Sectors

Underweight The S&P airlines index got a rare respite last week when United Airlines reported strong results and, perhaps more importantly, scaled back capacity growth plans. Regarding the latter, recall that earlier this year the company had announced a significant expansion, triggering fears of a return to the bad old days of industry overindulgence and a fare war. With respect to the earnings themselves, ticket prices appear to be more resilient than we had feared and are mostly offsetting fuel price increases; airfare's declining share of the consumer's wallet looks to have bottomed (second panel). Further, higher prices are not impacting the operating efficiency gains of the past five years as load factors are still near peak levels (third panel). The upshot is that margins may soon arrest their descent (bottom panel); we reiterate our underweight recommendation with an upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. A Break In The Clouds? A Break In The Clouds?

Please note that our next publication will be a joint special report with BCA’s Geopolitical Service that will be published on Wednesday, August 1st instead of our usual Monday publishing schedule. Further, there will be no publication on Monday, August 6th. We will be returning to our normal publishing schedule thereafter. Highlights We continue to explore a cyclical over defensive portfolio bent, and the capex upcycle along with higher interest rates are our key investment themes for the remainder of the year. A number of sentiment indicators have broken out (Chart 1), and our sense is that the SPX will also hit fresh all-time highs in the coming quarters. While buybacks vaulted to uncharted territory in Q1/2018 (Chart 2), our profit growth model suggests that EPS will continue to expand at a healthy clip for the rest of the year (Chart 3) and 10% EPS growth is achievable in calendar 2019. Positive macro forces remain in place with the ISM - manufacturing and non-manufacturing - surveys reaccelerating. Beneath the surface, the new-orders-to-inventories ratio is gaining traction and even the trade-related subcomponents (new export orders and imports) are ticking higher. High backlogs also suggest that SPX revenue growth will remain upbeat (Chart 4). Non-farm payrolls are expanding on a month-over-month basis for 93 consecutive months, a record (Chart 5), at a time when the real fed funds rate remains near the zero line (Chart 6). As a result, the economy is overheating. Corporate selling price inflation is skyrocketing, according to our gauge, with our diffusion index catapulting to multi-decade highs. This represents a positive margin backdrop as wage inflation remains muted (Chart 7). While at first sight, valuations appear dear, a simple thought experiment suggests that soon they will deflate1 (Chart 8). And, on a forward price-to-earnings-to-growth (PEG) basis, valuations have sunk to one standard deviation below the historical mean (Chart 9). Two key risks that we are closely monitoring that can put our cyclically positive equity market view offside are: a sustained rise in the U.S. dollar infiltrating profit growth (Chart 10), and corporate balance sheet degradation short-circuiting the broad equity market (Chart 11). Chart 1Sentiment Is Breaking Out Sentiment Is Breaking Out Sentiment Is Breaking Out Chart 2Buybacks Are Soaring Buybacks Are Soaring Buybacks Are Soaring Chart 3Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Chart 4...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont Chart 5Record Jobs Growth... Record Jobs Growth... Record Jobs Growth... Chart 6...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy Chart 7Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Chart 8The Market Is Not That Expensive... The Market Is Not That Expensive... The Market Is Not That Expensive... Chart 9...By Several Measures ...By Several Measures ...By Several Measures Chart 10A Strong Dollar Is A Risk A Strong Dollar Is A Risk A Strong Dollar Is A Risk Chart 11Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Feature S&P Industrials (Overweight) While our industrials CMI remains very near 20-year highs, it has lost its upward momentum this year due almost entirely to the strength of the U.S. dollar, though sliding global PMI surveys have also started to weigh (second panel, Chart 13). Combined with heightened fears of a trade war, the internationally geared S&P industrials have come under pressure. Chart 12S&P Industrials (Overweight) S&P Industrials S&P Industrials Chart 13Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Still, demand growth has been resilient and continues to soar as the capex upcycle has not yet run its course and the implications for top line and profit growth are unambiguously positive (third and bottom panels, Chart 13). Should some let up emerge from the current break down of international trade, we would expect earnings to resume their role as the fundamental driver for industrials. Our valuation gauge has rapidly declined this year as extreme bearishness is not reflected by the strong profit backdrop. From a technical perspective, S&P industrials have been the most oversold since the Great Recession. S&P Energy (Overweight, High-Conviction) Our energy CMI has continued to push higher from the extremely depressed levels of 2016 and 2017. Still, the much better cyclical environment has started to get reflected in relative share prices with the S&P energy index besting all other GICS1 sectors in Q2. We recently refined our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterated its high-conviction status. We believe the steep recovery in underlying commodity prices, which the market has thus far failed to show much confidence in, has started to restore some semblance of normality in the exploration & production (E&P) stocks space (top panel, Chart 15). Chart 14S&P Energy (Overweight, High Conviction) S&P Energy S&P Energy Chart 15A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (second panel, Chart 15). Accordingly, we raised the S&P oil & gas E&P index to an overweight stance. Simultaneously, weakening crack spreads (third panel, Chart 15) and rising gasoline inventories (bottom panel, Chart 15) have given us cause for concern for refiners. As a result, we trimmed the S&P oil & gas refining & marketing index to underweight, though this did not shake our high-conviction overweight position on the broad S&P energy index. Our Valuation Indicator (VI) remains near deeply undervalued territory, and indicates an attractive entry point for fresh capital. Our Technical Indicator (TI) has fully recovered from oversold levels and now sends a neutral message. S&P Financials (Overweight) The pace of improvement in our financials cyclical macro indicator (CMI) has not abated. However, the usual tight correlation between the CMI and the relative performance of the S&P financials index has broken down. An important culprit has been the heavyweight S&P banks sub-index and its transition from a correlation with the 10-year UST yield and toward the 10/2 yield curve slope earlier this year (top and second panels, Chart 17). While the former is still up year-over-year, the latter has continued to flatten and the result is likely a squeeze on banks' net interest margins, a key profit driver; we recently booked gains of 6% and removed it from the high-conviction overweight list, and the S&P banks index is currently on downgrade watch. Chart 16S&P Financials (Overweight) S&P Financials S&P Financials Chart 17Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Still, our key three reasons for being overweight the S&P financials index remain unchanged. Rising yields and the accompanying higher price of credit are a boon to financials and a core BCA theme for 2018 remains higher interest rates. The global capex upcycle, another of BCA's key themes for 2018, has paused for breath, though it has been replaced by soaring U.S. demand. This exceptional willingness of U.S. CEOs to expand their balance sheets should mean capital formation will proceed at well above-trend pace, and further underpin C&I loan growth (third panel, Chart 17). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 17). Market bearishness has more than offset the positive fundamentals and the S&P financials index has underperformed in 2018; the result has been a steep fall in our VI to nearly one standard deviation below normal. The bearishness is also reflected in our TI which has recently collapsed into oversold territory. S&P Consumer Staples (Overweight) Our consumer staples CMI has moved sideways since our last update, near a depressed level. This is reflected in the share price performance; defensives in general and staples in particular have been woefully unloved this year. However, we believe positive macro undercurrents have made bargain basement prices in consumer staples an exceptional deal, particularly for investors willing to withstand short term volatility for a long-term investment gain. We recently pointed out that, while non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. The bearish read on this would be that this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (top panel, Chart 19). Chart 18S&P Consumer Staples (Overweight) S&P Consumer Staples S&P Consumer Staples Chart 19Staples Are Poised For A Recovery Staples Are Poised For A Recovery Staples Are Poised For A Recovery Meanwhile consumer staples exports are flying in the face of a rising U.S. dollar, which has typically presaged relative earnings gains (second panel, Chart 19). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 19). Both our VI and TI concur; as they are both more than a standard deviation below fair value. S&P Health Care (Neutral) Earlier this month, we lifted the S&P pharma and biotech indexes to neutral and, given that these sectors command roughly a 50% weighting in the S&P health care sector, these upgrades also lifted the health care sector to a neutral portfolio weighting. Sentiment has moved squarely against the sector and the bar for upward surprises has been lowered enough to create fertile ground for upside surprises. As shown in the second panel of Chart 21, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how our VI has remained under pressure and our TI has sunk. Chart 20S&P Health Care (Neutral) S&P Health Care S&P Health Care Chart 21Peak Pessimism In Health Care Peak Pessimism In Health Care Peak Pessimism In Health Care Still, our health care CMI has been treading water at relatively low levels, but our S&P health care earnings model suggests that at least a bottom in profit growth has formed (bottom panel, Chart 21). S&P Technology (Neutral) We lifted the S&P technology index to neutral earlier this year to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel, Chart 23).2 Software and tech hardware & peripherals are the two key sub-indexes we prefer and have also put on our high-conviction overweight list. Chart 22S&P Technology (Neutral) S&P Technology S&P Technology Chart 23A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel, Chart 23). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel, Chart 23). The technology CMI has also turned positive this year after falling for the previous three, though an appreciating dollar and higher interest rates continue to suppress an otherwise exceptionally robust macro environment. Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is in overbought territory, though it has been at this high level for several years. S&P Utilities (Neutral) Our utilities CMI appears to have found a bottom, arresting the linear downtrend of the previous decade. Declining earnings have steadied out as the industry has found some discipline; new investment has declined and turbine & generator inventories have ticked up (second panel, Chart 25). The result of declining investment has been a slight improvement in capacity utilization, albeit still at a relatively low level (third panel, Chart 25). Chart 24S&P Utilities (Neutral) S&P Utilities S&P Utilities Chart 25Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom The uptick in capacity utilization has driven a surge in industry pricing power, despite flat natural gas prices which have historically been the industry price setter; this could be the precursor to a recovery in sector earnings (bottom panel, Chart 25). Still, as with other defensive sectors, utilities have underperformed cyclical sectors in the last year; this has been exacerbated by utilities trading as fixed income proxies. Our VI does not provide much direction as it has been in the neutral zone for the past year, underscoring our benchmark allocation recommendation. Our TI fell steeply earlier this year, though it has recovered and offers a neutral reading. S&P Materials (Neutral) The materials CMI has come under pressure as the Fed has continued to tighten monetary policy. A further selloff in bonds remains the BCA view for 2018, implying rising real rates will weigh on the sector for at least the remainder of the year. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher (real rates shown inverted, top panel, Chart 27). Chart 26S&P Materials (Neutral) S&P Materials S&P Materials Chart 27This Time Is Different For Chemicals This Time Is Different For Chemicals This Time Is Different For Chemicals On the operating front, chemicals sector productivity has made solid gains over the past year and the sell-side bearishness for much of the past decade has finally reversed (second panel, Chart 27). Further, overcapacity, the usual death knell of the chemicals cycle, seems to be a thing of the past as the industry has massively scaled back on capital deployment on the heels of a mega global M&A cycle (third panel, Chart 27). Net, operating improvements might offset macro headwinds. Our VI echoes this neutral message and sits on the fair value line. Our TI is somewhat more bullish and is edging toward an oversold position. S&P Real Estate (Underweight) Our real estate CMI looks to have found a bottom earlier this year, though the only time it has been worse was during the Great Financial Crisis. Real estate stocks are continuing to behave like fixed income proxies, as they have since the overhang from the GFC gave way to a yield focus (top panel, Chart 29). In the context of a tightening monetary backdrop, we would need compelling operating or valuation reasons to maintain even a benchmark allocation in the sector; these are both absent. Chart 28S&P Real Estate (Underweight) S&P Real Estate S&P Real Estate Chart 29Dark Clouds Forming Dark Clouds Forming Dark Clouds Forming On the operating front, the commercial real estate (CRE) sector is waving a red flag. The occupancy rate has clearly crested and rents are headed down with it, warning of declining sector cash flows (second panel, Chart 29). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel, Chart 29). We recently initiated a trade to capitalize on relative CRE weakness by going long the S&P homebuilding index/short the S&P REITs index.3 Such overwhelming bearishness would suggest the sector would be relatively cheap, but our VI suggests that REITs are fairly valued. Our TI is has been unwinding an oversold position and is now in neutral territory. S&P Consumer Discretionary (Underweight) In early March, we identified three key factors that we expected to weigh on the consumer discretionary sector: a rising fed funds rate, quantitative tightening and higher prices at the pump. As highlighted in Chart 31, all of these factors remain intact and underlie the two-year decline in the consumer discretionary CMI. Chart 30S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary S&P Consumer Discretionary Chart 31The Amazon Effect The Amazon Effect The Amazon Effect Further, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (fed funds rates shown inverted, top panel, Chart 31). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 31). Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents nearly a quarter of its market value, and about to get even larger in the upcoming introduction of the Communications Services GICS1 sector, but only comprises 3% of this sector's net income. Our TI agrees with our VI and is well into overbought territory. S&P Telecommunication Services (Underweight) Our telecom services CMI, bounced off its 30-year low earlier this year, but not nearly enough for a bullish position to be established. Rather, our bearish thesis remains unchanged: A combination of still-tepid pricing power weighing on earnings (second panel, Chart 33), weak consumer spending (bottom panel, Chart 33) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel, Chart 33), should all keep relative performance suppressed. Chart 32S&P Telecommunication Services (Underweight) S&P Telecommunication Services S&P Telecommunication Services Chart 33Pricing Power Is Still On Hold Pricing Power Is Still On Hold Pricing Power Is Still On Hold Valuations have fallen significantly - our VI continues to touch new lows - and our TI has been indicating a persistently oversold position, but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Despite the neutral CMI reading, we downgraded small caps earlier this year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 35). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Chart 34Size Indicator (Favor Large Vs. Small Caps) Style View Style View Chart 35Small Cap Leverage Is Critical Small Cap Leverage Is Critical Small Cap Leverage Is Critical Our call has thus far been slightly offside as small caps have been outperforming: investors have sought the trade-friction free shelter that small caps offer compared with internationally exposed large caps. Extreme optimism also reigns throughout the small cap world (third panel, Chart 35). However, we continue to think a turn is merely a matter of time; the NFIB's "good time to expand" reading is at its highest level in the history of the survey (bottom panel, Chart 35) which means small cap CEOs are more likely to push their already-stretched balance sheets closer to the breaking point. Our TI is telling us that small caps are overbought, but the VI continues to offer a neutral message. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "How Expensive Is The SPX?" dated July 6, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Buying Opportunity," dated April 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low Term Premia Across Developed Markets Are Low Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Bond Yields Now Tend To Rise When Equity Prices Go Up Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Long-Term Inflation Expectations Have Remained Subdued For Over Two Decades Long-Term Inflation Expectations Have Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening From Quantitative Easing To Quantitative Tightening From Quantitative Easing To Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Developed Markets: Inflation Has Remained Low Despite Shrinking Output Gaps Developed Markets: Inflation Has Remained Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Inflation In The 1960s Took Off Once The Economy Began To Overheat Inflation In The 1960s Took Off Once The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets Chart 11Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets Chart 13Upside Risks To U.S. Inflation Upside Risks To U.S. Inflation Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Investors Are Too Complacent Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

The long S&P homebuilding/short S&P REITs pair trade is off to a flying start. Already, this market- and industry-neutral trade has generated alpha for our portfolio to the tune of 7% since the early-July inception.1 There is a long runway ahead for additional gains in this pair trade. Importantly, the recent slew of bank earnings releases had a common thread: across the board, banks are pulling in their horns with regard to extending commercial real estate (CRE) loans. This represents a bearish backdrop for the overextended CRE sector (second panel). As the Fed continues to tighten the monetary screws, delinquency rates have nowhere to go but up, especially in CRE that currently enjoys an ultra-low starting point (fourth panel). Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. Through The Roof Through The Roof

Overweight (High Conviction) The S&P software index has continued to soar this year, helping the NASDAQ set an all-time high this week. Capex surveys are bouncing around the highest levels this millennium; such optimism has typically led software investment and, hence, earnings growth (second and third panels). The market has fully adopted an ebullient stance on U.S. software with the result that our high-conviction overweight trade has gained 15% versus the SPX since the late-November inception.1 At least part of the ascent of the S&P software index has been due to M&A premia being built into stock prices, with CA already being the subject of a takeover bid from AVGO. With the amount of industry consolidation, a speculative lift is hardly a surprise (bottom panel). Still, we view this as the flightiest sort of valuation upside and, from a portfolio management perspective, this morning we suggest that clients institute a stop in this high-conviction call at the 10% relative return mark, in line with our late-January introduced risk management policy. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index, but recommend a 10% stop. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Software Is Roaring Software Is Roaring

Overweight - Downgrade Alert We put the S&P banks index on downgrade alert in mid-May and removed it from the high-conviction overweight list for a relative gain of 6%, on the back of budding evidence that the bank/yield curve correlation was getting re-established as the one with the 10-year Treasury yield was getting shattered. We also warned that were banks not to participate in the next bond market selloff we would pull the trigger and downgrade to neutral. On the eve of Q2 earnings season there is hope for a reversal of fortunes in this key financials sub-index. The U.S. economy is overheating and pricing pressures are making their way through to the CPI. This should be fertile ground for bank equities as they represent the nervous system of the economy by providing much needed credit. Indeed, commercial & industrial (C&I) loans - the largest credit segment in bank balance sheets - have soared; not only are they making new all-time highs in level terms, but momentum is gaining steam (middle panel). This is not only centered on C&I loans, but other categories are also expanding nicely, especially residential mortgage loans. Loan origination is synonymous with profit growth at a time when the regulatory noose is getting relaxed and banks anew passed the Fed's strict stress tests. Tack on shareholder friendly activities and there is much to like about banks this earnings season. Bottom Line: Stay overweight banks, but stay tuned. Banks On Banks Banks On Banks

Highlights Investors are too complacent about the risks of a trade war. Standard economic models understate the potential economic damage that a trade war could cause. Global equities would suffer mightily from a trade war. Deep cyclical sectors would be hardest hit. Financial equities would also fare poorly. Regionally, European and EM stock markets would underperform. A trade war would benefit Treasurys and other safe-haven government bonds. A contained trade war would likely be somewhat dollar-bearish. In contrast, a full-out war could send the greenback soaring. Feature From Phony War To Real War? After months of posturing, Trump's trade war is starting to heat up. The U.S. imposed tariffs of 25% on $34 billion of Chinese goods last Friday. Tariffs on another $16 billion of goods are set to go in effect on July 20th. China has stated that it will retaliate in kind. On Tuesday, Trump further upped the ante, announcing that he will levy a 10% tariff on an additional $200 billion of Chinese imports by August 31. He also threatened tariffs on another $300 billion on top of that if China still refuses to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than what China exported to the U.S. last year! China is not the only country in Trump's crosshairs. The Trump administration levied tariffs of up to 25% on steel and aluminum from the EU, Canada, Mexico, and other U.S. allies on June 1, 2018. The affected regions have retaliated with their own tariffs. As Marko Papic, BCA's chief geopolitical strategist, has repeatedly stressed, there is little reason to think that trade tensions will ease over the coming months. Protectionism is popular with the American public (Chart 1). Trump ran on a protectionist platform and now he is trying to fulfill his campaign promises. It does not help that Trump is accusing foreign governments of doing things they are not doing. Chart 2 shows that U.S. tariffs are actually higher than in most other G7 economies. As we have argued in the past, the U.S. runs a persistent current account deficit because it has a higher neutral real rate of interest - otherwise known as r-star - than most other countries.1 Standard interest rate parity equations imply that a country with a relatively high neutral rate will have an "overvalued" currency that is expected to weaken over time, whereas a country with a low neutral rate will have an "undervalued" currency that is expected to strengthen over time. Intuitively, this must happen because investors will only hold low-yielding bonds if they expect