Regulation

Highlights Financial markets have slipped into a 'risk off' phase. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events. Equity bear markets are usually associated with recessions. On that score, we do not see any warning signs of an economic downturn. However, geopolitical risks are rising at a time when valuation measures suggest that risk assets are vulnerable. We do not see the debt ceiling or the failure of movement on U.S. tax reform as posing large risks for financial markets. However, trade protectionism and, especially, North Korea are major wildcards. We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. BCA Strategists debated trimming equity exposure to neutral. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. On a positive note, we have upgraded our EPS growth forecasts, except in the Eurozone where currency strength will be a significant drag in the near term. The Fed faced a similar low inflation/tight labor market environment in 1999. Policymakers acted pre-emptively and began to tighten before inflation turned up. This time, the FOMC will want to see at least a small increase in inflation just to be sure. Wages may be a lagging indicator for inflation in this cycle. Watch a handful of other indicators we identify that led inflection points in inflation in previous long economic expansions. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook, which has led to very lopsided rate expectations. Keep duration short. Feature Chart I-1Trump Popularity Headwind For Tax Reform September 2017 September 2017 A 'risk off' flavor swept over financial markets in August. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to North Korean tensions to the Texas flood and the terror attack in Spain. Trump's popularity rating is steadily declining, even now among Republican voters (Chart I-1). This has raised concerns that none of his business-friendly policies, tax cuts or initiatives to boost growth will be successfully enacted. It is even possible that the debt ceiling will be used as a bargaining chip among the various Republican factions. The political risks are multiplying at a time when the equity and corporate bond markets are pricey. Valuation measures do not help with timing, but they do inform on the potential downside risk if things head south. At the moment, we do not see any single risk as justifying a full retreat into safe havens and a cut in risk asset allocation to neutral or below. Nonetheless, there is certainly a case to be cautious and hold some traditional safe haven assets. Timing The Next Equity Bear Market It is rare to have an equity bear market without a recession in the U.S. There have been plenty of market setbacks that did not quite meet the 20% bear-market threshold, but were nonetheless painful even in the absence of recession (Black Monday, LTCM crisis, U.S. debt ceiling showdown and euro crises). Unfortunately, these corrections are very difficult to predict. At least with recessions, investors have a fighting chance in timing the exit from risk exposure. The slope of the yield curve and the Leading Economic Indicator (LEI) are classic recession indicators, and for good reason (Chart I-2). Over the past 50 years they have both successfully called all seven recessions with just one false positive. We can eliminate the false positive signals by combining the two indicators and follow a rule that both must be in the red to herald a recession.1 Chart I-2The Traditional Recession Indicators Have Worked Well The Traditional Recession Indicators Have Worked Well The Traditional Recession Indicators Have Worked Well It will be almost impossible for the yield curve to invert until the fed funds rate is significantly higher than it is today. Thus, it may be the case that a negative reading on the LEI, together with a flattening (but not yet inverted) yield curve, will be a powerful signal that a recession is on the way. Neither of these two indicators are warning of a recession. Global PMIs are hovering at a level that is consistent with robust growth. The erosion in the Global ZEW and the drop in the diffusion index of the Global LEI are worrying signs, but at the moment are consistent with a growth slowdown at worst (Chart I-3). Financial conditions remain growth-friendly and subdued inflation is allowing central banks to proceed cautiously when tightening (in the case of the Fed and Bank of Canada) or tapering (ECB). As highlighted in last month's Overview, the global economy has entered a synchronized upturn that should persist for the next year. The U.S. will be the first major economy to enter the next recession, but that should not occur until 2019 or 2020, barring any shocks in the near term. That said, risk asset prices have been bid up sharply and are therefore vulnerable to a correction. Below, we discuss five key risks to the equity bull market. (1) Is All Lost For U.S. Tax Cuts? Our recent client meetings highlight that investors are skeptical that any fiscal stimulus or tax cuts will see the light of day in the U.S. Tax cuts and infrastructure spending appear to have been priced out of the equity market, according to the index ratios shown in Chart I-4. We still expect a modest package to eventually be passed, although time is running out for this year. Tax reform is a major component of Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart I-3Some Worrying Signs On Growth Some Worrying Signs On Growth Some Worrying Signs On Growth Chart I-4Fiscal Stimulus Largely Priced Out Fiscal Stimulus Largely Priced Out Fiscal Stimulus Largely Priced Out One implication of Tropical Storm Harvey is that it might force Democrats and Republicans to cooperate on an infrastructure bill for rebuilding. Even a modest spending boost or tax reduction would be equity-market positive given that so little is currently discounted. The dollar should also receive a lift, especially given that the Fed might respond to any fiscally-driven growth impulse with higher interest rates. (2) Who Will Lead The Fed? There is a significant chance that either Yellen will refuse to stay on when her term expires next February or that Trump will appoint someone else anyway. In this case, we would expect the President to do everything he can to ensure that the Fed retains its dovish bias. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. Cohn could not arrive at the Fed and change the course of monetary policy on day one. The FOMC votes on rate changes, but in reality decisions are formed by consensus (with one or two dissents). The only way Cohn could implement an abrupt change in policy is if the Administration stacks the Fed Governors with appointees that are prepared to "toe the line" (the Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. Nonetheless, it is not clear why President Trump would take a heavy hand in monetary policy when the current FOMC has been very cautious in tightening policy. The bottom line is that we would not see Cohn's appointment to the Fed Chair as signaling a major shift in monetary policy one way or the other. (3) The Debt Ceiling A more immediate threat is the debt ceiling. Recent fights over Obamacare and tax reform have pit fiscally conservative Republicans against the moderates, and it is possible that the debt ceiling is used as a bargaining chip in this battle. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors or a halt to other entitlement programs. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is considerably divided on the issue. This augurs well for a clean bill to raise the debt ceiling as the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown in the first half of October, just before the debt ceiling is hit. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. That said, the risk of even a shutdown has been diminished by events in Houston. It would be very difficult and damaging politically to shut down the government during a humanitarian emergency. (4) Trade And Protectionism The removal of White House Chief Strategist Stephen Bannon signals a shift in power toward the Goldman clique within the Trump Administration. National Economic Council President Gary Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. The mainstream media has interpreted this shift within the Administration as reducing the risk of trade friction. We do not see it that way. President Trump still sounds hawkish on trade, particularly with respect to China. Our geopolitical experts point out that there are few constraints on the President to imposing trade sanctions on China or other countries. He could use such action to boost his popularity among his base heading into next year's midterm elections. On NAFTA, the Administration took a hard line as negotiations kicked off in August. This could be no more than a negotiating tactic. Our base case is that it will be some time before investors find out if negotiations are going off the rails. That said, the situation is volatile for both NAFTA and China, and we can't rule out a trade-related risk-off phase in financial markets over the next year. (5) North Korea North Korea's missile launch over Japan highlights that the tense situation is a long way from a resolution. The U.S. is unlikely to use military force to resolve the standoff. There are long-standing constraints to war, including the likelihood of a high death toll in Seoul. Moreover, China is unlikely to remain neutral in any conflict. However, the U.S. will attempt to establish a credible threat in order to contain Kim Jong-un. From an investor's perspective, it will be difficult to gauge whether the brinkmanship and military displays are simply posturing or evidence of real preparations for war.2 We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. Adding it all up, there is no shortage of things to keep investors awake at night. We would be de-risking our recommended portfolio were it not for the favorable earnings backdrop in the major advanced economies. Profit Outlook Update Chart I-5EPS Growth Outlook EPS Growth Outlook EPS Growth Outlook Second quarter earnings season came in even stronger than our upbeat models suggested in the U.S., Eurozone and Japan. This led to upward revisions to our EPS growth forecast, except in the Eurozone where currency strength will be a significant drag in the near term. The U.S. equity market enjoyed another quarter of margin expansion in Q2 2017 and the good news was broadly based. Earnings per share were higher versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Looking ahead, an update of our top-down model suggests the EPS growth will peak just under 20% late this year on a 4-quarter moving average basis, before falling to mid-single digits by the end of 2018 (Chart I-5). The peak is predicted to be a little higher than we previously forecast largely due to the feed-through of this year's pullback in the dollar. In Japan, a solid 70% of reporting firms beat estimates. Chart I-6 shows that Japan led all other major stock markets in positive earnings surprises in the second quarter. Manufacturing sectors, such as iron & steel, chemicals and machinery & electronics, were particularly impressive in the quarter, reflecting yen weakness and robust overseas demand. Japanese earnings are highly geared to the rebound in global industrial production. Moreover, Japan's nominal GDP growth accelerated in the second quarter and the latest PPI report suggested that corporate pricing power has improved. Twelve-month forward EPS estimates have risen to fresh all times highs, and have outperformed the U.S. in local currencies so far this year. Corporate governance reform - a key element of Abenomics - can take some credit for the good news on earnings. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. We expect trailing EPS growth to peak at about 25% in the first half of 2018 on a 4-quarter moving total basis, before edging lower by the end of the year. This is one reason why we like the Japanese market over the U.S. in local currency terms. Second quarter results in the Eurozone were solid, although not as impressive as in the U.S. and Japan. The 6% rise in the trade-weighted euro this year has resulted in a drop in the earnings revisions ratio into negative territory. Our previous forecast pointed to a continued rise in the 4-quarter moving average growth rate into the first half of 2018. However, we now expect the growth rate to dip by year end, before picking up somewhat next year. If the euro is flat from today's level, our model suggests that the drag on EPS growth will hover at 3-4 percentage points through the first half of next year as the negative impact feeds through (Chart I-7, bottom panel). Chart I-6Japan Led In Q2 Earning Surprises September 2017 September 2017 Chart I-7Currency Effects On Eurozone EPS Currency Effects On Eurozone EPS Currency Effects On Eurozone EPS Our top-down EPS model highlights that Eurozone earnings are quite sensitive to swings in the currency. In Chart I-7, we present alternative scenarios based on the euro weakening to EUR/USD 1.10 and strengthening to EUR/USD 1.30. For demonstration purposes we make the extreme assumption that the trade-weighted value of the euro rises and falls by the same amount in percentage terms. Profit growth decelerates by the end of 2017 in all three scenarios because of the lagged effect of currency swings. The projections begin to diverge only in 2018. EPS growth surges to around 20% by the end of next year in the euro-bear case, as the tailwind from the weakening currency combines with continuing robust economic growth. Conversely, trailing earnings growth hovers in the 5-8% range in the euro bull scenario, which is substantially less than we expect in the U.S. and Japan over the next year. EPS growth remains in positive territory because the assumed strength in European and global growth dominates the drag from the euro. The strong euro scenario would be negative for Eurozone equity relative performance versus global stocks in local currencies, although Europe might outperform on a common currency basis. The bottom line is that 12-month forward earnings estimates should remain in an uptrend in the three major economies. This means that, absent a negative political shock, the equity bull phase should resume in the coming months. Monetary policy is unlikely to spoil the party for risk assets, although the bond market is a source of risk because investors seem unprepared for even a modest rise in inflation. FOMC Has Seen This Before The Minutes from the July FOMC meeting highlighted that the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike and how policy should adjust to changing financial conditions. Chart I-8The FOMC Has Been Here Before The FOMC Has Been Here Before The FOMC Has Been Here Before The majority of policymakers are willing for now to believe that this year's soft inflation readings are driven largely by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excess risk taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. The hawks are thus anxious to resume tightening, despite current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. In this month's Special Report beginning on page 18, we have a close look at the impact of "Amazonification" in holding down overall inflation. We do not find the evidence regarding e-commerce compelling, but the jury is still out on the impact of other technologies. If robots and new business strategies are indeed weighing on inflation, it would mean that the Phillips curve is very flat or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. The last time the Fed was perplexed by a low level of inflation despite a tight labor market was in the late 1990s (Chart I-8). The FOMC cut rates following the LTCM financial crisis in late 1998, and then held the fed funds rate unchanged at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period at 1% to 1½%, even as the unemployment rate steadily declined and various measures pointed to growing labor shortages. The FOMC 's internal debate in the first half of 1999 sounded very familiar. The minutes from meetings at that time noted that some policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. Some argued that significant cost saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite the absence of any clear indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, exactly the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation/tight labor market environment before, but in the end patience ran out and policymakers acted pre-emptively. Inflation Warning Signs During Long-Expansions We have noted in previous research that inflation pressures are slower to emerge in 'slow burn' recoveries, such as the 1980s and 1990s. In Chart I-9, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth was a lagging indicator. Economic commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. This is not to say that we should totally disregard wage information. But it does mean that we must keep an eye on a wider set of data. Indicators that provided some leading information in the previous two long cycles are shown in Chart I-10. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart I-10 because it does not have enough history. At the moment, the headline PPI, ISM Prices Paid and BCA's pipeline inflation pressure index are all warning that inflation pressures are gradually building. However, this message is not confirmed by the St. Louis Fed's index and corporate selling prices. We are also watching the velocity of money, which has been a reasonably good leading indicator for U.S. inflation since 2000 (Chart I-11). Chart I-9In The 80s & 90s Wage Growth ##br##Gave No Early Warning On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On Inflation Chart I-10Leading Indicators Of Inflation ##br##In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Chart I-11Money Velocity And Inflation Money Velocity And Inflation Money Velocity And Inflation Our Fed view remains unchanged from last month; the FOMC will announce its balance sheet diet plan in September and the next rate hike will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation edges higher in the coming months. Some indicators are pointing in that direction and recent dollar weakness will help. Wake Me When Inflation Picks Up Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook. They also believe that persistent economic headwinds mean that monetary policy will need to stay highly accommodative for a very long time. Only one Fed rate hike is discounted between now and the end of 2018, and implied forward real short-term rates are negative until 2022. While we do not foresee surging inflation, the risks for market expectations appear quite lopsided. We expect one rate hike by year end, followed by at least another 50 basis points of tightening in 2018. The U.S. 10-year yield is also about almost 50 basis points below our short-term fair value estimate (Chart I-12). Moreover, over the medium- and long-term, reduced central bank bond purchases will impart gentle upward pressure on equilibrium bond yields. Twenty-eighteen will be the first time in four years in which the net supply of government bonds available to private investors will rise, taking the U.S., U.K., Eurozone and Japanese markets as a group. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. The currency appreciation will keep a lid on inflation in the near term. However, we see the euro's ascent as reflective of the booming economy, rather than a major headwind that will derail the growth story. Overall financial conditions have tightened this year, but only back to levels that persisted through 2016 (Chart I-13). Chart I-12U.S. 10-year Yield Is Below Fair Value U.S. 10-year Yield Is Below Fair Value U.S. 10-year Yield Is Below Fair Value Chart I-13Financial Conditions Financial Conditions Financial Conditions It will take clear signs that the economy is being negatively affected by currency strength for the ECB to back away from tapering. Indeed, the central bank has little choice because the bond buying program is approaching important technical limits. European corporate and peripheral bond spreads are likely to widen versus bunds as a result. The implication is that global yields have significant upside potential relative to forward rates, especially in the U.S. market. Duration should be kept short. JGBs are the only safe place to hide if global yields shift up because the Bank of Japan is a long way from abandoning its 10-year yield peg. Treasury yields should lead the way higher, which will finally place a bottom under the beleaguered dollar. Nonetheless, we are tactically at neutral on the greenback. Conclusions Chart I-14Gold Loves Geopolitical Crises September 2017 September 2017 In light of rising geopolitical risk, the BCA Strategists recently debated trimming equity exposure to neutral. Some argued that the risk/reward balance has deteriorated; the upside is limited by poor valuation, while there is significant downside potential if the North Korean situation deteriorates alarmingly. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasurys, Swiss bonds and JGBs have been the best performers in times of crisis (Chart I-14).3 The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Gold has tended to perform well in geopolitical events and recessions, although not in financial crises. We continue to prefer Japanese to U.S. stocks in local currency terms, given that EPS growth will likely peak in the U.S. first. Japanese stocks are also better valued. Europe is a tough call because this year's currency strength will weigh on earnings in the next quarter or two. However, the negative impact on earnings will reverse if the euro retraces as we expect. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. Our dollar and duration positions have been disappointing so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the idea that structural headwinds to inflation will forever dominate the cyclical pressures. This means that the bond market is totally unprepared for any upside surprises on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to us to be predominantly to the upside. Lastly, crude oil inventories are shrinking as our commodity strategists predicted. They remain bullish, with a price target of USD60/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst August 31, 2017 Next Report: September 28, 2017 1 Please see BCA Global ETF Strategy, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com 3 Please see BCA Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com II. Did Amazon Kill The Phillips Curve? A "culture of profound cost reduction" has gripped the business sector since the GFC according to one school of thought, permanently changing the relationship between labor market slack and wages or inflation. If true, it could mean that central banks are almost powerless to reach their inflation targets. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. In theory, positive supply shocks should not have more than a temporary impact on inflation if the price level is indeed a monetary phenomenon in the long term. But a series of positive supply shocks could make it appear for quite a while that low inflation is structural in nature. We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence at the macro level. The admittedly inadequate measures of online prices available today do not suggest that e-commerce sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points. Moreover, it does not appear that the disinflationary impact of competition in the retail sector has intensified over the years. Today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. However, the fact that retail margins are near secular highs outside of department stores argues against this thesis. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High profit margins for the overall corporate sector and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. Anecdotal evidence is all around us. The global economy is evolving and it seems that all of the major changes are deflationary. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. Central banks in the major advanced economies are having difficulty meeting their inflation targets, even in the U.S. where the labor market is tight by historical standards. Based on the depressed level of bond yields, it appears that the majority of investors believe that inflation headwinds will remain formidable for a long time. One school of thought is that low inflation reflects a lack of demand growth in the post-Great Financial Crisis (GFC) period. Another school points to the supply side of the economy. A recent report by Prudential Financial highlights "...obvious examples of ... new business models and new organizational structures, whereby higher-cost traditional methods of production, transportation, and distribution are displaced by more nontraditional cost-effective ways of conducting business."1 A "culture of profound cost reduction" has gripped the business sector since the GFC according to this school, permanently changing the relationship between labor market slack and wages or inflation (i.e., the Phillips Curve). Employees are less aggressive in their wage demands in a world where robots are threatening humans in a broadening array of industrial categories. Many feel lucky just to have a job. In a highly sensationalized article called "How The Internet Economy Killed Inflation," Forbes argued that "the internet has reduced many of the traditional barriers to entry that protect companies from competition and created a race to the bottom for prices in a number of categories." Forbes believes that new technologies are placing downward pressure on inflation by depressing wages, increasing productivity and encouraging competition. There are many factors that have the potential to weigh on prices, but analysts are mainly focusing on e-commerce, robotics, artificial intelligence, and the gig economy. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. The latter refers to the advent of new business models that cut out layers of middlemen between producers and consumers. Amazonification E-commerce has grown at a compound annual rate of more than 9% over the past 15 years, and now accounts for about 8½% of total U.S. retail sales (Chart II-1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart II-2). Amazon's business model not only cuts costs by eliminating middlemen and (until recently) avoiding expensive showrooms, but it also provides a platform for improved price discovery on an extremely broad array of goods. In 2013, Amazon carried 230 million items for sale in the United States, nearly 30 times the number sold by Walmart, one of the largest retailers in the world. Chart II-1E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share Chart II-2Amazon Dominates September 2017 September 2017 With the use of a smartphone, consumers can check the price of an item on Amazon while shopping in a physical store. Studies show that it does not require a large price gap for shoppers to buy online rather than in-store. Amazon appears to be impacting other retailers' ability to pass though cost increases, leading to a rash of retail outlet closings. Sears alone announced the closure of 300 retail outlets this year. The devastation that Amazon inflicted on the book industry is well known. It is no wonder then, that Amazon's purchase of Whole Foods Market, a grocery chain, sent shivers down the spines of CEOs not only in the food industry, but in the broader retail industry as well. What would prevent Amazon from applying its model to furniture and appliances, electronics or drugstores? It seems that no retail space is safe. A Little Theory Before we turn to the evidence, let's review the macro theory related to positive supply shocks. The internet could be lowering prices by moving product markets toward the "perfect competition" model. The internet trims search costs, improves price transparency and reduces barriers to entry. The internet also allows for shorter supply chains, as layers of wholesalers and other intermediaries are removed and e-commerce companies allow more direct contact between consumers and producers. Fewer inventories and a smaller "brick and mortar" infrastructure take additional costs out of the system. Economic theory suggests that the result of this positive supply shock will be greater product market competition, increased productivity and reduced profitability. In the long run, workers should benefit from the productivity boost via real wage gains (even if nominal wage growth is lackluster). Workers may lower their reservation wage if they feel that increased competitive pressures or technology threaten their jobs. The internet is also likely to improve job matching between the unemployed and available vacancies, which should lead to a fall in the full-employment level of unemployment (NAIRU). Nonetheless, the internet should not have a permanent impact on inflation. The lower level of NAIRU and the direct effects of the internet on consumer prices discussed above allow inflation to fall below the central bank's target. The bank responds by lowering interest rates, stimulating demand and thereby driving unemployment down to the new lower level of NAIRU. Over time, inflation will drift back up toward target. In other words, a greater degree of the competition should boost the supply side of the economy and lower NAIRU, but it should not result in a permanently lower rate of inflation if inflation is indeed a monetary phenomenon and central banks strive to meet their targets. Still, one could imagine a series of supply shocks that are spread out over time, with each having a temporary negative impact on prices such that it appears for a while that inflation has been permanently depressed. This could be an accurate description of the current situation in the U.S. and some of the other major countries. We have sympathy for the view that the internet and new business models are increasing competition, cutting costs and thereby limiting price increases in some areas. But is there any hard evidence? Is the competitive effect that large, and is it any more intense than in the past? There are a number of reasons to be skeptical because most of the evidence does not support Forbes' claim that the internet has killed inflation. (1) E-commerce affects only a small part of the Consumer Price Index As mentioned above, online shopping for goods represents 8.5% of total retail sales in the U.S. E-commerce is concentrated in four kinds of businesses (Table II-1): Furniture & Home Furnishings (7% of total retail sales), Electronics & Appliances (20%), Health & Personal Care (15%), and Clothing (10%). Since goods make up 40% of the CPI, then 3.2% (8% times 40%) is a ballpark estimate for the size of goods e-commerce in the CPI. Table II-1E-Commerce Market Share Of Goods Sector (2015) September 2017 September 2017 Table II-2 shows the relative size of e-commerce in the service sector. The analysis is complicated by the fact that the data on services includes B-to-B sales in addition to B-to-C.2 However, e-commerce represents almost 4% of total sales for the service categories tracked by the BLS. Services make up 60% of the CPI, but the size drops to 26% if we exclude shelter (which is probably not affected by online shopping). Thus, e-commerce in the service sector likely affects 1% (3.9% times 26%) of the CPI. Table II-2E-Commerce Market Share Of Service Sector (2015) September 2017 September 2017 Adding goods and services, online shopping affects about 4.2% of the CPI index at most. The bottom line is that the relatively small size of e-commerce at the consumer level limits any estimate of the impact of online sales on the broad inflation rate. (2) Most of the deceleration in inflation since 2007 has been in areas unaffected by e-commerce Table II-3 compares the average contribution to annual average CPI inflation during 2000-2007 with that of 2007-2016. Average annual inflation fell from 2.9% in the seven years before the Great Recession to 1.8% after, for a total decline of just over 1 percentage point. The deceleration is almost fully explained by Energy, Food and Owners' Equivalent Rent. The bottom part of Table II-3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table II-3Comparison Of Pre- and Post-Lehman Inflation Rates September 2017 September 2017 (3) The cost advantages for online sellers are overstated Bain & Company, a U.S. consultancy, argues that e-commerce will not grow in importance indefinitely and come to dominate consumer spending.3 E-commerce sales are already slowing. Market share is following a classic S-shaped curve that, Bain estimates, will top out at under 30% by 2030. First, not everyone wants to buy everything online. Products that are well known to consumers and purchased on a regular basis are well suited to online shopping. But for many other products, consumers need to see and feel the product in person before making a purchase. Second, the cost savings of online selling versus traditional brick and mortar stores is not as great as many believe. Bain claims that many e-commerce businesses struggle to make a profit. The information technology, distribution centers, shipping, and returns processing required by e-commerce companies can cost as much as running physical stores in some cases. E-tailers often cannot ship directly from manufacturers to consumers; they need large and expensive fulfillment centers and a very generous returns policy. Moreover, online and offline sales models are becoming blurred. Retailers with physical stores are growing their e-commerce operations, while previously pure e-commerce plays are adding stores or negotiating space in other retailers' stores. Even Amazon now has storefronts. The shift toward an "multichannel" selling model underscores that there are benefits to traditional brick-and-mortar stores that will ensure that they will not completely disappear. (4) E-commerce is not the first revolution in the retail sector The retail sector has changed significantly over the decades and it is not clear that the disinflationary effect of the latest revolution, e-commerce, is any more intense than in the past. Economists at Goldman Sachs point out that the growth of Amazon's market share in recent years still lags that of Walmart and other "big box" stores in the 1990s (Chart II-3).4 This fact suggests that "Amazonification" may not be as disinflationary as the previous big-box revolution. (5) Weak productivity growth and high profit margins are inconsistent with a large supply-side benefit from e-commerce As discussed above, economic theory suggests that a positive supply shock that cuts costs and boosts competition should trim profit margins and lift productivity. The problem is that the margins and productivity have moved in the opposite direction that economic theory would suggest (Chart II-4). Chart II-3Amazon Vs. Walmart: ##br##Who's More Deflationary? September 2017 September 2017 Chart II-4Incompatible With A Supply Shock Incompatible With A Supply Shock Incompatible With A Supply Shock By definition, productivity rises when firms can produce the same output with fewer or cheaper inputs. However, it is well documented that productivity growth has been in a downtrend since the 1990s, and has been dismally low since the Great Recession. A Special Report from BCA's Global Investment Strategy5 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, in many industries it appears that productivity is over-estimated. If e-commerce is big enough to "move the dial" on overall inflation, it should be big enough to see in the aggregate productivity figures. Chart II-5Retail Margin Squeeze ##br##Only In Department Stores Retail Margin Squeeze Only In Department Stores Retail Margin Squeeze Only In Department Stores One would also expect to see a margin squeeze across industries if e-commerce is indeed generating a lot of deflationary competitive pressure. Despite dismally depressed productivity, however, corporate profit margins are at the high end of the historical range across most of the sectors of the S&P 500. This is the case even in the retailing sector outside of department stores (Chart II-5). These facts argue against the idea that the internet has moved the economy further toward a disinflationary "perfect competition" model. (6) Online price setting is characterized by frictions comparable to traditional retail We would expect to observe a low price dispersion across online vendors since the internet has apparently lowered the cost of monitoring competitors' prices and the cost of searching for the lowest price. We would also expect to see fairly synchronized price adjustments; if one vendor adjusts its price due to changing market conditions, then the rest should quickly follow to avoid suffering a massive loss of market share. However, a recent study of price-setting practices in the U.S. and U.K. found that this is not the case.6 The dataset covered a broad spectrum of consumer goods and sellers over a two-year period, comparing online with offline prices. The researchers found that market pricing "frictions" are surprisingly elevated in the online world. Price dispersion is high in absolute terms and on par with offline pricing. Academics for years have puzzled over high price rigidities and dispersion in retail stores in the context of an apparently stiff competitive environment, and it appears that online pricing is not much better. The study did not cover a long enough period to see if frictions were even worse in the past. Nonetheless, the evidence available suggests that the lower cost of monitoring prices afforded by the internet has not led to significant price convergence across sellers online or offline. Another study compared online and offline prices for multichannel retailers, using the massive database provided by the Billion Prices Project at MIT.7 The database covers prices across 10 countries. The study found that retailers charged the same price online as in-store in 72% of cases. The average discount was 4% for those cases in which there was a markdown online. If the observations with identical prices are included, the average online/offline price difference was just 1%. (7) Some measures of online prices have grown at about the same pace as the CPI index The U.S. Bureau of Labor Statistics does include online sales when constructing the Consumer Price Index. It even includes peer-to-peer sales by companies such as Airbnb and Uber. However, the BLS admits that its sample lags the popularity of such services by a few years. Moreover, while the BLS is trying to capture the rising proportion of sales done via e-commerce, "outlet bias" means that the CPI does not capture the price effect in cases where consumers are finding cheaper prices online. This is because the BLS weights the growth rate of online and offline prices, not the price levels. While there may be level differences, there is no reason to believe that the inflation rates for similar goods sold online and offline differ significantly. If the inflation rates are close, then the growing share of online sales will not affect overall inflation based on the BLS methodology. The BLS argues that any bias in the CPI due to outlet bias is mitigated to the extent that physical stores offer a higher level of service. Thus, price differences may not be that great after quality-adjustment. All this suggests that the actual consumer price inflation rate could be somewhat lower than the official rate. Nonetheless, it does not necessarily mean that inflation, properly measured, is being depressed by e-commerce to a meaningful extent. Indeed, Chart II-6 highlights that the U.S. component of the Billion Prices Index rose at a faster pace than the overall CPI between 2009 and 2014. The Online Price Index fell in absolute and relative terms from 2014 to mid-2016, but rose sharply toward the end of 2016. Applying our guesstimate of the weight of e-commerce in the CPI (3.2% for goods), online price inflation added to overall annual CPI inflation by about 0.3 percentage points in 2016 (bottom panel of Chart II-6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart II-7). Online prices fell relative to the overall CPI for most of the time since the early 1990s, with the relative price decline accelerating since the GFC. However, our estimate of the contribution to overall annual CPI inflation is only about -0.15 percentage points in June 2017, and has never been more than -0.3 percentage points. This could be an underestimate because it does not include the impact of services, although the service e-commerce share of the CPI is very small. Chart II-6Online Price Index Online Price Index Online Price Index Chart II-7Electronic Shopping Price Index Electronic Shopping Price Index Electronic Shopping Price Index Another way to approach this question is to focus on the parts of the CPI that are most exposed to e-commerce. It is impossible to separate the effect of e-commerce on inflation from other drivers of productivity. Nonetheless, if online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. We combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure according to the BLS' annual Retail Survey (Chart II-8). The sectors in our aggregate e-commerce price proxy include hotels/motels, taxicabs, books & magazines, clothing, computer hardware, drugs, health & beauty aids, electronics & appliances, alcoholic beverages, furniture & home furnishings, sporting goods, air transportation, travel arrangement and reservation services, educational services and other merchandise. The sectors are weighted based on their respective weights in the CPI. Our e-commerce price proxy has generally fallen relative to the overall CPI index since 2000. However, while the average contribution of these sectors to the overall annual CPI inflation rate has fallen in the post GFC period relative to the 2000-2007 period, the average difference is only 0.2 percentage points. The contribution has hovered around the zero mark for the past 2½ years. Surprisingly, price indexes have increased by more than the overall CPI since 2000 in some sectors where one would have expected to see significant relative price deflation, such as taxis, hotels, travel arrangement and even books. One could argue that significant measurement error must be a factor. How could the price of books have gone up faster than the CPI? Sectors displaying the most relative price declines are clothing, computers, electronics, furniture, sporting goods, air travel and other goods. We recalculated our e-commerce proxy using only these deflating sectors, but we boosted their weights such that the overall weight of the proxy in the CPI is kept the same as our full e-commerce proxy discussed above. In other words, this approach implicitly assumes that the excluded sectors (taxis, books, hotels and travel arrangement) actually deflated at the average pace of the sectors that remain in the index. Our adjusted e-commerce proxy suggests that online pricing reduced overall CPI inflation by about 0.1-to-0.2 percentage points in recent years (Chart II-9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart II-8BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index Chart II-9BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index Admittedly, data limitations mean that all of the above estimates of the impact of e-commerce are ballpark figures. Conclusions We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence. The available data are admittedly far from ideal for confirming or disproving the "Amazonification" thesis. Perhaps better measures of e-commerce pricing will emerge in the future. Nonetheless, the measures available today do not suggest that online sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points, and it does not appear that the disinflationary impact has intensified by much. One could argue that lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. Nonetheless, if this were the case, then we would expect to see significant margin compression in the retail sector. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High corporate profit margins and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Finally, today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. Rising online activity means that we need fewer shopping malls and big box outlets to support a given level of consumer spending. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. To the extent that central banks were slow to recognize that equilibrium rates had fallen to extremely low levels, then policy was behind the curve and this might have contributed to the current low inflation environment. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Robert F. DeLucia, "Economic Perspective: A Nontraditional Analysis Of Inflation," Prudential Capital Group (August 21, 2017). 2 Business to business, and business to consumer. 3 Aaron Cheris, Darrell Rigby and Suzanne Tager, "The Power Of Omnichannel Stores," Bain & Company Insights: Retail Holiday Newsletter 2016-2017 (December 19, 2016). 4 "US Daily: The Internet And Inflation: How Big Is The Amazon Effect?" Goldman Sachs Economic Research (August 2, 2017). 5 Please see Global Investment Strategy Weekly Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 6 Yuriy Gorodnichenko, Viacheslav Sheremirov, and Oleksandr Talavera, "Price Setting In Online Markets: Does IT Click?" Journal of the European Economic Association (July 2016). 7 Alberto Cavallo, "Are Online And Offline Prices Similar? Evidence From Large Multi-Channel Retailers," NBER Working Paper No. 22142 (March 2016). III. Indicators And Reference Charts Stocks struggled in August on the back of intensifying geopolitical risks, such that equity returns slipped versus bonds in the month. The earnings backdrop remains constructive for global stocks. In the U.S., 12-month forward EPS estimates continue to climb, in line with upbeat net revisions and earnings surprises. Nonetheless, the risk/reward balance has deteriorated due to escalating risks inside and outside of the U.S. Allocation to risk assets should still exceed benchmark, but should be shy of maximum settings. It is prudent to hold some of the traditional safe haven assets, including gold. Our new Revealed Preference Indicator (RPI) remained at 100% in August, sending a bullish message for equities. We introduced the RPI in the July report. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. WTP topped out in June and the same occurred in August for the Japan and the Eurozone indexes. While the indicators are still bullish, they highlight that flows into the equity markets in the major countries are beginning to moderate. These indicators would have to clearly turn lower to provide a bearish signal for stocks. The VIX increased last month, but remains depressed by historical standards. This implies that the equity market is vulnerable to bad news. However, investor sentiment is close to neutral and our speculation index has pulled back from previously elevated levels. These suggest that investors are not overly long at the moment. Our monetary indicator is only slightly negative, but the equity technical indicator is close to breaking below the 9-month moving average (a negative technical sign). Bond valuation continues to hover near fair value, according to our long-standing model that is based on a simple regression of the nominal 10-year yield on short-term real interest rates and a moving average of inflation. Another model, presented in the Overview section, estimates fair value based on dollar sentiment, a measure of policy uncertainty and the global PMI. This model suggests that the 10-year yield is almost 50 basis points on the expensive side. We think that Fed rate expectations are far too benign, suggesting that bond yields will rise. 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 ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: 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

