanu, The Conjuring 2, Central Intelligence, The Legend of Tarzan, Lights Out, Suicide Squad, Sully, Storks, The Accountant, Rules Don't Apply, The Lego Batman Movie, Fist Fight, CHiPs, Going in Style, Unforgettable, King Arthur: Legend of the Sword, Wonder Woman, The House, Annabelle: Creation, The Lego Ninjago Movie, and The Disaster Artist. 2 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, and Weekly Reports, "Trump and Trade," December 9, 2016, and "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 4 Please see BCA Research Webcasts, Geopolitical Strategy Crow's Nest, "China: How Is Our View Working Out?" dated January 25, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Please see Daniel H. Rosen, "A Post-Engagement US-China Relationship," Rhodium Group, January 19, 2018, available at rhg.com. 9 In fact, in the case of washing machines, the U.S.-based GE Appliances stands to gain from the tariff and has been owned by China's Haier Electronics Group since 2016. 10 Several clients have asked us about China's Cyber-Security Law, which has been in the process of implementation since July 2017 and will go fully into effect by the end of 2018. The law is meant to give the Chinese government the option of exercising control over all networks in the country. State security agencies are deeply involved in its enforcement and oversight. Foreign business interests fear that the law's new obligations will be onerous and potentially damaging - including potential violations of corporate security over intellectual property, source code, supply chain details, and data storage and transmission. 11 Please see Stephen E. Becker, Nancy Fischer, and Sahar Hafeez, "Update on US Investigation of China's IP Practices," Lexology, January 8, 2018, available at www.lexology.com. 12 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 13 Wang has served as the top interlocutor with the U.S. in the U.S.-China Comprehensive Economic Dialogue. 14 Please see "China eyes black swans, gray rhinos as 2018 growth seen slowing to 6.5-6.8 percent: media," Reuters, January 28, 2018, available at www.reuters.com. "Gray rhinos," coined by author Michele Wucker, refer to high-probability, high-impact risks, whereas the proverbial "black swan" is a low-probability, high-impact risk. These terms have both been making the rounds more frequently in Chinese policymaking circles since last year. 15 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 16 What is fascinating about Trump's statement is that he cited the 1.8 million figure. There are actually only about 800,000 people who officially participated in President Obama's Deferred Action for Childhood Arrivals program. But estimates suggest that another 1,000,000 young adults are in the U.S. illegally, yet did not register. Trump has come under criticism from conservative, anti-immigration groups for essentially moving the goalposts beyond what even the Democrats had wanted. 17 Canada, for example, has a purely merit-based immigration system that is considerably tough on family reunification. (Reunification has even been suspended because of a large backlog.) In Europe, family reunification laws are extremely strict. Even spouses are not automatically allowed residency status in several major European countries unless they fulfill various conditions. 18 Please see footnote 2 above.

Highlights A potential rise in U.S. inflation and China's growth slowdown represent formidable headwinds to EM risk assets. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices. These two will dent the EM risk asset rally. Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. A new fixed-income trade: bet on a steeper swap curve in Mexico relative to Canada. Feature The global macro landscape in 2018 will be shaped by the two tectonic shifts: U.S. fiscal stimulus amid vigorous growth, and policy tightening in China amid lingering credit and money excesses. The former will grease the wheels of the already robust U.S. economy, generating a whiff of inflation and fueling a further selloff in the U.S. bond market. China's tightening will in turn weigh on commodities prices and curtail the emerging market (EM) economic recovery. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices producing formidable headwinds to EM risk assets. As such, we are reiterating our recommendation to underweight EM risk assets versus their DM peers. As to the absolute performance, we believe EM risk assets are close to a major market top. A Whiff Of U.S. Inflation Strong U.S. growth could in fact be damaging to EM financial markets, as it will likely augment U.S. consumer price inflation. Investors are currently extremely sanguine on U.S. inflationary pressures. An upside surprise to inflation will lift U.S. interest rate expectations further, supporting the greenback and hurting EM carry trades. There is some evidence that U.S. inflation is about to pick up: The New York Federal Reserve underlying inflation gauge is rising, signaling higher inflation ahead (Chart I-1). The nascent revival in the MZM (money of zero maturity) impulse presages a trough in inflation (Chart I-2). Chart I-1Fed Price Pressure Gauge Signifies Higher Inflation Fed Price Pressure Gauge Signifies Higher Inflation Fed Price Pressure Gauge Signifies Higher Inflation Chart I-2U.S. Money Growth And CPI U.S. Money Growth And CPI U.S. Money Growth And CPI The weak U.S. dollar will also help augment inflation in America. U.S. import prices from emerging Asia and Mexico have been rising - even before the latest carnage in the U.S. dollar (Chart I-3). This will filter through into higher domestic price pressures. Chart I-3U.S. Import Prices Are Rising U.S. Import Prices Are Rising U.S. Import Prices Are Rising In brief, fiscal stimulus amid buoyant growth as well as overwhelming optimism among consumers and businesses is creating fertile ground for companies to raise prices. This will amplify corporate profit growth but will also lead to higher inflation. We are not making a case that U.S. inflation is about to surge. Our thesis is that market participants are very complacent on inflation. The money market is pricing in only 96 basis points in rate hikes in 2018-'19. In the meantime, the term premium in the U.S. yield curve is extremely depressed. Therefore, even modest inflation surprises will likely produce an additional meaningful selloff in U.S./DM bond markets. Will global share prices rise in response to strong corporate profit growth, or sell off in the face of higher U.S. inflation? Our hunch is that share prices will suffer as rising bond yields cause multiples to shrink. Rising bond yields will overpower the profit growth impact on share prices. The basis is that multiples are disproportionately and inversely linked to percentage change interest rates but are proportionately and positively linked to EPS.1 At still-low yields, a 50-basis-point rise in bond yields constitutes a sizable percentage change in the bond yield, likely leading to a meaningful P/E de-rating. Current sky-high bullish sentiment towards equities combined with elevated valuations and overbought conditions will mean that even a modest rise in inflation readings will likely trigger equity market jitters. EMs will underperform DMs amid such a selloff, as the former has benefited much more than the latter from low interest rates. Bottom Line: U.S. fiscal stimulus is arriving at a time when final demand is robust, the labor market is tight and business and consumer confidence is buoyant. This will encourage companies to raise prices, resulting in a whiff of U.S. inflation. The latter will rattle markets in the months ahead. China: Tightening Amid Credit/Money Excesses Inflation in China has already been steadily rising (Chart I-4). Interest rates adjusted for inflation remain low. Rising inflation along with still-lingering credit and money excesses necessitates policy tightening. We have written extensively about China's ongoing tightening trifecta - liquidity tightening, increased regulatory oversight and clampdown as well as an anti-corruption crackdown in the financial industry.2 Regulatory tightening in particular could inflict a particular bite as it outright constrains banks' ability to originate credit. This tightening has already led to record low broad money growth, and credit growth is downshifting too (Chart I-5). The cumulative impact of this tightening will play out in the months ahead, weighing further on money and credit growth and ultimately on final demand. Chart I-4China: Inflation Is In Steady Uptrend China: Inflation Is In Steady Uptrend China: Inflation Is In Steady Uptrend Chart I-5China: Broad Money And Credit Growth bca.ems_wr_2018_01_31_s1_c5 bca.ems_wr_2018_01_31_s1_c5 On the fiscal front, local government spending has languished in recent months (Chart I-6, top panel) and general (central plus local) government spending growth has been lackluster (Chart I-6, bottom panel). In 2017, local government annual spending amounted to RMB 19 trillion, or 22% of nominal GDP. Central government expenditures are about 6-fold smaller. Local governments rely on land sales to replenish their coffers, but timid money growth points to weaker land sales ahead (Chart I-7). In the meantime, their annual borrowing is restricted by the central government. Overall, this will constrain local government expenditures in 2018. Chart I-6China: Government Expenditures China: Government Expenditures China: Government Expenditures Chart I-7China: Land Sales To Slump bca.ems_wr_2018_01_31_s1_c7 bca.ems_wr_2018_01_31_s1_c7 The combined credit and fiscal spending impulse heralds a relapse in mainland imports of goods and commodities (Chart I-8). This constitutes a major threat to commodities prices, and consequently to EM. A pertinent question is whether financial markets will react to rising U.S. inflation or a slowdown in Chinese growth. Clearly, one could argue that strong U.S. growth would offset a mainland growth slump, resulting in a stable global macro environment. However, financial markets are an emotional discounting mechanism, and they do not always follow rational thinking. For example, in the first half of 2008 - just a few months ahead of the Global Financial Crisis - global financial markets were preoccupied with mounting global inflation due to strong growth in EM/China. At the time, oil and many other commodities prices were literally surging, and U.S. bond yields were climbing (Chart I-9). Global financial markets were not concerned with the ongoing U.S. recession, shrinking bank loans and deflating house prices. Chart I-8China's Impact On Rest Of The World China's Impact On Rest Of The World China's Impact On Rest Of The World Chart I-92008: An Inflation Scare Just ##br##Before Deflationary Bust 2008: An Inflation Scare Just Before Deflationary Bust 2008: An Inflation Scare Just Before Deflationary Bust In retrospect, financial markets traded on the theme of