a currency to strengthen. The result is a current account deficit for countries with overvalued currencies such as the U.S., and a current account surplus for regions with undervalued currencies such as the euro area (Chart 3). Chart 1Free Trade Is Not In Vogue In The U.S. How To Trade A Trade War How To Trade A Trade War Chart 2Tariffs: Who Is Robbing The U.S.? How To Trade A Trade War How To Trade A Trade War Chart 3Interest Rates And Current Account Balances How To Trade A Trade War How To Trade A Trade War The Economic Costs Of A Trade War How much damage could a trade war do to the global economy? As it turns out, this is a surprisingly difficult question to answer. Standard economic theory offers little guidance on the matter. By definition, global exports are always equal to imports. In a conventional Keynesian model, countries with trade deficits would gain some demand from a trade war, while countries with surpluses would lose some demand. However, the contribution of net exports to global demand would always be zero. Granted, there would be some efficiency losses, but in the standard Ricardian model of comparative advantage, they would not be that large. As Box 1 explains, the deadweight loss from a tariff can be computed as one-half times the change in the tariff rate multiplied by the percentage-point decline in imports that results from the tariff. Suppose, for example, that a trade war leads to a 10% across-the-board increase in U.S. tariffs, which causes U.S. imports to fall by 30%.2 Given that imports are 15% of U.S. GDP, the resulting deadweight loss would be 0.5*0.1*0.3*15=0.225% of GDP. That's obviously not a lot. The True Cost Of A Trade War Is Likely To Be High Our sense is that the true cost of a trade war would be much greater than these simple models suggest. There are at least six reasons for this: Most simple models assume that labor and capital are completely fungible and that the economy is always at full employment. In practice, it is doubtful that workers could easily move to companies that would benefit from tariff protection from those that would suffer from retaliatory measures. Workers have specialized skills. Likewise, a piece of machinery that is useful in one sector of the economy may be completely useless in another. Industries are often concentrated in particular regions. As such, a trade war could severely degrade the value of the existing stock of human and physical capital. This would result in lower potential GDP. It would also result in temporarily higher unemployment as workers, laid off from firms which have been adversely affected by tariffs, are forced to scramble for a new job elsewhere. Comparative advantage is not the only source of trade gains. Arguably more important are economies of scope and scale. A firm that has access to a global market can spread fixed costs over a larger quantity of output, thus lowering average costs (and ultimately prices). The existence of large global markets also allows companies to offer niche products that might not be worthwhile to develop for smaller markets. Modern trade is dominated by the exchange of intermediate goods within complex supply chains (Chart 4). This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. U.S. firms are particularly vulnerable to supply-chain disruptions because the Trump administration has dotardly chosen to levy tariffs mainly on intermediate and capital goods (Chart 5). This stands in contrast to China and the EU, which have raised tariffs mainly on final goods in a politically strategic manner (agricultural products in Trump-supporting rural areas and Harley Davidson bikes, which are manufactured in Paul Ryan's home district in Wisconsin). Chart 4Trade In Intermediate Goods Dominates How To Trade A Trade War How To Trade A Trade War Chart 5The U.S. Is Not Very Smart In ##br## Implementing A Protectionist Agenda How To Trade A Trade War How To Trade A Trade War Uncertainty over the magnitude and duration of a trade war could cause companies to postpone new investment spending. A vast economic literature pioneered by Avinash Dixit and Robert Pindyck has shown that firms tend to defer capital expenditure decisions when faced with rising uncertainty.3 Furthermore, as I discussed in an academic paper which was published early on in my career, business investment is typically higher when firms have access to larger markets.4 Higher tariffs could lead to an implicit tightening in fiscal policy. If the U.S. raises tariffs by an average of ten percentage points across all imports, a reasonable estimate is that this would imply a tightening in fiscal policy by around 1% of GDP - enough to wipe out the entire stimulus from Trump's tax cuts. Of course, the tariff revenue could be injected back into the economy through more tax cuts or increased spending. However, given the possibility that gridlock will increase in Washington if the Republicans lose the House of Representatives in November, it is far from obvious that this would happen. A trade war would lead to lower equity prices and higher credit spreads. This would translate into tighter financial conditions. Historically, changes in financial conditions have been highly correlated with changes in real GDP growth (Chart 6). Changes in financial conditions have, in turn, led the stock market. The S&P 500 index has risen at an annualized pace of 10% since 1970 when BCA's Financial Conditions Index (FCI) was above its 250-day moving average, while gaining only 1.5% when the FCI was below its 250-day average (Chart 7). Given today's elevated valuations across many asset markets, the risk is that a trade war triggers a sizable correction in asset prices. Chart 6Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Chart 7The Link Between Financial Conditions ##br##And The Stock Market The Link Between Financial Conditions And The Stock Market The Link Between Financial Conditions And The Stock Market Protecting Your Equity Portfolio From A Trade War We think investors are understating the risks of a trade war. This, along with a host of other reasons, prompted us to downgrade global risk assets from overweight to neutral on June 20.5 As bad as a trade war would be for Main Street, it would be even worse for Wall Street. The mega- cap companies that comprise the S&P 500 have a lot more exposure to foreign markets and global supply chains than the broader U.S. economy. The "beta" of corporate profits to changes in GDP growth is also quite high (Chart 8). Chart 9 shows how U.S. equity sectors performed during days when the S&P 500 suffered notable losses due to heightened fears of protectionism. We identified seven separate days, including Wednesday's selloff, which was spurred by Trump's threat to impose tariffs on another $200 billion of Chinese imports. Chart 8Profits Are Much More Volatile Than GDP Profits Are Much More Volatile Than GDP Profits Are Much More Volatile Than GDP Chart 9This Is How Markets Trade When They Are Worrying About Trade Wars How To Trade A Trade War How To Trade A Trade War The chart shows that deep cyclical sectors such as industrials, materials, and energy fared badly during days of protectionist angst. Financials also underperformed, largely because such days saw a flattening of the yield curve. Tech, health care, and telecom performed broadly in line with the S&P 500. Consumer stocks outperformed the market, but still declined in absolute terms. Utilities and real estate were the only two sectors that saw absolute price gains. Considering that the sector composition of European and EM bourses tends to be more tilted towards cyclicals than the U.S., it is not surprising that the former have underperformed during days of increased protectionist worries. Bonds: Yields Likely To Rise, But A Trade War Is A Risk To That View In contrast to equities, a trade war would benefit Treasurys and other safe-haven government bonds. Admittedly, the imposition of tariffs would push up import prices. However, the effect on inflation would be temporary. Just as the Fed tends to disregard one-off increases in commodity prices, it will play down any transient boost to inflation stemming from a trade war. Instead, the Fed will focus on the growth impact, which is likely to be negative. To be clear, trade jitters are not the only thing affecting bond yields. Judging by numerous business surveys, the U.S. economy is starting to overheat (Chart 10). Last week's employment report does not alter this conclusion. While the unemployment rate rose by 0.2 percentage