Highlights Hurricane Harvey will prove a bigger market-mover than North Korea's latest missile test; The worst flood in Houston's history will improve U.S. policymaking and remove domestic risks; North Korea justifies hedging against violent incidents, but actors are constrained from full-scale war; Insights from our travels in Asia suggest that U.S.-China cooperation is still meaningful. China's reform reboot faces constraints; Abenomics is not done yet. Feature As we go to press, two crises are developing. The one that has rattled the markets - and that we focus on in this Weekly Report - is the North Korean missile launch. However, we think the more investment-relevant one is the slow-moving Hurricane Harvey, which is about to inundate Houston - a metropolitan area with nearly 7 million people - with more rain. We cannot predict the ultimate impact on the economy of the developing natural disaster, but we do know that Houston is experiencing the greatest flood in its history. The scale of human suffering is likely being massively underestimated at present. Comparisons with Hurricane Katrina are not without merit, but Houston has a population about five times that of New Orleans. Investors may rightly ask, so what? The stock market actually rallied at the height of Hurricane Katrina and one would struggle to pick its date on a chart of the S&P 500. The impact on the economy and markets is likely to be tepid in the near term once again. The significance of Hurricane Harvey is its likely impact on politics. First, there is now no chance that the debt ceiling will be breached. We discussed the low odds last week and we reiterate them here. Second, odds are that a government shutdown is unlikely as well. It is unfathomable to shut down the government during an emergency. Imagine if the Federal Emergency Management Agency (FEMA) had to cease operations. Wall or no wall on the Mexican border, Republicans in Congress and the White House will fund the government. More than that, Americans suffering in a Red State that voted for President Trump could be the catalyst that Republicans need to put their intra-party differences aside and start working with vigor on legislation, including tax reform. We could even contemplate legislative action on a bipartisan infrastructure plan, although the ability of U.S. policymakers to put aside grief and focus back on partisan bickering never ceases to amaze. The bottom line for us is that in six months' time, when investors look back on late August 2017, it will be Hurricane Harvey that is cited as having been market-relevant in the long term, not North Korea's n-th missile launch. That said, North Korea remains relevant. It has launched an avowed ballistic missile over Japan for the first time (as opposed to a space launch vehicle, which it has done in 1998 and 2009). The launch originated near Pyongyang, a warning to the U.S. that any strikes against launch sites would be complex (involving civilians) and tantamount to an attack on the capital and a declaration of war. The United States and its allies will be forced to respond to this brinkmanship by trying harder to establish that the military option is indeed credible despite the well-known constraints (the decimation of Seoul). Therefore more market volatility will ensue in the coming months and year. We do not rule out major violent incidents, though full-scale war still seems highly unlikely due to hard constraints on the various actors. (Please see "Appendix" for our updated checklist on whether the U.S. will attack.) While we do not expect either Pyongyang or Hurricane Harvey to derail the bull market, we recognize that valuations are stretched, volatility is low, and the market may be looking for a reason to sell off significantly. In this report, we discuss insights on North Korea and other key issues gleaned from our recent travels abroad. BCA's Geopolitical Strategy went on the road this summer for five weeks. We visited the American Midwest, Australia, New Zealand, Singapore, Taiwan, China, Japan, South Korea and the U.K. There we had the pleasure of speaking with clients across the asset management industry. Each region had its own set of specific questions and concerns, as well as insights. Over the next two weeks, we plan to share these with our entire client base. Going on the road is critical for investment strategists. It is an opportunity to stress-test and sharpen one's view through interaction with sophisticated investors. Meeting clients also ensures that you are asking the right questions. We are happy to report that our three main questions - how stimulative will U.S. tax reform be; is China willing to deleverage; and is Italy a potential source of global risk-off - are indeed on all of our clients' minds. This does not mean that everyone came to the same conclusions that we did, but at least we know that we are looking for the same answers. Sino-American Split Is Overstated Investors are no longer as quick to dismiss one of our central geopolitical theses: that the U.S. and China are on a path likely to end in the "Thucydides Trap."1 However, one of our clients was not so sure that U.S.-China relations are deteriorating as rapidly as they appear to be. He observed a pattern in bilateral trade that suggested to him that the two countries are working together, under the table, to keep relations from collapsing despite the unprecedented challenges posed by the post-2008 global political and economic environment. He began with the simple point that the U.S.'s rising trade protectionism against Chinese steel in recent years actually made it easier for President Xi to take aim at overcapacity problems in the steel sector in China. After U.S. steel imports from China collapsed, from 20% of total in 2008 to 3% in 2016, China was able to embark on a long-delayed purge of excess steel capacity, shutting down a reported 87mmt over the past year and a half (Chart 1). China moved up the steel product value chain partly as a result of U.S. actions.2 China also appears to have responded promptly to U.S. complaints about agricultural imports. In late 2016, amid a heated and protectionist presidential campaign, the U.S. government threatened to impose tariffs on China's grain exports and demanded that subsidies be removed so that U.S. companies could compete on a level playing field in China's domestic market. Corn prices were at a nine-year low; Beijing was giving rebates to domestic corn exporters and had amassed large corn inventories. Within a few months, in March 2017, China launched the agricultural side of its supply-side reforms. It removed the supports for corn, allowing prices to plummet and making way for lower Chinese supply and thus more U.S. imports (Chart 2). Chart 1U.S. And China Attack Chinese Steel Capacity U.S. And China Attack Chinese Steel Capacity U.S. And China Attack Chinese Steel Capacity Chart 2China's Supply-Side Agriculture Reforms China's Supply-Side Agriculture Reforms China's Supply-Side Agriculture Reforms Most recently, the client emphasized, China launched one of its periodic crackdowns on intellectual property violations.3 Enforcement was observable in China's mainstream online services, which largely lost the ability to stream content for which they lacked the rights.4 As with steel, China has a self-interest in these reforms, especially as it generates its own intellectual property. But it cannot have detracted from China's urgency that the U.S. announced a formal investigation in early August to determine whether China's intellectual property violations deserve punitive actions.5 It is as if China anticipated the U.S.'s moves coming out of the U.S.-China Comprehensive Economic Dialogue in July. In these and many other cases, a pattern seems to emerge: U.S. trade grievances boil up, U.S. authorities threaten punitive actions, China responds to the threat by vowing retaliation and pushing through supply-side reforms that are already in its interest. The process appears to be a win-win, however precarious. The client also suggested that the U.S. may be offering to become more constructive toward certain Chinese initiatives. For instance, China is pressing forward on the long-delayed launch of an oil futures contract on the Shanghai International Energy Exchange in the second half of 2017. This new benchmark would ostensibly rival Brent and West Texas Intermediate contracts and be settled in RMB instead of USD. To our client, China's moving forward with this scheme, immediately after top-level trade negotiations with the U.S., seemed to reveal the U.S.'s tacit support for RMB internationalization. Certainly the U.S. nodded at the IMF including the RMB in its special drawing rights basket.6 Presumably, then, the U.S. and China have not entirely lost the ability to deal with each other on sensitive issues in an atmosphere fraught with distrust. Moreover, both sides can attempt to roll with the punches. China can blame the difficulties of necessary internal reforms on U.S. protectionism, while U.S. protectionist impulses can be mitigated via China's internal reforms. This dynamic could become the silver lining in Sino-American relations in 2018, a year in which Xi will have the best opportunity to push reforms while Trump may be most eager to take protectionist actions ahead of the midterm election. A silver lining to a black cloud, of course. Bottom Line: Risks to Sino-American relations remain serious, but the two sides still retain some ability to manage tensions. The question is how much ability? Our own view has been that 2017 would largely be a year of Trump issuing "a shot across the bow" and then negotiating. Concrete, aggressive action would be more likely to occur in 2018. This remains our baseline case. But silent coordination of the kind described above could perhaps improve trade relations enough to satisfy Trump in 2018 and delay a Sino-U.S. confrontation. China has long dealt with protectionist threats from the U.S. by conceding various reforms and policy adjustments, especially by increasing U.S. imports. The U.S. has long accepted such a response. We doubt that this tactic will be enough in this day and age, but maybe so. North Korea Could Cause A Recession What about U.S.-China cooperation on North Korea? It appears as if coordination has improved in the face of a potential conflict. At the peak of tensions this summer, China has offered to implement sanctions, cutting off some trade and joint ventures, while the U.S. has given reassurances about U.S. military intentions in the event of a conflict.7 However, judging by conversations with clients on the mainland, a large gap still exists between U.S. and Chinese perceptions. In particular, Chinese clients pushed back against any implication that China is responsible for reining in North Korea's bad behavior. They highlighted China's emphasis on national autonomy, the idea that every country should be left alone to address its own problems in its own jurisdiction. Otherwise countries should resolve differences through diplomacy and dialogue, conducted as equals. The threat or use of force always makes things worse. The current North Korean situation is, from this perspective, America's fault. The North Koreans pursue nuclear-tipped ballistic missiles in order to deter a U.S. attack, having seen what happened to other nuclear aspirants like Iraq, Syria, and most recently Libya.8 In short, China sympathizes with its formal ally North Korea. It demands peaceful negotiations and denounces the threat of regime change. And it does not believe U.S. officials when they renounce regime change as an option, as Secretary of State Rex Tillerson has recently done. "No one will believe that," one of our clients said, and least of all North Korea. (Quite reasonably, we would add.) This argument reinforces our view that China will not impose crippling sanctions on the North, even if it tries to pressure Pyongyang back to the negotiating table. Since the North cannot be expected to give up its nuclear weapons, the negotiations themselves will be limited from the outset. The U.S. essentially has to accept the status quo, possibly even the perpetual threat of a North Korean nuclear strike. This, in turn, increases the probability that the Trump administration will be disappointed with the outcome. Which is precisely why we expect the U.S. not only to bulk up its military alliance in the region but also to impose more "secondary sanctions" and trade tariffs on China. Sino-American tensions will get harder and harder to manage. While we can foresee skirmishes and violent incidents, we think the probability of a full-scale Second Korean War is low. Diplomacy is not exhausted, the U.S. alliance with regional powers remains intact, and, most importantly, North Korea has not committed an act of war (or acted as if it is about to, which would prompt U.S. preemption). Regarding the big picture, some of our clients are not so sanguine. One of them pointed out recent academic research arguing that armed conflict, as a cause of death in the human population, has declined. The number of violent deaths per 100,000 people has fallen from historic levels in the hundreds down to an average of 60 in the twentieth century, which includes two world wars, and down to the single digits in the post-WWII era (Chart 3). The client asks: Is this drop in war deaths sustainable? The implication is that the level of deaths has nowhere to go but up. Chart 3Human Deaths By War Have Collapsed In Post-WWII Era Insights From The Road - Asia Insights From The Road - Asia The client coupled this thought with another bearish theory. It is widely known that recessions are normally preceded by large financial or economic imbalances. Today many investors are encouraged by the apparent lack of any such imbalance. They read this as saying, "let the good times roll." Our client viewed it another way, suggesting that the imbalance that will cause the next major recession will be non-financial and non-economic, e.g. ecological, epidemiological, geopolitical, etc. Chart 4Global Conflicts Increasing In Frequency Global Conflicts Increasing In Frequency Global Conflicts Increasing In Frequency The client was not specifically hinting at a North Korean conflagration, though probably not ruling it out either. He was mostly concerned with the historic drop in deaths by conflict and how it might be reversed in the near future. Unfortunately this bleak suggestion that war might make a secular comeback is not incompatible with our view that geopolitical multipolarity goes hand in hand with a higher incidence of internationalized conflicts (Chart 4), which could be exacerbated by a decline in global trade. On the other hand, the fall in deaths is a product of a range of political, economic, social and scientific advances, and may not be reversed through geopolitical tensions alone. Bottom Line: The U.S. and China remain far apart in their perceptions of who is to blame for North Korea and what is to be done. China will not take responsibility for "solving" the problem as the U.S. demands. This reinforces our view that North Korean tensions have not yet peaked and remain market-relevant. We ultimately believe that a peaceful solution will prevail, but getting from here (tensions) to there (a negotiated settlement) entails further risks. China Will Try To Reform, But Won't Touch The Property Bubble "They've got to do something about the corporate leverage." This was the conclusion of a client who agreed with our view that President Xi Jinping will likely accelerate his reform agenda after the nineteenth National Party Congress this fall, and that deleveraging is the key indicator (Chart 5). Some clients in China - specifically banks - confirmed that they were under pressure from tightening financial regulation and as a result were both slowing the pace of lending and becoming more scrutinizing of borrowers' creditworthiness. Borrowing rates have ticked up (Chart 6). Chart 5High Time For Some Belt-Tightening High Time For Some Belt-Tightening High Time For Some Belt-Tightening Chart 6Chinese Cost Of Capital Ticks Up Chinese Cost Of Capital Ticks Up Chinese Cost Of Capital Ticks Up Clients also suggested that Chinese leaders would soon re-emphasize the country's transition away from GDP targets as a measure of successful governance and economic stewardship. When the Xi administration came to power, it sought to de-emphasize GDP targets and introduced new and alternative targets - such as urban and rural income per capita, labor productivity, corruption, air pollution - into its assessments of economic progress. But the administration was forced to return to GDP targets amid growth fears in 2015, prompting Premier Li Keqiang to promise "at least" 6.5% growth for the next five years. Now the attempt to elevate qualitative measures of governance looks set to resume. Xi held two meetings of the Central Leading Group for Deepening Overall Reform this summer, in which he noticeably prioritized "green growth" rather than plain old growth, and pushed for replicating and applying more broadly the pilot reforms that have been implemented since his reform agenda was first laid out in 2013. In mid-July, at the National Financial Work Conference, Xi called for local officials to be held accountable for local government debt - even beyond their term in office. And in late July, Yang Weimin, a key economic policymaker who reports to Xi, said, "we won't allow the leverage ratio to rise for the sake of maintaining growth."9 The implication is that GDP growth will be allowed to fall as the government attempts to make progress on difficult reform initiatives. Chart 7Bonds More Important In China Bonds More Important In China Bonds More Important In China Several clients also expressed confidence that China would resume economic "opening up" before long. It is well known that, over the past year, Beijing has sought to attract FDI by promising to implement a nationwide "negative list" and removing certain sub-sectors from that list, in a bid to counter recent weak FDI inflows and ongoing capital outflow pressure. Beijing has also taken steps to deepen its financial sector, such as by expanding and regularizing its bond markets (Chart 7) in preparation for opening the Hong Kong-Shanghai "bond connect," which will allow foreign investors to buy Chinese bonds and, we think, generate strong demand. To add to this list, clients stressed that China is beginning to think about what happens after it lifts the capital controls put in place last year to halt outflows. A number of institutions are interested in expanding their overseas portfolios when they get the "all clear." We would expect the re-opening to come after the central government completes a round of reforming, recapitalizing, and restructuring banks and SOEs, which could push the timing well into 2018 or 2019. But clients are clearly chomping at the bit - which may suggest that they anticipate capital controls to be lifted sooner rather than later. One important reform item that we were told not to expect is the imposition of a nationwide property tax. Chinese authorities delayed the implementation of the tax in 2016 due to the desire to reflate the property market. Presumably they will return to this initiative now that the economy has recovered: it makes long-term sense to give local governments a more stable source of revenue and to suck some air out of the property bubble gradually so that it does not burst (Chart 8). However, clients are skeptical about any reforms that could harshly suppress real estate prices due to the heavy concentration of household wealth in the property sector (Chart 9). Chart 8Provinces To Be Weaned Off Of Land Sales? Provinces To Be Weaned Off Of Land Sales? Provinces To Be Weaned Off Of Land Sales? Chart 9Chinese Wealth Stored In Housing Insights From The Road - Asia Insights From The Road - Asia If the property bubble should be popped, people's life savings would vanish into thin air and there would be chaos in the streets. A client in Hong Kong remarked that the Chinese public will pretty much accept anything as long as property prices continue to rise. Since everyone agrees that social stability is the critical aim of the ruling party, it stands to reason that reforms will not be allowed to threaten the property sector, at least not directly. If the property sector prevents serious attempts at deleveraging, then the environmental agenda