rising global inflation in the first half of 2008 even though the U.S. was already in a recession, and was heading into the most severe deflationary bust of the past 80 years. Similarly, the financial markets today could trade on the U.S. inflation theme for a couple months, even though China will be slowing. Bottom Line: China's policy tightening is particularly dangerous because it is occurring amid substantial and still-lingering credit, money and property market excesses. Won't Strong DM Growth Support China And Other EMs? Our investment stance on EM has been and remains negative, despite our positive view on U.S. and European growth. The key rationale for this stance is that EMs are much more leveraged to China than to the U.S. and Europe. Hence, our view assumes de-synchronization of growth between EM and DM. In our opinion, an EM slowdown will be largely due to China's deceleration and the latter's impact on commodities prices and non-commodity economies in Asia via trade. South America, Russia, South Africa, Malaysia and Indonesia are commodities producers, and as such are sensitive to fluctuations in commodities prices. The rest of Asia - Korea, Taiwan, Singapore, Thailand and the Philippines - are still exposed to the mainland economy as the latter is their largest export destination. Thus out of the EM sphere, China's dynamics will have a limited impact on only Mexico, India, and Turkey. However, Mexico is at risk of a NAFTA abrogation, while Turkey is at risk of runaway inflation and monetary profligacy. India on the other hand has its own problems and its bourse is unlikely to do well, given it is overbought and expensive. Furthermore, while we are bullish on the growth outlook in central European economies, they are too small to matter from an EM benchmark perspective. It might be useful to contemplate the late 1990s macro dynamics when major decoupling occurred between DM and EM. The booming economies of the U.S. and Europe did not prevent recurring crises in EM in the second half of the 1990s. Chart I-10 illustrates that U.S. and European imports growth was surging at that time, but EM stocks and currencies collapsed. What's more, despite the economic boom in DM during that period - U.S. and euro area real GDP growth rates averaged 4.2% and 2.6%, respectively, between 1996 and 1998 - commodities prices were in a bear market (Chart I-11). Chart I-10EM Crises In 1997-98: U.S. And ##br##Europe's Imports Were Booming EM Crises In 1997-98: U.S. And Europe's Imports Were Booming EM Crises In 1997-98: U.S. And Europe's Imports Were Booming Chart I-11Booming DM GDP And ##br##Falling Commodities Prices Booming DM GDP And Falling Commodities Prices Booming DM GDP And Falling Commodities Prices One might suspect that EM crises in the second half of the 1990s occurred because booming DM growth led to rising U.S. bond yields. However, Chart I-12 portrays that U.S. bond yields actually fell in 1997 and 1998 due to the deflationary shock stemming from the EM turmoil. Chart I-12EM Crises Occurred Amid ##br##Falling U.S. Bond Yields EM Crises Occurred Amid Falling U.S. Bond Yields EM Crises Occurred Amid Falling U.S. Bond Yields By and large, the 1997-98 EM crises occurred despite buoyant DM growth and falling DM bond yields. Nowadays, advanced economies carry much smaller weight in global trade and GDP than they did 20 years ago. Furthermore, EMs are much less dependent on exporting to DMs than they were two decades ago. In addition, China was not an economic powerhouse 20 years ago like it is today, and it did not buy as much from the rest of EMs as it does today. Presently, China holds the key to the EM outlook, and the link is through Chinese imports of goods and commodities. As China's credit and fiscal spending impulse suggests, mainland imports are likely to slow, weighing on commodities prices (refer to Chart I-8 on page 6). To be sure, we are not suggesting that EMs are facing crises similar to what transpired in 1997-98. The point of this comparison is to highlight that robust DM growth in of itself is not sufficient to head off an EM downturn if the latter faces a negative shock from China. With respect to DM growth benefiting China itself, it is critical to realize that China's exports to the U.S. and EU together account for only 6.6% of Chinese GDP (Chart I-13). By far, the largest component of the mainland economy is capital spending, constituting 42% of GDP. Construction and infrastructure are an integral part of capital expenditures, and they are very sensitive to money/credit cycles. Finally, from a global trade perspective, China and the rest of EM account for 46% of global imports, while the U.S. and EU account for 20% and 15%, respectively (Chart I-14). Hence, the total import bill of EM including China is larger than that of the U.S.'s and EU's imports combined. This entails that the pace of global trade growth is set to moderate if EM/China domestic demand decelerates. Chart I-13What Drives Chinese Economy: ##br##Capex Not Exports To DM What drives Chinese Economy: Capex Not Exports To DM What drives Chinese Economy: Capex Not Exports To DM Chart I-14Important Of EM/China In Global Trade Important Of EM/China In Global Trade Important Of EM/China In Global Trade Bottom Line: Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. Investment Conclusions A manifestation of the above-discussed tectonic macro shifts - a rise in U.S. inflation and China's slowdown - will be a U.S. dollar rally and weakening commodities prices. These two macro shifts will produce a perfect storm for EM risk assets. As a harbinger of a forthcoming selloff in EM exchange rates and DM commodities currencies (AUD, NZD and CAD), their implied volatility measures are already picking up (Chart I-15). As to a China/Asia slowdown, Korean, Taiwanese and Singaporean manufacturing output volume growth rates have already relapsed (Chart I-16). Their exports and corporate profits still appear robust because of rising prices. This certifies that there are inflationary pressures, even in Asia. Chart I-15Currency VOLs Are Rising Currency VOLs Are Rising Currency VOLs Are Rising Chart I-16Asian Manufacturing Output Volume Asian Manufacturing Output Volume Asian Manufacturing Output Volume All in all, we maintain a negative stance on EM risk assets in absolute terms and recommend underweighting them versus their DM peers. Within the EM universe, our equity market overweights are Taiwan, India, Korean technology, Thailand, Russia, central Europe and Chile. Our underweights are South Africa, Turkey, Brazil, Peru and Malaysia. Among currencies, our favorite shorts are the TRY, the ZAR, the MYR and the BRL. For investors who prefers relative EM currency trades, we recommend the following longs for crosses: RUB, TWD, THB, CNY and INR. For fixed-income trades, please refer to our open position table on page 18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Bet On A Steeper Swap Curve Relative To Canada For Mexican financial markets, the key uncertainty at the moment is the outcome of the ongoing NAFTA negotiations. Mexico's macro backdrop argues for considerable central bank easing, as inflation is about to roll over and domestic demand is extremely weak. However, if the U.S. pulls out of NAFTA - the odds of which are considerable, as our Geopolitical Strategy team has argued3 - the peso will sell off and interest rates are likely to rise. How should investors position themselves in Mexican fixed-income markets given this binominal outcome from the NAFTA negotiations and uncertainty over its timing? One way is to position for a swap curve steepening in Mexico, and hedge it by betting on a swap curve flattening in Canada by entering the following pair trades (Chart II-1): Chart II-1Mexico, Canada And Their ##br##Relative Swap Curve Mexico, Canada And Their Relative Swap Curve Mexico, Canada And Their Relative Swap Curve Receive 6-month and pay 10-year swap rates in Mexico Pay 6-month and receive 10-year swap rates in Canada In A Scenario Where The U.S. Withdraws From NAFTA: The Mexican swap curve would invert due to short-term rates going up more than long-term rates. In Canada, potential risks from NAFTA abrogation and tightening monetary policy amid frothy property markets and high household debt will cap upside in its long-term interest rates. With its long-term bond swap rates at par with those in the U.S., it seems as though the Canadian fixed income market is underpricing the risk of potential growth disappointments beyond the near run. In essence, should the U.S. withdraw from NAFTA, the loss realized on the Mexican steepener leg would partially be offset by the potential gain on the Canadian flattener leg. In A Scenario Where The U.S. Does Not Withdraw From NAFTA: The Mexican swap curve would start steepening. The rationale is that domestic dynamics suggest inflation has peaked and Banxico should begin its easing cycle soon. Monetary and fiscal policies have been extremely restrictive in Mexico, and considerable monetary easing is justified going forward: A significant part of the rise in inflation in 2017 was caused by peso depreciation in 2016. Last year's peso rally suggests that inflation should start to roll over soon (Chart II-2). Besides, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of 2016 - will subside as the base effect it has caused fades. In brief, the consumer inflation rate will rapidly decline, justifying substantial monetary easing. Banxico's 425 basis points in rate hikes since the end of 2015 are still filtering through the economy. The persistent slowdown in money and credit growth will continue to weigh on domestic demand for the time being. Notably, retail sales volume and gross fixed capital formation are both contracting while domestic vehicles sales are shrinking sharply (Chart II-3). Chart II-2Mexico: Inflation Is Set To Drop Mexico: Inflation Is Set To Drop Mexico: Inflation Is Set To Drop Chart II-3Mexico: Consumer And Business ##br##Spending Are Extremely Weak Mexico: Consumer And Business Spending Are Extremely Weak Mexico: Consumer And Business Spending Are Extremely Weak Due to currently high inflation, real wage growth remains weak. This will continue to weigh on consumer spending (Chart II-4). Fiscal policy has been tightening. Fiscal expenditures, excluding interest payments, are contracting in nominal terms (Chart II-5). Chart II-4Mexico: Real Wage Growth Is Very Timid Mexico: Real Wage Growth Is Very Timid Mexico: Real Wage Growth Is Very Timid Chart II-5Mexico: Fiscal Policy Is Super Tight Mexico: Fiscal Policy Is Super Tight Mexico: Fiscal Policy Is Super Tight Canada is currently on the opposite side of the business cycle spectrum relative to Mexico. The Canadian economy is very strong, being led by domestic demand. Real consumer spending is growing at its fastest pace in nearly 10 years, while the unemployment rate is at 40-year lows. Moreover, a