points, this was mainly because of a jump in the participation rate. Considering that the number of workers outside the labor force who want a job is near a record low, the ability of the economy to draw in additional workers is limited (Chart 11). Chart 10The U.S. Economy Is Overheating The U.S. Economy Is Overheating The U.S. Economy Is Overheating Chart 11A Small Pool Of People Want ##br##To Jump Into The Labor Market A Small Pool Of People Want To Jump Into The Labor Market A Small Pool Of People Want To Jump Into The Labor Market Historically, continuing unemployment claims have closely tracked the unemployment rate over time (Chart 12). The fact that continuing claims have dropped by 9% since the end of January, while the unemployment rate has dipped by only 0.1 percentage points, suggests that the unemployment rate will fall further over the coming months. On balance, we continue to maintain our bearish recommendation on Treasurys, but acknowledge that a trade war is a risk to that view. Trade Wars And Currencies Unlike safe-haven bonds, whose yields are likely to decline in proportion to the magnitude of the trade war, the impact on the dollar is more difficult to predict. On the one hand, a modest trade dispute is likely to be somewhat dollar bearish, inasmuch as it hurts U.S. growth and forces the Fed to slow the pace of rate hikes. Since most other major central banks are not in a position to cut rates, expected rate differentials between the U.S. and its trading partners would narrow. On the other hand, a severe trade war would probably be dollar bullish. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. still tend to attract capital inflows into the safe-haven Treasury market. The U.S. is a fairly closed economy, and hence would be relatively less affected by a breakdown in global trade. Commodities are also likely to suffer if trade flows decline (Chart 13). Lower commodity prices tend to be bullish for the greenback. Moreover, as we discussed in our latest Strategy Outlook, a tit-for-tat trade war with China could force the Chinese government to devalue the yuan. That would have a knock-on effect on other emerging market currencies. Chart 12Unemployment Can Fall Further Unemployment Can Fall Further Unemployment Can Fall Further Chart 13Commodities Are A Potential Victim Of Trade War Commodities Are A Potential Victim Of Trade War Commodities Are A Potential Victim Of Trade War Notably, the greenback has fared better recently than it did earlier this year during days when protectionist rhetoric intensified. On Wednesday, the broad trade-weighted dollar gained 0.3% while the DXY picked up 0.6%. This supports our view that the dollar will strengthen over the remainder of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 2 This assumes an elasticity of import demand of 3, which is broadly consistent with most academic estimates. 3 Avinash K. Dixit, and Robert S. Pindyck, "Investment Under Uncertainty," Princeton University Press, (1994). 4 Peter Berezin, "Border Effects Within A Dynamic Equilibrium Trade Model," The International Trade Journal, 14:3 (2000), 235-282. 5 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. BOX 1 The Deadweight Loss From A Trade War Box Chart 1Tariffs Increase Budget Revenues, But Lead To A Bigger Loss In Consumer Surplus How To Trade A Trade War How To Trade A Trade War In the simplest models of international trade, an increase in tariffs leads to higher prices, resulting in a loss of consumer surplus. This is depicted by the blue region (ABCE) in Box Chart 1. The government collects revenue from the tariff shown by the red-colored rectangle (ABDE). The difference between the loss in consumer surplus and the gain in revenue - often referred to as the "deadweight loss" from a tariff - is depicted by the green-colored triangle (BCD). Arithmetically, the area of the triangle can be calculated as: Deadweight loss = 0.5 x Tariff x (Pre-tariff level of imports - Post-tariff level of imports) If one divides both sides by GDP, the formula reduces to: Deadweight loss/GDP = 0.5 x Tariff x Percentage Point Change In Import Share of GDP Resulting From Tariff There are many things in the real world that are not captured by this equation. For example, if the country that imposes the tariff is sufficiently large, this could push down the international price of the goods that it imports. The country would then benefit from an improvement in its terms of trade. As Robert Torrens showed back in the 19th century, if a country has any degree of market power (i.e., it is not a complete price-taker on international markets), there will always be a level of tariffs that makes it better off. The caveat is that this "optimal tariff" only exists if other countries do not retaliate. If everyone retaliates against everyone else, everyone will be worse off from a trade war. Moreover, as discussed in the main text, there are many factors that this simple model does not capture which could result in significant economic damage from raising tariffs even when retaliation does not take place, especially in cases where the tariffs are imposed on intermediate and capital goods. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Neutral As noted in yesterday's Daily Insight, we lifted the S&P pharma and biotech indexes to neutral earlier this month. These sectors command roughly a 50% weighting in the S&P health care sector and, accordingly, the July 3rd upgrade to a benchmark allocation in both of these sub-groups also lifts the health care sector to a neutral portfolio weighting. Such a move may be well timed as we move into the second quarter earnings season; the bar for upward surprises is extremely low as analysts have thrown in the towel on the sector. As shown in the second panel at the side, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how valuations have fallen despite a depressed denominator (third panel). Further, any sector profit outperformance could prove sticky if the Trump Administration does not clamp down on pharma pricing power as initially feared and allows health care companies to resume their long term outsized revenue growth trend. We would not hesitate to lift exposure further to overweight were the federal government to put forth a bill with minimal damage inflicted upon drug prices, were the greenback to keep on appreciating and were a steep 'risk off' phase to grip the broad equity market. Bottom Line: We have lifted the S&P health care sector to neutral. Please see our July 3rd Weekly Report for more details. Bearishness Reigns - Time To Upgrade Health Care Bearishness Reigns - Time To Upgrade Health Care

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist Highlights The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on mainland growth. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets, including commodities and EM. The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. A narrowing interest rate differential between China and the U.S. will continue exerting downward pressure on the RMB's value versus the dollar. Our credit stress test on Turkish banks suggests their stocks are not yet cheap assuming the non-performing loan ratio rises to 15%. Stay short banks and the lira. Feature China's economic slowdown, ongoing trade wars and accumulating U.S. inflation pressures will continue propping up the U.S. dollar, thereby sustaining a perfect storm for EM financial markets. This is taking place amid the poor structural fundamentals in the developing economies and the existing overhang of investor positions in EM. Altogether this argues for more downside in EM financial markets. A strong dollar is also a bad omen for developed markets' stock indexes. The reason being that the dollar is a countercyclical variable, and the greenback's rallies usually coincide with global trade downturns that are bearish for global cyclical equity sectors (Chart I-1). Needless to say, tariffs on imports are ultimately negative for global trade, and will exacerbate the global growth slowdown that has been occurring since early this year. In fact, there is anecdotal evidence that global trade has so far temporarily benefited from mounting expectations of tariffs.1 Companies have ordered more inputs and shipped more goods in advance of higher tariffs coming into effect. This is why global shipments and manufacturing production have so far held up reasonably well, while business expectations have plummeted (Chart I-2). Consequently, global trade and manufacturing production will likely record