will become all the more significant as the focus of the Xi administration in its second five-year term. The administration began by increasing central government spending for environmental regulation more than for any other category of spending (Table 1). And Xi's statements in July, previewing the National Party Congress, emphasized fighting pollution as one of three chief focal points (the others were controlling systemic risks and fighting poverty). Table 1Fiscal Priorities Of Recent Chinese Presidents Insights From The Road - Asia Insights From The Road - Asia In recent months, central inspectors have fanned out across the country to conduct local pollution inspections ahead of end-of-year deadlines. These have fueled market speculation about deep curbs coming to industrial overcapacity, causing the prices of certain commodities that China produces, like aluminum, to surge (Chart 10). These commodity prices have likely already seen the biggest moves - given China's sharp slowdown in 2014 and reflation in 2015-16 - but they are still sensitive to the policy mix in China, i.e. the relative amounts of capacity cuts and deleveraging that take place. Chart 10Supply-Side Reform Has Boosted Metals Supply-Side Reform Has Boosted Metals Supply-Side Reform Has Boosted Metals Bottom Line: Clients across the Asia-Pacific region were focused on the question of Chinese structural reforms. We got the sense that there was much skepticism over whether they would indeed be growth-constraining. But when pushed, clients focused on real estate prices as the one threshold policymakers would not dare to cross in China. What About Japan? A Visit With Mr. K One of our most esteemed clients is a seasoned Japanese global investor who shall go by the moniker of "Mr. K" in the following dialogue (and for future reference). Mr. K opened the dialogue with us by asking us for our view of Japan. Mr. K: What is your view on my country, on Japan? GPS: We tend to think that the current reflationary policy will continue. The Tokyo metropolitan elections did not sound the death knell for Prime Minister Shinzo Abe (Chart 11). The BoJ has become more, not less, dovish, and is not likely to follow other central banks in tightening policy anytime soon. Abe retains control of both houses of the Diet and can increase government spending to boost the economy. And the LDP will continue reflation even if Abe falls. Mr. K: This may be true, reflation will continue. However, the Japanese economy is reaching a plateau after five years of Abenomics. The recent strong GDP numbers were not well-received because consumers feel the stagnation (Chart 12). Global demand, and Chinese demand, have provided a positive backdrop for Japanese manufacturers, but the domestic outlook is not wildly optimistic. Chart 11Abe No Longer In Free-Fall Insights From The Road - Asia Insights From The Road - Asia Chart 12Japanese Feel Stagnant Despite Strong Growth Japanese Feel Stagnant Despite Strong Growth Japanese Feel Stagnant Despite Strong Growth With economic policy, the key phrase is "TINA," There Is No Alternative. There is no alternative to Abe at the moment. If you look back at the Democratic Party of Japan's support in 2011 under Prime Minister Yoshihiko Noda, it was a real contender. Today, it is far from rivaling the LDP (Chart 13). The voting population is, apparently, comfortable. It is true that if Abe leaves, it will not make much of a difference, as long as the LDP remains in power. The younger generations do not seem troubled by the current state of affairs. They are well-trained to endure economic stagnation. There is a sense that those who stand out feel uncomfortable. College graduates looking for jobs are very conservative. While with Generation X there was always the expectation that tomorrow would be a brighter day, Generation Millennial has come not only to accept stagnation, but even to like the stability of flat growth. GPS: Isn't this kind of stagnation a good thing? Isn't it a case of Japan being in a "Goldilocks" phase? Mr. K: Stability and stagnation can be good for markets. First, the macro environment is decent. Corporations have large cash balances, external demand is strong, wage demand is subdued, and the exchange rate is weak. However, risk-taking is not prized, whether in the education system or the media. Public discourse tends to discourage high-risk investments. And risk-takers have not been properly rewarded over the past two decades in Japan (Chart 14), so confidence and risk-appetite are weak. Also, deflation is hard to defeat. The "100 Yen Shop" (dollar store) retail model is a good example. The goods are all cheap, but as long as you can bring more people in, you can make a profit. This is almost all deflationary. Moreover, the Japanese have nothing to spend on! They no longer need new cars, or big computers; they just need mobile phones, maybe a Nintendo Switch, etc. Second, as to the financial markets, greater deregulation is necessary to attract non-Japanese capital flows. Maybe then valuations will normalize (Chart 15). It is essential to see if leading companies continue to gain global competitiveness, in anything from Internet services to gaming. Watch valuations and watch cash flow. Chart 13Opposition Still Can't Touch Ruling LDP Opposition Still Can’t Touch Ruling LDP Opposition Still Can’t Touch Ruling LDP Chart 14Risk-Takers Punished In Japan Risk-Takers Punished In Japan Risk-Takers Punished In Japan Chart 15Japanese Valuations Still Low Japanese Valuations Still Low Japanese Valuations Still Low The key firms are not necessarily the keiretsu, but secondary or new manufacturers that are driving growth. Small caps are more leveraged to foreign exchange, whereas neither the Japanese domestic economy nor the value of the yen matter much to large multinationals anymore. To capitalize on the internal economy you want to be long small caps. Or better yet, long semi-large caps: those companies equivalent to the U.S. companies that make the difference between the S&P 500 and the S&P 600. These are some of the best plays in Japan because they are domestic-oriented and sensitive to the weaker yen. This will provide a tailwind for stocks elsewhere. Local property markets also offer a very good return over the risk-free rate. GPS: What do you make of our view that Abe will push reflationary policy ahead of his efforts to revise the constitution? Given that he needs a strong economy to pass the popular referendum? Mr. K: It is harder to increase fiscal spending in Japan than one might think. However, the North Korean threat is not going anywhere. And the media love "tensions." GPS: So it seems like you are positive about the markets in Japan, but are not yet sold on Abenomics? Mr. K: I suppose the lesson is, if it isn't too cold, stay on the ski slopes. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 For this term, please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, as well as Allison's new book, Destined For War: Can America and China Escape Thucydides's Trap? (New York: Houghton Mifflin Harcourt, 2017). 2 Please see BCA China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge," dated August 17, 2017, available at cis.bcaresearch.com. 4 Please see "China cracks down on distribution of illegal publications," Xinhua, July 25, 2017, available at news.xinhuanet.com. China also highlighted the BRICS countries' joint efforts at enforcing intellectual property as it prepared to host the BRICS conference in Xiamen, Fujian in September. Please see Ministry of Commerce, "Ministry Of Commerce Holds Press Conference on 2017 BRICS Trade Ministers' Meeting," August 4, 2017, available at english.mofcom.gov.cn. 5 Please see the Office of the United States Trade Representative, "USTR Announces Initiation of Section 301 Investigation of China," August 2017, available at ustr.gov. 6 Other examples of U.S. cooperation with Chinese initiatives include the U.S. sending a small delegation to take part in the One Belt One Road (OBOR) conference in May. 7 In particular, Chairman of the Joint Chiefs of Staff Dunsford visited China, met with the Central Military Commission, and vowed to improve military-to-military relations. 8 Or a country like Ukraine, which agreed to give up its nuclear arsenal as soon as it became independent in 1994, only to see its territory carved up by global powers 20 years later (13 years after it emptied its missile silos). 9 Please see Sidney Leng, "China shifts gear from growth to debt cuts in race against rising tide of red ink," South China Morning Post, July 27, 2017, available at www.scmp.com. Appendix Table 2Will The U.S. Attack North Korea? Insights From The Road - Asia Insights From The Road - Asia Geopolitical Calendar

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

Highlights The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. With U.S. equity valuations stretched, prolonged uncertainty in Northeast Asia may be a catalyst for a pullback. The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lags that of consumer prices. Feature Safe haven assets caught a bid last week while risk assets sold off as investors weighed geopolitical tensions in Northeast Asia and more uncertainty over fiscal policy in Washington. Last week's U.S. economic data highlighted the disconnect between a tighter labor market and a lack of wage pressures. Meanwhile, the data suggest that growth outside the U.S. is accelerating. Nonetheless, history shows that investors should be patient while waiting for an upturn in inflation. Next Up: Tax Cuts The GOP will deliver on tax cuts this year despite disarray at the White House and an incompetent Congress, but fiscal stimulus may fail to live up to its hype. Furthermore, a fiscal lift from infrastructure spending is unlikely anytime soon. Republicans need a win ahead of the 2018 mid-term elections and they have already laid the groundwork for tax reform via the budget reconciliation process. Moreover, cutting taxes is easier to justify politically than removing an entitlement program (i.e. Obamacare). Tax rates probably will not be lowered by as much as originally promised because conservative Republicans in the House will demand "revenue offsets" to pay for tax cuts. Internal GOP battles over how to fund tax cuts could spill over into some tension regarding raising the debt ceiling. However, it is in neither political party's interests to create another "fiscal cliff" out of thin air. The GOP needs Democratic votes to pass this legislation in the Senate and the Democratic leadership has indicated it is willing to support it. At what price? House Minority leader Nancy Pelosi and Senate Minority leader Chuck Schumer may link the debt ceiling and spending bill to tax reform, and push for the tax cuts to extend to the middle class and to be revenue neutral. There is a chance that both parties will agree to temporarily eliminate the debt ceiling, perhaps beyond the 2018 mid-term elections. In any event, we expect a last minute resolution to both the U.S. debt ceiling and the potential government shutdown in September. Thus, there should be no lasting impact on financial markets from the debt ceiling debate. Turning to government regulation, the NFIB survey shows that small businesses are pleased with the Trump administration's attack on red tape. President Trump has made progress on slowing regulation and is on track to enact one-tenth the amount of economically significant regulation1 passed by the Obama administration (Chart 1). By this metric, Trump is even more frugal than Reagan. Trump and the GOP-held Congress have rolled back Obama-era rules and delayed others. Still, regulatory change is slow to impact the economy and it may take years for the regulatory rollback to provide any meaningful lift to growth. Accordingly, the "Trump Put"2 is still in place. U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively (Chart 2). Chart 1Trump Has Had Success In Slowing Regulation Still Waiting For Inflation Still Waiting For Inflation Chart 2The Trump Put The Trump Put The Trump Put Bottom Line: Trump will not be impeached until after the 2018 mid-term election, and only then if the Democrats manage to take control of the House. The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. The intensifying Mueller investigation and White House incompetence will only fuel the "Trump Put", which has been positive for U.S. equities, neutral for Treasuries, and bad for the dollar, all else equal. A significant uptick in inflation could overwhelm the "Trump Put" and spark a dollar rally. As such, investors should focus on inflation prospects rather than on White House politics. Fire And Fury Investors are on high alert and with the Q2 earnings season over, may look beyond the positive news on corporate profits for direction. Our colleagues in the BCA Geopolitical Strategy service have long maintained that Northeast Asia is ripe for economic/political risk.3 The underlying driver of uncertainty on the Korean Peninsula is the Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the U.S. and its allies. The immediate consequence is mounting friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea, are all heating up. North Korea's regime is highly unpredictable as evidenced by events in the past few weeks. In that sense, it is more significant than the other "proxy battles" between the U.S. and China. In essence, North Korea is no longer merely an object of satire. A new round of negotiations over North Korea's nuclear and missile programs is about to begin. The potential for a military conflict is high unless diplomacy succeeds in convincing North Korea to freeze its weapons programs. The events on the Korean peninsula are unfolding as we expected they would. North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty, but not a regime change. The U.S. has forsworn regime change as an intention and China has recommitted to new sanctions. South Korea is pro-engagement. Moreover, we are seeing the U.S. establish a credible military as part of the "arc of diplomacy," comparable to U.S.-Iran relations 2010-15. Bottom Line: We do not expect a pre-emptive strike by the U.S. on North Korea, as the constraints to conflict are extremely high and not all diplomatic options have been exhausted. Nonetheless, with U.S. equity valuations stretched, prolonged uncertainty in the region may be a catalyst for a pullback. A Rosy Global Picture The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Global real GDP estimates continue to move higher, a welcome departure from years past when estimates slid relentlessly lower (Chart 3). Since the start of 2017, global GDP estimates for this year have increased from 2.8% to 3%, while 2018 forecasts have accelerated from 2.7% to 2.9%. This upward trajectory has occurred despite a recalibration by many major central banks away from accommodative policies. Aggressive central bank actions or escalating tensions in Northeast Asia, or both, may halt the improving growth forecasts. Falling oil prices would also challenge a quickening of global growth, but our view is that oil prices will move higher in the coming months.4 Chart 3Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global leading indicators are on the upswing (Chart 4). The BCA Global Leading Indicator Index (excluding the U.S.) in July 2017 was the strongest since 2010 when it slowed after a sharp rebound from the global financial crisis. The increase in growth still has room to run. Admittedly, the LEI's diffusion index has dipped below 50%. It would be a warning sign for global growth if the diffusion index does not soon turn up. Nominal global GDP growth is speeding up, boosted by improving consumer and business confidence, rising capital spending and declining policy uncertainty (Chart 5). The global economic surprise index is also climbing, which provides additional support. Investors may be concerned that the global PMIs have peaked (Chart 6), but they remain at levels consistent with above-trend GDP growth and we see no reason why they should drop below 50. Chart 4LEIs Pointing Higher LEIs Pointing Higher LEIs Pointing Higher Chart 5Supports For Global Growth In Place Supports For Global Growth In Place Supports For Global Growth In Place Chart 6Global Economic Activity Brightening bca.usis_wr_2017_08_14_c6 bca.usis_wr_2017_08_14_c6 Industrial production (IP) overseas is expanding nearly twice as fast as in the U.S. (Chart 5). This suggests that U.S. economic activity will be pulled up by foreign demand. A stronger dollar (as much as a 10% appreciation in the next year) may dampen U.S. exports and earnings, but this will be more a problem for 2018 than 2017. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both U.S. economic growth and profits of U.S. firms with significant business abroad. Solid foreign demand will help the economy hit the Fed's GDP target and also support additional, but gradual, tightening by the central bank. Stay overweight U.S. equities and remain short duration. Waiting For Wages Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Both primary and secondary indicators point to a tighter U.S. labor market. The July jobs report (released in early August) was yet another sign that the slack in the jobs market is vanishing.5 Data released last week on job openings (JOLTS) and the National Federation of Independent Business (NFIB) further supported this trend, and indicated that the labor market may tighten even more. Job openings rose to a new all-time high along with BCA's quit rate less layoffs indicator (Chart 7). The hire rate remained at a cycle peak. The NFIB data was equally impressive, with hiring plans and job openings surging in July. Small businesses are also finding it increasingly difficult to find quality labor. (Chart 7, panel 4) The strength in the labor market has not yet translated into accelerating wages, but patience is required. The July NFIB survey noted that "while a tight job market may point to higher wages and rising consumer spending down the road, which is also good for small businesses, the current expansion efforts by small business owners are being choked by their difficulties in hiring and keeping workers." The NFIB's compensation plans (Chart 7) provided quantitative support for the group's qualitative assessment. However, the latest readings on labor compensation from the Q2 productivity report, the tepid July average hourly earnings data and the Atlanta Fed wage tracker suggest that the labor market is still not tight enough to generate much wage pressure (Chart 8). Chart 7Widespread Evidence That##BR##Labor Market Is Tightening Widespread Evidence That Labor Market Is Tightening Widespread Evidence That Labor Market Is Tightening Chart 8Not Much Wage##BR##Pressure Yet Not Much Wage Pressure Yet Not Much Wage Pressure Yet Inflation And Long-Expansion Dynamics That said, wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lag that of consumer prices. In previous research we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart 9 compares the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart 9). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Inflation pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed slowly. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat. The result was an extended late-cycle phase that was very rewarding for equity investors because the economy and earnings continued to grow. Of course, inflation eventually did turn higher, signaling the beginning of the end for the expansion and equity bull phase. In Chart 10, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth gave no warning that an inflation upturn was imminent. Indeed, wages were a lagging indicator of consumer price inflation. Chart 9Labor Market, Inflation And Stocks##BR##In The Long 80's & 90's Expansions Labor Market, Inflation And Stocks In The Long 80's & 90's Expansions Labor Market, Inflation And Stocks In The Long 80's & 90's Expansions Chart 10In The 80's & 90's Wage Growth##BR##Gave No Early Warning On On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On On Inflation Market commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. Chart 11Leading Indicators Of Inflation##BR##In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries This is not to say that we should totally disregard wage information. But it does suggest that we must keep an eye on a wider set of data. Indicators that provided some leading information for inflation in the previous two long cycles are shown in Chart 11. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart 11 because it does not have enough history. All of these indicators have moved higher over the past 18 months, after bottoming at extremely low levels in 2015 and early 2016. However, they have all pulled back to some extent in recent months. This year's pipeline inflation "soft patch" continued into July, according to last week's release of the Producer Price Index. The easing in cost pressures at the producer level has been broadly based (i.e. one cannot blame special factors). These indicators suggest that consumer price inflation, according to either the CPI or the PCE, will struggle to rise in the next few months. The July CPI report revealed another tepid 0.1% monthly rise in the core price index, while the year-over-year rate remained at 1.7%. Rising prices for health care goods and services were offset by price declines for new and used cars. The diffusion index for the CPI moved up to the zero line in July, indicating that disinflation was a little less broadly based in the month. Bottom Line: Our base case is that core PCE inflation edges higher in the coming months, which will be enough for the FOMC to justify a rate hike in December. We also expect that inflation will be high enough in 2018 for the Fed to hike rates by more than is discounted in the bond market. Nonetheless, the warning signs of an inflation upturn are mixed at best. It would flatter our stocks-over-bonds recommendation if we are wrong on the inflation outlook, but our short duration stance would not be profitable in this case. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Office of Information and Regulatory Affairs (OIRA) of Office of Management and Budget (OMB): https://www.reginfo.gov/public/do/eAgendaMain and https://www.reginfo.gov/public/do/eoCountsSearchInit?action=init 2 Please see Geopolitical Strategy Weekly Report, "How Long Can The Trump Put Last" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Weekly Report, "North Korea: Beyond Satire, dated April 18, 2017, available at gps.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "KSA's Tactics Advance OPEC' 2.0's Agenda," dated August 10, 2017, available at ces.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Stay The Course" dated August 7, 2017, available at usis.bcaresearch.com.