record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints and a tight labor market (Chart II-6, top and middle panel). Chart II-6Canadian Economy Is ##br##Above Full-Employment Canadian Economy Is Above Full-Employment Canadian Economy Is Above Full-Employment As such, the output gap is positive and growing, which has historically led to rising inflation (Chart II-6, bottom panel). Robust growth and rising inflation will force the Bank of Canada to hike rates further. In the meantime, real estate and consumer credit in Canada are overextended, leaving the Canadian consumer at risk from much higher interest rates. The threat that monetary tightening will hurt domestic demand in the future will cap the swap curve in Canada relative to Mexico. On the whole, in the scenario where the U.S. remains in NAFTA, the potential for swap curve steepening in Canada is less than in Mexico. Investment Recommendations We have been recommending that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA negotiations before going overweight the country's currency, fixed-income markets and possibly equities relative to their EM peers. In the face of lingering NAFTA uncertainty, fixed-income investors should contemplate the following relative trade: Receive 6-month and pay 10-year swap rates in Mexico / pay 6-month and receive 10-year swap rates in Canada. Overall, this trade is exposed to minimal losses in the scenario where the U.S. withdraws from NAFTA but is exposed to considerable gains where the U.S. remains in NAFTA, making the overall risk/reward attractive. Provided the NAFTA negotiations could drag till year-end, this trade offers a reasonable risk-reward for traders. It offers a profitable opportunity to profit from Mexico's swap curve steepening, while limiting downside in case NAFTA is terminated before year-end. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 This is due to the fact that interest rates are in the denominator of the Gordon Growth model while EPS/dividends are in the numerator. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, the link is available on page 19. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy Investors Are Giddy Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma BCA Valuation Indicator Surpasses One Sigma BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E February 2018 February 2018 As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Profit Growth Still Accelerating Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS U.S. Buybacks To Lift EPS U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) Timing The Exit (I) Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Equity ScoreCard: Watch For A Dip Below 3 Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) Timing The Exit (II) Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist February 2018 February 2018 To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes February 2018 February 2018 We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes February 2018 February 2018 U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 February 2018 February 2018 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted EURO: A Lot Of Bullish News Is Discounted EURO: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC February 2018 February 2018 Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 February 2018 February 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Robots Are Getting Cheaper Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Global Robot Usage Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) February 2018 February 2018 As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Stock Of Robots By Country (I) Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) February 2018 February 2018 While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots U.S. Investment in Robots U.S. Investment in Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density February 2018 February 2018 Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity February 2018 February 2018 Chart II-10U.S.: Unit Labor Costs Vs. Robot Density February 2018 February 2018 In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density February 2018 February 2018 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed February 2018 February 2018 The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density February 2018 February 2018 The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density February 2018 February 2018 Chart II-16Japan: Where Is The Flood Of Robots? Japan: Where Is The Flood OF Robots? Japan: Where Is The Flood OF Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The U.S. government shutdown showed that the path of least resistance is for more fiscal spending; President Trump is turning to trade and foreign policy amid a lack of popularity at home; North Korean diplomacy is on track, but U.S.-China relations and Taiwan are potential black swans; Iran and the U.S. are playing a risky double game that will add geopolitical risk premium to oil; NAFTA will be a bellwether for Trump's future actions on issues that carry greater constraints, like Iran and China; Book profits on French vs German industrials and China volatility; close U.S. curve steepener and long PHP/TWD. Feature This weekend, investors woke up to the nineteenth government shutdown since 1976, a product of "grand standing" on both sides of the aisle. Our low-conviction view, which we elucidated last week, is that President Donald Trump will be forced to migrate to the middle on policy as the midterm election approaches.1 Chart 1Trump Hitting (And Building!) A Wall Watching Five Risks Watching Five Risks Despite a roaring stock market, strong economic fundamentals, and decade-low unemployment, President Trump's popularity continues to flounder. There is now even a perceptible decline in his support among GOP voters. Key problems for Trump have been the failure to repeal the Affordable Care Act and the intensification of the Mueller investigation (Chart 1). We suspect that he will try to preempt an electoral disaster in November by means of bipartisan deal-making and more orthodox policies. The government shutdown, although not entirely unexpected, undermined the view that President Trump is thinking about moderating his stance. That said, the Democrats are as much, if not more, to blame. With the Republicans in charge of Congress and the White House, it is clear that the Democrats thought that voters would ultimately see the shutdown as the GOP's fault. This was a dangerous assumption given that current polling suggests the Democrats have more to lose. One positive about the short-lived imbroglio is that it was the first government shutdown in twenty years that had little to do with government spending, whether the appropriations bill explicitly or entitlements. While immigration is an intractable issue, the disagreement between Republicans and Democrats is not about dollars. This is good news for the markets as it means that more spending will likely be necessary to grease the wheels of compromise. Our mantra continues to be that the political path of least resistance will lead towards profligacy. While the media's focus is on domestic politics, the real risks remain in the international arena. The two are connected. As political science theory teaches us, policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy. To this arena we turn, starting with China-U.S. relations and the other potential risks in Asia (the Korean Peninsula and Taiwan). We also briefly turn to Iran and NAFTA. What binds all these risks is that it is essentially up to President Trump whether they become market-relevant or not. Korean Diplomacy Is On Track In mid-September North Korean tensions peaked (Chart 2).2 Leader Kim Jong Un chose to demonstrate known missile capabilities rather than escalate the crisis. Chart 2Markets Have Called Kim's Bluff Markets Have Called Kim's Bluff Markets Have Called Kim's Bluff Chart 3North Korea Is Running Out Of Cash North Korea Is Running Out Of Cash North Korea Is Running Out Of Cash We expected this choice given Pyongyang's considerable military constraints. Kim is a rational actor following his father Kim Jong Il's nuclear negotiations playbook.3 Just as brinkmanship reached new highs, Kim Jong Un declared victory and offered to play nice. Specifically, he launched his most advanced missile yet on November 28 (the Hwasong-15) and immediately thereafter North Korean state media declared that North Korea has "finally realized the great historic cause of completing the state nuclear force," complete with a fireworks celebration in Pyongyang.4 Kim confirmed this message personally on January 1 while offering an olive branch to South Korea for the New Year. Apparently, then, Kim is responsive to the United States' threats of devastating military retaliation against any attack. Kim is also responsive to the fact that China's President Xi Jinping has joined the U.S. coalition imposing sanctions on the North (Chart 3), squeezing North Korea's economy. The deep drop in exports to China suggests that the North will run into foreign-exchange problems if it does not adjust its posture - not to mention shortages of goods like fuel that China is gradually cutting off (Chart 4). In short, the U.S. established a credible military threat in 2017, just as it did with Iran in 2012 (Chart 5). China responded to the U.S. and established a credible economic threat of its own. Kim has de-escalated. Kim said in his New Year declaration that he would only use his nuclear deterrent if the U.S. committed an act of aggression. Rhetoric about destroying American cities is gone. Meanwhile Kim has engaged South Korea in direct negotiations, with military-to-military talks possibly to follow, and both sides will make a display of friendship at the Olympic Games in South Korea in February. Chart 4China Is Enforcing Sanctions China Is Enforcing Sanctions China Is Enforcing Sanctions Chart 5Credible Threat Cycle: North Korea Mirrors Iran Watching Five Risks Watching Five Risks While our view that diplomacy will reduce tensions is on track, we caution that the underlying disagreement is driven by North Korea's weapon capabilities and remains unresolved. The North Korean issue is not a red herring and the diplomatic route may continue to be bumpy from time to time.5 Markets could still be rattled by surprise North Korean provocations. Nevertheless, we do not expect a replay of the 2017 level of "fire and fury" that caused the U.S. 10-year treasury yield to drop from 2.31% to 2.05% between June and September 2017. If the North should jerk back toward a belligerent posture and decisively throw away this opportunity for diplomacy, then we will watch closely to determine whether its provocations truly alter the status quo and whether the U.S. shows any sign of greater willingness to respond with force. Otherwise we will simply monitor the diplomatic talks and watch for any signs of internal stress in North Korea as global sanctions tighten.6 Bottom Line: Korean risks remain market-relevant as the crisis is not resolved and talks are just beginning. Nevertheless, diplomacy is taking shape. We remain long the Korean two-year government bond versus the ten-year on the back of global trends and continued de-escalation. China-U.S. Relations May Sour Anyway Over the past year we have warned clients that U.S.