considerable weakness later this year. Since markets are typically forward looking, asset prices will adjust beforehand. Chart I-1Global Industrial Stocks And U.S. Dollar Global Industrial Stocks And U.S. Dollar Global Industrial Stocks And U.S. Dollar Chart I-2Global Trade Is Heading South Global Trade Is Heading South Global Trade Is Heading South We are maintaining our negative stance on EM stocks, currencies, credit markets and high-yielding local bonds. China Is Easing Liquidity, But Don't Hold Your Breath Chart I-3Chinese Interest Rates And EM Stocks: ##br##Positively Correlated Chinese Interest Rates And EM Stocks: Positively Correlated Chinese Interest Rates And EM Stocks: Positively Correlated China's softening industrial data, growing anecdotal evidence of a worsening credit crunch in the economy, U.S. tariffs, and plunging domestic share prices have been sufficient for the authorities to ease liquidity conditions in the Chinese banking system. Not surprisingly, many investors are wondering whether the worst is over for Chinese stocks and China-related financial markets worldwide, including those in EM. At the current juncture, liquidity easing by the PBOC is a necessary but not sufficient condition to turn positive on this nation's industrial cycle as well as EM risk assets. We have the following considerations on this topic: First, China's risk-free interest rates - government bond yields - led the selloff in both EM and Chinese stocks (Chart 3). These bond yields have plunged since November, foreshadowing the slowdown in China's growth and the carnage in EM/Chinese financial markets. By and large, there has been a positive correlation between EM share prices and China's local bond yields and interbank rates as illustrated on Chart I-3. For example, EM stocks, currencies and credit markets rallied substantially in 2017 in the face of rising interest rates in China. Likewise, they dropped in the second half of 2015 as bond yields and money market rates in China plunged. The rationale behind the positive correlation between EM risk assets and Chinese interest rates is that the latter rise and EM risk assets rally when the mainland economy is improving. The opposite is also true. At the moment, Chinese risk-free bond yields will likely continue to drop as additional slowdown in growth is in the cards. This heralds a further drop in EM financial markets. Second, any major stimulus will constitute a retraction of the Chinese government's policy of deleveraging and containing financial risks. The latter is the code phrase Chinese authorities use to stop fueling bubbles and speculative excesses. Hence, any policy stimulus will for now be measured and insufficient to boost growth this year. China is saddled with massive debt and money overhangs and a bubbly property market. Ongoing enormous expansion in money supply (i.e., RMB deposits)2 (Chart I-4) and a narrowing interest rate differential over the U.S. will continue exerting downward pressure on the RMB's value (Chart I-5). Chart I-4'Helicopter Money' In China Helicopter Money' In China Helicopter Money' In China Chart I-5The RMB Will Depreciate Further The RMB Will Depreciate Further The RMB Will Depreciate Further Even though capital controls have tightened since 2015, the capital account is not perfectly closed. As such, shrinking interest rate deferential versus the U.S. warrants further yuan depreciation. In short, the authorities cannot reduce interest rates further and expand money/credit growth at a double-digit rate without tolerating sizable currency deprecation. If the Chinese authorities opt for a large fiscal and credit stimulus again, the nation's structural imbalances will grow further. In this scenario, the Middle Kingdom's secular growth outlook will deteriorate, and policymakers' manoeuvring room to stimulate in the future will narrow. Chart I-6China: The Industrial Cycle Is Slumping China: The Industrial Cycle Is Slumping China: The Industrial Cycle Is Slumping Crucially, China's enormous money and credit creation are entirely unrelated to its high savings rate. Money and credit in China have been driven by speculative behavior of Chinese banks and borrowers not households' high savings rate. We have discussed these issues in detail in our past special reports3 and will not expand on them here. Third, there has been money/credit tightening on three fronts in China - liquidity, regulatory and anti-corruption. Even though liquidity conditions in the banking system are now ameliorating, as evidenced by the plunge in interbank rates, the regulatory clampdown on the shadow banking system as well as the anti-corruption campaign targeting the financial industry are still underway. The latter policy initiatives will continue to curb credit creation by suppressing banks' and shadow banking institutions' ability and willingness to finance the real economy. In fact, it is not inconceivable that the regulatory clampdown and anti-corruption campaign will have a larger impact on credit supply than the decline in borrowing costs. Finally, policy easing and tightening works with a time lag. China's business cycles and related financial markets do not always respond swiftly to changes in policy stance. Specifically, monetary and fiscal policies were easing substantially from the middle of 2015, yet EM/China-related risk assets continued to plummet for six months until February 2016. Conversely, policy was tightening in China throughout 2017, yet EM/China-related asset markets did well in 2017. In brief, there could be a long lag between a change in policy stance and a reversal in financial markets. For now, we reckon that the cumulative effect of policy tightening of the past 18 months will continue to seep through the Chinese economy till the end of this year. Chart I-6 demonstrates that various industrial cycle indicators continue to deteriorate. Bottom Line: The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on Chinese growth and China-related risk assets, including commodities and EM. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets. More Downside The indicators that have been useful in foretelling the turmoil in EM financial markets this year are signaling that a negative stance is still warranted: One indicator that gave an early warning signal for the current EM selloff was EM sovereign and corporate bond yields. At the moment, the average of EM dollar-denominated corporate and sovereign bond yields continues to presage lower EM stock prices, as demonstrated in Chart I-7 - bond yields are shown inverted in this chart. Chart I-7Rising EM Borrowing Costs Are Bearish For Their Stocks Rising EM Borrowing Costs Are Bearish For Their Stocks Rising EM Borrowing Costs Are Bearish For Their Stocks Notably, EM share prices display lower correlation with U.S. bond yields and U.S. TIPS yields than with EM corporate and sovereign bond yields (Chart I-8). Why are EM share prices exhibiting a stronger correlation with EM bond yields rather than with U.S. Treasury yields? The basis is that EM equities are sensitive to EM - not U.S. - borrowing costs. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate and sovereign U.S. dollar bond yields - i.e. EM borrowing costs in dollars - will decline, and EM share prices will rally (Chart I-7). But when EM corporate (or sovereign) yields rise - irrespective of whether because of rising U.S. Treasury yields or widening EM credit spreads - EM borrowing costs in dollars rise, and consequently equity prices come under considerable selling pressure. In other words, a drop in U.S. bond yields on its own is not enough for EM share prices to advance, and conversely, a rise in U.S. bond yields is not sufficient for EM stocks to drop. It is movements in EM U.S. dollar bond yields, which are comprised of U.S. Treasury yields and EM credit spreads, that matter for the direction of EM equity prices. Regarding local bond yields, EM share prices typically exhibit a strong negative correlation with EM domestic government bonds yields - the latter are shown inverted on this chart (Chart I-9). Since we expect EM currencies to depreciate further and, given the negative correlation between EM currency values and their local bond yields, the latter will continue rising. Chart I-8EM Stocks And U.S. Rates: ##br##Mixed Relationship EM Stocks And U.S. Rates: Mixed Relationship EM Stocks And U.S. Rates: Mixed Relationship Chart I-9EM Equities And Local Bond Yields: ##br##Strong Correlation EM Equities and Local Bond Yields: Strong Correlation EM