Highlights China's strong second-quarter growth numbers released early this week confirmed the synchronized global growth upturn within the major economies. Our model is predicting an imminent increase in the PBoC's benchmark lending rate. Higher rates in China are reflective rather than restrictive. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. The latest MFWC pledges "re-regulation" of the financial industry and remains committed to developing capital markets. Increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space. Feature The Bank of Canada hiked its policy rate by 25 basis points last week, the second major central bank to tighten after the Federal Reserve in the current cycle. While it is unclear whether central bankers maintain secret communication channels, effectively there appears to be a "coordinated recalibration" of monetary policies among major central banks, due largely to a synchronized growth upturn within the major economies. China's strong second-quarter growth numbers released early this week fit with this broad theme. There are rising odds that the People's Bank of China (PBoC) will join the proverbial global party with rate hikes. In addition, the Chinese authorities have pledged a tougher stance on the financial industry. Reflective Or Restrictive? China's latest data have shown across-the-board strength of late. Most indicators have surprised to the upside, rectifying our positive assessment.1 With the latest growth numbers, our model is predicting an imminent increase in the PBoC's benchmark lending rate (Chart 1). The model follows a modified version of "Taylor's Rule," in which external factors are also considered for open economies. In China's case, both improvement in growth and the Fed's interest rate hikes have played a strong role in setting the stage for higher policy rates in China. The model currently predicts 50 to 75 basis points in rate hikes by the PBoC. Historically, our interest rate model has done a reasonably good job in capturing the major turning points in China's policy rate cycles. This time around, the country's interest rate reforms may have complicated the model's predicting power. In short, the PBoC is in the process of diminishing the importance of the benchmark lending rate, while promoting market-based interest rates. The central bank has theoretically fully liberalized commercial bank interest rates since 2015, and therefore it is unclear whether it will abandon benchmark policy rates, which is viewed as an outdated tool. Instead, the PBoC has been trying to build an interest rate "corridor" in which it uses monetary and liquidity measures to guide market interest rates. The upper band of the interest rate corridor appears to be the interest rates of the PBoC's lending facilities - the cost for financial institutions to borrow from the central bank - while the lower band is the interest rate the PBoC pays on commercial banks' excess reserves (Chart 2). In this vein, the 6-month Medium Term Lending Facilities (MLF) interest rate has already been raised by 20 basis points since late last year, and interbank rates have been guided higher. Chart 1Rising Odds Of PBoC Rate Hikes Rising Odds Of PBoC Rate Hikes Rising Odds Of PBoC Rate Hikes Chart 2Interest Rate Corridor' ##br##Has Been Lifted Higher Interest Rate Corridor' Has Been Lifted Higher Interest Rate Corridor' Has Been Lifted Higher Chart 3Bank Loan Rate Is On The Rise Bank Loan Rate Is On The Rise Bank Loan Rate Is On The Rise Nonetheless, the upturn in our interest rate model justifies higher rates engineered by the PBoC. Regardless of whether the PBoC explicitly raises its policy lending rate, interest rates in China have already moved higher (Chart 3). Tighter liquidity and higher bond yields since late 2016 suggest that average bank lending rates should have increased by probably 50 basis points in recent months. Higher rates in China are a reflection of stronger growth rather than policy tightening to tame business activity, at least for now. After all, China's nominal GDP growth has rebounded from 6.4% in late 2015 to 11.1% in the second quarter of 2017 - a sharp turnaround in nominal business activity that calls for higher interest rates. Similarly, recent hawkish - or less dovish - rhetoric from other central banks all reflect improving growth where "emergency" levels of monetary accommodation are no longer needed (Chart 4). With the exception of Japan, BCA Central Bank Monitors, which measure pressure on central bankers to raise or reduce interest rates, have mostly climbed above zero of late, underscoring the need for tighter money among most developed countries. By the same token, it is premature to conclude that any policy tightening by the PBoC will lead to major growth problems in China. Chart 4Emergency' Levels Of Accommodation No Longer Needed Emergency' Levels Of Accommodation No Longer Needed Emergency' Levels Of Accommodation No Longer Needed Where does the RMB fit in? The PBoC's tightening bias suggests there is less incentive to target a lower exchange rate, both against the dollar and in trade-weighted terms. The central bank will continue to intervene to smooth out volatility. From investors' perspectives, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction: we doubt there is meaningful upside in the RMB against the dollar in the near term, but the odds of significant RMB/USD depreciation have been further reduced. In other words, the RMB/USD exchange rate is still largely dominated by broader dollar performance, and the RMB is not a "high beta" currency to play the dollar. In short, we maintain our positive view on China's growth outlook, as discussed in greater detail in last week's bulletin. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. Financial Reforms And Markets As growth has mostly surprised to the upside, policymakers' focus appears to have shifted to controlling financial risks, as highlighted by the key messages from the 5th National Financial Work Conference (NFWC) this past weekend. The NFWC convenes twice a decade, and usually sets the policy tone for the following years. Compared with the previous meeting five years ago that featured "deepening reforms and promoting development" as the key theme of the financial industry, the current session clearly strikes a more conservative tone. Top leadership declared that the financial sector must serve the needs of the "real economy," and that preventing systemic financial risks is the government's "eternal theme." Importantly, a cabinet level committee has been established to coordinate regulatory oversight on the financial industry - a task currently shared between the central bank and three regulators. The overall message from the latest NFWC is consistent with the regulatory crackdown on financial excesses since late last year.2 Overall, we share policymakers' sentiment that China's financial sector deregulation in recent years has gone too far.3 The dramatic leverage-fueled equity market boom-bust cycle in 2015 offered a crude awakening to the authorities against imprudent financial deregulation. Meanwhile, reform measures also ushered in a proliferation of institutions that prolonged financial intermediation channels. Without proper regulatory coordination, the authorities' attempts to reduce excesses has typically pushed speculative activity off the books of financial institutions, making it even more difficult to monitor and regulate. In fact, regulations on the financial sector have already been tightened of late. Derivatives, internet-based financing firms and asset-backed securities have all been put under much tighter regulatory scrutiny. The macro-prudential assessment (MPA) on financial institutions has been adopted since earlier this year - the latest MFWC suggests that "re-regulation" of the financial industry will continue in the coming years. The long-term impact of tighter control over the financial sector on the economy and financial markets remains to be seen. On one hand, imprudent financial deregulation and prolonged financial intermediation channels have done little to address the financing needs of small private enterprises, but have amplified risks and raised funding costs for the overall corporate sector - a suboptimal outcome that needs to be corrected. On the other hand, China's vast domestic savings need to be properly intermediated to the economy. We have long held the view that so long as the banking sector and debt instruments play the dominant role in financial intermediation, the accumulation of debt in the overall economy is all but inevitable.4 In this vein, any attempt to block financial intermediation aimed at "deleveraging" will prove both ineffective and counterproductive, with unintended consequences. An easier bet is that the authorities will remain committed to developing capital markets, both equities and corporate bonds, to provide alternative funding sources for the corporate sector. Procedures for initial public offerings (IPOs) and debt issuances will be simplified. The share of debt and equities in total social financing will continue to grow from a structural point of view (Chart 5). From investors' perspective, increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space, where multiples are unsustainably high and will continue to be de-rated (Chart 6). There are certainly some compelling growth stories among small caps that are worth cherry-picking, but overall investors should remain cautious for this asset class. Chart 5Debt And Equity Issuance##br## On A Structural Uptrend Debt And Equity Issuance On A Structural Uptrend Debt And Equity Issuance On A Structural Uptrend Chart 6Domestic Small Caps##br## Will Continue To Derate Domestic Small Caps Will Continue To Derate Domestic Small Caps Will Continue To Derate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China Outlook: A Mid-Year Revisit," dated July 13, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Legacies Of 2015," dated December 16, 2015, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit 18% later this year before moderating in 2018. Are the NIPA and S&P profit measures sending different signals? Business capital spending remains in an uptrend despite businesses' reluctance to spend ahead of changes in corporate tax policy. The commercial real estate sector (CRE) is beginning to show early signs of stress. Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. Feature Q2 Earnings Season Is Here Chart 1Strong Earnings Growth##BR##In 2017 Will Support Equities Strong Earnings Growth In 2017 Will Support Equities Strong Earnings Growth In 2017 Will Support Equities The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 1). The consensus is anticipating an 8% year-over-year increase in EPS in Q2 2017 versus Q2 2016, and 11% for 2017. Energy, technology, and financials, all are forecast to lead the way in earnings growth in Q2, but utilities and telecom will be the laggards. The favorable profit picture for Q2 and the rest of the year reflects the rebound in oil prices, which are expected to boost energy sector EPS by 671%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. The focus in Q2 for investors and corporate executives will be on the improving economic conditions in Europe and EM, the U.S. dollar and the sustainability of margins. Guidance from CEOs and CFOs on trends in 2H 2017 and beyond are more important than the actual Q2 results. Note that guidance can be tracked using Chart 2. Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 22017 EPS Estimates Rebounding And 2018 Stable 2017 EPS Estimates Rebounding And 2018 Stable 2017 EPS Estimates Rebounding And 2018 Stable In Q2, firms with high overseas sales should benefit from the improved growth profile in Europe and Japan. Global GDP growth projections for this year and next have steadily escalated, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. On the other hand, the U.S. dollar should be a modest drag on earnings in Q2; the dollar is up 2% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (May 31) mentions of a "strong dollar" were unchanged compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Our view is that the dollar will appreciate by another 10%. This appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur in 2018 due to lagged effects. Another upleg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Investors are skeptical that margins can advance for the fourth consecutive quarter in Q2. Our view is that we are in a temporary sweet spot for margins and that should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. Bottom Line: Look for another solid performance for earnings and margins in Q2 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, investors should position their portfolios for decelerating earnings and compressed profit margins in 2018. Will The Real Profit Margin Stand Up While the markets focus on Q2 earnings, margins and corporate guidance for the next month or so, we take a broader view. For some time we have highlighted the importance of the mini-cycle in U.S. earnings growth; the corporate sector is in a catch-up phase following last year's profit recession, a trend that extends beyond the energy patch. EPS growth has surged this year on the back of slightly stronger sales and rising S&P 500 margins. The National Accounts (NIPA) data, on the other hand, paint a different picture. Earnings growth for the entire corporate sector fell sharply in the first quarter and margins continued to slide. If the NIPA data are telling the true story, then the equity market is in trouble because it suggests that the earnings outlook is much weaker than what is discounted in stock prices. There are many definitional differences that make it difficult to reconcile the NIPA and S&P data.1 Nonetheless, we can make some general observations. Chart 3 presents the four-quarter growth rate of NIPA profits2 and a proxy for aggregate S&P earnings. For the latter, we multiplied earnings-per-share by the divisor to obtain an estimate of the level of aggregate earnings in dollar terms (i.e. not on a per-share basis). The bottom panel of Chart 3 compares the level of profits, each indexed to be 100 in 2011 Q1. The charts highlight that while there have been marked differences in annual growth rates between the two measures, the levels were close to the same point in the first quarter of 2017. The dip in NIPA profit growth in Q1 was not reflected in the S&P measure. It appears that this is partly due to different profiles for profit growth in the energy and financials sectors. However, it does not appear that the difference in margins is linked to a significant divergence in aggregate profits. Most of the margin divergence is related to the denominator of the calculation (Chart 4). The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. We believe that the S&P data are painting a more accurate picture because sales are straight forward to measure, while value-added is complicated to construct. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P data are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop remains positive for stocks for now. The same is true in the Eurozone and Japan, where margins are also rising. It is worrying that a much of this year's advance in U.S. equity markets has been concentrated in only a few stocks, but that belies the breadth of the profit recovery (Chart 5). The proportion of S&P industry groups with rising earnings estimates is 75%, reflecting broad-based upgrades. Chart 3S&P And NIPA##BR##Profit Comparison S&P And NIPA Profit Comparison S&P And NIPA Profit Comparison Chart 4Denominator Explains##BR##S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Chart 5Positive Earnings Revisions##BR##Are Broadly Based Positive Earnings Revisions Are Broadly Based Positive Earnings Revisions Are Broadly Based Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates. Bottom Line: The solid earnings backdrop is why we remain overweight stocks versus bonds and cash. Stay extra vigilant for warning signs of a bear market in view of the poor valuations. Valuation has never been good leading indicator for bear markets, but it may provide information on the risks. Capital Spending Check Up Business capital spending remains in an uptrend. Investors are concerned that the below expectations readings on capex in recent months may be the start of a new trend for a significant part of the economy. We look at it another way. Managements are postponing investment decisions until they get more clarity on federal tax policy. In short, corporations are struggling with how much and when spend, rather than whether to invest at all. The key supports for sustained corporate spending remain despite the tepid May durable goods report. C&I loan growth has ticked back up and our model (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to move higher on a 12-month basis (Chart 6). Our research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were soft (+1.1% annualized gain) in Q1, household spending in Q2 accelerated and is on track to post 3%+ growth. We expect household spending to continue to improve in the second half of 2017.3 Moreover, the recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite the recent monthly wiggles in the data (Chart 7). Chart 6Model Points To##BR##Further Improvement Model Points To Further Improvement Model Points To Further Improvement Chart 7Capital Spending##BR##Remains In An Uptrend Capital Spending Remains In An Uptrend Capital Spending Remains In An Uptrend CEO confidence recently soared to a 13-year high in Q1, adding to the positive backdrop for capex. The last reading on this survey was taken in the first quarter of 2017 when managements eagerly anticipated that business-friendly legislation was pending. The next survey (due in mid-July) may show a bit more restraint from CEOs given the lack of legislative progress in Washington (Chart 7, top panel). Bottom Line: The fundamentals supporting solid business spending remain in place. However, our positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending. Stressing The Commercial Real Estate Market The commercial real estate sector (CRE) is beginning to show early signs of stress. The recent softening in CRE does not suggest that recession is imminent, but investors should understand whether a sustained drop in CRE prices poses a risk to the global financial system. At best, business spending on construction is coincident with the overall economy, but most often lags due to long lead times required on projects (Chart 8). Chart 8Commercial Real Estate Lags Commercial Real Estate Lags Commercial Real Estate Lags Our colleagues in the Global Investment Strategy service4 highlighted the risks to the CRE market, noting that CRE-related debt is rising, prices have surpassed pre-recessionary levels, vacancy rates outside of the industrial sector are bottoming, and rent growth is losing steam (Chart 9). Likewise, we share Boston Fed President Rosengren's5 concern that if CRE's recent tailwinds (muted inflation, low financing rates, declining unemployment rate, robust economic growth in the U.S. relative to overseas developed economies, and favorable demographics) turn to headwinds, then the impact on the market and the wider economy may have a disproportionate impact on CRE. The BCA Beige Book Real Estate Monitor corroborates a softening in recent quarters. The monitor takes the real estate (both commercial and residential) comments from each Beige Book and uses the approach outlined in our April 17 publication6 (Chart 10). Chart 9Commercial Real Estate##BR##Indicators Softening Commercial Real Estate Indicators Softening Commercial Real Estate Indicators Softening Chart 10Introducing The##BR##Beige Book CRE Monitor Introducing The Beige Book CRE Monitor Introducing The Beige Book CRE Monitor Stretched CRE valuations may exacerbate any price declines in CRE if the markets sense that the tide is turning. Falling prices may lead to a drop in the value of collateral-backing CRE loans, which in turn, could cause lenders to restrict credit in the sector and spark an additional downturn in prices. Moreover, Table 1 highlights the risk that GSE reform may cause two large holders of CRE debt to begin to curtail lending. Small banks have more absolute exposure to CRE loans than large banks, according to the table, and overall, banks' share of CRE lending (53%) is nearly four times as high as GSE's exposure. Table 1Holders Of Commercial Real Estate Loans Summer Stress Out Summer Stress Out CRE's risks are evident in the latest round of bank CCAR stress tests. The Fed modeled a 15% drop in CRE prices through Q4 2018 in its "adverse" scenario and a 35% drop in the same period in its "severely adverse" scenario. The Fed7 found that under these scenarios, common equity Tier 1 capital ratio at the participating firms would drop from 12.5% (Q4 2016) to 9.2% and 7.2% respectively by Q1 2019. Bottom Line: Commercial real estate has benefitted from a Fed-led tailwind since the end of the 2007-2009 recession. That said, some of the tailwinds are turning to headwinds and investors should be prepared for a reversal in this sector sometime in the second half of 2018 as economic and earnings growth slows, which could set the stage for a recession in 2019. That said, it is a positive sign for the economy that the commercial real estate sector is one of the few areas showing any signs of stress, implying that the conditions for a recession in the next 6 to 12 months remain low. Is Dodd-Frank Dead? The Republicans' Financial CHOICE Act, which would roll back key aspects of the landmark Dodd-Frank Wall Street reform, has hurdles to overcome before its passage through the U.S. Senate. Two of BCA's publications have examined the impact on consumers, investors and financial markets. BCA's Geopolitical Strategy8 service noted that Republicans want to overturn Dodd-Frank to increase the financial sector's profits, credit growth, economic growth and animal spirits. A repeal would also satisfy the Republicans' ideological goal to reduce state involvement, which grew due to the law. Also, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over 10 years, in line with the GOP's political bent. The CHOICE Act would create an "escape hatch" to allow banks to maintain a capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. The intent is to boost lending, earnings and growth. According to the Geopolitical Strategy, if the bill becomes law, U.S. banks comprising an estimated $1.5 trillion in assets would become less restricted and eligible to adopt riskier trading practices. The greatest impact will be in areas with a higher concentration of small community banks and credit unions. These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio (Chart 11). Chart 11Banks With $1.5 Trillion Could Gain Risk Appetite Summer Stress Out Summer Stress Out Other aspects of the bill would: Repeal the FDIC's liquidation fund: The private sector would take over responsibility for managing liquidations. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: The Government Accountability Office (GAO) would audit the Fed's board of governors and regional banks, including their handling of monetary policy. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. Cut penalties for violating regulations. Chart 12Small Banks Benefit##BR##From Bank Deregulation Small Banks Benefit From Bank Deregulation Small Banks Benefit From Bank Deregulation Investors could capitalize on financial sector reform by favoring small U.S. bank equities over large bank stocks. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to subsequently fall back, has recently perked up (Chart 12). Relative earnings have been flat in the same period. If Dodd-Frank is partially watered down, then these banks should see earnings improve, and drive up their share prices. BCA's U.S. Equity Strategy is positive on global bank equities. In particular, U.S. banks have better fundamentals than their counterparts in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates. BCA's Fiscal Note Financial Sector Index suggests that the flow of legislative and regulatory proposals is becoming less onerous on the financial sector. Chart 13 is an aggregation of the favorability scores, which assess whether the bill would be favorable to the financial sector. It provides a snapshot of the regulatory environment for the financial sector at any point. Chart 13Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked on to the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The post-election rally for bank stocks is mostly over. Investors have an opportunity to favor small banks versus large ones. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 The first problem is that the S&P data are expressed on a per-share basis. Moreover, the NIPA data adjusts for inventory and depreciation allowance. S&P margins are calculated using sales in the denominator, while we generally use GDP as the denominator for calculating NIPA profits. 2 The NIPA data shown include financials and profits earned overseas, as is the case for the S&P. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot", June 19, 2017, available at usis.bcaresearch.com. 4 Please see BCA's Global Investment Strategy Weekly Report "The Timing Of The Next Recession," published June 16, 2017, available at gis.bcaresearch.com. 5 "Trends In Commercial Real Estate", Eric S. Rosengren, at Risk Management for Commercial Real Estate Financial Markets Conference, NYU Stern School of Business, May 9, 2017. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published April 17, 2017, available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/publications/files/2017-ccar-assessment-framework-results-20170628.pdf 8 Please see BCA's Geopolitical Strategy Weekly Report "How Long Can The "Trump Put" Last?," published June 14, 2017, available at gps.bcaresearch.com.