-China tensions are the fundamental source of geopolitical risk globally and in Asia Pacific; that North Korea is a derivative of this fact; and that China's cooperation in policing North Korea would only temporarily dissuade the Trump administration from imposing punitive measures on China over trade. Despite China's assistance with North Korea, Trump will be driven by domestic American politics to slap tariffs on China in addition to those levied on January 22.7 First, Trump is committed to an "America First" trade policy and to economic nationalist voters. Thus he may need to show more muscle against China ahead of the midterm elections. This is particularly true for the key rust-belt states that handed him the election in 2016, where four Democratic senators' seats are in competition in November (not to mention nine other senate seats that could be swayed for similar reasons) (Chart 6). It is politically embarrassing to Trump that China racked up its largest trade surplus ever with the U.S. in his first year in office and is on track to continue racking up surpluses (Chart 7). While Beijing has vowed to open up market access and import more goods and services, these promises have yet to impress (Chart 8). Chart 6Trump's Base Expects Protectionism Trump's Base Expects Protectionism Trump's Base Expects Protectionism Chart 7China's Exports To U.S. Are Growing... China's Exports To U.S. Are Growing... China's Exports To U.S. Are Growing... Administrative rulings on several trade disputes early this year will give Trump ample opportunity to take additional trade action against China. The critical question, however, is whether Trump will continue to focus on item-by-item trade remedies (perhaps at an accelerated pace), or whether he goes beyond previous administrations and demands that China make progress on structural and systemic issues. The latter is more politically difficult and would have greater macro consequences. The U.S. has recently suggested that it made a mistake by bringing China into the WTO. This comes after the December WTO meeting in which the administration was able to secure a joint statement with Japan and Europe that increased the pressure on China.8 At the same time, Trump is weighing a significant decision (due by August, but possible any day now) on China's alleged systemic intellectual property theft, which Trump says is likely to require a "fine" (penalty). And comments by White House officials suggest that the administration may be going after China's promotion of state-owned enterprises (SOEs) as well as forced technology transfers (Chart 9).9 These are structural demands on China that will create much bigger frictions than tariffs on a few sub-sectors. Chart 8...While Imports Remain Tepid ...While Imports Remain Tepid ...While Imports Remain Tepid Chart 9Foreign Firms Forced To Transfer Tech Foreign Firms Forced To Transfer Tech Foreign Firms Forced To Transfer Tech Second, assuming that the U.S. and international community reach some kind of deal to reduce Korean tensions over the next six-to-eighteen months - for instance, a missile-test moratorium and corresponding easing of sanctions. It is likely still to be a complicated and ugly deal, as Pyongyang has no intention of giving up its nuclear and missile capabilities. The U.S. will have to make unpopular compromises with a rogue regime, comparable to the Iranian nuclear deal of 2015. The deal will leave a bitter taste in Trump's mouth and the administration will likely blame China for failing to prevent the North from achieving its nuclear status. It will rotate to address other long-standing disagreements with China, and may well look for compensation for Korea by taking a harder line on trade. Bottom Line: Korean diplomacy may delay or soften Trump's trade policies but cannot change his domestic political calculus. The Trump administration is more, not less, likely to impose further punitive trade measures on China as the midterm election draws near. We expect Chinese equity volatility to remain high. We are closing our recommendation to go long the CBOE China ETF Volatility Index, which has appreciated by 26.5%. This is not an investable index but an indicator of volatility in ETFs. A Fourth Taiwan Strait Crisis? The rumor is going around that China and Taiwan are on the verge of a "Fourth Taiwan Strait Crisis." Clients all over the world - from Hong Kong to San Francisco to Toronto - are asking us about cross-strait tensions and the risk of war. As we go to press, Taiwanese President Tsai Ing-wen has just publicly acknowledged that war is possible. Taiwan could indeed be a geopolitical "black swan." It was one of our top five black swans for 2016,10 and several extraordinary events that year suggested that our concerns are warranted: China cut off all communication with the island; the Taiwanese navy accidentally fired a missile towards the mainland on the Communist Party's birthday; and a U.S. president-elect spoke directly with a Taiwanese president for the first time since 1979, creating an uproar in Beijing.11 Today, in the wake of Xi Jinping's concentration of power at the nineteenth National Party Congress,12 and Beijing's heavy-handed crackdown on Hong Kong throughout 2017,13 there is renewed concern that China is about to stage a major intervention to rein in Taiwan. There is even talk that China could be preparing to mount a surprise attack.14 The rumors are arising from a confluence of events. On the mainland side, Xi is personally powerful and has made it a priority to lead China into a "New Era" of greater Chinese influence globally. This means that a decision to take bolder action on Taiwan could come from individual whim rather than a collective decision within the party (which would tend to maintain the status quo). Xi has also taken personal control of the military through promotions, and reasserted that the "party controls the gun," making it less likely that he would meet institutional resistance in any major foreign policy initiative. Finally, Xi has hardened Communist Party policies toward Taiwan, reflected in increased military drills, controversial new air traffic routes, and tougher language in the five-year policy blueprint that he presented to the party congress. On the Taiwanese side, the Democratic Progressive Party (DPP), which is the party that leans toward independence from the mainland, dominates the country's politics. The DPP not only won the presidency but also won legislative control for the first time in the January 2016 election.15 The DPP is also the leading party on lower levels of government. And young Taiwanese people increasingly identify as exclusively Taiwanese.16 While President Tsai has been relatively pragmatic so far, her party has fewer domestic political constraints than in the past - leaving room for the party's more radical side to have more influence or for Tsai to overreach. Internationally, Tsai has allies in Trump and Prime Minister Shinzo Abe of Japan - both nationalists who favor Taiwan and harbor deep suspicions about the reviving communism emanating from Beijing. Hence we still see Taiwan as a potential black swan event in the coming years. However, we would put a near 0% subjective probability on the likelihood that China will spring a massive surprise attack in the near future. Why? Xi is not yet breaking the status quo: Xi has not yet shown himself to be a reckless revisionist. China's foreign policy assertiveness is a gradual process that began in the mid-2000s - it traces the country's growing economic importance and need for supply-line security (Chart 10). Xi has trod carefully in both the East and South China Seas, and both of these strategic thrusts are connected with China's security vis-à-vis Taiwan, as well as vis-à-vis the U.S. and Japan. There is no reason to think that China is ready to launch a multi-front attack against the combined forces of the U.S., Taiwan, Japan, and the rest of the American alliance system. North Korea's new missile capabilities do not tip the scales in China's favor either. Incidentally, even Xi's tougher rhetoric at the party congress echoed the 2005 "Anti-Secession" law, so that more evidence would be needed to conclude that a drastic policy shift is under way.17 China may even want to avoid antagonizing the Taiwanese ahead of local elections later this year. Trump is not yet breaking the status quo: Trump's Asia policy has been consistent with that of previous administrations.18 And Trump's moves to assure Taiwan of U.S. commitment to its defense are status quo. After all, the Democratic Party is historically more enthusiastic about supplying Taiwan with arms (Chart 11). Trump has assured Xi Jinping he will adhere to the "One China" policy; and it is rarely observed that Trump's controversial phone call with Taiwanese President Tsai followed the first-ever tête-à-tête between a Chinese president and his Taiwanese counterpart.19 As long as Trump upholds the norm, the U.S. remains committed to Taiwan's defense yet will refuse to let Taiwan lock it into excessive tensions with China. This policy actually reduces the probability of a miscalculation by Beijing or Taipei. By contrast, the probability would rise if China and Taiwan perceived that the U.S. was withdrawing from its commitments, as Taiwan might want to suck the U.S. back in, or China might see Taiwan as vulnerable. Incidentally, if the Trump administration is not rushing into conflict over Taiwan, then Japan's Abe administration certainly is not. Tsai is not yet breaking the status quo: President Tsai has so far played a pragmatic role. While she is dissatisfied with the "1992 Consensus," which holds that there is only "One China" but two different interpretations of it, she has not rejected the status quo, and she has not implied that Taiwan should be its own state (either of which would cause a huge reaction from the mainland). And there is no serious prospect of a popular independence referendum ("Twexit"?) on the horizon, which would assuredly prompt Beijing to aggressive measures. Chart 10China's Assertiveness Grows With Trade China's Assertiveness Grows With Trade China's Assertiveness Grows With Trade Chart 11Trump Has Not Changed Status Quo Trump Has Not Changed Status Quo Trump Has Not Changed Status Quo In order for us to increase the probability of a Taiwanese war, we would have to see one of these three players start behaving in a way that truly violates the status quo that has prevailed since the U.S. and China normalized relations in 1979. The real risk for Taiwan comes if the U.S. and China fail to arrest the secular decline in relations that began in the mid-2000s. A serious misunderstanding between these two would have a range of global repercussions, and could lead to miscalculation over Taiwan. Unfortunately, a miscalculation is conceivable within Trump's and Tsai's terms, which last until 2020. Consider the following scenario as an example. The U.S. is currently demanding that China assist with the North Korean problem, and may believe that it can compensate China by delaying any punitive trade measures. However, China may be expecting something else - it may be expecting the U.S. to downgrade relations with Taiwan. (In other words, China says, we diminish the North Korean threat to the U.S. mainland, you diminish the Taiwanese threat to the Chinese mainland.) Instead of giving China what it wants, the U.S. may provide Taiwan with new weapon capabilities in response to China's militarization of the South China Sea. In this way, U.S.