Equities and Local Bond Yields: Strong Correlation The risky-to-safe-haven currency ratio4 continues to fall after experiencing a major breakdown early this year (Chart I-10, top panel). Historically, this ratio has been correlated with EM share prices and currently heralds further downside (Chart I-10, bottom panel). This ratio also is agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the general trend in the greenback. Hence, this indicator answers the question of the direction of EM share prices, regardless of the dollar's trend. Finally, key to EM performance has been corporate profits. Presently, the outlook for EM corporate profits is still negative, as suggested by the negative readings on China's money and credit (Chart I-11). Chart I-10Are Risk Assets In A Bear Market? bca.ems_wr_2018_07_12_s1_c10 bca.ems_wr_2018_07_12_s1_c10 Chart I-11EM Corporate Profits Will Likely Shrink EM Corporate Profits Will Likely Shrink EM Corporate Profits Will Likely Shrink Bottom Line: EM risk asset will continue selling off and underperforming their DM counterparts. Stay short/underweight EM risk assets. The Dollar's Trend Is Still Up The U.S. dollar is instrumental to EM financial market trends. We expect the dollar rally to persist for now - at least through the end of this year. The underlying inflation gauge measure calculated by New York Fed points to further acceleration in U.S. consumer price inflation (Chart I-12). Furthermore, America's job market is continuing to tighten. In brief, U.S. domestic demand will stay robust even as global trade slumps. These will limit the Federal Reserve's ability to back off from tightening, even if EM financial markets continue to sell off. Chart I-12U.S. Inflation Risks Are To The Upside U.S. Inflation Risks Are To The Upside U.S. Inflation Risks Are To The Upside Remarkably, a strong U.S. exchange rate is needed to cap America's growth and inflation and to boost growth in the rest of the world, especially in Asia. Given the widening growth momentum between the U.S. and Asia, the dollar will likely need to rally significantly to reverse the growth differential currently moving in favor of America. This will be especially true if more trade tariffs are imposed. Odds are that the RMB will depreciate further given the backdrop of lower interest rates in China - discussed above. That will cause a downturn in emerging Asian currencies. A strong dollar, a slowdown in Chinese/EM demand for commodities and large net long positions by investors in oil and copper all argue for a considerable drop in commodities prices in the months ahead. This is bearish for Latin American and many other EM exchange rates. Bottom Line: The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. With respect to currency positions, we recommend investors to continue to short a basket of EM currencies such as BRL, ZAR, TRY, MYR and IDR versus the dollar. CLP and KRW are also among our shorts given our bearish outlook for copper prices, global trade and Asian currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkish Banks: A Bargain Or Value Trap? 12 July 2018 Turkish bank stocks have now fallen by 40% in local currency terms and by 55% in U.S. dollar terms since their peak early this year (Chart II-1), prompting the question whether they have become a bargain or are still a value trap. Banks represent 30% of the Turkey MSCI index and are integral to the performance of this bourse. Although Turkish banks appear to be cheap with their price-to-trailing earnings ratio at 4.5 and their price-to-book value ratio at 0.62, they are still vulnerable to a substantial rise in non-performing loans (NPL) and ensuing provisioning, write-off and equity dilution. Turkey has been experiencing an enormous credit binge for years and its interest rates have risen by 600 basis points since the start of the year. Yet, current NPLs and provisions stand at a mere 3% and 2.3% of total outstanding loan, respectively (Chart II-2). Chart II-1Turkish Stocks: A Long-Term Perspective Turkish Stocks: A Long-Term Perspective Turkish Stocks: A Long-Term Perspective Chart II-2Turkish Banks Are Underprovisioned Turkish Banks Are Underprovisioned Turkish Banks Are Underprovisioned The creditworthiness of debtors is worse when one takes into account that Turkish companies have large foreign currency debt and a record amount of foreign debt obligations due in 2018 (Chart II-3). In our credit stress test, we assume that in the baseline scenario the non-performing credit assets (NPCA) ratio will rise to 15% (Table II-1). Taking into account that the NPL-to-total loan ratio reached 18% in 2002 after the 2001 currency crisis, we believe 15% is a reasonable estimate. Chart II-3Turkey: Record High Foreign Debt Obligations Turkey: Record High Foreign Debt Obligations Turkey: Record High Foreign Debt Obligations Table II-1Credit Stress Test For Turkish Banks EM: A Perfect Storm EM: A Perfect Storm To put this number further into perspective, India - one of the very few countries within the EM universe to have somewhat fully recognized its NPLs - currently has an NPL ratio of 15% on its public banks. Chart II-4Turkish Equities: ##br##A Cyclically-Adjusted P/E Ratio Turkish Equities: A Cyclically-Adjusted P/E Ratio Turkish Equities: A Cyclically-Adjusted P/E Ratio If we assume that Turkish bank stocks at the end of this cycle will trade at a price-to-book ratio of 1 after adjusting for all credit losses, then banks' stock prices are currently about 17% overvalued in the baseline scenario of 15% NPCA (Table II-1, the middle row). In all three scenarios, we assume a recovery rate of 40%. With regards to the overall equity market, Chart II-4 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is currently around 5, compared to the historical average of 8. For the bourse's CAPE ratio to drop to two standard deviations below its mean, share prices have to fall by another 20-25%. This is plausible given the outlook for more populist economic policies following the recent elections. Besides, corporate profits will contract considerably because of the monetary tightening that has occurred since early this year. The exchange rate is critical for Turkish financial markets. As such, revisiting currency valuation is also important. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of July 11 the lira was slightly more than one standard deviation below its historical mean (Chart II-5). For it to reach two standard deviations below its mean, it would roughly take another 15-17% depreciation, versus an equal-weighted basket of the dollar and euro. Given the current macroeconomic backdrop and the outlook for more unorthodox policies, including possible capital controls following President Erdogan's appointment of his son-in law as the key economic policymaker, the lira will likely undershoot. Meantime, foreign holdings of Turkish local bonds and stocks were not yet depressed as of June 29 (Chart II-6). Chart II-5Turkish Lira: An Undershoot Is Likely Turkish Lira: An Undershoot Is Likely Turkish Lira: An Undershoot Is Likely Chart II-6Foreign Ownership Is Still High Foreign Ownership Is Still High Foreign Ownership Is Still High Bottom Line: Provided Turkey's political outlook has deteriorated further after the recent elections, we assess that only after a 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with a 15-20% drop in stocks in local currency terms, will Turkish equities be a true bargain and warrant a positive stance. For now, dedicated EM equity and fixed income portfolios (both credit and local currency bonds) should continue to underweight Turkey. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the following article Global automakers hail more ships as trade battles heat up. 2 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available on ems.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, link is available on page 17. 