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

Feature EM risk assets refuse to sell off - regardless of new information and developments that historically would have caused these markets to tumble. Indeed, political turmoil and changes in Brazil and South Africa - two high-beta EM markets - have so far had limited impact on flows and market dynamics. Moreover, while our Reflation Confirming Indicator has rolled over, EM share prices have not reacted at all (Chart I-1). EM stocks have also decoupled with the equal-weighted average of global mining and energy equity indexes (Chart I-2). Chart 1Reflation Confirming Indicator And ##br##EM Stocks Reflation Confirming Indicator And EM Stocks Reflation Confirming Indicator And EM Stocks Chart 2Commodities Share Prices And ##br##EM Equities: Unsustainable Divergence Commodities Share Prices And EM Equities: Unsustainable Divergence Commodities Share Prices And EM Equities: Unsustainable Divergence We do not subscribe to the thesis that EM assets have permanently decoupled from both commodities and their domestic credit cycles, and that tried and tested indicators no longer work. Technology and social media share prices have been instrumental to this latest decoupling, as we wrote in last week's report.1 This group of stocks is in a full-blown mania phase, and it is hard to know when this will end. Yet, exponential price moves always occur at the end of a bull market, and are typically followed by bear markets. As we elaborated in last week's report, the investment call on social media and internet stocks is a bottom-up - not macro - call. Top-down analysis can add some value on the semiconductor cycle, and we suggested last week that it is likely topping out. This week new data releases support the thesis that Asian/global trade in general and the semiconductor cycle in particular are already decelerating. Korean exports data for the first 20 days of May, Japanese preliminary manufacturing PMI for May, and Taiwanese manufacturing output volume growth for April have all decelerated (Chart I-3). Finally, one technical piece of evidence that this rally is late is relative weakness in the equal-weighted MSCI equity indexes. In the EM space, the equally-weighted individual stock index has fared poorly against the EM market cap-weighted index since May 2016 (Chart I-4, top panel). In the U.S., the same measure of market breadth has deteriorated since December 2016 (Chart I-4, bottom panel). Chart 3Asia's Manufacturing Growth ##br##Is Already Decelerating Asia's Manufacturing Growth Is Already Decelerating Asia's Manufacturing Growth Is Already Decelerating Chart 4The EM And U.S. Equity Rally ##br##Has Been Driven By Large-Cap Stocks The EM And U.S. Equity Rally Has Been Driven By Large-Cap Stocks The EM And U.S. Equity Rally Has Been Driven By Large-Cap Stocks Bottom Line: EM financial markets are in the midst of irrational exuberance. The rally is late, but it is impossible to time the top. The forthcoming selloff will be large and protracted. Beware Of China's Budding Growth Slump Interest rates have risen in China sufficiently enough to cause a major growth slowdown in the mainland economy (Chart I-5). Liquidity tightening amid a lingering credit bubble could not be a more dangerous combination. In this context, financial markets are extremely complacent on EM/China plays. China's liquidity tightening continues, and is bound to create a decisive growth relapse in the months ahead, as well as dampen exports in countries that sell to China (Chart I-6). Chart 5China Growth To Slump China Growth To Slump China Growth To Slump Chart 6Exports To China To Slump Exports To China To Slump Exports To China To Slump Not only is the People's Bank of China (PBoC) guiding interest rates higher, but there is an ongoing regulatory crackdown on the financial system. Regulators are forcing banks to bring Wealth Management Products (WMPs) and other off-balance-sheet items onto their balance sheets. As a result, banks' capital adequacy and risk matrixes will deteriorate, and they will be forced to slow down credit creation. Chart 7EM Share Prices Ex. Tech Have Not Broken Out EM Share Prices Ex. Tech Have Not Broken Out EM Share Prices Ex. Tech Have Not Broken Out Remarkably, policymakers are determined to get things under control. According to The Wall Street Journal,2 key policymakers have issued strongly worded statements. "Strong medicine must be prescribed," said Guo Shuqing, chairman of the China Banking Regulatory Commission (CRBC), according to people familiar with the matter. "If the banking industry gets into a mess," he added, "I will resign." He was appointed as the head of the CRBC last October, and likely has a mandate from the President to tackle speculative excesses in the financial system. In its first quarter Monetary Policy Implementation Report,3 the PBoC repeatedly used the phrase "preventing bubbles." Besides, in his statements, the chairman of the PBoC has frequently emphasized the need to normalize credit growth and curb speculative activities. The former head of the insurance regulator, who has been "accommodating" and "tolerant" of risky activities by insurance companies, was jailed last fall for corruption. These are strong indications confirming that policymakers are determined to curb speculative financial activities. Provided how entrenched and large various speculative financial schemes and the credit bubble have become in China, it will be impossible to tackle speculative excesses without a slowdown in overall credit growth and associated harm to the real economy. This is not to say that policymakers are tightening with intentions to cause a growth collapse. Policymakers in all countries always tighten to cap inflation or credit excesses or normalize interest rates - i.e., they never tighten to cause a major shock to the real economy. This applies to Chinese policymakers at the moment, especially ahead of the party Congress later this year. That said, when the existing imbalances in the economy or financial system are sufficiently large, even minor tightening can cause a financial accident or growth relapse. It is not within policymakers' powers to predict or prevent it. They may alter their policy after the fact, but markets will sell off considerably beforehand. We do not know exactly how financial dynamics in China will evolve in the months ahead, but we are certain that the market consensus is too complacent and that EM asset prices are at major risk. Bottom Line: It is impossible to predict financial accidents (stress among specific institutions) but we are certain that China's credit growth and, consequently, capital spending are bound to slow considerably in the coming months. This bodes ill for producers of commodities and industrial goods both within and outside China. Accordingly, EM risk assets will suffer the most. As a final note, EM ex-technology share prices have not yet broken out and we do expect them to relapse from the current levels (Chart I-7). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?," dated May 17, 2017, link available at ems.bcaresearch.com. 2 Lingling Wei and Chao Deng, "China's War on Debt Causes Stocks to Drop, Bond Yields to Shoot Up and Defaults to Rise," May 5, 2017, The Wall Street Journal. 3 Please refer to http://www.pbc.gov.cn/zhengcehuobisi/125207/125227/125957/3307990/3307409/index.html (In Chinese only). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Brazilian President Michel Temer has been accused of crimes much worse than what got his predecessor impeached; Further instability is likely, with low probability that Temer's impeachment would restart reforms; Only a technocratic government, or brand new election, could produce a market-friendly outcome. Odds are that Brazil's public debt load will continue to escalate, and that in two years or so the debt-to-GDP ratio will spiral out of control. Without structural reforms and higher commodities prices, Brazilian financial markets are looking into the abyss. Stay put on Brazilian financial markets. Feature Investors cheered the impeachment of Brazil's President Dilma Rousseff, bidding up Brazilian assets for over a year despite the challenging macroeconomic context. BCA's Emerging Markets Strategy and Geopolitical Strategy services have repeatedly cautioned investors not to buy the hype. Brazil was already "priced for political perfection" on May 12, 2016 when Rousseff was removed from office to face trial by the senate over fiscal accounting irregularities.1 And yet, the political context has been far from perfect. As we wrote last May: "It is highly unlikely that the political dysfunction within Brazil's political class will end with a Temer administration, at least not anytime soon." The latest corruption revelations have directly implicated acting president Michel Temer of the Brazilian Democratic Movement Party (PMDB) as well as Senator Aecio Neves, the leader of centrist and investor-friendly Brazilian Social Democratic Party (PSDB) and a key Temer ally in Congress. The market has placed a massive bullish bet in the abilities of the tentative Temer-Neves (PMDB-PSDB) entente cordiale to push through largely unpopular fiscal reforms through Congress. These reforms, none of which have passed yet (!), are now likely to stall until either an early election is called (best case scenario) or until the current government's mandate expires in October 2018. We have expected Brazil's political rally to dissipate. As we argued in 2016, without a new election, the interim government has no mandate for painful structural reforms. We are sticking to this view today. What Is Going On In Brazil? According to revelations in the Brazilian press, President Temer was caught in an audio recording asking the chairman of JBS Group - the world's largest meatpacker - to continue making payments to the former President of the Chamber of Deputies Eduardo Cunha, who was jailed for corruption in 2016. Cunha, a former Temer ally and member of PMDB, was indicted in the large scale "Operation Car Wash" corruption scandal involving the state-owned oil company Petrobras. The payments by JBS were allegedly meant to ensure that Cunha did not spill the beans on his co-conspirators. Cunha had previously disclosed that he possessed compromising information about several senior politicians linked to the Petrobras scandal. JBS Chairman Joesley Batista, himself under investigation, recorded a conversation with Temer on March 7 as part of his plea bargain negotiations with law enforcement officials. According to press reports, Temer asked Batista to continue payments to ensure Cunha's silence. As part of the same investigation, Senator Aecio Neves - the darling of the Brazilian investment community who narrowly lost the presidential election to Rousseff in 2014 - was filmed soliciting two million reals ($638,000) from Batista. This is not his first brush with the law, Neves was also under corruption investigation when he was the governor of the state of Minas Gerais. Neves's apartment has since been raided by the police as the corruption probe against Brazilian politicians reaches a fever pitch. How serious are the charges against the Temer and his ruling coalition? They are deadly serious. As an aside, we have been puzzled that investors have never posed the following question: how was it possible that the entire political and especially congressional system is so corrupt but Temer - the long-serving head of the largest party in the congress and one of the most shrewd politicians in Brazil - has not been involved in this corruption scheme. President Dilma Rousseff, former leader of the left-wing Workers Party (PT) and successor to President Inácio "Lula" da Silva, was impeached and removed from power for a lot less. There was never any actual evidence that Rousseff was personally involved in Operation Car Wash, at least at the time of her impeachment. In fact, the strongest legal case against Rousseff was that she failed to uphold the so-called Fiscal Responsibility Law. Essentially, Rousseff was impeached and removed from power because she stimulated the economy for political gain. A charge that practically every president in Brazil's history has been guilty of (if not every leader in the world!). Temer and Neves are accused of much greater crimes. If the reporting of the Brazilian press is accurate, Neves personally profited and continues to profit from Operation Car Wash. And Temer is then directly involved, to this day, in obstruction of justice and witness intimidation. These are not crimes by association or mere technicalities resulting from politically charged fiscal profligacy. Rather, they are serious crimes that could end with lengthy jail terms, let alone removal from power. Rousseff claimed that her removal from power was a coup d'état. She was correct to characterize it as such. Unlike in the U.S., where a president removed from power is replaced with the vice president from the same party, in Brazil vice presidents are often appointed from a coalition partner. As such, Vice President Temer replaced Rousseff and proceeded to alter Brazilian policy in a dramatic fashion. He abandoned the PMDB legislative alliance with left-wing PT, turned to the centrist PSDB for votes in Congress and proceeded to enact orthodox, conservative, supply-side reforms. While these are absolutely the reforms that Brazil needs, we never accepted the view that they are reforms that Brazilians want. In fact, Rousseff won the 2014 election against Neves, with Temer as her running mate, by campaigning on a populist platform against precisely these types of supply-side reforms. Bottom Line: We hate to tell our clients "we told you so," but Temer's 180-degree turn in policy was never going to work. Not without an election that bolsters his political mandate to enact painful structural reforms. We also cautioned our clients that corruption in Brazilian Congress was endemic and severe and would therefore not magically disappear with Rousseff's removal from power. As such, "impeachment was no panacea,"2 especially not when many members of Congress voting against Dilma were under investigation for corruption themselves! The high level of corruption is not because of a moral failing particular to Brazilian mentality. Rather, corruption is a feature of Brazil's fractured and regionalized politics that depend on side-payments and pork barreling to grease the wheels of legislative process. Rousseff's crimes appear paltry when compared to the (yet unproven) allegations against Temer and Neves. J-Curve Of Structural Reforms Amidst the 2016 political crisis, we argued that the only positive outcome for Brazilian politics and markets in the long-term would be a new election (Figure I-1).3 Why? Because we understood how painful fiscal reforms would have to be to deal with Brazil's disastrous fiscal position (Chart I-1). Without a new election, the interim Temer administration would not have the political capital to enact painful reforms. Figure I-1Brazil: Our Take On Possible Political Scenarios ##br##Before Former President Rousseff Was Impeached Brazil: Politics Giveth And Politics Taketh Away Brazil: Politics Giveth And Politics Taketh Away Chart I-1Brazil's Fiscal Position Brazil's Fiscal Position Brazil's Fiscal Position The market has disagreed with us for a full year now. However, the rally based on political hopes was always unsustainable. First, investors have misunderstood the nature of political corruption in Brazilian politics and just how intrinsic the problem has been. In retrospect, Rousseff may have been the least corrupt major politician in Brazil! Second, investors have ignored the message of our J-Curve of structural reforms (Diagram I-1). Diagram I-1Structural Reforms Are Painful: ##br##Stylized Representation Brazil: Politics Giveth And Politics Taketh Away Brazil: Politics Giveth And Politics Taketh Away Reform is always and everywhere painful, otherwise it would be the form. Every government pursuing reforms has to get through the "danger zone" on our J-curve of structural reform. As reforms are passed and enacted, they begin to "bite." This is when the protests against reforms mount and the government loses its political capital. If the policymakers in charge of the reform effort are already starting with low political capital - as the Temer and his congressional coalition most certainly did in August 2016 - than the "danger zone" is essentially insurmountable. We have disagreed with the market as it has confused Rousseff's removal from power with widespread support for reforms that amount to economic austerity. As we often repeated in client meetings, "a vote for impeachment is not a vote for austerity." With general election only roughly one year away in October 2018, we doubted that the Temer administration would have the political capital to push through such reforms. After all, every government wants to be reelected and pursuing painful reforms ahead of the elections is not feasible election winning strategy. What has the Temer coalition managed to do thus far? It must have done a lot, given the positive market performance over the past 12 months? False. The market has rallied despite remarkably shoddy evidence of actual reforms. As we predicted in our analyses throughout 2016, the post-Rousseff Brazilian policymakers have been dogged by lack of political capital. Out of five major reform efforts, only two have passed - oil-auction legislation (Production Sharing Agreement Bill) and a fiscal-spending cap. We do not wish to claim that the latter is insignificant but as we discuss below they are insufficient to stabilize Brazil's public debt load. The main three reform efforts that would have significant long-term effect on Brazil's fiscal sustainability - social security reform, labor reform, and tax reform - have stalled and are now likely to fail (Table I-1). Table I-1President Temer's Proposed Structural Reforms & Their Status Brazil: Politics Giveth And Politics Taketh Away Brazil: Politics Giveth And Politics Taketh Away Brazilian Senator Ricardo Ferraço, of the centrist PSDB, in charge of drafting the labor reform report for the Senate, has already canceled the work on the proposal. Ferraço issued a statement that said, "the institutional crisis we are facing is devastating and we need to prioritize finding a solution. Everything else is secondary now." This is a major blow against labor reforms, which already passed the lower house in April. We suspect that it will largely be impossible to restart and, more importantly, pass the reforms without an election that gives a new government a political mandate. Alternatively, a technocratic government led by technocrats without political ambitions, could try to enact reforms until the next election. Without a new election or a technocratic government, members of centrist PSDB and center-left PMDB will start to distance themselves from the allegedly corrupt Temer administration. It makes no political sense for Congressmen like Ferraço to sacrifice their own political capital on the cross of austerity just a year from the start of the electoral campaign in the summer of 2018. Bottom Line: The results made clear by Figure I-1 are not surprising and were eminently forecastable. However, the market ignored the structural realities of Brazilian politics, as well as the theoretical foundation of successful structural reforms, and charged ahead regardless. Without fiscal reforms outlined in Table I-1, however, Brazil will likely end up in a debt trap very soon. A Perilous Fiscal Situation Brazil's fiscal position and public debt remain on an unsustainable trajectory. In fact, there has been limited fiscal improvement compared to what financial markets have priced in. In particular: The constitutional amendment by Brazilian President Michel Temer's government that introduced a cap on government spending was a dilution of the Fiscal Responsibility Law adopted in 2000 which stipulated that the government had to run primary fiscal surpluses. Capping government expenditure growth to the inflation rate de facto represents a relaxation of structural fiscal policy. Under the new fiscal rules, the government is targeting not the primary fiscal deficit (and, by extension, public debt), but only government expenditures. This implies that in a case where government revenues fall short of projections, the government is not obliged to rein in spending. On the whole, Temer's government has relaxed rather than tightened structural fiscal rules. While this makes sense because the economy is in a depression and needs fiscal relief, it has been bad news for government creditors. As a final point, the former President Dilma Rousseff was impeached for violating this exact same law that the current government has now relaxed. The fiscal balance has stabilized around 9% of GDP in the past year, but this has been due to one-off temporary measures. With nominal GDP growth at around 5%, the bulk of the 16% rise in collected income taxes from a year ago came from one-off measures such as the repayment of funds by the Brazilian Development Bank (BNDES) to the government, taxes on foreign asset repatriation and other temporary actions (Chart I-2). In short, Temer's government has resorted to one-off measures to improve the country's fiscal