-China competition could shift to the Taiwan Strait in the aftermath of any Korean settlement. In the meantime, we see Taiwan as vulnerable to China's discrete economic sanctions, which China has not hesitated to use in this or other diplomatic spats (Chart 12).20 Chart 12Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Bottom Line: What is clear to us is that U.S.-China tensions continue to grow and Taiwan could become more frightened, or more emboldened, in the "security dilemma" between them. But until we see signs that any of the relevant powers are actively attempting to break the status quo, we see war as a distant prospect. More likely, today's robust trade between China and Taiwan could suffer a hit due to politics, and tit-for-tat cross-strait sanctions could be imposed. We are closing our tactical trade of long Philippine peso / short Taiwanese dollar for a loss of 5%. This was a speculative play on the divergence in diplomatic relations with China. Taiwan has allowed its currency to rise to avoid antagonizing President Trump, while China and Taiwan have so far avoided the diplomatic crisis that we expect eventually to occur, as outlined above. Iran: Could America Pivot Back To The Middle East? BCA's Geopolitical Strategy correctly forecast the U.S.-Iran détente two years before the nuclear deal was agreed in the summer of 2015.21 At the heart of this call was our read of global forces, namely the paradigm shift in the global distribution of power away from American hegemony towards multipolarity (Chart 13). As the U.S. pivoted its geopolitical focus towards China, Iran became a thorn in its side, forcing it to maintain considerable presence in the Middle East. Without a formal détente with Iran - of which the Joint Comprehensive Plan of Action (JCPOA) is the fulcrum - such a pivot to Asia would be extremely difficult. On January 12, President Trump imperiled our forecast by threatening not to waive sanctions against Iran the next time they come due (May 12).22 To avoid that fate, President Trump wants to see three major changes to the JCPOA: An indefinite extension of limits on Iran's uranium enrichment; Immediate access for inspectors to all nuclear sites; Adding new provisions to limit development of ballistic missiles. These additions are likely to kill the deal, although Trump appears to have directed his comments to the European signatories only. This could potentially create a loophole in the crisis, by allowing Europe to agree to new thresholds for re-imposing sanctions outside of the deal's framework. Pressure from the U.S. president comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. In a surprising statement, President Rouhani said, "it would be a misrepresentation and also an insult to Iranian people to say they only had economic demands ... people had economic, political, and social demands." He went on to say that "We cannot pick a lifestyle and tell two generations after us to live like that ... The views of the young generation about life and the world is different than ours." We agree with President Rouhani. First, 49% of Iran's population is under the age of 30 (Chart 14). Meanwhile, the Supreme Leader and the twelve members of the "Guardian Council" - which has the power to veto parliamentary legislation and to vet presidential candidates - have an average age of 73.23 As with the 2009 Green Revolution, which was brutally repressed, Iran's demographics provide the kindling for a potential regime change. Chart 13American Hegemony Ended,##br## Global Multipolarity Ascending American Hegemony Ended, Global Multipolarity Ascending American Hegemony Ended, Global Multipolarity Ascending Chart 14Iran's Youth:##br## A National Security Risk Iran's Youth: A National Security Risk Iran's Youth: A National Security Risk Second, Iran's economy is clearly not the main reason for the angst. While unemployment is elevated at 12%, it is only slightly above its two-decade average. Meanwhile, inflation is well below its average, with real GDP growth at 5.8% by the end of 2016 (Chart 15). Considering that inflation peaked at 44%, and real GDP growth bottomed at -16% during the most severe sanctions, the current situation is not dire. What has irked the population is that while the private sector suffered throughout the sanctions ordeal, government spending remained elevated (Chart 16). This is not merely because of automatic stabilizers amidst a deep recession. Instead, Iran has elevated its military spending as new geopolitical opportunities presented themselves in the region (Chart 17). It currently spends more on its military as a percent of GDP than any peer in the region (save for Saudi Arabia, its chief rival). It is openly engaged in military conflict in both Syria, Iraq, and Yemen, while it continues to support allies militarily, economically, and diplomatically across the region, particularly Hezbollah in Lebanon. Chart 15Economic Situation Poor But Not Dire Economic Situation Poor But Not Dire Economic Situation Poor But Not Dire Chart 16Government Felt No Pain During Sanctions Government Felt No Pain During Sanctions Government Felt No Pain During Sanctions Chart 17Iran Overspends On Military Iran Overspends On Military Iran Overspends On Military Third, Chart 18 shows that Iran is becoming "dangerously wealthy." Both the 1979 Islamic Revolution and the 2009 Green Revolution occurred at, or near, the peak of Iran's wealth. The 25 years preceding each event saw the country's GDP per capita triple and double, respectively. Chart 18Wealth Is Also A National Security Risk Wealth Is Also A National Security Risk Wealth Is Also A National Security Risk Political scientists Ronald Inglehart and Christian Welzel have empirically shown that wealth changes people's basic values and beliefs, from political and economic beliefs to religion and sexual mores.24 This is the process of modernization. Economic development gives rise to cultural changes that make individual autonomy, gender equality, and even democracy likely. Iran has essentially come full circle since 1979. We suspect that the conservative hardliners in the regime understand the revolutionary context well. After all, they were themselves in their 30s when they rebelled against the old corrupt regime. As such, they will welcome President Trump's pressure as it gives them a raison d'être and an opportunity to undermine the moderate President Rouhani who staked his presidency on the success of the nuclear deal. The risk in this scenario is that the domestic arena of the ongoing "two-level game" will prevent both the U.S. and Iran from backing away from a confrontation. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by rhetorically threatening to close the Straits of Hormuz - as they did repeatedly in 2011 - or by boarding foreign vessels in international waters.25 Geopolitical tensions would therefore serve to undermine President Rouhani's embrace of diplomacy and to de-legitimize any further protests, which would be deemed treasonous. For Trump, a belligerent Iranian response to his pressure would in turn legitimize his suspicion of the nuclear deal. What about the global constraints of multipolarity that compelled the U.S. to seek a détente with Iran in order to pivot to Asia? They remain in place. As such, President Trump's simultaneous pressure on Iran and China runs counter to U.S. strategy, given its limited material resources and diplomatic bandwidth. It is therefore unsustainable. What we cannot forecast, however, is whether the White House will realize this before or after it commits the U.S. to a serious confrontation. Bottom Line: Domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. The two countries are playing a dangerous two-level game that could spiral out of control in the Middle East. For the time being, however, we expect merely a minor geopolitical risk premium to seep into the energy markets, supporting our bullish BCA House View on oil prices. NAFTA: Of Global Relevance On a recent client trip through Toronto and Ottawa we were unsurprisingly asked a lot of questions regarding the fate of NAFTA. The deal is not just of importance to Canada but to the world. It is a bellwether for our low-conviction view that President Trump is going to moderate to the middle on policy issues ahead of the midterm elections. We encourage clients to read our November Special Report titled "NAFTA - Populism Vs. Pluto-Populism."26 In it, we cautioned clients that the probability of NAFTA being abrogated by Trump is around 50%. Why so high? Because there are few constraints: Economic: The U.S. economy has been largely unaffected by NAFTA (Chart 19) and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico. Political: Investors and the media are overstating the importance of the Midwest automotive and agricultural sectors to Trump's base. Trump's Midwest voters knew well his view on NAFTA when they voted for him. In fact, they voted for him because of his NAFTA view. Investors have to realize that Americans do not support unbridled free trade (Chart 20). Constitutional/Legal: There is an argument that Congress could stop President Trump from withdrawing from NAFTA, but the only way to do so would be to nullify his executive orders or legislate a law that prevents the president from withdrawing. However, given the point from above, Congress is afraid to go against the median voter. The immediate implications for investors are that both the CAD and MXN could face downside pressure following the Montreal round of negotiations ending January 29. Both fell by 1.2% and 1.9% respectively in the week of trading following the third round of negotiations in September (Chart 21). Chart 19U.S. Economy:##br## Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Chart 20America Belongs To##br## The Anti-Globalization Bloc Watching Five Risks Watching Five Risks Chart 21NAFTA Negotiations##br## Are