4 Average of cad, aud, nzd, brl, clp & zar total return indices relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Dhaval Joshi, Senior Vice President Chief European Investment Strategist Feature We live in strange economic times. Financial markets applauded President Trump's Keynesian stimulus package, even though it will lift the U.S. structural deficit to a crisis-era level approaching 7% of GDP. Yet markets seem uncomfortable about the merest hint of fiscal stimulus in Italy, where the government finances are close to a structural balance! (Table I-1) Table I-1Italy's Structural Deficit Has Almost Disappeared Monetarists Vs Keynesians: The 21st Century Battle Monetarists Vs Keynesians: The 21st Century Battle Meanwhile the ECB must supposedly maintain negative interest rates to support a fragile Italy; and the Fed must supposedly hike rates many more times to prevent the U.S. overheating. In this Special Report, we ask: might the policy prescription of tight fiscal/loose monetary for Italy and loose fiscal/tight monetary for the U.S. be completely back to front? For Italy, Mainstream Economists Are Prescribing Wrong Remedies For many years, mainstream economists prescribed remedies for sluggish growth in southern Europe on the basis of three articles of blind faith. First, that the ailment in Italy (and previously in Spain and Portugal) arose from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that government borrowing is at best a necessary evil and at worst a recipe for disaster; As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, and aggressively shrinking government deficits. Of course, carefully chosen structural reforms are no bad thing for an economy. But can you name an economy in the world that would not benefit from carefully chosen structural reforms? The misguided obsession with structural reforms has caused mainstream economists to miss the real cause of Italy's ailment - its crippled banking system (Feature Chart). Feature ChartItaly's Problem In One Picture: A Crippled Banking System Italy's Problem In One Picture: A Crippled Banking System Italy's Problem In One Picture: A Crippled Banking System In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage to the national income stream generating a deflationary headwind for the economy. This headwind will persist until the banks are repaired to fulfil their intermediation task of recycling savings and debt repayments. Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart I-2). The upshot is that the real money supply has shrunk despite low private sector indebtedness (Chart I-3 and Chart I-4), record low interest rates and massive injections of liquidity into the banking system. Why? Chart I-2Italian Bank Lending Has Fallen In Real Terms Italian Bank Lending Has Fallen In Real Terms Italian Bank Lending Has Fallen In Real Terms Chart I-3Italy Is Less Indebted... Italy Is Less Indebted... Italy Is Less Indebted... Chart I-4...Than France ...Than France ...Than France The simple reason is that after the 2008 global financial crisis Italian banks' balance sheets were left unrepaired and undercapitalized (Chart I-5 and Chart I-6). For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition - namely, the government - must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Chart I-5After The 2008 Crisis Italian Banks ##br##Were Left Unrepaired... After The 2008 Crisis Italian Banks Were Left Unrepaired... After The 2008 Crisis Italian Banks Were Left Unrepaired... Chart I-6...And ##br##Undercapitalized ...And Undercapitalized ...And Undercapitalized When To Use Fiscal Stimulus, And When Not To Deficit spending is often associated with crowding out and misallocation of resources. But when the banking system is not recycling savings and debt repayments within the private sector, the opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the un-recycled private sector savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Unfortunately, this concept has met with great resistance. Most people are aware of the size of government debt and deficits, but few people are aware of the leakage to the national income stream that occurs when a dysfunctional banking system is unable to recycle savings and debt repayments within the private sector. By not making this crucial connection, people believe that government spending would be profligate. They do not realise that if the private sector as a whole is saving money, the public sector must borrow and spend the money to keep the economy afloat. This leads to important lessons on when Keynesian stimulus is highly effective and when it is ineffective. When the solvency of the private sector - including, crucially, the banking system - is healthy, bank lending responds well to changes in interest rates (Chart I-7 and Chart I-8). Hence, in such a world, monetary policy should be the main tool for regulating economic activity. This describes the recent situation in most developed economies, including the U.S. Fiscal stimulus is largely ineffective because it leads to crowding out, and a sub-optimal allocation of resources. Chart I-7Lower Interest Rates Have Stimulated ##br##Bank Lending In Germany... Lower Interest Rates Have Stimulated Bank Lending In Germany... Lower Interest Rates Have Stimulated Bank Lending In Germany... Chart I-8...And ##br##France... ...And France... ...And France... However, when the private sector and/or the banking system is insolvent and dysfunctional, it is monetary stimulus that becomes ineffective. No extent of depressing interest rates and/or central bank liquidity injections will stimulate bank lending (Chart I-9). This describes the recent situation in Italy. The broad money supply becomes very dependent on government spending, making fiscal stimulus highly effective. Chart I-9...But Not In Italy ...But Not In Italy ...But Not In Italy But can monetary stimulus still help via the exchange rate channel? A weaker euro boosts the competitiveness of firms selling euro priced products in international markets. Therefore, firms exporting discretionary goods and services which are price elastic could benefit. Against this, the weaker euro makes everyone in the euro area poorer in terms of the goods and services they can buy from outside the euro area. This is particularly significant for non-discretionary items - food and energy - of which Europe is a large importer. Given that the volumes of these purchases tend to be inelastic, their price increase in euro terms can weigh down the real spending power of euro area consumers. The upshot is that a weaker exchange rate's aggregate impact on an economy depends on how the winners and losers net out. Italy might become more competitive vis-à-vis its non-euro trading partners, but Italian consumers may suffer a loss of real spending power - which would partly or wholly cancel out the benefit to the exporters. What Is The Prescription Right Now? In summary, neither the monetarists nor the Keynesians are all-powerful. In a world where the private sector is dysfunctional, the effectiveness of both monetary and fiscal policies are opposite to those in a world in which the private sector is functional. Therefore, it is crucial to recognise which of these two phases the economy is in, and then implement the economic policies, monetary or fiscal, most effective in that phase. What are the key messages right now? In Italy, the banking system is still healing and not fully functional. This suggests that for Italy, the ECB's ultra-loose monetary policy is largely ineffective whereas fiscal stimulus - even modest - would be highly effective (Chart I-10). But in the other major economies, including the U.S., the private sector is fully functional. This means that monetary policy is effective, whereas fiscal stimulus will be largely ineffective (Chart I-11). Interestingly, in a just-released paper 'Fiscal Policy in Good Times and Bad' the Federal Reserve Bank of San Francisco reaches exactly the same conclusion, pointing out that:1 Chart I-10A Strong Recent Connection Between ##br##Fiscal Thrust And GDP Growth In Italy A Strong Recent Connection Between Fiscal Thrust And GDP Growth In Italy A Strong Recent Connection Between Fiscal Thrust And GDP Growth In Italy Chart I-11A Weak Connection Between Fiscal##br## Thrust And GDP Growth In The U.S. A Weak Connection Between Fiscal Thrust And GDP Growth In The U.S. A Weak Connection Between Fiscal Thrust And GDP Growth In The U.S. "A number of macroeconomic forecasters expect the Tax Cuts And Jobs Act to boost 2018 GDP growth by around a percentage point... (but) the true boost is more likely to be well below that, as small as zero..." Pulling all of this together, we end with two takeaways for investors: don't bet on the ultra-loose monetary policy in the euro area continuing indefinitely; and as the San Francisco Fed advises, don't bet on President Trump's Keynesian stimulus being a game changer for U.S. growth. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the FRBSF Economic Letter 'Fiscal Policy in Good Times and Bad', Tim Mahedy and Daniel J. Wilson, July 9, 2018 available at https://www.frbsf.org/economic-research/files/el2018-18.pdf