position. Unless the economy and tax collection recover strongly in the next 12 months, Brazil's fiscal position will worsen substantially, and public debt servicing will become unsustainable. Furthermore, the federal government's transfers to states have surged as the latter are facing their own fiscal crises due to revenue shortfalls. Local governments are reluctant to curb spending amid the ongoing depression, and will continue to pressure the federal government for more transfers. This will worsen public debt dynamics. Importantly, the social security deficit, presently at 2.4% of GDP, will continue to escalate without meaningful reforms (Chart I-3). According to IMF estimates,4 the social security deficit will reach 14% of GDP by 2021 if no reforms are implemented. This is assuming robust economic recovery this year and solid growth in the years ahead. Given social security reforms are unlikely to occur and economic growth will continue to underwhelm amid heightened political uncertainty, odds are that the impact of the social security deficit on the public debt dynamics will be worse than the IMF projections suggest. Moreover, the gap between local currency interest rates and nominal GDP growth remains extremely wide (Chart I-4). To offset this, the government has to run primary surpluses. The primary deficit is currently 2.3% of GDP. Chart I-2Income Tax Collection Has Been ##br##Boosted By One-Off Measures Income Tax Collection Has Been Boosted By One-Off Measures Income Tax Collection Has Been Boosted By One-Off Measures Chart I-3Brazil's Social Security System ##br##Is On Unsustainable Track Brazil's Social Security System Is On Unsustainable Track Brazil's Social Security System Is On Unsustainable Track Chart I-4An Untenable Gap An Untenable Gap An Untenable Gap That said, tightening fiscal policy amid the ongoing economic depression is politically suicidal. Finally, our public debt simulation suggests that unless economic growth recovers strongly, Brazil's public debt-to-GDP ratio will rise above 90% of GDP by the end of 2019 - in both our baseline and most pessimistic scenarios. Notably, our baseline scenario assumes nominal GDP growth of 5.5% in 2017, and 7% in both 2018 and 2019 (Table I-2). These are not bearish assumptions, but and could prove optimistic given the escalating political crisis. This debt simulation assumes that interest rates will stay above 10%, but it also assumes no bailout for public banks and state-owned companies, or a rise in transfers to state governments. Table I-2Brazil: Public Debt Sustainability Scenarios 2017-2019 Brazil: Politics Giveth And Politics Taketh Away Brazil: Politics Giveth And Politics Taketh Away Bottom Line: Odds are that Brazil's public debt load will continue to escalate, and that in two years or so the debt-to-GDP ratio will spiral out of control. The Economy, Corporate Profits And Markets There has been no recovery in either the economy or corporate profits (excluding commodities companies). Brazilian share prices have rallied massively in the past 17 months, yet profits in companies leveraged to the domestic business cycle have continued to shrink. Specifically, EPS for consumer staples companies and banks have dropped a lot in local currency terms, despite the equity market rally (Chart I-5). It is normal that share prices lead profits by six to 12 months, but the current rally in Brazil is already 16 months old. In short, the discrepancy between share prices and EPS is unprecedented and unsustainable. Ongoing profit weakness is consistent with a lack of recovery in domestic demand, which is corroborated by the macro data: retail sales volumes, manufacturing production and capital goods imports have not grown at all; their pace of contraction has simply moderated (Chart I-6). Chart I-5No Recovery In Corporate Profits ##br##In Non-Commodities Sectors No Recovery In Corporate Profits In Non-Commodities Sectors No Recovery In Corporate Profits In Non-Commodities Sectors Chart I-6No Recovery In Economy No Recovery In Economy No Recovery In Economy In Brazil, key to its financial markets is the exchange rate. If and when the currency appreciates, interest rates will decline and share prices will rally and the economy will eventually revive - and vice versa. In turn, the exchange rate is driven not by the interest rate differential versus the U.S., as shown in Chart I-7, but by commodities prices, with which it strongly correlates (Chart I-8). Chart I-7Interest Rate Differential And ##br##Exchange Rate: No Correlation Interest Rate Differential And Exchange Rate: No Correlation Interest Rate Differential And Exchange Rate: No Correlation Chart I-8BRL Is Sensitive To Commodities Prices BRL Is Sensitive To Commodities Prices BRL Is Sensitive To Commodities Prices BCA's Emerging Markets Strategy team believes commodities prices have peaked and will decline in the months ahead. This, along with renewed political turmoil, warrants a bearish stance on the Brazilian currency. While the central bank has large foreign currency reserves and could sell U.S. dollars to support the real, this cannot preclude a selloff in the nation's financial markets. Selling foreign currency by a central bank entails withdrawing local currency from the banking system, tighter local liquidity and higher interest rates. Hence, a central bank can defend the exchange rate from depreciation if it tolerates higher interbank rates. Higher interest rates will, however, be devastating for Brazil. If the central bank of Brazil, having used its international reserves to defend the currency, decides to inject local currency liquidity into the system to bring down local rates, the outcome will be currency depreciation. In a nutshell, a central bank cannot control both the exchange rate and local interest rates if the nation has an open capital account structure. Remarkably, Chart I-9 contends that in Brazil, the exchange rate correlates with central bank lending to commercial banks. If the central bank lends to commercial banks, the currency depreciates, and vice versa. Facing the choice between currency depreciation and higher local rates, the Brazilian central bank will choose the former because of its perilous public debt situation as well as the imperative of a revival in credit growth. Hence, the Brazilian central bank is unlikely to defend the currency on a sustainable basis. If the currency depreciates, local bonds, sovereign and corporate U.S. dollar credit and share prices will sell off too. Bottom Line: Without structural reforms and higher commodities prices, Brazilian financial markets are looking into the abyss. Investment Recommendations Politics has fueled the rally in Brazilian assets since early 2016, and now politics taketh away. With the political tailwinds reversing, investors will have nothing left to base their decisions on but the terrible macroeconomic picture. We maintain our bearish stance on Brazilian financial markets: We continue to short the BRL versus both the U.S. dollar and the Mexican peso. The real is not cheap at all while the peso offers good value (Chart I-10). Chart I-9Central Bank's Liquidity Provision ##br##To Banks Vs. Exchange Rate Central Bank's Liquidity Provision To Banks Vs. Exchange Rate Central Bank's Liquidity Provision To Banks Vs. Exchange Rate Chart I-10BRL Is Not Cheap, MXN Is BRL Is Not Cheap, MXN Is BRL Is Not Cheap, MXN Is Dedicated EM equity and credit investors should continue underweighting Brazil in their respective portfolios. Finally, local rates will be under upward pressure as the currency depreciates. We remain offside this market. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Santiago E. Gomez, Consulting Editor santiago@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Brazil: Priced For Political Perfection," dated May 12, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Brazil: Impeachment Is No Panacea," dated April 26, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Brazil's Political Honeymoon Is Over," dated August 18, 2016, available at gps.bcaresearch.com. 4 Cuevas et al., IMF Working Paper: Fiscal Challenges of Population Aging in Brazil, March 2017

Highlights U.S. fiscal stimulus will be priced back into markets; Northeast Asia is consumed with domestic politics for now; China's financial crackdown raises risks, but so far looks contained; South Korea's relief rally will lead to buyer's remorse; Japan's constitutional reforms portend more reflation. Feature The market has lost faith in U.S. fiscal stimulus. The bond market has given back all of the expectations of faster growth and higher inflation (Chart 1). Hopes of populist, budget-busting tax cuts appear to have been dashed by the Putin-gate scandal and alleged White House obstruction of justice. As a result, the DXY has fallen to pre-election levels, while the Goldman Sachs high tax-rate basket of equities has fallen to its lowest level relative to the S&P 500 since February 2016 (Chart 2). We continue to believe that tax reform, or just tax cuts, will happen this year or early next year and that the market will have to re-price fiscal stimulus and budget profligacy at some point this year.1 As such, we are not ready to close our tactical recommendations of going long the high-tax rate basket relative to S&P 500 (down 1.62% since April 5) or playing the 2-year / 30-year Treasury curve steepener (down 11.4 bps since November 1). Republicans in Congress will push through tax reforms or cuts for the sake of remaining competitive in the upcoming midterm elections. And we doubt their commitment to budget discipline. That said, it is not clear that the equity market needs tax reforms to continue its upward trajectory. The Atlanta Fed's GDPNow model is predicting growth of 4.1% in the second quarter while the NY Fed's Nowcast is forecasting 2.3%. BCA U.S. Equity Strategy's earnings model continues to predict continued healthy profit growth for the remainder of the year both in the U.S. and abroad (Chart 3).2 In fact, if expectations of stimulus in the U.S. fully dissipate, the USD will take a breather - giving global stocks a boost - and the Fed will be able to take it easy on tightening U.S. rates, easing global monetary conditions. Chart 1Market No Longer##br## Believes In Trump Stimulus... Market No Longer Believes In Trump Stimulus... Market No Longer Believes In Trump Stimulus... Chart 2...Or Trump ##br##Tax Cuts ...Or Trump Tax Cuts ...Or Trump Tax Cuts Chart 3Corporate Profit ##br##Outlook Still Strong Corporate Profit Outlook Still Strong Corporate Profit Outlook Still Strong Perhaps far more important for global and U.S. risk assets is global growth. And the fulcrum of global growth has been China's economic performance. As the only country willing to run pro-cyclical monetary and fiscal policy, China has had a disproportionate impact on global growth since 2008. As such, we turn this week to the geopolitics and politics of Northeast Asia. China: How Far Will Deleveraging Go? Chinese financial policy tightening caught the market by surprise this year. The running assumption was that policy would be fully accommodative in order to ensure stability ahead of the all-important nineteenth National Party Congress in October or November.3 However, it is possible that the assumption is flawed. First, as we have pointed out in the past, China does not have a record of proactive economic stimulus ahead of party congresses (Chart 4). Second, President Xi Jinping may be far more secure in his position than is understood. Chart 4Not Much Evidence Of Aggressive Stimulus Ahead Of Mid-Term Party Congresses In China Not Much Evidence Of Aggressive Stimulus Ahead Of Mid-Term Party Congresses In China Not Much Evidence Of Aggressive Stimulus Ahead Of Mid-Term Party Congresses In China The crackdown on the financial sector in recent months suggests that Xi's administration has a greater appetite for risk ahead of the party congress than is generally believed: The administration is continuing to tamp down on the property sector. The PBoC has drained liquidity and allowed interbank rates to rise (Chart 5). The China Banking Regulatory Commission (CBRC) has launched inspections and new regulations on wealth management products and the shadow lending sector. The China Insurance Regulatory Commission (CIRC) has imposed new restrictions, including preventing insurers from selling new policies. One can make a good case that these measures will be limited so as not to cause excessive disruption in the financial system. All of the key Communist Party statements, from Premier Li Keqiang's recent comments to those made by the economic leadership in December, at the beginning of this tightening cycle, have emphasized that stability remains the priority.4 The PBoC's measures have been marginal; other measures have mostly to do with supervision. Notable personnel changes affecting the top economic and financial government positions fall under preparations for the party congress and do not necessarily suggest a new ambitious policy initiative is under way.5 Moreover, the government has already stepped back a bit in the face of the liquidity squeeze. One of the signs of the PBoC's tighter stance was its discontinuation of its Medium-Term Lending Facility in January, but this has since been reinstated.6 And throughout May the PBoC has injected increasing amounts of liquidity into the interbank system, marking an apparent tactical shift (Chart 6). Furthermore, government spending is already growing again after a brief contraction. Chart 5People's Bank Tightens Marginally... People's Bank Tightens Marginally... People's Bank Tightens Marginally... Chart 6...But Keeps Interbank Rates On A Leash ...But Keeps Interbank Rates On A Leash ...But Keeps Interbank Rates On A Leash In light of these decisions, it seems policy tightening is intended not to be stringent but merely to keep the financial sector - especially the shadow banking sector - in check during a year in which the assumption is that regulators' hands are tied. After all, an unchecked expansion of leverage throughout the year could interfere with the stability imperative. There are two major risks to this view. First, there is the danger of unintended consequences: China is overleveraged: The fundamental problem for China is that there is too much leverage in the system and there has not been a bout of deleveraging for several years (Chart 7). Much of the leverage is off-balance sheet as a result of the rapid growth in shadow lending. There are complex and opaque webs of counterparty risk. When authorities crack down, they cannot be certain that their actions will not spiral out of control. Recently, heightened scrutiny of "mutual guarantees," a type of shadow lending between corporations, led to the default of a company in Shandong that prompted a local government bailout, and more such credit events have occured.7 Policymakers are human: It is a fallacy to assume that Chinese policymakers are omnipotent. The mishaps of 2015-16 put a point on this. A state-backed newspaper has recently reiterated that its "deleveraging" campaign is not finished - the government could accidentally push too far.8 The rise in bond yields has already inverted the yield curve, causing the five-year bond yield to rise higher than the ten-year (Chart 8). This is a red flag and warrants caution.9 Quick fixes have negative side-effects: China escaped the last round of financial jitters, in 2015-16, by using its time-tried technique of credit and fiscal spending to boost the property market and build infrastructure, while imposing draconian capital controls. The growth rebound came at the expense of more debt, less economic rebalancing, and less financial openness. Chart 7China Is Massively Overleveraged China Is Massively Overleveraged China Is Massively Overleveraged Chart 8China's Yield Curve Has Inverted China's Yield Curve Has Inverted China's Yield Curve Has Inverted Second, there is the risk that Xi Jinping's calculus ahead of the party congress is not knowable. It may well be the case that Xi's position in the party is strengthened by a disruptive financial crackdown. The party congress is already under way: The party congress runs all year; it is not merely a one-off event this fall. Senior party officials will come up with a list of candidates for promotion in June or July. Then the PSC and former PSC members will likely meet behind the scenes to hash out their final list, which the Central Committee will ratify in the fall. If financial jitters were supposed to be strictly avoided for the party congress, then the current crackdown would never have begun. The outcomes are uncertain: The negotiations for the Politburo and PSC are not a foregone conclusion no matter how well positioned Xi appears to be as the "core" of the Communist Party. A simple assessment of the current Politburo suggests that the factions are evenly balanced when it comes to the current Politburo members capable of filling the five positions on the new PSC. Two of these positions should go to President Xi's and Premier Li Keqiang's successors, likely to be of opposing factions, while there will probably be three remaining slots that will have to be divvied up among an equal number of candidates from the two main factions (Table 1). Xi may still need to win some battles for influence behind the scenes in order to stack the Central Committee, Politburo, and PSC with his people for 2017 and beyond.10 His anti-corruption campaign has slowed down but is not over (Chart 9). This is all the more imperative for him since his retirement could be rattled by future enemies, given that he has removed the longstanding impunity of former PSC members. Table 1Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Despite these risks, we still tend to think that for China, as for the world, political risks are overstated in 2017 and understated in 2018.11 If Xi deliberately courts instability this year, as opposed to merely staying vigilant over the financial sector, then it will mark a major break from the norms of Chinese politics. The true risk to China's stability - aside from the unintended consequences discussed above - arises after the party congress, when Xi's political capital is replenished and he can attempt to reboot his policy agenda. Previous presidents Hu Jintao and Jiang Zemin both launched reform pushes after their midterm congresses in 2007 and 1997, respectively. Hu's reform drive was cut short by the global financial crisis, while Jiang's was large-scale and disruptive and paved the way for a decade of higher potential GDP. Having consolidated power in the party, bureaucracy, and military, and tightened controls over the media, Xi Jinping will be in a position in 2018 to launch sweeping reforms should he choose to do so. Presumably these reforms would follow along the lines of those he outlined in the Third Plenum of the Eighteenth Central Committee back in 2013 - they would be pro-market reforms focused on raising productivity by transferring more wealth to households and SMEs at the expense of state-owned enterprises and local governments.12 To illustrate the process of structural reform, we have often used the notion of the "J-Curve" in Diagram 1. This shows that painful reforms deplete political capital, creating a "danger zone" for political leaders in which they lose popularity as economic pain hurts the public. Xi's work over the past five years to fight corruption and rebuild the party's public image have given him the ability to start the J-Curve process from a higher point than otherwise would have been the case. He will start at point D in the diagram, instead of point A, which means that the low point E may not embroil him as deeply in the danger zone of serious political instability as point B. Chart 9Embers Still Burning In ##br##Anti-Corruption Campaign Embers Still Burning In Anti-Corruption Campaign Embers Still Burning In Anti-Corruption Campaign Diagram 1The J-curve Of##br## Structural Reform Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets But there is still no guarantee that he intends to expend his political capital in this way. The current round of financial tightening could be preliminaries for bigger moves next year - or it could be just another mini-cycle in the ongoing process of "managing" China's massive leverage. If China decides to execute a major deleveraging campaign, either now or next year, it will have a negative effect on global commodity demand (particularly base metals), on commodity exporters, on emerging markets in general, and ultimately on global growth. It would be beneficial for Chinese growth in the long run but negative in the short run, and in terms of Chinese domestic risk assets would open up opportunities for investors to favor "new (innovative) China" versus "old (industrial) China." Bottom Line: We remain long Chinese equities versus Taiwanese and Hong Kong equities for now, but are wary of any sign of doubling down on policy tightening in the face of more frequent and intense credit events. That would indicate that the Chinese leadership has a higher risk appetite than anyone expects and may be willing to induce serious financial disruption before the party congress. Korea: Drunk On Moonshine The Korean election is over and with it much of the heightened uncertainty that accompanied