FX-Relevant NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant More broadly, NAFTA is an important bellwether for the direction of Trump's policy. He has practically no constraints to abrogating the deal. If his intention is to renegotiate two separate deals - or simply reactivate the 1988 Canada-U.S. Free Trade Agreement - then it makes sense for him to end NAFTA and score political points at home. As such, if he does not, it will indicate that the White House is not truly populist but has been captured by the Republican establishment. Bottom Line: If President Trump does not abrogate NAFTA, which comes with few constraints, then he has clearly decided to throw his lot in with the U.S. establishment, which has consistently been more pro-trade than the American voter. This would be highly bullish for investors as it would suggest that the (geo)political risk premium would dissipate going forward. In fact, the decision on NAFTA could be a broad indicator for future decisions on trade relations with China, Iranian sanctions, and policy writ large. For if Trump sides with the establishment on an issue with minimal constraints, then he is more likely to do so on issues with greater constraints. This month, we are closing our 2/30 curve steepener recommendation, which is down 90bps since inception. The two alternative ways we have played rising U.S. growth and inflation prospects - shorting the 10-year Treasury vs. the Bunds and shorting the Fed Funds December 2018 futures - are in the money, 27bps and 46bs respectively. We are keeping both open for now. In addition, we are closing our long French industrial equities relative to German industrials for a gain of 10.26%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 The playbook is really Nikita Khruschev's. 4 Please see "NK celebrates completion of nuke arsenal with fireworks," The Korea Herald, December 2, 2017, available at www.koreaherald.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 7 Trump decided to impose tariffs on solar panels and washing machine, mostly affecting China and South Korea, on January 22. On steel and aluminum, Trump has until late April to decide, i.e. 90 days after reports from the Commerce Department due Jan. 15 and Jan. 22. Please see Andrew Restuccia and Doug Palmer, "White House preparing for trade crackdown," Politico, dated January 7, 2018, available at www.politico.com. 8 The U.S. Trade Representative's latest edition of an annual report to Congress over China's compliance with World Trade Organization (WTO) commitments declares that the U.S. "erred in supporting China's entry into the WTO on terms that have proven to be ineffective in securing China's embrace of an open, market-oriented trade regime." Please see "Joint Statement by the United States, European Union and Japan at MC11," December 2017, and "USTR Releases Annual Reports on China's and Russia's WTO Compliance," dated January 2018, available at ustr.gov. 9 Please see Lesley Wroughton, "Trump administration says U.S. mistakenly backed China WTO accession in 2001," Reuters, January 19, 2018, available at www.reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 11 Please see "China cuts communication with Taiwan," Al Jazeera, June 25, 2016, available at www.aljazeera.com; "Taiwan mistakenly fires supersonic missile killing one," BBC, July 1, 2016, available at www.bbc.com; Mark Landler and David E. Sanger, "Trump Speaks With Taiwan's Leader, An Affront To China," New York Times, December 2, 2016, available at www.nytimes.com. 12 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 13 Please see "U.S.-China: From Rivalry To Proxy Wars" in BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 14 Xi Jinping is rumored to have told Communist Party leaders in 2012 that the country would invade Taiwan by 2020. Please see Ian Easton, The Chinese Invasion Threat: Taiwan's Defense and American Strategy in Asia (Project 2049 Institute, 2017). 15 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 16 National Chengchi University's long-running data series on Taiwanese identity shows that 58% of Taiwanese people identify as Taiwanese, and 70% under the age of 40. However, 77.5% of twenty-year olds also support the political status quo, i.e. do not seek political independence. Please see Marie-Alice McLean-Dreyfus, "Taiwan: Is there a political generation gap?" dated June 9, 2017, available at lowyinstitute.org. 17 Please see Richard C. Bush, "What Xi Jinping Said About Taiwan At The 19th Party Congress," Brookings Institution, October 19, 2017, available at www.brookings.edu. 18 Even the North Korea threat portfolio was bequeathed to him from former President Barack Obama, and it is being managed largely by the Pentagon and navy. 19 In other words, the incoming Trump administration implied that if China's leader Xi Jinping can speak directly to Taiwan's leader Ma Ying-jeou, then U.S. President Donald Trump can speak to Taiwanese President Tsai Ing-wen. This is a sign that alliances are alive and well, and that there are tensions, but it is not a harbinger of war. 20 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 22 The JCPOA did not actually legislate the removal of sanctions against Iran as the Obama administration was unable to get the Republican-controlled Senate to agree. Instead, the president has to use his executive authority to continue waiving sanctions against Iran. 23 That is only two years away from the average life expectancy in Iran. 24 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change, and Democracy, Cambridge: Cambridge University Press, 2005. 25 Iranian military personnel - almost always the Navy of the Iranian Revolutionary Guards - seized British Royal Navy personnel in 2007 and U.S. Navy personnel in 2016. 26 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com.

Highlights The Japanese economy is booming. This is allowing the BoJ to move away from its QQE (Quantitive and Qualitative Easing) program. However, the YCC (Yield Curve Control) program will stay in place for the foreseeable future as inflation remains a direct function of financial conditions. Because yen positioning and valuations are so skewed, this could result in a yen rally, especially against the Euro. Short EUR/JPY. Like the Fed, the BoC will hike rates three times this year. However, the market already discounts more hikes in Canada than the U.S. We remain neutral USD/CAD. However, CAD will experience downside against the NOK. Short CAD/NOK. Feature Chart I-1JPY Vs. Bonds: The Divorce JPY Vs. Bonds: The Divorce JPY Vs. Bonds: The Divorce Something fascinating happened to USD/JPY in recent months: it began to decouple from U.S. bond yields (Chart I-1). To a large degree, this break in relationship reflected the dollar's own weakness, as the dollar index fell by 10% in 2017. But as weak as the dollar may have been last year, it has actually been flat since September 7. Another culprit behind the yen's decoupling from bond yields has been that as the European Central Bank announced the end of its own asset purchases program, the Bank of Japan has been seen as the next in line to diminish its purchases. On January 8th, the BoJ began moving in that direction, as it started to curtail its buying of long-dated JGBs. Since that day, not only have global bonds sold off, but the yen has regained vigor as well. We believe the yen bear market is not over, but a playable rally against the euro is likely to emerge. The Sun Is Rising The BoJ is justified in wanting to remove some policy stimulus. The Japanese economy is firing on all cylinders, and the improvement seems broad-based. Consumer confidence, buoyed by rising asset prices and an unemployment rate at 23-year lows, is hitting record highs (Chart I-2). This will continue to support real household spending, which is now growing at a nearly 2% pace after contracting steadily from 2015 to early 2017. Another support for household spending comes from the wage front. Contractual wages are already growing at their fastest pace since 2006, and wages excluding overtime pay are expanding at rates not seen since 1998 (Chart I-3). Moreover, the openings-to-applicant ratio is at its highest level since 1974. This increases the likelihood that Prime Minister Shinzo Abe's arm-wrestling with corporate Japan to increase wages will bear fruit, and that the upcoming spring wage negotiation will generate accelerating gains. Chart I-2Japanese Households Feel Ebullient CONSUMER CONFIDENCE SURVEY Japanese Households Feel Ebullient CONSUMER CONFIDENCE SURVEY Japanese Households Feel Ebullient Chart I-3Wage Growth Has Picked Up Wage Growth Has Picked Up Wage Growth Has Picked Up Business confidence is also surging. The Japanese manufacturing PMI number is elevated by Japanese standards, currently at 54, and small business confidence points toward an acceleration in industrial production (Chart I-4). Financial markets validate this picture as well. The surge in the Nikkei has grabbed the imagination of investors, but even more impressive has been the strength in small-cap equities, which have outperformed their large-cap counterparts by 17% since 2015 (Chart I-5). This development has coincided with a pick-up in credit growth, and is also normally associated with a robust growth outlook. The GDP model developed by our sister publication, The Bank Credit Analyst, encapsulates these various phenomena, and forecasts that Japanese real GDP growth could hit an annual rate of 3% in the first half of 2018 (Chart I-6). Thus, it would seem that the Japanese economy will continue to gain momentum. Chart I-4Japanese Companies Are Also##br## Feeling The Good Vibes Japanese Companies Are Also Feeling The Good Vibes Japanese Companies Are Also Feeling The Good Vibes Chart I-5Small Caps Point To##br## A Bright Outlook Small Caps Point To A Bright Outlook Small Caps Point To A Bright Outlook Chart I-6Japanese Growth ##br##Has Momentum Japanese Growth Has Momentum Japanese Growth Has Momentum But what underpins these improvements? First, the fiscal thrust in Japan has changed. Fiscal policy was a drag in Japan from 2012 to 2016, creating an average brake on economic activity of 0.6% of GDP per year. However, in 2017, fiscal policy eased to add 0.2% to GDP. Second, Japan has greatly benefited from the rebound in EM growth. According to the IMF, a 1% growth shock in EM affects Japanese growth by 50 basis points - nearly five times more than the effect of the same shock on the U.S. economy. This is because 43% of Japanese exports are shipped to EM economies. Third, the impact of EM activity on Japan is amplified by the countercyclical nature of the JPY. As global and EM growth expands more vigorous, the yen weakens, which eases Japanese financial conditions. This phenomenon was in full display last year, as financial conditions eased by a full standard deviation over the past 16 months. These developments are what have laid the ground for better growth