the impeachment and removal from office of President Park Geun-hye over the past year. The new president, Moon Jae-in of the Democratic Party, performed right around the polled expectations at 41% of the vote (Table 2). His competitor on the right wing, Hong Jun-pyo, outperformed expectations, though he still trailed well behind at 24%, giving Moon a large margin of victory by Korean standards that will help provide him with political capital (Chart 10). Table 2South Korean Presidential Election Results Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Chart 10Moon Will Have A Honeymoon Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Moon's election will bring relief to markets on both the domestic and geopolitical front. On the domestic front, he is proposing a series of policies that will cumulatively boost fiscal thrust and growth. On the geopolitical front, he will revive the "Sunshine Policy" (now "Moonshine Policy") of engagement with North Korea, reducing the appearance that the peninsula is slipping into war.13 The power vacuum in South Korea was a key driver of North Korea's belligerence in 2016, as the lead-up to South Korean elections has been in the past (Chart 11). South Korean presidents typically enjoy a substantial honeymoon period in which they are able to drive policy. The fact that the election occurred seven months early, as a result of the impeachment, gives Moon a notable boost to this period - he has seven months longer than he would have had before he faces any potential check from voters in the 2020 legislative elections. That is not to say that Moon has free rein. Ahn Cheol-soo's People's Party holds 40 seats in the National Assembly and is therefore in a "kingmaker" position - able to provide either the ruling Democratic Party or the fractured right-wing opposition with a majority of seats (Diagram 2). The People's Party is already criticizing Moon's call for increasing government spending by around 0.7% of GDP to fulfill his campaign pledges. True, the People's Party leans to the left and rose to power as a result of the median voter's shift to the left in the 2016's legislative elections. This may limit its ability to obstruct Moon's agenda at first. Nevertheless, it poses a substantial constraint on Moon's agenda through 2020. Chart 11Bull Market For##br## North Korean Threats Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Diagram 2Center-Left People's Party##br## Is The Korean Kingmaker Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Markets are relieved but not ebullient. The impeachment rally is over and eventually markets will realize that while Moon's agenda is pro-growth, it is not necessarily pro-corporate profits (Chart 12). He is promising to introduce a higher minimum wage, to convert temporary labor contracts into permanent ones, to increase social spending, and to toughen up labor and environmental regulation (Table 3). He has also appointed the so-called "chaebol sniper" as his point man in leading the reform of the country's chaebol industrial giants. On one hand, South Korea definitely needs corporate governance reform; on the other, the process will add uncertainty and Moon's approach may not be market-positive.14 Chart 12Relief Rally Likely To Disappoint Relief Rally Likely To Disappoint Relief Rally Likely To Disappoint Table 3South Korean President's Campaign Proposals Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets To get an indication of what kind of impact Moon's economic agenda may have, it is helpful to compare that of his mentor, Roh Moo-hyun, president from 2002-7. Roh gave a boost to consumption, both government and private, and saw a relative drop off in fixed capital accumulation, which fits with the broad agenda of supporting workers and households and removing privileges for Korea's traditional export-oriented industrial complex (Chart 13). Roh proved very beneficial for the financial sector, wholesale and retail trade, and health and social work. Education and public administration received some support but were flat overall (Chart 14 A & B). If Moon follows in Roh's footsteps, he will be beneficial for the domestic-oriented economy. Chart 13South Korea's Left Wing##br## Boosts Domestic Consumption South Korea’s Roh Moo-Hyun Boosted Domestic Consumption South Korea’s Roh Moo-Hyun Boosted Domestic Consumption Chart 14ASouth Korea's Left Wing Boosts Finance,##br## Domestic Trade, And Health Care (I) South Korea’s Roh Moo-Hyun Boosted Finance, Domestic Trade, And Health Care (I) South Korea’s Roh Moo-Hyun Boosted Finance, Domestic Trade, And Health Care (I) Chart 14BSouth Korea's Left Wing Boosts Finance,##br## Domestic Trade, And Health Care (II) South Korea’s Roh Moo-Hyun Boosted Finance, Domestic Trade, And Health Care (II) South Korea’s Roh Moo-Hyun Boosted Finance, Domestic Trade, And Health Care (II) Abroad, the Moonshine Policy is likely to have some success, at least in the medium term. The Trump administration is pursuing a strategy comparable to the U.S.'s nuclear negotiations with Iran from 2011-15, in which it tries to rally a coalition to impose tougher sanctions on the rogue state with the purpose of entering into a new round of negotiations that will actually generate concrete results. The "arc of diplomacy" will take time to get going and could last several years - it is essentially a last-ditch effort to convince North Korea to pause its nuclear and missile advances. The tail risk of conflict on the Korean peninsula will be moved out to the end of this effort, perhaps around the end of Trump's term.15 Meanwhile, Moon is already patching up trade relations with China, according to reports, after the latter imposed sanctions on Korea for deploying the U.S. THAAD missile defense system (Chart 15). He will also seek joint infrastructure projects with China and Russia to connect the peninsula. China has a vested interest in Moon's success because it is attempting to demonstrate to the Trump administration that it is cooperating on North Korean security. Chart 15China Likely To Ease##br## Sanctions On South Korea China Likely To Ease Sanctions On South Korea China Likely To Ease Sanctions On South Korea Chart 16South Korean Inflation##br## And Credit Impulse Weak South Korean Inflation And Credit Impulse Weak South Korean Inflation And Credit Impulse Weak The geopolitical risk to markets is, first, that North Korea miscalculates the threshold of other nations' patience, continues with provocations, and eventually causes an incident that derails the new negotiations. This is possible given the North's record of belligerent acts and the fact that both the Trump administration and the Abe administration could cut diplomacy short in the face of a truly disruptive provocation for domestic political reasons. Second, there is a risk that Trump decides to escalate North Korean tensions again, whether to distract from domestic scandals or to reinforce the military deterrent in the event that China and South Korea appear to be giving North Korea a free pass in another round of useless talks. If Moon pursues a unilateral détente with North Korea, without adequate coordination with the U.S., and pushes for the removal of THAAD missiles, then the U.S. and South Korea are headed for a period of higher-than-normal alliance tensions that could become market-relevant.16 Bottom Line: We remain short KRW/THB. Core inflation and domestic demand remain weak in Korea, which reinforces the central bank's recent decision to stick to an accommodative monetary policy. Credit growth is cyclically weak, which reinforces the fact that rate cuts are still on the table (including the possibility of a surprise rate cut like in mid-2016) (Chart 16). Finally, the KRW has been relatively strong compared to the currencies of Korea's competitors (Chart 17). Chart 17South Korean Won Has Outpaced The Yuan And Yen South Korean Won Has Outpaced The Yuan And Yen South Korean Won Has Outpaced The Yuan And Yen In terms of equities, the top six chaebol have come under scrutiny, but Samsung has rallied despite lying at the center of the corruption scandal. The others have not performed well amid the economic slowdown. We see no opportunity at present to short the chaebol in relation to the broader market. Broadly, however, Moon's policies will add burdens to large internationally competitive industrials while boosting small and medium-sized enterprises. We also remain short the Korean ten-year government bond versus the two-year (see Chart 12, panel three, above). Moon's policy bent will subtract from a 1% budget surplus (2016) and worsen the long-term trajectory of the country's relatively low public debt (39% of GDP). Insofar as his foreign policy succeeds, it entails a larger future debt burden as a result of efforts to integrate with North Korea, which is relevant to long-term bonds well before reunification appears anywhere on the horizon. At bottom, we are structurally bearish South Korea because of rising headwinds both to U.S.-China relations and to the broader globalization process that has benefited South Korea so much in the recent past. Japan: Is Militarism The Final Act Of Abenomics? Japan has reached peak political capital under Shinzo Abe. The ruling Liberal Democratic Party, with its New Komeito coalition partner, continues to play in a totally different league from its competitors - there is no political alternative at the moment (Chart 18). The ruling party has a de facto two-thirds supermajority in both houses of the Diet. Abe himself is more popular than any recent prime minister, and has retained that popularity over a longer period of time (Chart 19). He has secured permission from his party to stay on as its president until 2021, though he faces general elections in December 2018 to stay on as prime minister. Chart 18Japan: Liberal Democrats Still Supreme Japan: Liberal Democrats Still Supreme Japan: Liberal Democrats Still Supreme Chart 19Shinzo Abe Remains The Man Of The Hour Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Political capital is a fleeting thing, so Abe must use it or lose it. This is why we have insisted that he would press forward rapidly with attempts to revise Japan's constitution, his ultimate policy goal, which he has now confirmed he will do. His proposed deadline is July 2020 for the new provisions coming into force.17 Constitutional revision is not only about enshrining the Japanese Self-Defense Forces (JSDF) so as to normalize the country's defense policy. It is also about Japan becoming an independent nation again, capable of forging its own destiny outside of the one foreseen by the American framers of the post-WWII constitution. Though Abe has specific constitutional aims, any change to the constitution will demonstrate that change is possible and break a taboo, advancing Abe's broader goal of nudging the Japanese public toward active rather than passive policies.18 Hence Japanese politics are about to heat up in a big way. Abe has already done a trial run in his passage of a new national security law in September 2015. This law allowed the government to reinterpret the constitution so as to achieve many of his chief military-strategic aims (e.g. allowing the JSDF to come to the aid of allies in "collective self-defense"). Over the course of that year, Abe's popularity flagged, as public opinion punished him for shifting attention away from the economic reflation agenda that got him elected so as to focus on his more controversial, hawkish security agenda (Chart 20). Nevertheless, Abe stuck to the security agenda, in the face of some of the largest protests in Japan's post-Occupation history, and managed to shift back to the economy in time to notch another big victory in the upper house elections of 2016. We expect a similar process to unfold this time, though with bigger stakes and far less of a chance that Abe can "pivot" again. Under no circumstances do we see him reversing the constitutional drive now that he has the rare gift of supermajorities in the Diet; rather, he is going to spend his political capital. After all, there is no telling what could happen in the 2018 election. What are the market implications of this agenda? There may be some hiccups in consumer and business sentiment as a result of the rise in activism, political opposition, and controversy that is already beginning and will intensify as the process gets under way. Abe will be accused of putting the economy on the backburner. Abenomics is already of questionable success (Chart 21) and it will come under greater criticism as Abe shifts attention elsewhere, especially if global headwinds gain strength. Chart 20Abe Loses Support When He Talks##br## Security Instead Of Economy Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Chart 21Abenomics: ##br##Progress Is Gradual Abenomics: Progress Is Gradual Abenomics: Progress Is Gradual However, we recommend investors fade this narrative and buy Japan. Abe's constitutional changes must receive a simple majority in a nationwide popular referendum in order to pass - and Abe does not clearly have what he needs at the moment (Chart 22). This means that he cannot, in reality, afford to put Abenomics on the back burner, but instead must err on the side of monetary dovishness, fiscal stimulus, and reflation in order to win support for the non-economic agenda. There has been virtually no talk of fiscal stimulus this year, yet the policy setting is conducive to increasing spending as necessary. The Bank of Japan has explicitly embraced a monetary regime designed to allow for greater "coordination" with fiscal policy (Chart 23).19 There is no reason whatsoever to believe Abe is backing away from this stance. (Incidentally, the next consumption tax hike is not slated until October 2019, and could be delayed again.) Geopolitics are also fairly supportive of the Abe administration. First, the Korean situation is currently alarming enough to help justify the constitutional changes yet not alarming enough to provoke outright conflict. Abe is also making headway toward a historic improvement of relations with Russia, allowing Japan's military to pivot from the north to the south and west (i.e. China and North Korea). The chief risk for Abe is if North Korea surprises on the dovish side and new international diplomatic efforts appear so fruitful as to reduce domestic support for remilitarization. China, South Korea, and possibly North Korea will encourage the latter dynamic, while drumming up global criticism of Japan for warmongering. Meanwhile Japan will try to remind the domestic public and the U.S. that North Korea remains a clear and present danger and tends to take advantage of negotiations. Given the relatively positive geopolitical backdrop for Abe, the biggest risk to his agenda is an exogenous economic shock. Even then, if that shock stems from China and causes Beijing to rattle-sabers as a domestic distraction, then it will benefit Abe's remilitarization agenda. What would hurt Abe is if global growth sags but China and North Korea lay low. It is too soon to say that they will do this, but it is unlikely. Trump is also a wild card whose threats of "tough" policy toward China and North Korea may reemerge in 2018, in time to help Japan make constitutional changes that the U.S. generally supports. Bottom Line: Go long Japan. While there is no correlation between Japan's defense-exposed equity sector performance and the current government's remilitarization efforts, there is a clear case to be made that nominal GDP and defense spending will both be going up as a result of constitutional and economic policies (Chart 24). Abe will double down on reflation for at least as long as is necessary to maintain popular approval of his government ahead of a historic constitutional referendum. Chart 22Revise The Constitution? Yes.##br## End Pacifism? Maybe. Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Chart 23Japanese Reflation ##br##Will Continue Japanese Reflation Will Continue Japanese Reflation Will Continue Chart 24Expect Higher Nominal##br## Growth And Defense Spending Expect Higher Nominal Growth And Defense Spending Expect Higher Nominal Growth And Defense Spending Housekeeping: Play Pound Strength Through USD, Not EUR We are closing our short EUR/GBP position, open since January 25, for a loss of 1.77%. This trade has largely been flat. We put it on as a way to articulate our view that Brexit political risks are overstated and that the pound bottomed on January 16. The political call was right, but the pound has largely moved sideways versus the euro since then. We maintain our short USD/GBP, which is up 4.63% since March 29, as a way to articulate the same view that Brexit (and the upcoming U.K. elections) are not a risk. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Weekly Report, "Trump Thumps The Markets," dated May 19, 2017, available at gis.bcaresearch.com. 3 The party congress, which occurs every five years and marks the "midterm" of President Xi Jinping's administration, will see a sweeping rotation of Communist Party officials, including on the Central Committee, the Politburo, and the Politburo Standing Committee (PSC). 4 Please see "China able to keep its financial markets stable, Premier Li says," Reuters, May 14, 2017, available at www.reuters.com. For the December meeting, see "China's monetary policy to be prudent, neutral in 2017," Xinhua, December 16, 2016, available at www.chinadaily.com. 5 Finance Minister Xiao Jie, Commerce Minister Zhong Shan, NDRC Chairman He Lifeng, and China Banking Regulatory Commission Chairman Guo Shuqing have all recently been appointed, but they replaced leaders due to retire as part of the party congress reshuffle. Only the new China Insurance Regulatory Commission Chairman Xiang Junbo and the new Director o f the National Bureau of Statistics Wang Baoan were replaced for reasons other than retirement, having been stung by the anti-corruption campaign. By March 2018 the world should have a better sense of Xi's economic and financial "team" for 2018-22. 6 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 7 Zouping government, in Shandong, intervened into the case of Qixing aluminum company's insolvency in order to transfer control to Xiwang, a corn oil and steel producer that had given a mutual guarantee to Qixing. The Zouping authorities arrested the son of Qixing's chairman to force the transfer. Please see "Bond Buyers Blacklist Some Chinese Provinces After Run Of Defaults," Bloomberg, April 26, 2017, available at www.bloomberg.com. 8 Please see "China Deleveraging To Continue As Goals Not Yet Achieved: State Paper," Reuters, May 17, 2017, available at www.reuters.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com, and Global Investment Strategy Special Report, "The Signal From Commodities," dated May 19, 2017, available at gis.bcaresearch.com. 10 Xi may yet go after another big "tiger," Zeng Qinghong, the right-hand man of former President Jiang Zemin. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated in 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, and "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and China Investment Strategy Special Report, "Tracking The Reform Progress," dated October 22, 2014, available at cis.bcaresearch.com. 13 "Moonshine Policy" is a phrase we regrettably did not coin, but we discussed its coming in BCA Geopolitical Strategy Weekly Report, "What About Emerging Markets?" dated May 3, 2017, and "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 14 Moon has nominated Kim Sang-jo, a professor of economics at Hansung University in Seoul, to head his Fair Trade Commission. Kim is a long-time advocate for shareholders against the family-controlled chaebol and led a prominent law suit against Samsung. Past efforts at reforming the chaebol led by Presidents Kim Dae-jung and Roh Moo-hyun focused on improving balance sheets, protecting minority shareholders' rights, limiting the total amount of investment, and improving corporate management and accountability. It remains to be seen how Moon (and Kim Sang-jo, assuming his nomination is confirmed) will proceed, but the effort will bring domestic challenges to the top industrial conglomerates' operating environment at least initially. 15 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 16 South Korea's special envoy Hong Seok-hyun claims that Trump told him at the White House that he will work closely with Moon and is willing to try engagement with Pyongyang, conditions permitting, though he is not interested in talks for the sake of talks. This fits with our view that the U.S. saber-rattling this year was designed to make the military option more credible before pursuing a new round of diplomacy. 17 Please see BCA Geopolitical Strategy "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, and Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 18 So, for instance, if it should happen that, over the course of the coming debates, Abe is forced to drop his proposed revisions to the pacifist Article 9, he may still achieve changes to the amendment-making procedure in Article 96. The latter would be even more important for Japan's future, since it would make it easier for Japan to change the constitution for whatever reason in the coming decades. 19 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com.