and the change in the BoJ's tone. Bottom Line: Japan is doing very well. Consumers and businesses are upbeat, spending is on the rise and GDP is forecasted to accelerate even further. Easing fiscal belt-tightening, stronger EM economies, and the softening financial conditions are the factors behind these improvements. The BoJ is taking notice. How Far Can The BoJ Go? The BoJ had been itching to move policy for a few months now. In November 2017, BoJ Governor Haruhiko Kuroda was making noise about the concept of the "reversal rate." The reversal rate is the interest rate below which additional interest rate cuts become contractionary for economic activity. This is because below this level, lower rates hurt bank interest margins to such a degree that commercial banks start curtailing their lending to the private sector. The reason why the BoJ was getting more vocal about the reversal rate was because this rate is inversely related to the amount of securities held on commercial banks' balance sheets. If commercial banks hold plenty of government bonds, as interest rates fall to very low levels, the value of these securities increases, offsetting the negative impact of lower interest rate margins. The problem in Japan is that as the BoJ mopped up more JGBs than was issued by the government, and therefore the bond holdings of banks were dwindling at an alarming rate (Chart I-7). This meant that the reversal rate was rising, implying that the BoJ had less control over policy. When inflation surprised to the upside in December, financial markets reacted violently. While Japanese nominal yields did not budge much, Japanese inflation expectations surged, which prompted a collapse in Japanese real rates (Chart I-8). This produced a de facto easing in Japanese monetary conditions, creating the perfect cover for the BoJ to adjust its asset purchases: any negative impact from tweaking bond purchases would be mitigated and the BoJ, according to its view, would not lose control of financial conditions because of a falling reversal rate. Despite this shift in policy action and rhetoric, we do not yet foresee the end of the Yield Curve Control program. Inflation excluding food and energy only stands at a paltry 0.3%, still well below the BoJ's 2% target or even 1% - a level that is likely to result in a more real removal of easing. Additionally, the BoJ is in somewhat of a bind. It is true that the economy is doing much better, but this does not really help explain inflation dynamics. Japanese capacity utilization only explains 3% of the movements in Japanese core inflation; global utilization, only 10%; and inflation leads credit creation in Japan. Instead, the best factor to explain Japanese inflation has been financial conditions (FCIs). In no other country do FCIs explain inflation dynamics as much as they do in Japan. The recent movements in Japanese inflation are fully consistent with how Japanese FCIs have evolved since 2010. Based on this relationship, CPI excluding food and energy should likely peak at 0.7% in June 2018 (Chart I-9). Chart I-7Japanese Reversal Rate##br## Is Falling Because Of QQE Japanese Reversal Rate Is Falling Because Of QQE Japanese Reversal Rate Is Falling Because Of QQE Chart I-8Sudden Pick Up In##br## Inflation Expectations Sudden Pick Up In Inflation Expectations Sudden Pick Up In Inflation Expectations Chart I-9Inflation Is Picking Up Because##br## Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased However, if the BoJ removes accommodation too fast, the yen would rally and financial conditions would tighten sharply. In all likelihood, inflation would weaken substantially, nullifying the very reason to tighten policy in the first place. These very dynamics point to a continuation of YCC for at least the next 12 to 18 months. Bottom Line: Japan will soon fully do away with its QQE program. However, this is not indicative of a removal of yield curve controls. This is not only because Japanese inflation is extremely far off from the BoJ's target, but also because Japan's inflation rate is hyper-sensitive to financial conditions. Therefore, any tightening in financial conditions created by a stronger yen - the likely market response of tighter policy - will cause inflation to collapse, nullifying the very need for tighter policy. Investment Implications USD/JPY is expensive, trading 16% above the fair value implied by purchasing power parity. Additionally, the yen is supported by a generous current account surplus of 4% of GDP. Moreover, global investors have been underweighting duration. This phenomenon tends to be negative for the yen. When investors are as underweight duration as they are currently, the yen becomes more likely to rally (Chart I-10). It is true that in 2014, investors were as negative on bonds as they are today, but USD/JPY sold off. This was because back then, the BoJ announced an increase to its asset purchase program. Today, the BoJ is moving toward ditching its QQE program, which is likely to prompt a short-covering rally. Now, the key question for investors is what currency should be sold against the yen. We posit the euro is an interesting alternative to the USD. EUR/JPY is exceptionally expensive at present. On a long-term basis, EUR/JPY is trading well outside its normal range on a purchasing-power-parity basis (Chart I-11). Moreover, while USD/JPY is mildly expensive according to metrics that incorporate rate differentials and risk appetite, EUR/USD is very dear based on a similar comparison. The implication is that EUR/JPY is trading at an exceptionally demanding level in terms of short-term valuations (Chart I-12). Hence, tactically, the timing is becoming increasingly ripe to short this cross Chart I-10Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Chart I-11EUR/JPY Is Expensive EUR/JPY Is Expensive EUR/JPY Is Expensive Chart I-12Tactical Risk For EUR/JPY Tactical Risk For EUR/JPY Tactical Risk For EUR/JPY . Further arguing in favor of shorting EUR/JPY instead of USD/JPY are relative financial conditions. Euro area financial conditions have tightened much more than U.S. financial conditions relative to Japan's (Chart I-13). As a consequence, even when adjusting for sector biases, European stocks are currently underperforming Japanese equities by a greater margin than the underperformance of U.S. equities. This highlights that Japan's relative economic outlook burns brighter when compared to the euro area than when compared to the U.S. This also means that the yen has more room to rally against the euro than the USD. Finally, relative positioning between the euro and the yen is also exceptionally skewed. As Chart I-14 illustrates, when speculators are simultaneously long the euro and short the yen, EUR/JPY tends to experience subsequent corrections. Chart I-13Euro Area FCIs Tightened ##br##More Than U.S. Ones Euro Area FCIs Tightened More Than U.S. Ones Euro Area FCIs Tightened More Than U.S. Ones Chart I-14Skewed Positioning##br## In EUR Skewed Positioning In EUR Skewed Positioning In EUR The aforementioned factors point to a potentially large yen rally, but the durability of this rally is likely to be limited. The BoJ will only be dropping a QQE program that it had already only half-implemented in recent months, as bond purchases were well below its JPY80 trillion-yen objective. The BoJ is still committed to its YCC program for the foreseeable future. Only a rejection of this program will create a durable support for the yen. In the meanwhile, as any yen rally will tighten financial conditions and hurt inflation, any yen rally is to be rented rather than owned, as terminal policy rates in Japan still have little scope to rise. Bottom Line: Ditching QQE is likely to result in a yen rally. Such a rally is likely to be most pronounced against the euro as valuations, positioning, and financial conditions are especially exacerbated when compared to the European currency. To be clear, the yen rally is likely to be a countertrend move, as a strong yen will exert serious deflationary pressures on Japan, which means the BoJ's YCC program will remain firmly in place. We are shorting EUR/JPY at 133.79. CAD: Stuck Between The BoC And NAFTA Chart I-15Canada Will Experience Rising Wages Canada:##br## Inflationary Conditions Emerging Canada Will Experience Rising Wages Canada: Inflationary Conditions Emerging Canada Will Experience Rising Wages Canada: Inflationary Conditions Emerging The Bank of Canada (BoC) is meeting next week and the odds are rising that it will lift policy rates this month. The Canadian economy is very strong too, led by the domestic sector. Real consumer spending is growing at its fastest pace in nearly 10 years, the unemployment rate is at 40-year lows, and capex is recovering after having been decimated by the collapse in oil prices from 2014 to 2016. Thanks to this backdrop, the Canadian economy is hitting its own capacity constraints. The BoC estimates that the Canadian output gap has closed. Moreover, the recent Business Outlook Survey confirms this message: A record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints, and the growing number and intensity of labor shortages points to a tight labor market (Chart I-15). Tight capacity and higher wages will support the already-visible rebound in core inflation, which has already reached 1.8%. As a result, we expect the BoC to tighten rates as much as the Federal Reserve this year. However, the impact of this development on the CAD might be limited. Investors are already pricing in more hikes in Canada than in the U.S. over the next 12 months - 82 basis points versus 60 basis points, respectively. Moreover, speculators are once again very long the loonie, implying an elevated hurdle for strong economic data to actually lift CAD further. Moreover, NAFTA remains a major risk for Canada. As Marko Papic, our Chief Geopolitical Strategist, wrote in a November Special Report, President Trump does have uninhibited power when it comes to abrogating NAFTA (Table I-I).1 If NAFTA were to collapse, Canada would most likely ultimately revert to the still-preferential Canada-U.S. Free Trade Agreement. Thus, the impact on Canada-U.S. trade would likely be temporary. However, the brunt of the pain should be felt in Canadian capex spending. The high degree of uncertainty associated with unwinding NAFTA would cause companies to abandon expansion plans in Canada, and prompt them to expand their North American capacity directly in the U.S., thereby bypassing the regulatory risk created in the supply chain. This would dampen the future growth profile of Canada. Table I-1Trump Faces Few Constraints On Trade Yen: QQE Is Dead! Long Live YCC! Yen: QQE Is Dead! Long Live YCC! Oil is unlikely to fill the void for CAD. At near US$70/bbl, Brent has hit our Commodity and Energy strategists' target. OPEC 2.0 will be unwilling to accommodate much higher prices, as this would incentivize shale producers to expand capacity, recreating the supply glut dynamics that existed prior to the 2014 crash. Additionally, the West Canada Select benchmark, the oil price most relevant for Canada, remains at a substantial discount to WTI and Brent. This is because there is not enough pipeline capacity to ship oil outside of Alberta. Canada is drowning in its own oil. This situation is not about to change. Chart I-16CAD/NOK Is Stretched CAD/NOK Is Stretched CAD/NOK Is Stretched Based on this combination, we are neutral USD/CAD on a 12-month basis, even if a move back to 1.29 is likely over the coming weeks. However, while Canadian oil is trading at a discount, the CAD has performed better than the NOK, the other petrocurrency in the G10 space. This suggests that shorting CAD/NOK may be a cleaner way to play the risks inherent to the Canadian dollar. First, the Canadian dollar is very expensive relative to the Norwegian krone right now, trading 11% above its purchasing-power-parity rate (Chart I-16). Even when adjusting for other factors like productivity and commodity prices, CAD is trading at its largest premium to the NOK since 1994. This represents a risk for CAD/NOK as the loonie is exposed to trade policy risks, while the nokkie is not. Second, the balance-of-payments picture remains highly favorable for the NOK. Norway runs a current account surplus of 5.5% while Canada runs a deficit of 2.8%. Additionally, Norway sports a Net International Investment position (NIIPs) of 210% of GDP, the largest in the G10. Strong NIIPs are associated with rising real effective exchange rates. Third, while the Canadian economy's momentum is well known by investors - this is the reason why they are so long the CAD and expecting so many hikes from the BoC - the positives in Norway are being ignored. Norway's leading economic indicator is still rising, and Norwegian industrial production and real GDP growth are accelerating. Fourth, the Norges Bank is responding to weakness in the NOK. At its December meeting, it adjusted its tone, as the NOK is easing monetary conditions too much in the eyes of the Norwegian central bank. This suggests the 25-basis-point hike currently expected out of Norway could be too low. It also highlights that the exceptional 60-basis-point gap between Canada and Norway in terms of expected 12-month rate hikes is also likely to normalize. Finally, CAD/NOK is trading toward the top of both its long-term and near-term historical trading ranges. While positioning on the CAD is now quite extended on the long side, speculators are short the NOK, according to Norges Bank data. Thus, with NAFTA in question, a fully priced BoC outlook, and the unlikelihood that the WCS-Brent discount narrows, risks are skewed toward a lower CAD/NOK going forward. Bottom Line: The Canadian economy is booming. This means the BoC will keep pace with the Fed and increase rates at least thrice this year. However, markets are already discounting more hikes in Canada than they are in the U.S. Moreover, oil prices have limited upside from here, and the WCS benchmark will continue to trade at a deep discount to Brent. Thus, while USD/CAD has limited upside, it has limited downside as well. However, CAD/NOK faces plenty of downside risks from current levels. We are shorting this cross this week, with an entry point at 6.398. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism" dated November 10, 2017, available at gis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: Nonfarm payrolls surprised to the downside, coming in at 148 thousand. Moreover, labor force participation rate surprised to the downside, coming in at 62.7%. ISM non-manufacturing PMI also underperformed expectations, coming in at 55.9. However, consumer credit change outperformed expectations, coming in at 27.95 billion dollars. The dollar began the week on a strong, which ultimately dissipated, on relatively hawkish ECB minutes and policy tweaks in Japan. Overall, we expect the market to continue to price the fed dot plot, putting upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the Euro area has been positive: Core inflation outperformed expectations, coming in at 1.1%. Moreover, the economic sentiment indicator also outperformed expectations, coming in at 116. Retail sale yearly growth also surprised to the upside, coming in at 2.8%. Finally, the unemployment rate declined from 8.8% to 8.7% In spite of the positive data the euro has fallen this weekThe Euro begun the week on the weak side but surged in the wake of the ECB's hawkish minutes. This has happened due to the surge in rate expectations in the U.S., as the market has continued to price in the fed. Overall, we expect to see downside in EUR/JPY as the BoJ has more room to back off its ultra-dovish policy than the ECB. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Labor Cash earnings yearly growth outperformed expectations, coming in at 0.9%. They also increased relative to October. However consumer confidence surprised to the downside, coming in at 44.7 and declining from the previous month. The yen has been surging this week, with USD/JPY falling by 1.7%. This was caused because the BoJ signaled that they would reduce their buying of long dated bonds. The market interpret this as a signal that the BoJ will start exiting from its ultra-dovish monetary policy. These developments should continue to provide upside to the JPY, particularly against the Euro. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production yearly growth outperformed expectations, coming in at 2.5%. Moreover, manufacturing production yearly growth also surprised to the upside, coming in at 3.5%. However, Halifax House Prices yearly growth underperformed expectations, coming in at 2.7% as the month-on-month growth contracted by 0.6%. The pound has been flat, this week against the dollar, while it has lost about 1% against the euro. Overall, the BoE is limited in the capacity to raise rates meaningfully. Moreover, inflation should start to ease following the rate hike and the rise in the pound. This will put downward pressure on the pound. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been mixed: Building permits yearly growth outperformed expectations, coming in at 17.2%. However, the trade balance in November surprised to the downside, coming in at -628 million. It also decreased from -302 million one month earlier. AUD/USD has been flat this week, however AUD/NZD has fallen by roughly 1%. While it is true that global growth continues to be strong, key indicators like Korean and Taiwanese export growth have rolled over. Moreover money supply growth in China continues to decrease. All of this points to a temporary slowdown in Chinese industrial activity, which would lead to weakness in AUD/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The kiwi has rallied by nearly 5% since the start of the year, as global growth continues to stay robust. Overall, we expect that the NZD will continue to outperform the AUD this year, as New Zealand is less sensitive to a tightening in financial conditions than Australia. However on a longer time horizon, the upside for the Kiwi is limited, as the new populist government has not only vowed to decrease immigration into the country, but also for the RBNZ to have a dual mandate. Both of these policies will depress the neutral rate in New Zealand, and consequently put downward pressure on the kiwi. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been mostly positive: The unemployment rate surprised positively, as it declined to 5.7% from 5.9% Moreover, net change in employment also outperformed expectations, coming in at 78.6 thousand. Housing starts yearly growth also outperformed expectations, coming in at 217 thousand. However, the Ivey Purchasing Manager Index underperformed, coming in at 60.4. USD/CAD jumped on Tuesday following reports that Trump will exit the NAFTA accord. Overall we believe that the Canadian dollar will have limited upside from here on out, as the market is now pricing in more hikes in Canada than in the U.S. This weakness could be taken advantage of by shorting CAD/NOK, as this cross is much overvalued according to multiple metrics. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been positive: Headline inflation came in line with expectations, at 0.8%, meanwhile month on month inflation surprised to the upside, coming in at 0%. The unemployment rate also came in line with expectations, at a very low level, coming in at 3%. Finally, retail sales yearly growth surprised to the upside substantially, coming in at -0.2%, compared to 2.6% last month. EUR/CHF has stayed relatively flat since last week. Overall, we expect limited upside in the franc. As the SNB will stay active in the foreign exchange market. In order for the SNB to change its policy, inflation in Switzerland will have to stay at a high level for a considerable amount of time. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Headline inflation outperformed expectations, coming in at 1.6%. Moreover core inflation also surprised to the upside, coming in at 1.4% However, manufacturing output growth underperformed expectations, coming in at 0.3% USD/NOK is down by roughly 0.7%, as oil prices continue to approach the 70 dollar mark. Nevertheless, we believe that the upside for USD/NOK is limited from here, as the market will start pricing in more rate hikes from the Fed. That being said, investors willing to bet on more oil strength could short EUR/NOK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 After falling precipitously at the end of 2017, USD/SEK has been relatively flat this year. Overall, while Stefan Ingves continues to be very dovish, he conceded in the latest minutes that a change in monetary policy is getting closer. Meanwhile, Deputy Governor Jansson stated that while he supports to continue with asset purchases, to keep the repo rate unchanged would be "difficult to digest". Investors willing to bet on a slowdown in the Euro area caused by tightening financial conditions could short EUR/SEK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut Governments Will Want Their Cut Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Where Low Rates Have Fueled House Prices Where Low Rates Have Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Rent Growth Is Cooling Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Low Volatility Is In High Demand Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Will Bitcoin Be DeFANGed? Will Bitcoin Be DeFANGed? Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Yen Is Already Cheap... Yen Is Already Cheap... Chart 15...And Unloved ...And Unloved ...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Euro Area Economic Surprises Edging Lower Euro Area Economic Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Euro Positioning: From Deeply Short To Record Long Euro Positioning: From Deeply Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades