Trade

Highlights Q1 earnings season looks robust, but trade policy is an uncertainty. Sizeable shifts in equity technicals and sentiment since the start of the year; valuation still stretched. Global growth may have peaked but fiscal, monetary and legislative backdrop remains supportive. The market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. Feature Chart 1Despite Setback In March, ##br## U.S. Labor Market Remains Strong Despite Setback In March, U.S. Labor Market Remains Strong Despite Setback In March, U.S. Labor Market Remains Strong U.S. equity prices fell last week as trade policy remained on the front pages. Gold was one of the few beneficiaries of the tariff talk. Investors hope to turn the page this week as the Q1 2018 earnings season kicks into high gear, but trade-related market volatility is here to stay. The bar is high for 2018 earnings growth, and the focus may shift to the prospects for 2019 sooner rather than later. The modest selloff in the S&P 500 since late January led to a shift in sentiment, but the technical picture for U.S. equities is mixed. Global growth may be rolling over, but we find that risk assets perform well anyway, if fiscal, monetary and legislative policy is aligned. Trump's actions on tariffs do not mean that we are necessarily headed for a trade war. The tariffs proposed but both sides have not yet been implemented and there is still time for compromise. We do not see March's modest 103,000 increase in non-farm payrolls as signaling a weaker labor market. First, the monthly data can be volatile. The soft increase in March follows an outsized 326,000 gain in February. The 3-month average, more reflective of the underlying trend, is a solid 202,000. Second, average hourly earnings increased by 0.3% m/m, which nudged the annual wage inflation rate to 2.7% from 2.6%. Firming earnings growth is a sign of a strong labor market (Chart 1). Despite the soft increase in March payrolls, the U.S. labor market and economy are on a firm footing. Aggregate hours worked increased by 2.0% at a quarterly annualized rate in Q1. Such a pace is consistent with about 3% GDP growth. Firm growth will allow inflation to head back to the 2% target and allow the Fed to continue with its gradual rate hikes. S&P 500 Earnings: Q1 2018 The consensus expects an 18% year-over-year increase in the S&P 500's EPS in Q1 2018 versus Q1 2017, and 20% in 2018. Energy, materials, financials and technology will lead the way in earnings growth in Q1, while real estate and consumer discretionary will struggle. Excluding the energy sector, the consensus expects a stout 17% increase in profits. The robust profit environment for Q1 2018 and the year ahead reflects sharply higher oil prices compared with early 2017 and the impact of last year's Tax Cut and Jobs Act. Moreover, improved global growth and still modest labor costs will support the Q1 results. Trade policy will likely replace tax cuts as a key topic when corporate managements report Q1 outcomes and provide guidance for Q2 and beyond. While no tariffs have yet been imposed, analysts will want to understand the impact that the proposed actions will have on input costs and margins. Moreover, investors must gauge to what extent trade policy-related uncertainty is weighing on business sentiment (details below in "Trade Skirmish...Or Trade War?"). Market volatility, rising interest rates and the modest upswing in U.S. labor costs will also be discussed during the Q1 earnings calls. As always, guidance from corporate leaders for Q2 2018 and ahead are more important than the actual results for Q1 2018. The markets probably have already priced in a robust 2018 earnings profile due to the Tax Cut and Jobs Act, and are looking ahead to 2019 (Chart 2). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 20% increase expected this year. Chart 2The Bar Is High For 2018 EPS, But The Focus Is On 2019 The Bar Is High For 2018 EPS, But The Focus Is On 2019 The Bar Is High For 2018 EPS, But The Focus Is On 2019 Chart 3 shows that elevated readings on the ISM provide a very favorable backdrop for EPS in 2018. As indicated in Chart 4, industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Industrial production growth may be peaking, but we don't expect it to soften much on a year-over-year basis. Chart 3Elevated ISM Good News For 2018 EPS Growth Elevated ISM Good News For 2018 EPS Growth Elevated ISM Good News For 2018 EPS Growth Chart 4Stout Readings On IP Support S&P 500 Revenue Gains Stout Readings On IP Support S&P 500 Revenue Gains Stout Readings On IP Support S&P 500 Revenue Gains Global GDP growth estimates for 2018 and 2019 continue to move steadily higher in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 5). Chart 5U.S. And Global Growth Estimates Are Still Accelerating... ##br## But For How Much Longer? U.S. And Global Growth Estimates Are Still Accelerating... But For How Much Longer? U.S. And Global Growth Estimates Are Still Accelerating... But For How Much Longer? Chart 6The Dollar Should Not Be A Big Concern ##br## In Q1 Earnings Season The Dollar Should Not Be A Big Concern In Q1 Earnings Season The Dollar Should Not Be A Big Concern In Q1 Earnings Season The greenback should not be an issue for corporate results in Q1 2018 based on minimal references to a robust dollar in the past six Beige Books. This significantly differs from 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, a modestly weaker dollar has allowed profit and sales gains of global firms to rebound and outpace those of domestic businesses (Chart 7). Margins for U.S. companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but rebounded last year and are higher than margins of domestic companies. Nonetheless, a slowdown in growth outside the U.S. may reverse these trends (Please read below, "Global Growth Has Peaked, Now What?"). Investors are skeptical that margins can advance in Q1 2018 for the seventh consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. Chart 7Global EPS, Margins Outpacing Domestic Global EPS, Margins Outpacing Domestic Global EPS, Margins Outpacing Domestic Chart 8Strong S&P Growth Ahead, Will Start To Slow Soon Strong S&P Growth Ahead, Will Start To Slow Soon Strong S&P Growth Ahead, Will Start To Slow Soon Bottom Line: BCA expects that the earnings backdrop will be supportive of equity prices in 2018 (Chart 8). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on 2019 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Technical, Sentiment And Valuation Update BCA's Technical Indicator is not at an extreme (Chart 9, panel 1) and the 7.8% pullback in the S&P 500 since January 26, 2018 leaves the index in the middle of its recovery trend channel (panel 2). The failure of the index to break out of this channel earlier this year suggests that a period of consolidation for equities awaits. Moreover, the upward slope in the NYSE advance/decline line (panel 3) is in jeopardy. The final panel of Chart 9 shows that stocks are no longer extremely overvalued, but they remain overvalued nonetheless. Stretched valuations say more about medium- and long-term returns than near-term performance.1 Chart 9Technicals And Valuations For U.S. Equities Technicals And Valuations For U.S. Equities Technicals And Valuations For U.S. Equities Chart 10Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated The shift in the equity sentiment since the market top in January is notable. BCA's investor sentiment composite index, which hit an all-time high at the end January, has pulled back in the past few months (Chart 10, panel 1). However, this metric has not yet returned to its long-term average (solid line on top panel of Chart 10). The drop in sentiment is broadly based; individual investors and advisors who serve them (panels 2 and 4) along with traders (panel 3) have lately curtailed their bullishness. Recent shifts in several other sentiment surveys are also worth noting: The American Association of Individual Investors, a contrary indicator of sentiment, turned bullish in recent weeks. The percentage of respondents who were bearish moved above 30%, while the percentage of bulls dipped to 32%. Neither measure is at an extreme (Chart 11). The National Association of Active Investment Managers (NAAIM) says that active managers have reduced equity risk since the beginning of Q4 2017 (Chart 12). At 52%, the average equity exposure of institutional investors is at the lowest level since March 2016 and is nearly half the 102% exposure at the start of 2017. In contrast, the March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. As in previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and has remained there. The index is at its highest point since the 2000 market peak (Chart 13, panel 1). Moreover, net speculative positions of S&P 500 stocks are roughly in balance, but have turned net short in recent weeks. Nonetheless, this metric is not at an extreme (panel 3). Chart 11Individual Investors Have Turned More Bearish Individual Investors Have Turned More Bearish Individual Investors Have Turned More Bearish Chart 12Active Managers Still Overweight Equities... Active Managers Still Overweight Equities... Active Managers Still Overweight Equities... Chart 13Equity Speculation Is High... Equity Speculation Is High... Equity Speculation Is High... Chart 14Pullback Has Relieved Some Technical Pressure Pullback Has Relieved Some Technical Pressure Pullback Has Relieved Some Technical Pressure The S&P 500 is close to its 200-day moving average. In late 2017, this indicator was at the upper end of its post-2000 range (Chart 14, panel 1). BCA's composite technical measure is in the middle of the 2007-2017 range and is not a concern (Chart 14, panel 5). Moreover, the percentage of NYSE stocks above their 10- and 30-week highs are below average and at the low end of their recent ranges. Furthermore, new highs minus new lows is at neutral (panel 2). Bottom Line: The 7.8% pullback in the S&P 500 since January 26 has relieved some technical pressure on the market, and sentiment levels are less stretched than at the late January 2018 peak. Moreover, institutions have cut their equity exposures. Nonetheless, stock speculation is rampant and valuations are elevated, which suggests lower returns in the coming decade. Moreover, a slowdown in global growth in ongoing trade tensions suggest that the risk/reward balance for equities has deteriorated. Global Growth Has Peaked, Now What? Chart 15Is Global Growth Peaking? bca.usis_wr_2018_04_09_c15 bca.usis_wr_2018_04_09_c15 In last week's report we stated that while BCA expects global growth to be solid this year, there are signs that global growth may near a top.2 March's PMI data support that view. Chart 15 shows that the Markit Global PMI dipped to 53.4 in March from 54.1 in February; the 0.7 drop was the largest since February 2016 (panel 2). Last month,3 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. BCA expects the ongoing era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. However, some investors wonder if the peak in global growth changes our view of how risk assets will perform during periods of harmonized policy. We do not expect the peak in global growth to lead to a recession this year or next. Chart 16 and Table 1 show the performance of U.S.-based financial assets, gold, oil, the dollar and S&P 500 earnings when Fed, fiscal and legislative policies are stimulative and global growth is rolling over but still positive. There has been only a handful of such episodes, so investors should be cautious when interpreting these results. The S&P 500 beats Treasuries, investment-grade and high-yield credit outperforms Treasuries, and small caps outpace large caps. Gold and oil perform well in these periods, perhaps aided by a weaker dollar. S&P 500 earnings are positive. Chart 16Positive Policy Backdrop As Global Growth Is Rolling Over Positive Policy Backdrop As Global Growth Is Rolling Over Positive Policy Backdrop As Global Growth Is Rolling Over Table 1Three Periods Where Global Growth Rolled Over But Policy Backdrop Was Stimulative Policy Peril? Policy Peril? Bottom Line: A peak in global growth reduces the risk/reward balance for risk assets, and provides another reason to be cautious. Equity valuation, although improved recently, is still stretched. Central banks are slowly removing the punchbowl, margins have limited upside and the economic cycle is at a late stage. Long-term investors should already be scaling back on risk. Short-term investors should stay overweight risk for now, on the view that fiscal stimulus will provide a tailwind for earnings for the remainder of the year. Trade Skirmish...Or Trade War? BCA's Geopolitical Strategy service notes4 that the market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down by 5.7% since the White House announced tariffs on steel and aluminum and 2.34% since it declared impending levies against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets, the U.S. demands on China justify the moniker of a trade skirmish, rather than a full-on war. In view of our position, we think the 5.7% drawdown is appropriate, if a bit sanguine. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. Therefore, it is appropriate for the market to price in a 20%-30% probability of a trade war developing. Given that the market drawdown in such a scenario could be 20% or more, the market is appropriately discounting the risks. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities when a similar confrontation in the 1980s between Japan and the U.S. did not? First, the overvaluation of stocks is much greater today. Secondly, interest rates are much lower, restricting how much policymakers can react to adverse risks. Thirdly, supply chains are much more integrated, both globally and between China and the U.S. The U.S. Administration's trade policy is not haphazard. President Trump and U.S. Trade Representative Robert Lighthizer are on the same page: they have made China, and not NAFTA trade partners or South Korea, the target of U.S. protectionism (Chart 17). Chart 17China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs Table 2U.S. Gradually Exempting Allies From Tariffs Policy Peril? Policy Peril? The rapid pace at which the Administration pivoted from global tariffs to targeting China is an indication of what lies ahead. The U.S. uses the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 2). This strategy can work, as outlined last week,5 but there is plenty of room for mistakes. Trump also wants to change the U.S. policy on immigration and he may use NAFTA negotiations to gain leverage over Mexico. Therefore, there is a slight probability that Trump may trigger Article 2205 to leave NAFTA, but we believe the risk has declined substantively since our 50% estimate in November 2017. Bottom Line: The Trump Administration has pursued a well-considered but tough trade policy toward China. Nonetheless, Trump's actions do not mean that we are necessarily headed for a trade war. The tariffs proposed by both sides have not yet been implemented and there is still time for compromise. The U.S. Treasury will release a list of exemptions on May 1. On May 21, Treasury will reassess its list of China's investments in the U.S. and China will likely retaliate. June 5 marks the end of a 60-day negotiation period when the Administration must decide whether to implement the announced tariffs. There still is a 30% chance that the trade skirmish will morph into a trade war. Trump could significantly escalate matters if he declares a national emergency on trade in June. Expect more trade-related volatility in U.S. financial markets until that time. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Asset Allocation Special Report, "What Returns Can You Expect?", dated November 15, 2017, available at gaa.bcaresearch.com. 2 Please see BCA U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", dated April 2, 2018, available at usis.bcaresearch.com. 3 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", dated March 12, 2018, available at usis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan", dated March 30, 2018, available at gps.bcaresearch.com.

Highlights R-star is higher in the U.S. than in most other large economies. This includes China, where an elevated savings rate has depressed the neutral rate of interest. Countries with relatively high neutral rates like the U.S. will tend to run structural current account deficits, whereas countries with relatively low neutral rates will tend to run surpluses. The failure of the Trump administration to understand this basic economic lesson could inflame the ongoing trade spat between the two countries, at a time when populism is on the rise and China is challenging the U.S. for global influence. Fortunately, trade protectionism is less attractive when jobs are plentiful, as is the case in the U.S. today. Thus, we continue to see a market-friendly resolution to the ongoing conflict. Our base case remains that another global recession is still about two years away, which should keep the bull market in global equities intact. However, with global growth decelerating, financial conditions tightening at the margin, and the near-term signal from our proprietary MacroQuant model stuck in bearish territory for the second month in a row, the tactical picture for stocks remains rather murky. Feature Blame It On The Neutral Rate If the world of macroeconomics were set in a superhero universe, the real neutral rate of interest, otherwise known as R-star, would undoubtedly be cast as an arch-villain. R-star is the interest rate consistent with full employment and stable inflation. A depressed R-star has made the zero lower-bound constraint on nominal rates a vexing problem for central bankers. Not long after the Global Financial Crisis began, policy rates fell to ultra-low levels. But even this was not enough to engender a strong recovery. Most economies needed negative real rates. However, with inflation stuck at low levels, there was a limit to how far below zero real rates could go. Japan, of course, has been no stranger to this problem. Policy rates have been close to zero for over 20 years, yet inflation remains stubbornly low (Chart 1). Some commentators have dismissed this issue, noting that real per capita GDP has still managed to grow at a reasonably healthy clip. Unfortunately, this misguided optimism ignores the fact that Japan was only able to keep the economy from sinking into a depression by relying on massive budget deficits. With Japanese monetary policy rendered impotent, fiscal policy had to pick up the slack. High levels of excess private-sector savings were absorbed with continued government dissavings (Chart 2). The result is a gross government debt-to-GDP ratio of 240%. A low R-star has also been a major problem in the euro area. Before the European sovereign debt crisis erupted, Germany was able to export its excess savings to the peripheral countries, who were more than happy to load up on cheap debt so that they could live beyond their means (Chart 3). Chart 1Japan: Even Zero Interest Rates ##br##Were Not Enough To Spur Inflation Japan: Even Zero Interest Rates Were Not Enough To Spur Inflation Japan: Even Zero Interest Rates Were Not Enough To Spur Inflation Chart 2Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 3The European Periphery Is No Longer ##br##Absorbing Germany's Excess Savings The European Periphery Is No Longer Absorbing Germany's Excess Savings The European Periphery Is No Longer Absorbing Germany's Excess Savings Those days are over. Today, Germany's current account surplus stands at a gargantuan 8% of GDP, but much of Germany's savings are exported to the rest of the world. Consequently, the euro area current account balance has gone from roughly breakeven in the pre-crisis period to a surplus of 3% of GDP. This likely means that the neutral rate in the euro area has fallen further. R-Star In China Chart 4China Saves A Lot China Saves A Lot China Saves A Lot What about China? One might think that China's fast trend GDP growth rate would translate into a high neutral rate. However, the neutral rate is not just a function of trend growth. Most economic models state that the savings rate also affects the neutral rate.1 The more income people wish to save at any given interest rate, the lower the neutral rate will be. For a variety of institutional and cultural reasons, the Chinese save a lot (Chart 4). The national savings rate has averaged 50% of GDP for the past decade. In fact, despite an investment-to-GDP ratio of 44%, China still manages to run a current account surplus (remember the current account balance is just the difference between savings and investment). A Simple Thought Experiment The earth does not trade with Mars. As a result, the global current account balance must be zero; current account surpluses in one set of countries must be offset by current account deficits in another set of countries. Interest rates and exchange rates play a vital role in ensuring that this identity is satisfied. Imagine a bunch of island economies - all with different neutral rates - that do not trade with one another. Now suppose a technological breakthrough occurs that permits free trade and capital mobility. What would you expect to happen? Standard economic theory says that capital will flow towards the islands with relatively high interest rates. As shown in Chart 5, the flood of capital will push down the interest rate in those economies. A lower interest rate, in turn, will discourage saving and encourage investment, leading to a current account deficit. Capital inflows will also drive up the currency, while higher spending will push up consumer prices. Such a "real appreciation" of the exchange rate is necessary to ensure that increased spending falls primarily on foreign-made goods.2 Chart 5Interest Rates And Current Account Balances In An Open Economy U.S.-China Trade Spat: Is R-Star To Blame? U.S.-China Trade Spat: Is R-Star To Blame? On the flipside, capital will flow out of economies with low neutral rates, putting upward pressure on interest rates. A higher interest rate will lead to more savings and less investment, translating into a current account surplus. Countries with relatively low neutral rates will also see a real depreciation of their exchange rates. If there is complete free trade and capital mobility, the final equilibrium will be one where interest rates are equalized across all islands and the current account deficits of the islands with relatively high neutral rates are exactly offset by the current account surpluses of the islands with low neutral rates. In addition, countries with relatively high neutral rates will end up with exchange rates that appear somewhat overvalued relative to their fair value, while those with low neutral rates will have exchange rates that appear somewhat undervalued. U.S.-China Trade Tensions: An Inevitable Conflict There are many structural reasons why the U.S. and China are at loggerheads over trade these days. We predicted that Trump would win the presidency largely because we thought the political/media establishment was underestimating the importance of the populist wave sweeping across the U.S. and much of the world. Our geopolitical analysts share this view. They have also argued that China's growing economic, military, and technological prowess will inevitably put it into conflict with the U.S., which has been the world's sole hegemon ever since the Soviet Union collapsed.3 This week's report adds another structural reason to the list. While R-star in the U.S. is fairly low by historic standards, it is higher than in most other countries, reflecting America's favorable demographics, large fiscal deficit, and relatively spendthrift culture. This means that the U.S. must run a structural current account deficit. This, of course, is at odds with the Trump administration's stated objectives. Efforts by China or any other country to "talk up" their currencies in the hopes of placating Trump will fail. The U.S. economy is already operating at close to full employment. A weaker dollar would only shift the composition of spending towards domestically-produced goods. The U.S., however, does not have enough spare labor to produce these additional goods. All that would happen is that inflation would rise, rendering U.S. exporters less competitive. More stimulative fiscal policy will further increase the neutral rate of interest in the United States. Chart 6 shows that the budget deficit is set to widen to nearly 6% of GDP by 2019 even if the unemployment rate continues to decline. A larger budget deficit will drain national savings, shifting the savings schedule in the savings-investment diagram discussed earlier to the left. This will result in a bigger current account deficit (Chart 7). Chart 6The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Chart 7A Bigger U.S. Budget Deficit Will Cause The U.S. Neutral Rate To Rise, ##br## Leading To A Larger Current-Account Deficit U.S.-China Trade Spat: Is R-Star To Blame? U.S.-China Trade Spat: Is R-Star To Blame? Investment Considerations The specter of trade protectionism is here to stay, as is the prospect of escalating U.S.-China geopolitical tensions. Fortunately, beggar-thy-neighbor policies are less attractive when jobs are plentiful, as is the case in the U.S. today. Trump also remains constrained by the stock market's view of his actions. After all, this is a president who likes to measure the success of his economic agenda by the value of the S&P 500. As such, we expect both the U.S. and China to follow a two-pronged approach to trade issues over the coming months. Publicly, they will snipe at one another, threatening each other with tariffs and other trade barriers. Privately, they will seek out a compromise that avoids a full-out trade war. China's announcement this week that it will retaliate in kind to the U.S. decision to impose tariffs on $50 billion in Chinese imports should not have taken anyone by surprise. The Chinese government had repeatedly said that they would do precisely this. Importantly, U.S. tariffs do not kick in until June. Between now and then, negotiators from both sides will try to hammer out a deal. Just as with the steel and aluminum tariffs, the final set of tariffs will be a watered-down version of the original proposal. Political theatre will be the name of the game. As discussed in last week's Q2 Strategy Outlook, our base case remains that another global recession is still about two years away, which should keep the bull market in global equities intact.4 We warned investors to "Take Out Some Insurance" on February 2nd, one day before the VIX spike began.5 Now that the S&P 500 is 7% off its highs, our bet is that the path of least resistance for global equities over the next 12 months is up. Nevertheless, with global growth decelerating, financial conditions tightening at the margin, and the one-month ahead signal from the beta version of our forthcoming proprietary MacroQuant model stuck in bearish territory for the second month in a row, the tactical picture for stocks still looks rather murky (Chart 8). For the time being, short-term investors should sell the rallies and buy the dips. Chart 8MacroQuant Model: Tactical Picture For Stocks Still Looks Rather Challenging U.S.-China Trade Spat: Is R-Star To Blame? U.S.-China Trade Spat: Is R-Star To Blame? Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com U.S.-China Trade Spat: Is R-Star To Blame? U.S.-China Trade Spat: Is R-Star To Blame? 2 The real exchange rate can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services. Mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in domestic prices relative to foreign prices. 3 Please see Geopolitical Strategy Special Report, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015; and Global Investment Strategy Special Report, “The Looming Conflict In The South China Sea,” dated May 29, 2012. 4 Please see Global Investment Strategy Q2 Strategy Outlook, “It’s More Like 1998 Than 2000,” dated March 30, 2018. 5 Please see Global Investment Strategy Weekly Report, “Take Out Some Insurance,” dated February 2, 2018, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The U.S. and China have a roughly 60-day period to prevent the current trade "skirmish" from metastasizing into a full-blown trade war; The revised U.S.-Korea trade deal suggests that Trump's trade negotiators are credible and are targeting China, not U.S. allies; The U.S. will demand that China's recent RMB appreciation is backed by a long-term reduction in foreign exchange intervention; Tariff reciprocity is not significant, but market access and investment reciprocity are; China will offer concessions first, and will only go to a trade war if Trump imposes sweeping tariffs anyway; Short Chinese technology stocks; remain short China-exposed S&P500 stocks in expectation of further volatility. Feature The market is coming to terms with the fact that President Trump is willing to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down 5.7% since the White House announced Section 232 tariffs on steel and aluminum and 2.34% since it announced forthcoming Section 301 tariffs against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets,1 we believe that the current set of U.S. demands on China justify the moniker of a "trade skirmish," rather than a full-out war.2 That said, the 5.7% drawdown is appropriate, if a bit sanguine. Our "trade skirmish" view is low-conviction. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. As such, it is appropriate for the market to price a 20%-30% probability of a full-blown trade war. Given that the market drawdown in such a scenario could be 20% or more, the current market action is appropriately pricing the worst-case scenario. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities if a similar confrontation between Japan and the U.S. did not in the late 1980s? For three reasons. First, the overvaluation of stocks is much greater today. Second, interest rates are much lower, restricting how much policymakers can react to adverse risks. Third, supply chains are much more integrated today, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. As such, we think the current drawdown is appropriate. That said, the administration's policy is not haphazard. President Trump and U.S. Trade Representative (USTR) Robert Lighthizer are on the same page, making China - and not NAFTA trade partners or South Korea - the main target of U.S. protectionism (Chart 1). The rapid pace at which the administration pivoted from global tariffs to targeting China gives a clear indication of what is afoot. The U.S. is using the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 1).3 We think this strategy can work, as outlined last week, but there is plenty of room for mistakes that could derail it. Chart 1China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs Table 1U.S. Gradually Exempting Allies From Tariffs Trump's Demands On China Trump's Demands On China Trump also wants to change U.S. policy on immigration and could use the NAFTA negotiation to gain leverage over Mexico. There is therefore still some probability that Trump triggers Article 2205 to leave NAFTA, but we believe it has declined substantively since we put it at 50% in November, particularly given the U.S.-South Korea negotiations we discuss below.4 This week we take a look at the revised U.S.-Korea trade deal and what it suggests about the Trump administration's trade agenda more broadly. Then we update the status of the U.S.-China trade frictions, which are only temporarily subsiding, if at all. Lessons From The KORUS Talks The just-completed renegotiation of the U.S.-Korea free trade agreement (the "KORUS FTA") offers some clues to the Trump administration's trade tactics that may be relevant for future negotiations with NAFTA partners, China, and others. President Trump has repeatedly criticized the KORUS FTA, as the U.S. trade deficit with South Korea has ballooned since its implementation in March 2012 (Chart 2). Trump used the threat of withdrawing from the deal to pressure South Korean President Moon Jae-in not to ease sanctions on North Korea too rapidly. Chart 2Why Trump Likes Tariffs Why Trump Likes Tariffs Why Trump Likes Tariffs Now USTR Lighthizer and his South Korean counterpart, Hyun Chong-Kim, have agreed to the outlines of a revised deal.5 The key points are as follows: Steel tariff waiver for Korea: South Korea will receive a country-level exemption from the U.S.'s recently imposed steel tariffs.6 Going forward, Korean steel exports will be subject to quotas equivalent to 70% of the average annual import volume during 2015-17. Greater market access for U.S. autos: Korea will double the number of autos it imports on the basis of U.S. safety standards, from 25,000 to 50,000 per year from each U.S. carmaker. It can import more subject to its own safety standards. It will refrain from any new emissions-standards tests, will accept U.S. safety standards on auto parts, and will ease ecological policies and the customs process of verifying the origin of exports. Delayed market access for Korean trucks: The U.S. will retain the existing 25% tariff on Korean trucks through 2041, instead of 2021 (Chart 2, second panel). Fair treatment of U.S. pharmaceutical imports: Korea promises not to discriminate against U.S. drugs but to grant them fair treatment under KORUS provisions. Ancillary currency agreement: The two sides appended a "gentleman's agreement" on currency policies, which is not a formal part of the deal and not subject to legislative confirmation. South Korea agreed not to devalue the won competitively, or to manipulate it more broadly, and to provide greater transparency regarding its interventions in foreign exchange markets. There are three main takeaways from the above. First, the U.S. is obviously focusing on non-tariff barriers to trade, the main hindrance to trade in a world with already low tariff rates. The grievances with Korea were primarily due to safety standards, environmental policies, and burdensome administration that hindered U.S. exports despite the reduction of tariffs under the KORUS agreement. Second, USTR Robert Lighthizer - the seasoned negotiator of the historic 1980s trade disputes with Japan, and the man in charge of the current NAFTA and China negotiations - deserves his reputation as a competent policymaker. He apparently makes concrete demands and is capable of compromising to conclude deals. This reduces the risk, overstated by the media, that the inexperienced U.S. president is driving the trade negotiations. Third, the U.S. is not deliberately trying to punish its allies in pursuit of some mercantilist fantasy of closing every single trade imbalance. Strategic logic dictated that Washington and Seoul needed to conclude a deal quickly so as to better coordinate on North Korea, and they did so. It is highly unlikely that the concluded deal will end the U.S. trade imbalance with South Korea, but it will likely improve it substantively. Moon Jae-in continues to be a pragmatist in his dealings with Trump and Trump is joining Moon's "Moonshine" policy of engagement with North Korea. Talk of the U.S. abandoning its allies did not materialize. (Japan and Taiwan are likely to get deals soon.) Most importantly, this deal is a strong indication that the U.S. will continue to pressure China on its foreign exchange practices. It would make no sense for the U.S. to require its allies to disavow competitive devaluation and reduce currency interventions while not demanding similar assurances from China. On this front, China's recent appreciation of the yuan will not ultimately satisfy the U.S., as it is arbitrary. The U.S. will need to extract deeper guarantees, with the implicit threat of tariffs to prevent China from backsliding. Otherwise the U.S. would yield Chinese exporters a foreign exchange advantage relative to American trade partners who agree to stop intervening to preserve a favorable exchange rate with the USD. A simple comparison of these countries currency moves over the past eight years reveals how they have allowed less appreciation relative to the U.S. than in trade-weighted terms, and how China would benefit if the others were forced to stop this practice while it was left off the hook (Chart 3). Chart 3The U.S. Will Demand Currency Appreciation The U.S. Will Demand Currency Appreciation The U.S. Will Demand Currency Appreciation This last conclusion fits with our study of previous cases of U.S. trade protectionism, in which the end-game was dollar depreciation relative to key trade partners.7 The KORUS case can be considered alongside Lighthizer's and the Trump administration's handling of the Section 301 investigation into China's forced tech transfer and intellectual property theft. The Trump administration came out swinging with unilateral 25% tariffs on about $60 billion worth of goods, to be listed on April 6 and enacted sometime in June. But it also signaled that it would allow a consultation period, and initiated a case through the World Trade Organization, thus reinforcing (rather than undermining) the global trading system. These developments give some grounds for optimism in the NAFTA negotiations and (less so) in the China negotiations. While China is preempting U.S. demands on its currency policy, it will be averse to providing any permanent guarantees, or to painful structural demands. This is due to its concerns about overall stability and its suspicion that the U.S. is pursuing a broader strategic containment policy against it. We discuss these issues below. Bottom Line: The preliminary conclusions of the KORUS FTA negotiation suggest that the Trump administration's trade leadership is credible, while Trump himself is looking for quick and concrete trade "wins" that can be presented to his domestic voter base. This is a marginally market-positive sign. But its ramifications are limited with regard to China, where strategic tensions and geopolitical competition will make it much harder to strike a similar deal quickly. U.S.-China: Fade The "Mirror Tax," Focus On Market Access And Tech China announced tariffs on roughly $3-$3.5 billion worth of U.S. goods on April 2 - ranging from fruits and nuts to wine and pork - in retaliation for the steel and aluminum tariffs that the U.S. imposed in March under Section 232 of the Trade Expansion Act of 1962. China used the exact same tariff rates as the U.S. - 25% and 10% - while selecting the product list so as to produce roughly the same net trade impact in USD terms (Chart 4). The implication is that China will retaliate in kind to deter the U.S., but does not wish to "up the ante." This is largely what we expected, but the implication is significant: the U.S. is about to release a preliminary list on April 6 of $50-$60 billion worth of goods on which it will slap tariffs. This second round of tariffs - which is China-specific - follows from the probe under Section 301 of the Trade Act of 1974. China's recent decision suggests that if negotiations fail, it will respond with tariffs worth roughly the same amount, which is a much bigger exchange of fire for these two economies. The actual retaliatory action would most likely occur in June, when the U.S.'s list is finalized and implemented, though China may hint at its product list much sooner, adding to trade fears and market volatility.8 The Trump administration claims that its product list will be chosen by an algorithm to maximize the impact on Chinese exporters while minimizing the impact on the American consumer. Consistent with this aim, some reports indicate that the goods will be advanced technological products set to benefit from China's "Made in China 2025" plan, in which China has laid down aggressive domestic content requirements (Chart 5). Chart 4Tit For Tat Trump's Demands On China Trump's Demands On China Chart 5China's High-Tech Protectionism Trump's Demands On China Trump's Demands On China What is the Trump administration's goal? Treasury Secretary Steve Mnuchin declared at the G20 finance ministers' meeting that he did not want to penalize Chinese imports so much as promote U.S. exports. Is this a credible basis for assessing the administration's policy? Yes and no. We think Mnuchin is telling the truth, but not the whole truth. When it comes to blocking imports or boosting exports, Mnuchin is right: the U.S. goal is not simply to punish Beijing for past unfair trade practices by blocking imports of Chinese goods. True, the Trump administration has focused on a lack of reciprocity in tariff rates. But a "mirror tax" or "mirror tariff" with China, which Trump has referred to, would not make much of a difference to the trade balance: Chart 6AThe U.S. Exports Soybeans And Cars To China Trump's Demands On China Trump's Demands On China Chart 6BChina Exports Phones And Computers To The U.S. Trump's Demands On China Trump's Demands On China Taking a look at the top ten exports of the U.S. and China to each other (Chart 6 A&B), it is quite clear that China imposes higher tariffs on U.S. goods than the U.S. imposes on Chinese goods (Chart 7 A&B). This follows from World Trade Organization rules and the relative level of economic development of the two countries. Chart 7AAmerican Exports To China Face Higher Tariffs... Trump's Demands On China Trump's Demands On China Chart 7B... Than Chinese Exports To America Trump's Demands On China Trump's Demands On China If we equalize these tariffs by raising U.S. tariffs to the same level as their Chinese counterparts for the same good, we wind up with a very small $6.2 billion gain to the U.S. trade balance (Chart 8). If we focus only on the top ten goods that both countries export to each other, and impose a hypothetical mirror tax, we wind up with an even smaller gain for the U.S. of $3.9 billion (Chart 9). This is small fry and cannot be the administration's goal (at least not its main goal). The real goal is to gain greater market access for U.S. exports in China. Here the U.S. may have a case, as China lags both its developed and emerging market peers in sourcing its imports from the U.S. (Chart 10). While China comprises 24% of total EM imports, it comprises only 15% of U.S. exports to EM. Even in commodity exports, where the U.S. has made major inroads in China, Beijing has recently limited the American share (Chart 10, middle panel). Chart 8Equalizing Tariffs Has Little Impact Trump's Demands On China Trump's Demands On China Chart 9Equalizing Tariffs Has Little Impact (2) Trump's Demands On China Trump's Demands On China Chart 10U.S. Grievance Is About Market Access Trump's Demands On China Trump's Demands On China A simple, back-of-the-envelope comparison of the U.S.'s top exports to China and EM ex-China suggests that the U.S. can make a case that its exports are suffering unduly in China: China's share of top U.S. exports is lower than one might expect it to be relative to EM or EM-ex-China (Chart 11 A&B). The U.S.'s market share of China's imports in key goods is lower than it is in EM or EM-ex-China (Chart 12 A&B). The U.S. share of China's top imports is smaller than the DM-ex-U.S. share (Chart 13 A&B). Chart 11AChina Is Not A Large Enough Share Of U.S. Exports (Broad) Trump's Demands On China Trump's Demands On China Chart 11BChina Is Not A Large Enough Share Of U.S. Exports (Detailed) Trump's Demands On China Trump's Demands On China Chart 12AU.S. Is Not A Large Enough Share Of Chinese Imports (Broad) Trump's Demands On China Trump's Demands On China Chart 12BU.S. Is Not A Large Enough Share Of Chinese Imports (Detailed) Trump's Demands On China Trump's Demands On China Chart 13AU.S. Has Less Market Access In China Than Other Exporters Trump's Demands On China Trump's Demands On China Chart 13BU.S. Has Less Market Access In China Than Other Exporters Trump's Demands On China Trump's Demands On China China has granted the legitimacy of U.S. complaints by pledging several times in the last few months to open market access. The latest news from the negotiations suggests that some progress is being made.9 Clearly the above is a very rough measure. Chinese consumers may not want to buy as much stuff from the U.S. as from Europe and Japan. The U.S. doubtless needs to improve its global competitiveness, and even then it may not gain as much market share in China as its DM peers. Nevertheless, Washington sees itself as the power that brought China into the global economy and allowed it to join the WTO. If China wants the U.S. to allow it to play a greater role in running the world, the U.S. is demanding a beneficial economic relationship in return. One way China is offering to deal with the problem is by buying American goods at the expense of U.S. allies' goods. For instance, Beijing has offered to buy more semiconductors from the U.S. and fewer from Taiwan and South Korea. This would alleviate the U.S. trade deficit a little, but at a greater expense to U.S. allies (Table 2). It would open up an opportunity for China to make more strategic acquisitions in those weakened, neighboring industries. It is not clear that the Trump administration will accept such a "concession," unless it is coupled with much greater concessions as compensation for selling out the allies. Table 2China's Trade Concessions To The U.S. Could Impose Costs On U.S. Allies Trump's Demands On China Trump's Demands On China Similarly, China's concessions that have been offered so far - like lowering the 25% tariff on car imports - are tokens in the right direction but not sufficient to satisfy the U.S. at the current juncture. This means that the U.S. will demand structural changes that increase market access, from a stronger RMB to a more consumer-oriented economy, as part of what will be a drawn-out effort to encourage China to rebalance its macroeconomy. Of course, Treasury Secretary Mnuchin was only telling half the truth: the U.S. also wants to prevent China from stealing too much of America's market share too fast. When we look at China's comparative advantage - the goods categories in which China's export growth has been fastest in recent years, weighted by contribution to the total - the U.S. is the country that has the largest global market share in these very goods (Chart 14). For instance, telecoms equipment, car parts, TVs, electrical circuits, etc. The U.S.'s export mix is not as dependent on these goods as that of China's neighbors (Taiwan, Vietnam, Malaysia, Singapore, South Korea), but it is the chief exporter of these goods nevertheless. Because many of China's most competitive goods are still low value-added (toys, plastics, textiles, furniture), China is pursuing tech upgrades, innovation, and intellectual property: it would eat away at the U.S. share of more advanced goods. Chart 14China's Comparative Advantage Threatens U.S. Global Market Share Trump's Demands On China Trump's Demands On China The Trump administration is trying to slow China's advance and put a stop to China's aggressive poaching of foreign tech and IP.10 This will include restrictions on Chinese direct investment and acquisitions to be announced by Mnuchin on May 21. We expect him to intensify an inherently stringent vetting process. The administration has already taken a proactive stance by blocking Canyon Bridge Capital Partners from acquiring Lattice Semiconductor and Singaporean company Broadcom's attempted acquisition of Qualcomm.11 Rumor has it that the administration is now considering invoking the International Emergency Economic Powers Act of 1977, which authorizes the president to take actions "to deal with any unusual and extraordinary threat, which has its source in whole or substantial part outside the United States, to the national security, foreign policy, or economy of the United States, if the President declares a national emergency with respect to such threat." Trump would be able to cite China's use of state-backed companies, corporate espionage, and cyber-attacks in pursuit of technology and IP (Table 3). Table 3Trump Lacks Legal Constraints On Trade Issues... Especially When National Security Is Involved Trump's Demands On China Trump's Demands On China This is entirely aside from legislation pending in Congress, which the White House appears to support, that would provide the Committee on Foreign Investment in the United States (CFIUS) with the ability to block investments across entire industries, rather than on a case-by-case basis, and with a broader definition of national security and sensitive property and technologies.12 While American presidents have historically vetoed similar legislation against China, the Trump administration may not, depending on the outcome of talks. The key point is that the U.S. political establishment - across the spectrum - is alarmed about China's economic mercantilism. As Senator Elizabeth Warren recently declared to a group of top policymakers in Beijing: "Now U.S. policymakers are starting to look more aggressively at pushing China to open up the markets without demanding a hostage price of access to U.S. technology."13 Warren, a staunchly liberal senator from the Democratic stronghold of Massachusetts, is entirely on the same page as Trump. The takeaway for investors? China's tit-for-tat response to Trump's steel and aluminum tariffs should not be dismissed out of hand. The market is sensitive to trade fears and there is a clear avenue for them to get worse if the 60-day consultation period lapses without any major Chinese concessions. True, negotiations are ongoing and Trump's trade team has been shown to be both credible and willing to pursue trade disputes through the WTO. Nevertheless there are substantial measures aimed at China coming down the pike and the usual restraints on U.S. policy, centered on the U.S. business establishment lobbying policymakers, are not as effective as in the past. Bottom Line: The U.S.'s primary economic goal in the China negotiations is not to equalize tariffs but to open market access. The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. As such, Washington will expect robust guarantees to protect intellectual property and proprietary technology. Investment Conclusions Several clients have asked about the constraints on the different players if trade conflict should escalate over the coming months. On the surface the U.S. is in a stronger position because its outsized deficit with China means that measures constricting bilateral trade are inherently more damaging to China's output (Chart 15). Even some of China's best retaliatory options are difficult to put into practice, including selling U.S. treasuries or imposing sanctions on U.S. commodities (Table 4).14 Chart 15China More Exposed To Trade Than U.S. China More Exposed To Trade Than U.S. China More Exposed To Trade Than U.S. Table 4China's Retaliation Options Are Limited... Even In Agriculture Trump's Demands On China Trump's Demands On China The U.S. also faces a constraint in imposing measures on China because manufacturing value chains today sprawl across various countries and multinational corporations. Tariffs therefore punish countries, including U.S. allies, that provide inputs to China or American companies that profit from them - think Apple. Moreover, tariffs will not in themselves change the U.S.'s fundamental savings-investment balance, suggesting that demand for foreign goods will simply shift to other producers and the trade deficit will be unaffected. However, supply chain risk is ultimately not prohibitive for the U.S. China has long ranked among the most exposed to supply-chain disruptions, while the U.S. ranks among the least (Chart 16). Moreover, U.S. allies in Europe and ASEAN stand to benefit if supply chains are rerouted from China (Chart 17). While the U.S. and allies would suffer higher initial costs as a result, they would gain the strategic advantage of reducing China's centrality to global supply chains. The latter has given Beijing an advantage in acquiring technology and moving up the value chain. Chart 16China Most Exposed To Supply-Chain Risk Trump's Demands On China Trump's Demands On China Chart 17U.S. Allies Benefit If Supply Chains Move Trump's Demands On China Trump's Demands On China While the Xi Jinping administration is weaning China off export reliance and U.S. reliance, the country still employs 28% of its workers in the manufacturing sector, which leaves it more exposed to disruptions than the U.S. if trade frictions should spiral out of control and weaken overall demand (Chart 18). While American workers are intimately familiar with the boom-and-bust cycle of free labor markets, China has not struggled with significant unemployment since 2003 (Chart 19). Its middle class was much smaller then. Chart 18Employment Is A Constraint On China Employment Is A Constraint On China Employment Is A Constraint On China Chart 19China Unfamiliar With Large-Scale Job Loss China Unfamiliar With Large-Scale Job Loss China Unfamiliar With Large-Scale Job Loss In short, China will first attempt to appease the Trump administration through market access (and keeping the RMB strong) to maintain its supply-chain centrality and overall stability. If Trump accepts China's concessions, trade frictions will not spiral out of control - at least not this year. China will only accept a full-fledged trade war if Trump rejects its concessions and imposes punitive measures that threaten its stability. At that juncture, Xi would probably find it useful to demonize Trump and execute long-term changes to make China more self-sufficient, blaming the U.S.-initiated trade war for the painful consequences. This is why it matters if Trump's demands go beyond foreign exchange rates, improved market access, and IP enforcement - for instance, if they extend to capital account liberalization, the holy grail of American trade negotiations with China. Thus far, Trump's team has not raised this demand, but it is a subject we will revisit soon as it is likely to be China's red line, at least within the economic sphere. In light of our expectation for further trade-war related volatility, we would recommend shorting Chinese tech stocks15 and remaining short China-exposed U.S. stocks. The latter trade has been in the black by over 5% in just a week, but is currently up only 0.7%. It is a way to hedge the risk of further tensions between U.S. and China. Risks to this view are: if the U.S. reduces the Section 301 tariffs that it is threatening on or after April 6; if Treasury Secretary Mnuchin's investment restrictions due on May 21 are watered down; or if the U.S. makes no structural demands on China's economy but merely accepts temporary RMB appreciation and some big-ticket import orders. Otherwise the risk that trade tensions spiral out of control will remain elevated at least through the U.S. midterm elections on November 6. By then, Trump will need either to have cut a small-scale deal with China that he can tout for voters or to have taken more aggressive trade action pursuant to the Section 301 findings. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 5 A 60-day consultation period with both legislatures will follow but the deal will probably remain in more or less the same form. 6 Aluminum was not included, but South Korea is not a major source of aluminum products for the U.S. 7 Please see footnote 2 above. 8 Please see David Lawder, "Trump to unveil China tariff list this week, targeting tech goods," Reuters, April 2, 2018, available at www.reuters.com. 9 Treasury Secretary Steve Mnuchin spoke with Politburo member Liu He, who is Xi Jinping's top economic policymaker, and they reportedly pledged that they are "committed" to a solution on reducing the U.S. trade deficit. The U.S. is asking for a $100 billion reduction to the trade deficit within the year, as well as some progress on intellectual property enforcement. Supposedly the specific demands involve reducing the Chinese tariff on car imports and raising the foreign ownership cap on Chinese financial companies, the latter of which China has previously promised to do. Please see Andrew Mayeda, "U.S. Pushes China On Cars And Finance In Tariff Talks," Bloomberg, March 26, 2018, available at www.bloomberg.com. 10 Please see the U.S. Trade Representative, "Findings of the Investigation into China's Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation under Section 301 of the Trade Act of 1974," March 2018, available at ustr.gov. 11 In September 2017, the White House and Department of Treasury intervened in the attempt by a group of investors, including the state-owned China Venture Capital Fund, from acquiring Lattice, on the advice of CFIUS. Lattice makes computer chips that are highly versatile and can be used in military functions; the Chinese SOE was suspected of pursuing China's state-backed efforts to improve its semiconductor industry. Separately, in March 2018, President Trump blocked Singapore-based Broadcom's attempt to acquire Qualcomm, which would have been a hugely consequential tech merger due to the two companies' dominance in making processors. The Treasury Department feared that Chinese state entities might get access to Qualcomm's IP or that the merger might otherwise hinder Qualcomm's "technological leadership." Please see "CFIUS Case 18-036: Broadcom Limited (Singapore)/Qualcomm Incorporated," dated March 5, 2018, available at www.sec.gov. 12 Please see Andrew Mayeda, Saleha Mohsin, and David McLaughlin, "U.S. Weighs Use of Emergency Law to Curb Chinese Takeovers," March 27, 2018, available at www.bloomberg.com. 13 She was speaking with Liu He, seasoned diplomat Yang Jiechi, and Defense Minister Wei Fenghe. Please see Michael Martina, "Senator Warren, in Beijing, says U.S. is waking up to Chinese abuses," April 1, 2018, available at www.reuters.com. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Ags Could Get Caught In U.S. Tariff Imbroglio," dated March 15, 2018, and "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 15 Please see BCA China Investment Strategy Weekly Report, "After The Selloff: A View From China," dated February 15, 2018, available at cis.bcaresearch.com. Geopolitical Calendar

Highlights Recommended Allocation Quarterly - April 2018 Quarterly - April 2018 Due to the boost from U.S. fiscal stimulus, we do not expect recession until 2020. Despite some signs that growth is peaking, global economic fundamentals remain robust. Markets have wobbled because of the risk of trade war and rising inflation. We think neither likely to derail growth. Not one of our recession indicators is yet sending a warning signal. We are late cycle and volatility is likely to remain high (particularly if the trade war intensifies). But, given strong earnings growth and three further Fed rate hikes this year, we expect global equities to beat bonds over the next 12 months. Except for particularly risk-averse investors, who care mostly about capital preservation, we continue to recommend overweights in risk assets. We are overweight equities (especially euro area and Japan), cyclical equity sectors such as financials and industrials, credit (especially cross-overs and high-yield), and return-enhancing alternative assets such as private equity. Feature Overview Stimulus Trumps Tariffs Risk assets have been choppy so far this year, with global equities flat in the first quarter and the stock-to-bond ratio turning down (Chart 1). Markets were battered by worries about a trade war, signs of growth peaking, a rise in inflation, and bad news from the tech sector. This late in the cycle, with stock market valuations stretched and investors skittish about what might go wrong, we expect volatility to stay high. But the global economy remains robust - and will be boosted by U.S. fiscal stimulus - earnings are growing strongly, and the usual signs of recession and equity bear markets are absent. Though the going will be bumpy over coming quarters, we continue to expect risk assets to outperform at least through the end of this year. U.S. tariffs on steel and aluminum and the threat of $50 billion of tariffs on Chinese imports so far represent a trade skirmish, not a trade war. The amounts pale by comparison with the positive impact coming though from U.S. tax cuts, increased fiscal spending, and repatriation (Chart 2). In history, fights over trade have rarely had a serious impact on growth. They flared up frequently in the 1980s, which was a period of strong economic growth. Even the infamous Smoot-Hawley tariff increase of 1930 is now viewed by most economic historians as having played only a minor role in the collapse of trade during the Great Depression.1 Of course, trade war could escalate. China, as the biggest part of the U.S. trade deficit, is the White House's clear target (Chart 3). Japan in the 1980s, an ally of the U.S., agreed to voluntary exports restraints and to relocate production to the U.S. But China is a global rival.2 Chart 1A Tricky Quarter A Tricky Quarter A Tricky Quarter Chart 2Stimulus Tops Tariffs Quarterly - April 2018 Quarterly - April 2018 Chart 3China Is The Target China Is The Target China Is The Target For now, we expect the impact to be limited since some degree of compromise is the most likely outcome. President Trump sees the stock market as his Key Performance Indicator and would be likely to back off if stocks fell sharply. China knows that it has the most to lose in a prolonged fight. It might suit Xi Jinping's reformist agenda to boost consumption, cut excess capacity, and allow the RMB to appreciate modestly. While the U.S. has some justification for arguing that China's investment rules are unfair, China can also argue that it has made significant progress in recent years in reducing its dependence on exports, its current account surplus, and the undervaluation of its currency (Chart 4). But jitters will continue for a while. May could be a particularly tricky month, with the Iran sanctions waiver expiring on May 12, and the 60-day consultation period for China tariffs ending on May 21. Investors should expect that volatility, which in early January was remarkably low in all asset classes, should stay significantly higher until the end of this cycle (Chart 5). Chart 4...But Has Reduced Dependence On Exports ...But Has Reduced Dependence On Exports ...But Has Reduced Dependence On Exports Chart 5Volatility Likely To Stay High? Volatility Likely To Stay High? Volatility Likely To Stay High? Meanwhile, economic fundamentals generally remain strong. The Global Manufacturing PMI has dipped slightly from its cycle-high level in December, with recent currency strength causing some softness in the euro area and Japan (Chart 6). But the diffusion index shows that only three out of the 48 countries currently have PMIs below 50 (Egypt, Indonesia and South Africa). Consensus forecasts expect 2018 global GDP growth to come in at around 3.3%, similar to last year, and as yet show no signs of faltering (Chart 7). On the back of this, BCA's models suggest that global earnings growth will continue to grow at a double-digit pace for at least the rest of this year (Chart 8). Despite the strong growth, we see U.S. inflation picking up only steadily towards the Fed's 2% target.3 Jerome Powell in his first congressional testimony and press conference as Fed Chair showed no rush to accelerate the pace of rate hikes. We think the Fed is likely to hike four times, not three, but the market should not find this unduly hard to digest, as long as it is against a background of robust growth. Chart 6Dip In Growth Momentum? Dip In Growth Momentum? Dip In Growth Momentum? Chart 7Economists' Forecasts Not Faltering Economists' Forecasts Not Faltering Economists' Forecasts Not Faltering Chart 8Earnings Still Growing Strongly Earnings Still Growing Strongly Earnings Still Growing Strongly For the past year, we have highlighted a number of simple indicators we are watching carefully that have previously been reliable indicators of recessions and equity bear markets. Several have started to move in the wrong direction, but none is yet flashing a warning signal (Table 1, Chart 9). Table 1What To Watch For Quarterly - April 2018 Quarterly - April 2018 Chart 9No Warnings Flashing Here No Warnings Flashing Here No Warnings Flashing Here In February, BCA pushed out its forecast of the next recession to 2020, on the back of the U.S. fiscal stimulus. That would suggest turning more cautious on risk assets towards the end of this year - at which time some of these indicators may be flashing. But, until then we continue to recommend - except for the most risk-averse investors who care mainly about capital preservation and not about maximizing quarterly performance - an overweight allocation to risk assets. Garry Evans, Senior Vice President garry@bcaresearch.com Chart 10Not A Full Blown Trade War... For Now! Not A Full Blown Trade War.... For Now! Not A Full Blown Trade War.... For Now! What Our Clients Are Asking What Are The Implications Of U.S. Tariffs? Following recent announcements of tariffs on steel and aluminum and possible broad-based tariffs on Chinese imports, investors have started to worry about the future of global trade. But these moves should be no surprise since President Trump is merely delivering on electoral promises. From a macro-perspective, here are the key implications of rising trade barriers: An all-out trade war would certainly hurt U.S. growth, but a minor skirmish would have little impact. The U.S. is the advanced economy least exposed to global trade, which makes it harder for nations to retaliate. Running a large trade deficit, with imports from China representing 2.7% of GDP whereas exports to China are just 1.0% of U.S. GDP, gives the U.S. considerable leverage in negotiations. Additionally, the majority of Chinese imports from the U.S. are agricultural products, making it harder for China to retaliate with tariffs since these would raise prices for Chinese consumers (Chart 10). On the other hand, U.S. trade partners also have a case. With trade growth trailing output growth, other nations will be less willing to give in to U.S. threats. Additionally, unlike the Cold War era, when the U.S. had a greater influence on Europe and Japan, the world is moving toward a more multipolar structure. However, we do not believe nations will retaliate by dumping U.S. Treasuries, as that would deliver the U.S.'s desired end result of a weaker dollar. Chart 11Rising Wages Are The Missing Factor Rising Wages Are The Missing Factor Rising Wages Are The Missing Factor Finally, if tariffs lead to a smaller trade deficit and firms start to move production back to the U.S., aggregate demand will increase. And, given a positive output gap in the U.S., the Fed would be forced to turn more hawkish, ultimately forcing the dollar up. Equity markets do not like tariffs, and bonds will follow the path that real growth and inflation take. How the situation will develop depends on whether Trump embraces America's traditional transatlantic alliance with Europe and harnesses it for the trade war against China. If he does so, the combined forces of the U.S. and Europe will likely force China to concede. But if Trump goes it alone, a prolonged U.S.-China trade war could turn into a significant risk to global growth. How Quickly Will U.S. Inflation Rise? The equity sell-off in early February was triggered by a slightly higher-than-expected average hourly earnings number. In recent meetings, we find that clients, who last year argued that the structural pressures would keep inflation depressed ("the Philips Curve is dead"), now worry that it will quickly exceed 2%. And it is true that the three-month rate of change of core CPI has jumped recently (Chart 11, panel 1). Investors are clearly skittish about the risk of higher inflation, which would push the Fed to accelerate the pace of rate hikes. We continue to argue that core PCE inflation (the Fed's main measure) will rise slowly to 2% over the next 12 months, but we do not see it accelerating dramatically. Inflation tends to lag GDP growth by around 18 months and the pickup in growth from Q2 last year should start to feed through. This will be magnified by the 8% weakness in the US dollar over the past 12 months, which has already pushed up import prices by 2% YoY. What is missing, however, is wage pressure. Average hourly earnings are growing only at 2.6% YoY. We find that wage growth tends to lag profits by around 24 months (panel 2) and, since profits moved sideways for close to two years until Q2 last year, it may be a few quarters yet before companies feel confident enough to raise wages. Note, too, that wages have been weak compared to profits in this cycle. This is likely partly because of automation, but also because the participation rate for the core working population continues to recover towards its 2007 level, indicating there is more slack in the labor market than the headline unemployment data suggest (panel 3). Should Investors Still Own Junk Bonds? Chart 12Credit Cycle Still On Credit Cycle Still On Credit Cycle Still On The current late stage of the economic cycle has investors worried about the credit cycle and the outlook for corporate credit, in particular high-yield bonds. The number-one concern is stretched valuations. Spreads are close to all-time lows, which means investors should not expect significant capital gain. However, spreads can stay low for extended periods, especially in the late stages of the credit cycle. Junk bonds are a carry trade at this point, and investors can continue to pick up carry before a sustained period of spread widening sets in (Chart 12). A flattening yield curve is bad for junk returns, as it signals monetary policy is too restrictive. But, as inflation continues to trend higher, the curve is likely to steepen while allowing the Fed to deliver rate hikes close to its median projection. The key risk is a scenario in which inflation falters, but the Fed continues to hike. In this case a risk-off episode in credit markets would be likely, but this would be a buying opportunity and not the end of the cycle. Corporate balance-sheets have weakened, and logically investors should demand greater compensation to hold high-yield bonds. But spreads have diverged from this measure since early 2016. However, we expect improvements in corporate health since the outlook for profit growth is strong. However, a great deal of bond issuance has been used for share buybacks. If capital structures have less of an equity cushion, then recovery rates are likely to be lower when defaults do start to rise. Cross-asset volatility has returned. But credit spreads have remained calm thanks to accommodative monetary policy and easing bank lending standards. Also, stricter post-crisis bank capital regulations have mitigated the risk. Finally, the growing presence of open-ended junk bond funds and ETFs increases the risk that, once spreads start to widen, they will widen much more quickly than they would have otherwise. Who Should Invest In Hedged Foreign Government Bonds? In a recently published Special Report,4 we found that hedged foreign government bonds are a good source of diversification for bond portfolios. Hedging not only reduces the volatility of the foreign bonds, it reduces it so much that the risk-adjusted return ratio has significantly improved for investors with home currency in USD, GBP, AUD, NZD, CAD and EUR (Table 2). This is true across different time periods for most fixed income investors other than those in Japan, as shown in Chart 13. Table 2Domestic And Foreign Government Risk Return Profile (December 1999 - January 2018) Quarterly - April 2018 Quarterly - April 2018 Chart 13Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time Quarterly - April 2018 Quarterly - April 2018 So the answer depends on investors' objectives and constraints: If investors are comfortable with the volatility in their local aggregate bond indexes, which are already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K. and Canada are better off investing a large portion overseas. Global Economy Overview: Global growth remains robust, though momentum has slowed slightly in recent weeks. No recession is likely before 2020 at the earliest due to strong U.S. fiscal stimulus. Inflation will slowly rise towards central bank targets but there is little reason to expect it to accelerate dramatically, and so we see no need for aggressive monetary tightening. U.S.: Short-term, growth looks to have softened, with the Citigroup Economic Surprise Index turning down (Chart 14, top panel), and the regional Fed NowCasts for Q1 GDP growth pointing to 2.4%-2.7%. However, growth over the next two years should be boosted by the recent tax cuts and government spending increases, which we estimate will push up GDP growth by 0.8% in 2018 and 1.3% in 2019. Wages should start to rise from their current sluggish levels (average hourly earnings only up 2.6% YoY) given the tight labor market, which should boost consumption. Capex (panel 5) is likely to continue to recover due to tax cuts and a high level of businesses confidence. Euro Area: Growth has been steady in recent quarters, with Q4 GDP rising 2.5% QoQ annualized. However, lead indicators such as the PMI (Chart 15, top panel) have rolled over, probably because of the strong euro (up 6.2% in trade-weighted terms over the past 12 months). The effect has yet to be seen in exports, which continue to grow strongly, 6.2% YoY in February, but earnings results for Q4 surprised much less on the upside in the euro area than in the U.S. Chart 14Growth Robust, But Momentum Slowing Growth Robust, But Momentum Slowing Growth Robust, But Momentum Slowing Chart 15Strong Currencies Denting EU And Japanese Growth Strong Currencies Denting EU And Japanese Growth Strong Currencies Denting EU And Japanese Growth Japan: As an export-oriented, cyclical economy, Japan has also benefitted from better global conditions, with GDP rising by 1.6% QoQ annualized in Q4. However, like Europe, the stronger currency has begun to dent the external sector, with industrial production and the leading index slowing (Chart 15, panel 2). However, more encouraging signs are appearing domestically: retail sales rose by 2.5% YoY in January and part-time wages are up 2.0% YoY. As a result, inflation is finally emerging, with CPI (excluding food and energy) up 0.3% YoY. Emerging Markets: China's growth remains steady, with the Caixin PMI at 51 (panel 3). However, credit and money supply growth continue to point to a slowdown in coming months. This may be evident when March data (unaffected by the shifting timing of Chinese New Year) becomes available. Elsewhere in EM, growth has picked up moderately: Q4 GDP growth came in at an annualized rate of 7.2% in India, 3.0% in Korea, and even 2.1% in Brazil and 1.8% in Russia. Interest rates: A modest rise in inflation expectations (panel 4) has led to a rise in long-term rates, with the U.S. 10-year yield rising from 2.5% to almost 3% during Q1 before slipping back a little. We expect the Fed to hike four times this year, and think this will push up the 10-year Treasury yield to 3.3-3.5% by year-end. The ECB continues to emphasize that it will move only slowly to raise rates after halting asset purchases later this year, and we think the market has correctly priced the timing of the first hike for Q4 2019. We see no reason why the BoJ will end its Yield Curve Control policy, with inflation still well below the 2% target. Chart 16Cautiously Optimistic Cautiously Optimistic Cautiously Optimistic Global Equities Tip-Toeing Through The Late Cycle. Global equities experienced widespread corrections in the first quarter after a very strong start in January gave way to fear of rising inflation in the U.S., fear of slowing growth in China, and fear of rising geopolitical tensions globally. The return of macro volatility was so violent that it pushed the VIX to high readings not seen since 2015. Granted, a background of stretched valuations, complacency, and the "fear of missing out" also contributed to the market correction. The healthy correction of global equities from the high in late January has seen valuations contracting as earnings continued to grow at strong pace (Chart 16). BCA's house view is that global growth may be peaking, but should remain strong and above trend, underpinning decent earnings growth for the next 9-12 months. As such, we retain our pro-cyclical tilts in global equity allocations, overweight cyclical sectors and underweight defensive sectors; overweight high-beta DM markets (Japan and euro area); neutral on the U.S. and Canada; and underweight EM and Australia, the markets that would suffer most from a deceleration in Chinese growth. However, we are late in the cycle and valuations remain stretched by historical standards despite the recent correction. With macro volatility returning, investors should be very conscious of potential risks that could derail the uptrend in equities. For investors with higher aversion to risk, we suggest raising cash by selling into strength or dialing down the overweight of cyclicals vs defensives. Anatomy Of EM/DM Outperformance Since their low in early 2016, EM equities have outperformed DM in total return terms by more than 20%, of which 262 bps came in the first quarter of 2018, despite the rising volatility in all asset classes recently. As show in Chart 17, the outperformance of EM over DM has been dominated by three sectors: Technology, Financials and Energy. In the two-year period ending December 2017, over half of the EM outperformance came from the Tech sector, followed by Financials and Energy, accounting for 32% and 14% respectively. In Q1 2018, however, Tech's contribution dropped sharply to 0.3%, while Financials and Energy shot up to 51% and 33% respectively. Even though Energy is a relatively small sector, accounting for 6-7% of benchmark weights in both EM and DM, the diverging performance between EM and DM Energy sectors has played an important role in the EM outperformance. In the two years ending December 2017, EM Energy outperformed its DM counterpart by 32%, the same magnitude as the Tech sector (Table 3). In Q1 2018, EM Energy gained 7.6% while DM Energy suffered a 5.2% decline, resulting in a staggering 13% outperformance (Table 4). Chart 17Sector Contributions To EM/DM Outperformance Quarterly - April 2018 Quarterly - April 2018 Table 3Two-Year Performance Attribution* (December 2015 - December 2017) Quarterly - April 2018 Quarterly - April 2018 Table 4Q1/2018 Attribution* (December 2015 - December 2017) Quarterly - April 2018 Quarterly - April 2018 Country-wise, Brazil and China led the outperformance, helped by the Brazilian real's 30% appreciation against the U.S. dollar. BCA's EM Strategy believes that Brazilian equities and the real will both weaken given the country's weak governance and poor fiscal profile. Chart 18Style Performance Style Performance Style Performance We are neutral on Tech globally, and the general reliance of EM equities on Chinese growth, and the high leverage in EM do not bode well for EM equities. Remain underweight EM vs. DM. A Sector Approach To Style Year to date, the equal-weighted multi-factor portfolio has outperformed the global benchmark slightly, largely driven by the strong outperformance of Momentum and Quality, while Value and Minimum Volatility (MinVol) have underperformed (Chart 18, top three panels). This is in line with our previous regime analysis that indicated rising growth and inflation is a good environment for Momentum and Quality, but a bad one for Min Vol.5 As we have argued before, we prefer sector positioning to style positioning because 1) the major style tilts such as Value/Growth, Min Vol and Small Cap/Large Cap have seen significant sector shifts over time, and 2) sector selection offers more flexibility. As shown in Chart 18 (bottom three panels), the relative performance of Min Vol is a mirror image of Cyclicals vs Defensives, while Value/Growth is highly correlated with Cyclicals/Defensives. In a Special Report,6 we elaborated in-depth that sector selection is a better alternative to size selection, especially in the U.S. We maintain our neutral view on styles, and continue to favor Cyclicals versus Defensives. Given that we are at the late stage of the business cycle, investors with lower risk tolerance may consider gradually dialing down exposure to cyclical tilts. For stock pickers, this would mean favoring stocks with low volatility, high quality and strong momentum. Government Bonds Maintain Slight Underweight On Duration. Despite rising volatility due to changes in inflation expectations and uncertain developments in geopolitics, the investment backdrop has been evolving in line with our 2018 Strategy Outlook. Global growth continues at a strong pace (Chart 19) and our U.S. Bond Strategy has increased its yield forecast to the range of 3.3-3.6%, from 2.80-3.25% previously, reflecting both a higher real yield and higher inflation expectations. The U.S. 10-year Treasury yield increased by 34 bps in Q1 to 2.74%, still lower than our fair value estimate, implying that there is still upside risk for global bond yields. As such, investors should continue to underweight duration in global government bonds. Favor Linkers Vs. Nominal Bonds. The base case forecast from our U.S. Bond Strategy is that the U.S. TIPS breakeven will rise to 2.3-2.5% around the time that U.S. core PCE reaches the Fed's 2% target rate, likely sometime in 2H 2018. Compared to the current level of 2.05, this means the 10-year TIPS has upside of 25-45 bps, an important source of relative return in the low-return fixed income space (Chart 20). Maintain overweight TIPS vs. nominal bonds. In terms of relative value, however, TIPS are no longer cheap. For those who have not moved to overweight TIPS, we suggest "buying TIPS on dips". In addition, inflation-linked bonds (ILBs) in Australia and Japan are still very attractive vs. their respective nominal bonds (Chart 20, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Chart 19Further Upside In Bond Yields Further Upside In Bond Yields Further Upside In Bond Yields Chart 20Favor Inflation linkers Favor Inflation linkers Favor Inflation linkers Corporate Bonds We continue to favor both investment grade and high-yield corporate bonds within the fixed-income category. High-yield spreads barely reacted to the sell-offs in equities in February and March (Chart 21). We see credit spreads as a useful indicator of recessions and equity bear markets and so the fact that they did not rise suggests no broad-based risk aversion. Moreover, this resilience comes despite significant outflows from high-yield ETFs, $4.4 billion year-to-date, almost completely reversing the inflows over the previous three quarters. We still find spreads in this space attractive. BCA estimates the default-adjusted spread is still around 250 basis points (assuming default losses of 1.3% over the coming 12 months) which, while not cheap, is less overvalued than other fixed-income categories (Chart 22). Investment grade spreads, however, have widened in recent weeks (Chart 21), with the rise concentrated in the highest-quality credits. This is most likely because investors see little value in these securities. We keep our overweight but we focus on cross-over credits and sectors where valuations are still reasonable, for example energy, airlines and insurance companies. Excessive leverage remains a concern for corporate bond losses in the next recession. BCA's Corporate Health Monitor (Chart 23) has improved in recent quarters, mostly due to stronger profitability. But the deterioration in interest coverage ratios in recent years makes companies vulnerable to higher rates. We estimate that a 100 basis point increase in interest rates across the corporate curve would lead to a drop in the ratio of EBITDA to interest expenses from 4.0 to 2.5.7 Sectors such as Materials, Technology, Consumer Discretionary and Energy appear especially at risk.8 Chart 21IG Spreads Have Widened, But Not HY IG Spreads Have Widened, But Not HY IG Spreads Have Widened, But Not HY Chart 22Junk Bonds Still Offer Some Value Junk Bonds Still Offer Some Value Junk Bonds Still Offer Some Value Chart 23Leverage Is A Worry For The Next Recession Leverage Is A Worry For The Next Recession Leverage Is A Worry For The Next Recession Commodities Chart 24OPEC Agreements Hold The Key OPEC Agreements Hold The Key OPEC Agreements Hold The Key Energy (Overweight): Demand/supply fundamentals have been driving prices in crude oil markets (Chart 24). Fundamentals remain favorable as strong global demand is keeping the market in physical deficit. However, the outlook for demand has turned cloudy as the market may start to price in the possibility of a trade war which would dent growth. Also, threats of renewed sanctions against Iran and deeper ones against Venezuela could potentially disrupt supply sufficiently to push up the crude price. Given rising uncertainties with the demand and supply outlook, we expect increased volatility in the crude price. We maintain our forecasts for the average 2018 prices for Brent and WTI at $74 and $70 respectively. Industrial Metals (Neutral): As President Trump moves ahead with protectionist policies, markets are being spooked by the possibility of a trade war. Looking past the noise, since China remains the largest source of demand, price action will follow domestic Chinese market fundamentals which are a function of how authorities handle a possible growth slowdown. The possibility of global trade disruptions, coupled with a recovery in the U.S. dollar, suggests increased price volatility. We are particularly negative on zinc. Spanish zinc has been flooding into China, depressing physical premiums and causing inventory accumulation (Chart 24, panel 3). Precious Metals (Neutral): Rising trade protectionism, geopolitical tensions, and diverging monetary policy will be sources of increased market volatility for the rest of the year. When equity markets went through a minor correction earlier this year, gold outperformed global equities by 6%. However, rising interest rates and a potentially stronger U.S. dollar are two headwinds for the gold price. We continue to recommend gold as a safe haven asset against unexpected market volatility and inflation surprises (Chart 24, panel 4). Currencies Chart 25Dollar Will Stage A Recovery Rally Dollar Will Stage A Recovery Rally Dollar Will Stage A Recovery Rally U.S. Dollar: Following its 7% depreciation last year, the greenback is flat year to date. A positive output gap and strong inflation readings are giving the Fed enough reasons not to fall behind the curve. Secondly, the proposed fiscal stimulus is likely to increase the U.S.'s twin deficits which has historically been bullish for the currency, as long as it is accompanied by rising real rates. Finally, speculative positions in the dollar are net short, which means any positive surprises will be bullish for the currency. We expect the U.S. dollar to stage a recovery rally in the coming months (Chart 25, panel 1). Carry Trades: Cross-asset class volatility is making a strong comeback. Carry trades fare poorly in volatile FX markets. High-yielding EM currencies like the BRL, TRY, and ZAR will underperform, whereas low yielding safe-haven funding currencies like the Swiss franc and Japanese yen, in countries with outsized net international investment positions, will be the winners. Finally, the return of volatility could hurt global economic sentiment and possibly weigh on growth-sensitive currencies like the KRW, AUD and NZD (Chart 25, panel 2). Euro: Analyzing the euro's strength, we see a 9% divergence in performance between the EUR/USD pair and the trade-weighted euro. Global synchronized growth was driven predominantly by a recovery in manufacturing which benefited the euro area more than the U.S. Also looking at history, the euro tends to appreciate relative to USD in the last two years of economic upswings driven by strong growth. Finally, the recent divergence in relative interest rates is a clear sign that other fundamental factors, such as the current account balance, have been exerting pressure. Sentiment and positioning remain extremely euro bullish, hence any disappointment with economic data will force a correction (Chart 25, panel 3). GBP: Since 2017, the pound has strengthened by over 16% vs. USD. An appreciating currency has dented inflation readings, thereby limiting the pass-through effects via the Bank of England hiking rates. A hurdle to further appreciation is negative growth in real disposable income and declining household confidence. Finally, weak FDI inflows will hurt the U.K.'s basic balance. Since the BoE will find it difficult to tighten policy much, we expect a correction in the next few months (Chart 25, panel 4). Alternatives Investors have been increasing their allocation to alternatives, pushing AUM to a record $7.7 trillion. We continue to recommend allocations through three different buckets: 1) among return enhancers, we favor private equity vs hedge funds; 2) favor direct real estate vs. commodity futures in inflation hedges; 3) favor farmland & timberland vs. structured products as volatility dampeners. But alternatives have a few challenges that require special consideration. Private Equity: Key drivers of returns have changed. In the past, managers were able to succeed by "buying low/selling high". But today, investors need to pick general partners (GPs) who can identify attractive targets and effect strategic and operational improvements. $1.7 trillion of dry powder. Global buyout value grew by 19% in 2017, but deal count grew by only 2%. High valuations multiples, stiff competition, and an uncertain macro outlook will force funds to be selective. Competition from corporate buyers. GPs are fighting with large corporations looking for growth through acquisition. Private equity's share of overall M&A activity globally declined in 2017 for the fourth year running. Competition for targets is boosting entry multiples in the middle-market segment. Hedge Funds: Net exposure for long/short managers has remained static over market cycles, which means investors pay too much for market exposure. But if we see market rotation or increased dispersion of single stock returns, this hedge fund group will benefit. Discretionary macro will benefit from differing growth outlooks, idiosyncratic events, and local rate cycles. Also, potential for more dispersion in the large-cap space and at the index level will benefit systematic macro. Event-driven funds have been hurt by deal-spread volatility as shareholder opposition, anti-trust concerns and political issues led to deal delays. But we continue to favor short-term special situations in less-followed markets such as Asia. Real Estate: After strong growth in capital values, driven by low rates and cap rate compression, investors need to focus on income-driven total returns. Additionally, income returns do not vary across markets nearly as much as capital value growth. Increase focus on core strategies. Look for properties in prime locations with long and stable lease contracts. Investors can also consider loans made to high-quality borrowers which are secured against properties with stable cash flows. Private Debt: With ultra-low yields, private debt offers attractive risk-adjusted return, diversification, and a potential cash flow profile ideal for institutional investors. However, it is critical to source a differentiated pipeline of opportunities. Infrastructure debt, with a long expected useful life, can provide effective duration for liability matching. Risk-adjusted returns can be enhanced by directly sourcing and structuring. Risks To Our View We see the risks to our main scenario (strong growth continuing through 2019, moderate inflation, late cycle volatility, and rising geopolitical risks) as balanced. There are a number of obvious downside risks, including an escalating trade war, a sharp upside surprise to inflation, and the Fed turning more hawkish (perhaps in an attempt to demonstrate its independence if President Trump pressures it not to raise rates). Among the risks less appreciated by investors is a slowdown in China. Leading indicators of the Chinese economy, particularly money supply and credit growth, continue to slow (Chart 26). Xi Jinping's recent senior appointments suggests he is serious about structural reform, which would mean accepting slower growth in the short-term to put China on a sounder long-term growth path. Linked to this, we also think investors are insufficiently concerned about the impact of rising rates on emerging market borrowers. If, as we expect, U.S. long rates rise to close to 3.5% over the next year and the dollar strengthens, the $3.5 trillion of foreign-currency borrowing by EM borrowers could become a burden (Chart 27). Chart 26What If China Slows? bca.gaa_qpo_2018_04_03_c26 bca.gaa_qpo_2018_04_03_c26 Chart 27Highed Indebted EM Borrowers Are A Risk Highed Indebted EM Borrowers Are A Risk Highed Indebted EM Borrowers Are A Risk Chart 28Presidents Like Markets To Rise Quarterly - April 2018 Quarterly - April 2018 Upside risk centers on a continuation of strong growth and dovish central banks. We may be underestimating the impact of U.S. fiscal policy. Our assumption that it will peter out in 2020 may be wrong, if President Trump goes for further stimulus ahead of the presidential election - the third and fourth years of presidential cycles are usually the best for stocks (Chart 28). Wages may stay low because of automation. In the face of this the Fed may stay dovish: it already shows some signs of allowing an overshoot of its 2% inflation target, to balance the six years that it missed it to the downside. All this could produce a stock market meltup, similar to 1999. 1 See, for example, Clashing Over Commerce: A History of U.S. Trade Policy, Douglas J, Irwin, Chicago 2017, chapter 8. 2 For an analysis of the geopolitical implications, please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 27, 2018. 3 Please see the What Our Clients Are Asking: How Quickly Will U.S. Inflation Rise? on page 8 of this Quarterly Portfolio Outlook for the reasons why this is our view. 4 Please see Global Asset Allocation Special Report, "Why Invest In Foreign Government Bonds?" dated March 12, 2018 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?" dated July 8, 2016, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation Special Report, "Small Cap Outperformance: Fact Or Myth?" dated April 7, 2017, available at gaa.bcaresearch.com 7 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 8 Please see also What Our Clients Are Asking: Should Investors Still Own Junk Bonds, on page 9 of this Quarterly Update, for more analysis of this asset class. GAA Asset Allocation

Highlights Global growth has peaked, but will remain firmly above trend for the remainder of the year. The composition of global growth is shifting back towards the U.S. As often happens in the late stages of business-cycle expansions, asset markets have entered a more volatile phase. A global recession is likely in 2020. Equities: The correction is nearing an end, which will set the stage for a blow-off rally into year-end. For the time being, favor DM over EM stocks, Europe over the U.S., and value over growth. The "real" bear market will start next year. Government bonds: Global bond yields will trend higher over the next 12 months, but will begin moving lower by the middle of next year as recession risks mount. Over the long haul, yields are going higher - much higher. Credit: Spread product will eke out small gains relative to government bonds over the next 12 months. Spreads will blow out as the recession approaches. Investors will be shocked to learn that a lot of what they thought is investment-grade debt is really junk (or worse). Currencies: The U.S. dollar will bounce before resuming its bear market next year. The yen could weaken slightly against the dollar in 2018, but will hold its own against most other currencies. Energy-sensitive currencies such as the CAD will outperform other commodity currencies. Feature Booyah Writing frantically on October 8, 1998, CNBC commentator and former hedge fund manager Jim Cramer entitled his TheStreet.com piece with the indelible words "Get Out Now". Long-Term Capital Management had just imploded. Emerging Markets were crashing. Coming off the heels of a stratospheric ascent, the S&P 500 was down 22% from its highs. The tech-heavy NASDAQ had swooned 33%. The equity bull market had finally ended. Or so he thought. As fate would have it, the S&P 500 bottomed literally the very same minute that Cramer's piece came out.1 It went on to rise 68% before ultimately peaking in March 2000. Cramer would go on to avenge his 1998 call, wisely counseling his readers on October 6, 2008 to "take your money out of the stock market right now, this week." But on that fateful day in 1998, he was wrong. There are many differences in the economic environment between now and then, but on the crucial question of which way global equities are heading, history is likely to rhyme. As was the case in the late 1990s, the shakeout this year may be a prelude to a blow-off rally that takes stocks to new highs. Historically, equity bear markets and recessions almost always overlap (Chart 1). In fact, the most useful lesson I have learned over the past 25 years studying macro and markets is that unless you think a recession is around the corner, you should overweight stocks. It's as simple as that. Chart 1Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Fortunately, another recession is not around the corner. Interest rates are rising but are not yet in restrictive territory. Fiscal policy is being loosened, particularly in the U.S. Easy fiscal policy and still-accommodative monetary policy rarely produce recessions. As we discuss below, a global recession will eventually arrive - probably in 2020 - but that is still two years away. Stocks normally sniff out recessions before they start. However, the lead time is usually about six months. As Table 1 illustrates, equities typically do well in the second-to-last year of business-cycle expansions. We are probably in that window now. Table 1Too Soon To Get Out Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 A Whiff Of Stagflation So why the newfound angst? Partly, it is because markets were technically overbought and due for a correction. We warned clients as much in a report entitled "Take Out Some Insurance", published on February 2nd, one day before the VIX spike began.2 Fears of stagflation are also escalating. Inflation appears to be rising at the same time as global growth is slowing. Real potential GDP has increased at a snail's pace in the G7 economies over the past decade, the result of disappointing productivity gains and sluggish labor force growth (Chart 2). If the world is running out of spare capacity - and GDP growth is forced to climb down towards what many fear is an anemic trendline - then revenue and earnings growth are apt to decelerate. Chart 2Lackluster Productivity Gains And Anemic Labor##br## Force Growth Have Weighed On Potential GDP Lackluster Productivity Gains And Anemic Labor Force Growth Have Weighed On Potential GDP Lackluster Productivity Gains And Anemic Labor Force Growth Have Weighed On Potential GDP Escalating protectionism has further exacerbated anxieties about stagflation. President Trump has threatened to hike tariffs on steel and aluminum, go after China for allegedly stealing U.S. intellectual property, and pull out of NAFTA if a new deal is not negotiated in America's favor. An all-out global trade war would raise consumer prices and reduce output by impairing the efficient allocation of resources across countries. Investors have taken notice. None of these stagflationary concerns can be summarily dismissed, but they are less worrisome than they might appear. Let's start with trade wars. A Trade Spat, Not A Trade War We have long thought that we are in a secular bull market in populism. This is why we argued that investors were greatly understating the risks of Brexit in the weeks leading up to the referendum. It is also why we ignored the derision of others and predicted that Trumpism would prevail back in 2015 and that Trump himself would win the presidency by securing a larger-than-expected share of disgruntled white blue-collar workers in the Midwest.3 Trade protectionism, of course, is a major part of most populist agendas. However, the attractiveness of protectionism tends to ebb and flow depending on the state of the business cycle. There is a reason why the Smoot-Hawley tariff act was introduced during the Great Depression and not the Roaring Twenties. Both economically and politically, beggar-thy-neighbor policies are more appealing when unemployment is high and one more job abroad means one less job at home. That is not the case today, at least not in the U.S. Moreover, while the U.S. legal system gives the president free rein to impose tariffs and other trade barriers, Donald Trump is still constrained by the reaction of the business community and financial markets. After all, this is a president who likes to measure his self-worth by the value of the S&P 500. Needless to say, investors do not like protectionism. It is not surprising, therefore, that Trump has watered down his tariff rhetoric every time the stock market has sold off. It also not surprising that Trump has increasingly focused his wrath on China, a country with which the U.S. business community has had a love-hate relationship. A blue-ribbon commission recently estimated that intellectual property theft - most of it originating from China - costs the U.S. $225 billion-to-$600 billion per year.4 That is a lot of money that American companies could be making but aren't. China will undoubtedly complain that it is being unfairly singled out. It will also threaten retaliatory measures if the Trump administration imposes trade barriers on Chinese imports. In the end, those threats are likely to ring hollow. A war is only worth fighting if you think you can win. China has a very asymmetric trading relationship with the U.S., and one that gives it very little leverage. U.S. exports to China amount to less than one percent of U.S. GDP. That's peanuts - in some cases literally: Nearly half of U.S. goods exports to China consist of soybeans, wheat, cotton, nuts, and other agricultural products and raw materials. It would be difficult to tax them without hurting Chinese consumers. Of course, China could try to punish the U.S. by dumping Treasurys. But why would it? This would only drive down the value of the dollar, giving U.S. exporters a greater advantage. Trump wants that! Saying that you will retaliate against Trump's tariffs by no longer manipulating your currency is not exactly a credible threat.5 In the end, far from retaliating, China will try to placate Trump by easing restrictions on trade and foreign investment and making some politically-calculated purchases of U.S.-made goods. Boeing's stock sold off in the wake of escalating trade tensions. It probably should have risen. Peak Growth? In contrast to last year, global growth is no longer accelerating. Our Global Leading Economic Indicator is still rising, but the diffusion index, which measures the proportion of countries with rising LEIs, is down from its October 2017 high (Chart 3). Changes in the diffusion index have often foreshadowed changes in the composite LEI. An even more worrisome picture is painted by the OECD's LEI, which has actually dipped slightly over the past two months. The OECD's LEI diffusion index has also fallen below 50%. The Chinese economy appears to be slowing on the back of tighter monetary conditions (Chart 4). The Keqiang index, which combines data on electricity production, freight traffic, and bank lending, has come off its highs and our leading indicator for the index is pointing to further weakness. Property price inflation in tier 1 cities has fallen to zero. A number of clients noted during my visit to China last week that a wave of supply has hit the market over the past month following President Xi's warning that homes are for living and for not investing. A weaker Chinese property market could drag down construction spending, with adverse knock-on effects to commodity prices. Slower Chinese growth is rippling across the global economy (Chart 5). Korean exports - a bellwether for global trade - have decelerated. Japanese machinery orders have rolled over. The Baltic dry index has plunged by 40% from its December highs. The expectations component of the German IFO index has fallen to its lowest level since January 2017. Chart 3Global Growth Will Remain Above Trend,##br## But Has Probably Peaked For This Cycle Global Growth Will Remain Above-Trend But Ease From Blistering Pace Global Growth Will Remain Above Trend, But Has Probably Peaked For This Cycle Global Growth Will Remain Above-Trend But Ease From Blistering Pace Global Growth Will Remain Above Trend, But Has Probably Peaked For This Cycle Chart 4China's Industrial Sector Is Set ##br##To Slow Further China Is Slowing China's Industrial Sector Is Set To Slow Further China Is Slowing China's Industrial Sector Is Set To Slow Further China Is Slowing Chart 5Signs Of Slowing##br## Global Growth Signs Of Slowing Global Growth Signs Of Slowing Global Growth So far, the slowdown in global growth has been fairly modest. Goldman's global Current Activity Indicator (CAI), which combines both soft and hard data to gauge underlying economic momentum, was still up 4.9% in March, only slightly below recent cycle highs (Chart 6). The deterioration in a number of leading economic indicators suggests that the slowdown may have further to run. However, we would be surprised if it proves to be especially deep or long-lasting. Global financial conditions are still quite accommodative (Chart 7). Bank balance sheets are in good shape and rising capex intentions should support credit demand over the coming months, even in the face of somewhat higher borrowing costs. Improving labor markets should also bolster consumer confidence. Chart 6But Global Slowdown Has Been Fairly Modest But Global Slowdown Has Been Fairly Modest But Global Slowdown Has Been Fairly Modest Chart 7Global Financial Conditions Are Still Fairly Easy Global Financial Conditions Are Still Fairly Easy Global Financial Conditions Are Still Fairly Easy Back To The USA If global growth were decelerating because capacity constraints were starting to bite, this would be more worrying because it would mean any effort to stimulate demand would simply lead to more inflation rather than stronger economic growth. Reassuringly, that does not appear to be the case. The U.S. has slowed less than other large economies, even though it is closer to full employment. Notably, the manufacturing PMI has continued to rise in the U.S., but has dipped most everywhere else. Both Citigroup's and Goldman's economic surprise indices are still positive for the U.S., but have fallen into negative territory in Europe and Japan (Chart 8). Granted, Bloomberg consensus estimates suggest that U.S. growth will edge down to 2.5% in the first quarter. However, this may reflect ongoing seasonal adjustment problems. First quarter growth has averaged 1.7 percentage points less over the past decade than in the rest of the year. We are particularly skeptical of recent data showing that consumer spending has slowed, which is completely at odds with strong employment growth, rising home prices, and near record-high levels of consumer confidence. Looking out, U.S. demand growth should benefit from all the fiscal stimulus coming down the pike. We expect the fiscal impulse to rise from 0.3% of GDP in 2017 to 0.8% of GDP in 2018, and 1.3% of GDP in 2019 (Chart 9). The actual numbers could be even higher as our estimates do not include any additional expenditures on infrastructure, the possible restoration of earmarks (which could inflate pork-barrel spending), or the high likelihood that recent changes to the tax code will spawn all sorts of unforeseen loopholes, leading to lower-than-expected tax receipts. Chart 8U.S. Is The Standout U.S. Is The Standout U.S. Is The Standout Chart 9Fiscal Stimulus Bode Well For Growth Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Unfortunately, all this fiscal stimulus is coming at a time when the economy does not need it (Chart 10). The U.S. unemployment rate currently stands at 4.1%, 0.4 percentage points below the Fed's estimate of NAIRU. Given the prospect of continued above-trend growth, the unemployment rate is likely to be close to 3.5% by early next year, which would be below the 2000 low of 3.8%. Chart 10Now Is Not The Time For Fiscal Profligacy Now Is Not The Time For Fiscal Profligacy Now Is Not The Time For Fiscal Profligacy Rebalancing Global Demand: The Role Of The Dollar What happens when fiscal stimulus pushes aggregate demand beyond an economy's productive capacity? One possibility is that imports go up, thereby allowing the additional demand to be satiated with increased production from the rest of the world. For this to happen, however, the prices of foreign-made goods sold in the U.S. need to decline relative to the prices of domestically-produced goods. U.S. imports account for only 15% of GDP. Thus, if the prices of U.S.-made goods do not change relative to the prices of foreign-made goods, only 15 cents or so of every additional dollar of income will fall on imports. After all, consumers do not care about the intricacies of balance of payments statistics when they are deciding whether to buy a foreign or domestic automobile. They care about relative prices. This means that either the nominal trade-weighted dollar must appreciate or the U.S. price level must rise relative to foreign prices. Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.6 In theory, one can envision a scenario where the nominal dollar exchange rate depreciates while the real exchange rate appreciates over the long haul because inflation rises significantly in the U.S. relative to its trading partners. Much of the market commentary has implicitly focused on just such an outcome. Massive fiscal stimulus, as the story goes, will lift U.S. inflation by so much that the dollar will fall over time. The problem with this narrative is that it is difficult to square with the facts. Long-term inflation expectations have actually risen more in the euro area and Japan since Trump got elected (Chart 11). The true puzzle is that rising U.S. real yields have not translated into a stronger dollar (Chart 12). Chart 11Long-Term Inflation Expectations Have ##br##Risen More In Japan And The Euro Area##br## Than The U.S. Since Trump Took Over Long-Term Inflation Expectations Have Risen More In Japan And The Euro Area Than The U.S. Since Trump Took Over Long-Term Inflation Expectations Have Risen More In Japan And The Euro Area Than The U.S. Since Trump Took Over Chart 12The Dollar Has ##br##Decoupled From Interest##br## Rate Differentials The Dollar Has Decoupled From Interest Rate Differentials The Dollar Has Decoupled From Interest Rate Differentials A Trump Risk Premium? What happened, as Hillary Clinton might ask? One answer is that Trump happened. Larry Summers has argued that political uncertainty around Trump's antics (protectionism, the Mueller probe, the porn stars, etc.) has made holding U.S. assets more risky.7 This risk has been exacerbated by the prospect of large current account and fiscal deficits - the so-called "twin deficits" - stretching for as far as the eye can see. If this theory is correct, the increase in U.S. real bond yields may be less the result of better growth expectations and more the consequence of a rising risk premium on long-term government debt. It's an intriguing hypothesis, but it cannot explain why business confidence is near all-time highs or why the S&P 500, despite this year's selloff, has risen by 23% since the U.S. presidential election. It also cannot explain why the yield curve has flattened recently, which is not what you would expect if investors were shunning long-term bonds. Perhaps it is best not to overthink things. The dollar is a high-momentum currency (Chart 13). At the start of 2017, the greenback was overbought (Chart 14). Then global growth began to accelerate, which has historically has been bad news for the dollar (Chart 15). The lion's share of that growth also came from outside the U.S. None of this is true today, but the downward trend in the dollar has remained intact, and that is proving hard to break. Chart 13USD Is A Momentum Winner Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Chart 14USD Was Overbought At The Start Of 2017 USD Was Overbought At The Start Of 2017 USD Was Overbought At The Start Of 2017 Hard but not impossible. The dollar could get a bit of a reprieve. USD Libor has broken out recently (See Box 1 for details). As Chart 16 illustrates, there has been an extremely close relationship between the dollar index and the 3-month lagged value of the Libor-OIS spread. The cost of shorting the dollar is about to spike as borrowing rates linked to Libor reset over the next few weeks. The Libor spread will eventually come down, but perhaps not before the negative momentum against the dollar has turned into positive momentum. Chart 15Slowing Global Growth Tends##br## To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Chart 16Shorting The Dollar Is About##br##To Get A Lot More Expensive Shorting The Dollar Is About To Get A Lot More Expensive Shorting The Dollar Is About To Get A Lot More Expensive Fixed-Income: Hedged Or Unhedged? Chart 17Bond Yields, Currency-Hedged Bond Yields, Currency-Hedged Bond Yields, Currency-Hedged When European investors buy U.S. bonds, they take on exposure to both the value of the bond and what happens to the euro-dollar exchange rate. If they do not want to assume the currency risk, they can sell the dollar forward, effectively locking in the number of euros they will receive for every dollar sold. The purchase of the bond increases the demand for dollars, while the commitment to sell the dollar increases the supply of dollars. For the value of the dollar, it is largely a wash.8 Likewise, if U.S. investors do not want to bear currency risk when purchasing German bunds, they can sell the euro forward. This also entails two offsetting transactions: One that boosts the demand for euros and one that raises the supply of euros. The spike in USD Libor has increased the currency-hedged return of non-U.S. bonds relative to U.S. bonds. Chart 17 shows that the yield on 10-year Treasurys, hedged into euros, has fallen to 0.06%, which is below the 0.5% yield offered by German bunds. In contrast, the 10-year bund yield, hedged into dollars, has risen to 3.16% - which is above the 2.78% yield offered by Treasurys. All things equal, it becomes less attractive for foreign investors who wish to buy U.S. bonds to hedge currency risk as USD Libor rises. In contrast, it becomes more attractive for U.S. investors to currency-hedge their overseas bond purchases when USD Libor goes up. Unhedged bond purchases bid up the currency of the issuer, but hedged purchases do not. If a smaller share of foreign investors decide to hedge currency risk when buying Treasurys, while a larger share of U.S. investors decide to hedge currency risk when purchasing foreign bonds, the net demand for dollars will rise. This could help the dollar over the coming months. Go Long Treasurys/Short German Bunds, Currency-Unhedged The correlation between the German-U.S. 30-year bond spread and EUR/USD was extremely tight in 2017 but has completely broken down this year (Chart 18). At this juncture, betting on a normalization of this correlation - effectively, a bet that U.S. Treasurys will outperform bunds in currency-unhedged terms - has become too good to resist. In fact, it is almost a "can't lose" wager. Consider the fact that 30-year Treasurys are yielding 182 basis points above comparable-maturity bunds. The euro would have to rise to 1.23*(1.0182)^30=2.11 against the dollar over the next 30 years for investors to lose money on this investment. Chart 18Unsustainable Divergence? Unsustainable Divergence? Unsustainable Divergence? Granted, inflation is likely to be lower in the euro area. CPI swaps are forecasting that euro area inflation will be roughly 40 bps lower compared to the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.49. In other words, long-term investors betting on the euro are effectively betting on a major euro overshoot. The discussion above raises a more fundamental point. Investors often equate their view about the direction in which a currency is heading with whether to be bullish or bearish on it. We completely agree that the trade-weighted dollar will weaken over the long haul because most valuation metrics suggest that the greenback is still expensive. However, given the carry advantage the U.S. enjoys, long-term investors would still be better off overweighting U.S. fixed-income assets. Regional Equity Allocation U.S. equities have outperformed their global peers since the start of 2017 in local-currency terms but have underperformed in common-currency terms (Chart 19). If the dollar rebounds over the next few months, as we expect, this should boost the local-currency value of European stocks since many large multinational European companies generate sales in dollars. Sector skews should also work in Europe's favor. Financials are the largest overweight in euro area bourses, while technology is the biggest overweight in the U.S. (Table 2). Chart 19U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency Table 2Global Sector Skews: Tech Resides In The U.S. And Growth Indexes,##br## Financials Live In The Eurozone And Value Indexes Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 While global growth has peaked, it will remain firmly above trend. This will ensure that spare capacity continues to shrink, taking global bond yields higher. Since the ECB will not raise rates for at least another year, the yield curve in the euro area will steepen, boosting the profitability of European banks (Chart 20). Tech companies are particularly sensitive to changes in discount rates since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening (more than 50% of U.S. tech sales are derived from abroad). Recent concerns over the way Facebook and other tech companies have handled privacy issues could further sour sentiment towards the sector. The outlook for Japanese stocks is a tough call. Japan, like Europe, is trading at a discount relative to the U.S. based on our in-house valuation metrics (Chart 21). However, we do not see much downside for the yen, even after its recent appreciation. The currency remains very cheap by historic standards, Japan's current account surplus has widened to 4% of GDP, and unlike the euro, speculative positioning is short. While Japanese corporate earnings have been able to expand rapidly over the past 16 months without the support of a weaker currency, now that profit margins are near record highs (Chart 22), further gains in profits and equity prices are likely to be limited. Chart 20Euro Area Yield Curve ##br##Steepening Will Boost Banks Euro Area Yield Curve Steepening Will Boost Banks Euro Area Yield Curve Steepening Will Boost Banks Chart 21Japanese And Euro Area##br##Stocks Are Relatively Cheap Japanese And Euro Area Stocks Are Relatively Cheap Japanese And Euro Area Stocks Are Relatively Cheap The combination of higher U.S. rates, a stronger dollar, and weaker Chinese growth will weigh on EM equities over the coming months. There is $17 trillion in U.S. dollar-denominated debt held outside the U.S., most of it in emerging markets. Ironically, weaker Chinese growth will hurt other EMs more than it hurts China. China accounts for more than 50% of base metal demand compared to only 13.5% for oil (Chart 23). This means that the outlook for metal producers such as Brazil, South Africa, Chile, and Australia is more challenging than for energy producers such as Canada and Norway. Chart 22Global Profit ##br##Margin Picture Global Profit Margin Picture Global Profit Margin Picture Chart 23Base Metals Are More Sensitive##br## To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth Favor Value Over Growth We expect global value stocks to start outperforming growth stocks after more than a decade of deep underperformance (Chart 24). The valuation measures constructed by Anastasios Avgeriou and his global equity sector strategy team suggest that value stocks are trading more than two standard deviations cheap relative to growth stocks. Earnings revisions are also starting to move in favor of value names9. Similar to the U.S./euro area equity split, financials are overrepresented in value indices, while technology is overrepresented in growth indices. The weights of the energy and consumer discretionary sectors in the U.S. index are roughly the same as the weights of those two sectors in the euro area index. However, energy is overrepresented in global value indices while consumer discretionary is overrepresented in growth indices. Despite our outlook for a somewhat stronger dollar, our commodity strategists see upside for oil prices this year thanks to continued discipline by OPEC 2.0. This should help energy stocks. On the flipside, consumer discretionary stocks often struggle in a rising rate environment, so this should tilt the playing field in favor of value (Chart 25). Chart 24Value Versus Growth: ##br##Compelling Entry Point Value Versus Growth: Compelling Entry Point Value Versus Growth: Compelling Entry Point Chart 25Consumer Discretionary Stocks Do##br## Poorly In A Rising Rate Environment Consumer Discretionary Stocks Do Poorly In A Rising Rate Environment Consumer Discretionary Stocks Do Poorly In A Rising Rate Environment With all this in mind, we are initiating a trade recommendation to go long the All-Country World Value Index relative to the corresponding Growth Index starting today. Investment Conclusions Volatility typically rises in the late stages of business-cycle expansions, as inflation picks up and monetary policy becomes progressively less accommodative (Chart 26). We have entered such a phase. This does not mean that equities cannot go higher. Chart 27 shows that the VIX rose in the late 1990s, even as stocks zoomed to new highs. We are probably at the tail end of an equity correction now. A blow-off rally into year-end is likely. Chart 26A More Hawkish Fed Usually Means A Higher VIX A More Hawkish Fed Usually Means A Higher VIX A More Hawkish Fed Usually Means A Higher VIX Chart 27Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise We expect the fed funds rate to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, the U.S. fiscal impulse will have dropped back to zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to increasingly binding supply-side constraints, the economy could easily stall out in 2020. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller PE ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 3% over the next decade (Chart 28). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault investors for taking some money off the table now. A somewhat more defensive posture would certainly be warranted. Recall that the NASDAQ bubble burst in March 2000, but the S&P 500, excluding the technology sector, did not peak until May 2001. During the intervening period, S&P tech stocks underperformed the rest of the market by 70% (Chart 29). As was the case back then, a shift away from tech leadership may be afoot. This would support our value over growth, and euro area over the U.S., recommendations. Chart 28Demanding U.S. Valuations Point##br## To Low Long-Term Returns Demanding U.S. Valuations Point To Low Long-Term Returns Demanding U.S. Valuations Point To Low Long-Term Returns Chart 29The Force Of Tech At ##br##The Turn Of The Century The Force Of Tech At The Turn Of The Century The Force Of Tech At The Turn Of The Century Spread product should be able to eke out small gains relative to government bonds over the next 12 months. Ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 30). Spreads will blow out as the recession approaches. In this month's issue of The Bank Credit Analyst, my colleague Mark McClellan simulated the effect on investment grade credit from: 1) A 100 basis-point increase in interest rates across the curve; and (2) A more severe scenario where interest rates rise by 100 basis points and corporate profits fall by 25% peak- to-trough. Mark's calculations suggest that the next recession will see the interest coverage ratio drop more than in previous downturns (Chart 31).10 Investors may be shocked to discover that a lot of what they thought is investment-grade debt is really junk (or worse). Chart 30Ratings Migration Is Supportive For Credit But... Ratings Migration Is Supportive For Credit But... Ratings Migration Is Supportive For Credit But... Chart 31...Corporate Leverage Will Take Its Toll ...Corporate Leverage Will Take Its Toll ...Corporate Leverage Will Take Its Toll We suggested going long the dollar in August 2014. This view worked well for a while but struggled mightily last year. However, the broad trade-weighted dollar index has been fairly stable since September, and is actually up 2.3% since its January lows (Chart 32). The greenback is due for another rally, one that no doubt would catch many traders by surprise. After a heated internal debate, BCA shifted its house view on bonds towards a more bearish stance in July 2016. As fate would have it, our note entitled "The End Of The 35-Year Bond Bull Market" came out on the same day that the U.S. 10-year yield reached an all-time closing low of 1.37%.11 We observed in February that bond positioning had become extremely short and, thus, tactically, yields could come down a bit. This has indeed happened. Over a 12-month horizon, however, we continue to see yields rising more than what is currently priced in. Both the TIPS 10-year and 5-year/5-year forward breakeven rates are 20-40 basis point below the 2.3%-to-2.5% range that prevailed in the pre-recession period (Chart 33). Somewhat higher oil prices should also boost inflation expectations. Chart 32Up Then##br## Down Up Then Down Up Then Down Chart 33Breakevens Still Below Levels Consistent##br## With 2% Inflation Mandate Breakevens Still Below Levels Consistent With 2% Inflation Mandate Breakevens Still Below Levels Consistent With 2% Inflation Mandate In addition, the real yield component could rise as the market revises up its expectation of the terminal rate. Revealingly, the mean and median terminal dots in the Fed's Summary of Economic Projections increased by 8.3 and 12.5 bps, respectively, in March, but are still more than 100 bps below where they were five years ago. Bond yields will increase in the euro area, as the ECB continues to taper asset purchases. We see less scope for yields to rise in the U.K., as the Brexit hangover continues to weigh on growth. Yields in Japan will remain repressed due to the continuation of the Bank of Japan's Yield Curve Control regime. As the next recession approaches, global bond yields will fall, but are unlikely to take out their 2016 lows. As we discussed in a series of recent reports, both yields and inflation will make a series of "higher highs" and "higher lows" in the U.S. and most other countries over the next decade and beyond.12 Appendix B shows stylistic diagrams of how we expect returns across the major asset classes to evolve over the next decade. The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Box 1 What's Up With Libor? The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. 1 In his book, Confessions Of A Street Addict, which I highly recommend, Cramer wrote: On October 8, a dreary, chilly rainy Thursday in New York ... the stock market bottomed. At eighteen minutes after 12:00 P.M. I ought to know. I caused it. At 12:18 P.M. I capitulated. I couldn't take it anymore. I gave up both literally, at my fund, and virtually, on my website, TheStreet.com, where I penned a piece entitled "Get Out Now". And the prop wash from that article marked the low point in the most vicious bear market of the last century. 2 Please see BCA Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com. 3 Please see BCA Global Investment Strategy reports, "Trumponomics: What Investors Need To Know," dated September 4, 2015; "Worry About Brexit, Not Payrolls", dated June 10, 2016; "Three (New) Controversial Calls", dated September 30, 2016, available at gis.bcaresearch.com. Also see BCA New York Investment Conference presentations: "Five Controversial Calls - Call #5: The Trumpists Will Win" (September 2015), and "Three Controversial Calls - Call #1: Trump Wins And The Dollar Rallies" (September 2016). 4 Please see "Update To The IP Commission Report - The Theft Of American intellectual Property: Reassessments Of The Challenge And United States Policy," The Commission on the Theft of American Intellectual Property (The National Bureau of Asian Research), (2017). 5 The fact that China's foreign exchange reserves have been trending sideways since early last year does not mean that past interventions should be disregarded. Just as both theory and evidence suggest that quantitative easing affects bond yields primarily through the "stock channel" (how many bonds central banks own) rather than the "flow channel" (the purchase or sales of bonds in any given period), the yuan's value is also more affected by the stock of foreign assets the PBOC controls rather than its recent interventions. This makes intuitive sense. If a central bank drives down its currency by buying a lot of foreign assets, and then suspends further purchases, one might expect the currency to stop falling, but one would not expect it strengthen to where it was before the intervention began. 6 Expressed mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 7 Larry Summers, "Currency Markets Send A Warning On The US Economy," March 5, 2018. 8 We say "largely" a wash because while selling the dollar forward is not exactly the same as short-selling it in the spot market due to the presence of the so-called currency basis swap spread, it is economically similar. When European investors short-sell the dollar, they are effectively borrowing dollars at Libor, selling them for euros, and parking the proceeds in a short-term account that pays Euribor. Three-month U.S. Libor is 230 bps these days, while three-month Euribor is -33 bps. Thus, European investors lose 263 bps by currency-hedging their U.S. bond purchases. Conversely, when U.S. investors go short the euro, they are effectively borrowing euros, selling them for dollars, and then parking the proceeds in a short-term account paying Libor. Thus, they gain the equivalent amount from the decision to currency-hedge purchases of euro area bonds. 9 Please see BCA Global Alpha Sector Strategy Weekly Report, "Global Size And Style Update," dated March 9, 2018, available at gss.bcaresearch.com. 10 Please see BCA The Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?" dated March 29, 2018, available at bca.bcaresearch.com. 11 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 12 Please see BCA Global Investment Strategy Weekly Report, "What Central Bankers Don't Know: A Rumsfeldian Taxonomy," dated March 16, 2018; Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. Appendix A APPENDIX A CHART 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 2Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 3Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 4Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Appendix B APPENDIX B CHART 1Market Outlook: Bonds Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 2Market Outlook: Equities Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 3Market Outlook: Currencies Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 4Market Outlook: Commodities Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights With North Korean diplomacy on track, Taiwan is the country most exposed to U.S.-China trade and strategic tensions. The Taiwanese public supports the status quo; however, a majority sees itself as exclusively Taiwanese, and the desire for independence may grow over time. Domestic political changes in mainland China and in the United States are also conducive to greater geopolitical tensions affecting Taiwan. Beijing will likely refrain from excessive pressure in the lead-up to Taiwan's November local elections ... but an independence-leaning outcome could change that. Stay overweight Taiwan within Emerging Market portfolios, but be prepared to downgrade if latent geopolitical risks begin to materialize. Feature The decision by the United States to toughen its enforcement of trade rules with China marks a shift that will have lasting ramifications.1 The U.S. is concerned not only about the trade imbalance but also the national security risk posed by China's economic might and increasing technological prowess. Hence President Donald Trump has imposed trade measures on China despite Chinese President Xi Jinping's cooperation on North Korea. Xi has enforced sanctions on the North and thus forced Kim Jong Un to the negotiating table, even getting him to consider denuclearization (Chart 1). Global financial markets may "climb the wall of worry" about the latest tariffs because the Trump administration has moderated its rhetoric in practice, notably by choosing to prosecute China in the World Trade Organization. However, the protectionist shift in U.S. policy is a lasting one. American power is declining relative to China, and the two countries no longer share the same economic interdependency that acted as a deterrent to conflict in the past (Chart 2).2 Chart 1China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump Chart 2Structural Increase In U.S.-China Tensions Structural Increase In U.S.-China Tensions Structural Increase In U.S.-China Tensions Taiwan is the country that is most exposed to both trade and strategic tensions between the U.S. and China (Chart 3). Indeed, BCA's Geopolitical Strategy has held since January 2016 that Taiwan is a potential geopolitical black swan.3 Does this warrant shifting to an underweight stance in EM portfolios? Not yet. But it is a left tail risk that investors should have on their radar. Taiwan Is Filled With Dry Powder There are three reasons to suspect that Taiwan geopolitical risk is understated. First, Chinese President Xi Jinping has consolidated power and made himself into Chairman Mao Zedong's peer in the Communist Party's ideological hierarchy. He is in power indefinitely. Xi has also followed his predecessor Jiang Zemin, in the 1990s, in taking a tough approach to security and defense. Implicitly he wants to make sure that unification occurs by 2049, but some argue that he wants to achieve it within his lifetime, namely by 2035. The Taiwanese public is resolutely opposed to any timetable. The fundamental risk is that economic slowdown could disappoint the aspirations of a big and ambitious middle class, which could force Xi to pursue nationalism and foreign aggression as a way to maintain domestic control (Chart 4). Beijing is still unlikely to attack Taiwan other than as a last resort, due to the American alliance system protecting it: this remains a hard constraint for now. But aggressive economic sanctions and military posturing with the intention to coerce Taiwan are much more likely than investors realize today. Chart 3Taiwan's Economy As Well As Security On The Line Taiwan's Economy As Well As Security On The Line Taiwan's Economy As Well As Security On The Line Chart 4China's Stability Vulnerable To Growth Slowdown China's Stability Vulnerable To Growth Slowdown China's Stability Vulnerable To Growth Slowdown Second, Taiwan's independence-leaning Democratic Progressive Party (DPP) has gained control of every level of government on the island - the presidency, the legislature, the municipalities - since the large-scale, anti-mainland "Sunflower" protests of 2014. President Tsai Ing-wen, who replaced the outspokenly pro-China President Ma Ying-jeou, is vocally uncomfortable with the status quo. She has refused to positively affirm the "1992 Consensus," which holds that there is only "One China" but two interpretations. Beijing sees this idea as the basis of smooth cross-strait relations. Tsai has not in practice tried to break the status quo, but she is clearly interested in enhancing Taiwan's autonomy. Moreover, a youthful "Third Force" has emerged in Taiwanese politics, with the backing of former presidents Lee Teng-hui and Chen Shui-bian, arguing for independence and the right to hold popular referendums on the question of sovereignty. Any success of this movement will provoke a massive response from China. Third, U.S. President Trump has suggested in several poignant ways that his tougher approach to China will entail a more robust American guarantee of Taiwan's security. While he has promised Xi to uphold the "One China policy," he is actively upgrading diplomatic and possibly naval relations with Taiwan and considering more substantial arms sales to Taiwan.4 His negotiation style suggests that he is not afraid to touch this "third rail" in Sino-American relations. Moreover, in the wake of the 1995-96 Third Taiwan Strait Crisis, and again in the wake of the Global Financial Crisis, a hugely important shift in Taiwanese national identity accelerated. Today the public mostly identifies solely as Taiwanese, as opposed to both Taiwanese and Chinese (Chart 5). This trend has abated somewhat since the DPP rose to full control in 2014-16, but a 55% majority still sees itself as exclusively Taiwanese. Among the youth, that number is 70%. This dynamic raises the possibility that a political independence movement could one day emerge. Beijing, at any rate, is watching with great concern. Of course, this shift in national identity does not imply that Taiwanese want to declare independence for the state of Taiwan anytime soon. Only about 22% want the country to move toward formal independence, and only 5% want to declare independence today. Whereas 69% are comfortable maintaining the status quo for a long time (Chart 6). The Taiwanese want to preserve their de facto independence and continue to prosper. But support for independence has grown faster than support for the status quo since the 1994 consensus. The status quo barely, if at all, holds majority support if one removes from its ranks those who eventually want to see the country declare independence. And younger cohorts have larger majorities than older cohorts in favor of independence. Chart 5Majority Of Taiwanese Are Exclusively Taiwanese ... Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Chart 6... Yet Majority Support Status Quo For Now Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan The point is that there is a lot of "dry powder" in Taiwanese public opinion that could be ignited against China in the event of a change of circumstances, i.e. another military crisis or economic shock. Essentially, China is worried that someday this national identity could be weaponized. Chart 7China Gains Leverage Over Time China Gains Leverage Over Time China Gains Leverage Over Time How will China respond to the situation? So far it has not overreacted. Xi Jinping has launched more intimidating military drills and has hardened his rhetoric - including in key reports at the 2017 party congress and this year's National People's Congress. His administration has also pursued policies to emphasize its dominance, such as setting up new air traffic routes over the strait that Taiwan claims violate its rights.5 Nevertheless, the cross-strait status quo has not yet changed in any fundamental way that would suggest relations are about to explode. And this is fitting because the status quo is beneficial to the mainland, having created a vast imbalance of economic influence over Taiwan (Chart 7). This imbalance gives China the ability to use economic coercion to dissuade Taiwan's leaders from trying anything too daring. This year, in particular, there is reason to think that Xi Jinping may want to limit any provocations. Taiwan will hold local elections on November 24, an opportunity for the pro-China Kuomintang (KMT) to at least begin to claw back the political stature it has lost (Chart 8). A good showing in 2018 is essential for the KMT if it is to rebuild momentum for the 2020 general election. Tsai's and the DPP's approval ratings have fallen precipitously since her inauguration (Chart 9). Xi may deem that saber-rattling would be counterproductive by giving Tsai and the DPP a foil, when in fact the tide is already working against them. If the KMT's performance is abysmal in the November elections, then Beijing faces a problem. Its strategy of gaining influence over Taiwan through economic integration has not prevented the emergence of an exclusively Taiwanese identity. So far Beijing has not given up on this strategy but that might become a concern if the Xi administration treads softly this year and yet the DPP broadens its control of local offices. Worse still for Beijing would be sweeping gains for outspoken, pro-independence candidates, since China cannot expel them from the legislature as easily as it did their peers in Hong Kong. Chart 8Kuomintang Needs A Win In 2018 Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Chart 9DPP Only Leads KMT By A Little Now Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Bottom Line: Political changes in China, Taiwan, and the United States are conducive to souring relations across the strait. Moreover, Taiwanese national identity is dry powder that Beijing fears could be exploited by independence-leaning politicians - potentially with American backing from an aggressive President Trump. This three-way dynamic means that Taiwanese geopolitical risk is understated, despite the fact that these powers are all familiar with the dynamics and Beijing may not want to overly provoke voters ahead of local elections, knowing that heavy-handedness in 1995-96 encouraged Taiwanese uniqueness. Macro Backdrop And Trade Tensions Undermine DPP The problem for President Tsai and the ruling DPP, as local elections approach, is that the Taiwanese economy faces headwinds as Chinese and Asian trade slows down and as the Trump administration converts its protectionist rhetoric into action. Since last year, China has tightened financial conditions and regulation and has cracked down on corruption in the financial sector. The result is a slump in broad money supply that is now pointing to a drop in EM and Taiwanese exports (Chart 10). Indeed, a cyclical slowdown is emerging in Taiwan: The short-term loans impulse is weakening which suggests that Taiwanese export growth will slow further (Chart 11, top panel). The basis for this relationship is that short-term loans are used by Taiwanese businesses to fund their working capital needs as well as purchase inputs to fill their export orders. Further, broad money is also weak (Chart 11, bottom panel). Chart 10China Slowdown Spells Trouble For Taiwan bca.gps_sr_2018_03_30_c10 bca.gps_sr_2018_03_30_c10 Chart 11Taiwanese Money/Credit Growth Slowing Taiwanese Money/Credit Growth Slowing Taiwanese Money/Credit Growth Slowing The manufacturing sector is slowing, with the shipments-to-inventories ratio weak and manufacturing PMI dipping sharply (Chart 12). Worryingly, the new orders, export orders, and electronic-sector employment components of the manufacturing PMI are approaching a precarious level. Various prices of semiconductors are also starting to show signs of weakness globally which does not bode well for a market that relies heavily on this trade. The semiconductor shipment-to-inventory ratio has rolled over (Chart 13). Taiwanese exports to ASEAN are also slowing, which signifies that final demand for semiconductors is softening, as ASEAN economies lie at the final stage of the semiconductor supply chain process. Chart 12Manufacturing Indicators Rolling Over Manufacturing Indicators Rolling Over Manufacturing Indicators Rolling Over Chart 13Softness In Key Semiconductor Exports Softness In Key Semiconductor Exports Softness In Key Semiconductor Exports Further, global trade tensions have the potential to harm global growth and especially heavily trade-exposed economies like Taiwan. Taiwan is not guaranteed to benefit from the U.S.'s more aggressive posture toward China. Theoretically, if the U.S. imposes tariffs on goods from China that can be substituted by Taiwan, then Taiwan will benefit. But in practice, the U.S. is using tariffs as a threat to force China to open its market more to U.S. exports. One way that Beijing may respond is by purchasing American goods instead of goods that come from American allies like Taiwan. Beijing has already attempted this strategy by offering to increase imports of American semiconductors at the expense of Taiwan and South Korea. At the moment there are no details on how much of an increase China is proposing. In Table 1 we show several scenarios to assess the damage that could be inflicted on Taiwan if China substituted away from it. The impact on Taiwan's exports is not negligible. For instance, under the benign scenario, if U.S.'s share of semiconductor exports to China rise from 4%6 to 10%, then Taiwan's share of semiconductor exports to China would drop from 15% to 12%. That would amount to a $4 billion loss for Taiwan, approximately, which represents 1.4% share of its total exports and 4% of its overall semiconductor exports. This analysis assumes that the trade losses resulting from China's shift to its semiconductor import mix would harm Taiwan somewhat more than Korea. The latter holds a competitive advantage on Taiwan as Korea designs and manufactures unique semiconductors that are not as easily substitutable. At any rate, the damage to Taiwan's geopolitical and trade outlook would be more concerning than the loss of revenue. Table 1China's Trade Concessions To U.S. Could Impose Costs On U.S. Allies Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan It is unlikely that the Trump administration is willing to accept such a deal, which is flagrantly designed to appease the U.S. at the expense of its allies. But the exercise illustrates a broader dynamic in which U.S. negotiations with China threaten to disrupt trade relationships and supply chains that have benefited Taiwan in recent decades. The result will be greater uncertainty and a higher potential for negative shocks. Chart 14China Punishes Taiwan For 2016 Election China Punishes Taiwan For 2016 Election China Punishes Taiwan For 2016 Election Moreover, the Trump administration has not entirely exempted allies from trade pressure. For instance, Taiwan has appreciated the dollar a bit in response to the threat of punishment for currency manipulation from the U.S. Washington has also just secured assurances from South Korea that it will not competitively depreciate the won. If agreements like these stand, and yet China makes less robust or less permanent agreements regarding its own currency, South Korea and Taiwan could suffer marginal losses of competitiveness. Taiwan is also exposed to coercive economic measures from China. Since Tsai's election, Beijing has made a notable effort to reduce tourist travel to Taiwan, which is reflected in tourism and flight data (Chart 14). Given the context of political tensions, the risk of discrete sanctions will persist and could flare up at any time if an incident occurs that aggravates the distrust between the two governments. How will investors know if Taiwanese geopolitical risk is about to spike upwards? At the moment, geopolitical risk is subdued, according to a proxy based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 15). This indicator tracks well with previous cross-strait crises. It even jumped upon the heightened tensions around the 2016 election of Tsai, and her controversial phone call with Donald Trump after his election. At the moment it suggests that cross-strait tensions have subsided significantly, despite the cutoff in formal diplomatic communication. However, the low point of the measure, and the underlying political factors outlined in the previous section, suggest that it should rise going forward. Chart 15Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here In the short run, it will be important to watch the Trump administration's handling of diplomatic visits and arms sales to Taiwan. Trump's signing of the Taiwan Travel Act has elevated diplomatic exchanges in a way that is mostly symbolic but could still spark an episode of heightened tension with China that would result in economic sanctions. An unprecedented naval port call could turn into an incident. At the same time, the U.S. guarantees Taiwan's security and in token of that guarantee periodically provides Taiwan with weapons packages. Beijing, for its part, always protests these sales, more or less vigorously depending on the military capabilities in question. The currently slated one is not too big but there is a rumor that it will include F-35 stealth fighter jets; other surprises could occur. Traditionally, the biggest spikes in sales have fallen under Democratic, not Republican, administrations. However, Trump may change that. There is a consensus in Washington that policy toward China should get tougher. The Taiwan Travel Act, upgrading diplomatic ties, passed with unanimous consent in both the House and Senate. Taiwanese governments have a record of increasing military spending when Republican presidents sit in Washington. And the first DPP government, under Chen Shui-bian from 2000-08, marked a clear upturn in Taiwanese military spending growth (Chart 16). If the Trump administration decides to sell Taiwan weapon systems that make a qualitative difference in the military balance, it will raise tensions with Beijing and likely prompt economic sanctions against Taiwan. Chart 16Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant In the long run, there are three key negotiations taking place in the region that could increase Taiwanese geopolitical risk: U.S.-China trade negotiations: Taiwan has benefited from China's engagement with the U.S., and with the West more broadly, and stands to suffer if they disengage. That would herald rising strategic tensions that would put Taiwan's trade and security in jeopardy. Geopolitical risk would go up. North Korean diplomacy: Kim Jong Un has met with Xi Jinping and formally agreed to hold bilateral summits with Presidents Trump and Moon Jae-in of South Korea. He has also indicated that denuclearization is on the table. If the different parties enter onto a path towards a peace treaty and denuclearization, then Taiwan might worry that the U.S. will eventually remove troops from the peninsula - far-fetched but not out of the question. Taiwan would fear abandonment and could attempt to entangle the U.S. For its part, China could believe that cooperation on North Korea requires the U.S. to give China greater sway over Taiwan. Geopolitical risk would go up. The South China Sea: These sea lanes are vital to Taiwan as well as China, South Korea, and Japan. If the U.S. washes its hands of the matter, ceding China a maritime sphere of influence, Taiwan will face both greater supply risk and greater anxiety about American commitment to its security. Beijing might be emboldened to pressure Taiwan, or Taiwan might act out to try to secure American support. Geopolitical risk would go up. Bottom Line: Taiwan's economy is entering a cyclical slowdown on the back of China's slowdown and rollover in the semiconductor industry. At the same time, trade tensions emanating from the U.S.-China negotiations and political tensions emanating from the other side of the strait suggest that Taiwan's geopolitical risk premium will rise. Over the short term, Taiwan's local elections, the referendum movement, or U.S. diplomacy or arms sales could provide a catalyst for a cross-strait crisis. Over the long term, significant changes in U.S.-China relations, North Korea, or the South China Sea could put Taiwan in a more precarious position. Investment Conclusions While the absolute outlook for Taiwanese stock prices is negative, the potential downside in share prices in U.S. dollar terms is lower than for the EM benchmark. BCA's Emerging Markets Strategy recommends that EM-dedicated investors remain overweight Taiwanese risk assets relative to the EM benchmark. First, the epicenter of China's slowdown is capital spending in general and construction in particular. Various Chinese industrial activity indicators have already begun decelerating. This is negative for industrial commodity prices and countries that produce them. Taiwan is less exposed to China's construction slump than many other EM economies. Second, China's spending on technology will not slow much. As a part of its ongoing reforms, Beijing will encourage more investment in technology as well as upgrading industries across the value-added curve. Hence, China's tech spending will outperform its expenditure on construction and infrastructure. Taiwan is poised to benefit from this relative shift in China's growth priorities. Third, there are no fresh credit excesses in Taiwan like in some other EMs. Taiwan's banking system worked out bad assets extensively following the credit excesses of the 1980s-90s. Hence it is less vulnerable than its peers in the developing world. Finally, Taiwan has an enormous current account surplus of 14% of GDP and, contrary to many other EMs, foreign investors hold few Taiwanese local bonds. When outflows from EM occur, the Taiwanese currency will fall under less pressure and its financial system under much less stress. This will allow Taiwanese stocks to act as a low-beta defensive play. Crucially, despite some appreciation to appease Trump, the Taiwanese dollar is among the cheapest currencies in EM (Chart 17). Chart 17Cheap Taiwanese Dollar Removes Risk Cheap Taiwanese Dollar Removes Risk Cheap Taiwanese Dollar Removes Risk As for heightened geopolitical risk, BCA's Geopolitical Strategy would note that while we view Taiwan as a potential "black swan," nevertheless tail risks are not the proper basis for an investment strategy. We will continue to monitor the situation so that we can alert clients when a major, market-relevant deterioration in cross-strait relations appears imminent, based largely on the factors highlighted above. If the DPP remains dominant after the local elections later this year, or if "Third Forces" make notable gains, we would suspect that the Xi administration will shift to using more sticks than carrots. This could include economic sanctions and military saber-rattling. The question then will be whether Beijing (or Washington or Taipei) attempts a material change to the status quo. Ultimately - from a bird's eye point of view - a war is more likely in the wake of Xi Jinping's elimination of term limits, consolidation of power, and the secular slowdown in China's economy and rise of Chinese nationalism. But we see no reason to fear such a catastrophic outcome in the near term. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 Trump began, as president-elect, by holding an unprecedented telephone call with the Taiwanese president. His administration has since requested a new $1.4 billion arms package, opened legal space for port calls (including potentially naval port calls) in the 2018 Defense Authorization Act, and for higher-level diplomatic meetings via the Taiwan Travel Act, which became public law on March 16, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. Military drills have involved symbolic shows, like sailing China's only operational aircraft carrier along the mid-line of the Taiwan Strait, as well as more poignant maneuvers, like drilling north and south of Taiwan simultaneously. As for rhetoric, Xi omitted from his 2017 party congress speech any reference to hopes that the Taiwanese "people" would bring about unification; in his speech after the March National People's Congress, he warned of the "punishment of history" for those who would promote secession. 6 Shown as the average of 2015 and 2017.

Dear Client, Yesterday, my colleagues Marko Papic, Matt Gertken, and I had a webcast to discuss the rising threats of trade wars between the U.S. and China. If you have not listened to it yet, I encourage you to listen to it here. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A trade war between China and the U.S. is an increasing source of long-term risk for the global economy. While the tensions between China and the U.S. are likely to decline in the short run, their materialization as the global economy is set to hit a soft patch and as the Federal Reserve's policy is becoming tight further validates our view that financial market volatility is rising cyclically. The dollar and the yen should prove to be the main beneficiaries of this phenomenon. The U.K. economy remains soft and investors should not become complacent about British political risk. Moreover, British inflation is set to slow in response to tighter monetary conditions. Sell GBP/USD on a tactical basis. Feature Two weeks ago, we argued that volatility was making a comeback in global financial markets.1 The interim events have only confirmed this thesis. Geopolitical risk is rearing its unwanted head as macroeconomic vulnerabilities are already rising because U.S. policy will soon exit accommodative territory and global growth is experiencing a speed bump. The dollar and the yen should benefit from these circumstances. Trade Wars Are Back Trade wars are once again on the radar screen of investors. The U.S. is the bellicose country, but as we argued three weeks ago, this acrimony is not really generalized to the entire world: it is first and foremost pointed at China.2 The events of the past weeks are confirming this thesis, with U.S. President Donald Trump having announced the levy of a potential 25% tariff on US$60 billion of Chinese shipments to the U.S. Beijing also announced its own tariffs - a retaliation to the U.S.'s steel and aluminum tariffs - of at least 15% on US$3 billion U.S. exports to China. The response from China is a measured one, and BCA's Geopolitical Strategy service argues that President Xi Jinping will likely push Beijing to offer small concessions to the U.S., especially as President Trump is currently trying to rally the EU to his cause.3 However, while China is willing to pacify Trump for now, this recent episode highlights that the relationship between the two global superpowers is becoming increasingly fraught with tensions - a consequence of China's ascent and the U.S.'s relative decline (Chart I-1). Chart I-1The Incumbent Versus The Upstart Do Not Get Flat-Footed By Politics Do Not Get Flat-Footed By Politics While fears of a trade war are likely to recede in the short term, the longer-term outlook remains worrisome. China is likely to become more confrontational toward the U.S. as time passes, and vice-versa. This supports one of BCA's important theses: The apex of globalization is behind us. As a result, global trade is unlikely to expand anymore on a secular basis. China and the U.S. are also likely to become increasingly insular, which could hurt their future growth. Table I-1 highlights the G-10 economies most at risk from this phenomenon, at least measured by their combined exports to the two superpowers. Canada and Switzerland stand out as the two countries most exposed to a rise in future trade conflicts, with exports to China and the U.S. representing 20.6% and 9.6% of their respective GDP. Australia, Germany and New Zealand stand as the second group most at risk, with around 6% of their GDP dependent on these economies. Interestingly, Sweden, an economy that has historically fluctuated with EM growth indicators, seems modestly impacted by China and the U.S., with exports to those countries only representing 3.2% of GDP. However, this picture is misleading. While Swedish exports to the euro area represent 12% of GDP, 60% of Swedish overall exports are intermediate and capital goods. As a result, euro area demand for Swedish goods is deeply affected by fluctuations in Chinese and EM final demand. This means that Sweden is in fact on par with Australia regarding its exposure to a trade war between the U.S. and China. Ranked Exposure To The Warring Kingdoms Do Not Get Flat-Footed By Politics Do Not Get Flat-Footed By Politics The rising risks of a trade conflict between the U.S. and China has been very impactful on financial market volatility. This is because the world economy is being affected by two other negatives right now: global growth is set to decelerate and the Fed's real fed funds rate is moving close to equilibrium, which normally supports financial market volatility. Regarding the outlook for a growth slowdown this year, we have already highlighted that EM carry trades funded in yen have rolled over, which has historically led to a weakening in global industrial activity (Chart I-2). Not only are EM carry trades very sensitive to the outlook for global growth, they are also a key component of EM liquidity conditions: when carry trades are increasingly profitable, they attract capital which generate funds inflow in EM economies; when they become less profitable, the capital abandons these strategies, generating fund outflows out of the EM space. These dynamics end up affecting global economic conditions. The OECD's global leading economic indicator has also begun corroborating this message. Its diffusion index has collapsed below the 50% line, which normally leads to a deceleration in the LEI itself (Chart I-3, top panel). Meanwhile, Korean exports have clearly rolled over, providing another negative signal for global growth (Chart I-3, bottom panel). None of these charts suggest that growth will fall below trend anytime soon, but they clearly highlight that the sunniest days for global growth are behind us. Chart I-2Global Growth Is Slowing Global Growth Is Slowing Global Growth Is Slowing Chart I-3More Indicators Of A Slowdown More Indicators Of A Slowdown More Indicators Of A Slowdown Despite this backdrop, the U.S. Fed is being forced to tighten policy as the U.S. economy is at full employment and the federal government is expanding stimulus. Interestingly, the next two hikes or so are likely to bring the real fed funds rate above the neutral rate, or R-star. As Chart I-4 highlights, when this happens, volatility increases. The upside to volatility is only made more salient by the current upgrade to long-term geopolitical risks and the imminent soft patch in global growth. In this environment, the clearest winner could remain the yen. The yen enjoys rising volatility. This is first and foremost because when volatility picks up, carry trades are reversed, prompting investors to buy back funding currencies like the yen. AUD/JPY seems especially vulnerable in this context. Not only is this cross directly hurt by rising volatility (Chart I-5), but Australia also stands to lose from tensions between the U.S. and China. The U.S. dollar could also benefit for now if the current environment does lead to higher financial market volatility. Historically, the USD has benefited from periods of rising risk aversion,4 but the recent widening in the LIBOR-OIS spread could also exacerbate these pressures (Chart I-6). The widening in this spread may have been aggravated by technical considerations: as financial intermediaries begin to move away from LIBOR as the key interest rate benchmark for USD loans, liquidity in this market may decline. This in of itself would not represent a systematic decline in USD-liquidity. However, this year's U.S. corporate tax cuts are prompting important repatriations of profits held abroad, to the tune of US$300-400 billion. Because U.S. firms keep their earnings abroad in the form of high-quality U.S. securities, this repatriation is likely to mean there will be less collateral available to secure transactions in the offshore USD market. This increases the cost of dollar funding. Thus, some of the rise in the LIBOR-OIS spread does in fact reflect a real tightening in global liquidity conditions. This is why the widening in this spread could help the USD, albeit temporarily. Chart I-4Policy Is Getting Tighter, ##br##Higher Vol Will Ensue Policy Is Getting Tighter, Higher Vol Will Ensue Policy Is Getting Tighter, Higher Vol Will Ensue Chart I-5Short AUD/JPY As##br## A Volatility Hedge Short AUD/JPY As A Volatility Hedge Short AUD/JPY As A Volatility Hedge Chart I-6Money Market Tensions Will Help ##br##The Dollar In Coming Months Money Market Tensions Will Help The Dollar In Coming Months Money Market Tensions Will Help The Dollar In Coming Months Bottom Line: Even if the recent spike peters off in the short term, geopolitical tensions between China and the U.S. are on a structural uptrend, reflecting growing competition between the incumbent power and the rising upstart. Trade conflicts between these two nations will only grow as time passes, hurting global trade and global growth in the process. Small open economies like Canada, Australia and Sweden could be the main collateral damage of this process. Today, the pricing of this risk is likely to exacerbate pressure on financial volatility created by a soft patch in growth and a tightening Fed. The yen and the USD should benefit from these dynamics over the coming months. Sterling: Risks Brewing Ahead Early last year, in a report titled "GBP: Dismal Expectations,"5 we argued that investors were too pessimistic on the British economic outlook, and that the cheap pound could surprise to the upside. Since then, GBP/USD has rallied by nearly 20%, back to pre-Brexit levels. Apart from generalized dollar weakness, three main factors have been behind the surge in cable: Fears of a hard Brexit have dissipated. Brexit did not plunge the U.K. economy into immediate recession. The Bank of England and market participants were surprised by higher-than-expected inflation, prompting a rethink of policy. Hard Brexit Chart I-7Monetary Conditions Are No ##br##Longer Accommodative Monetary Conditions Are No Longer Accommodative Monetary Conditions Are No Longer Accommodative BCA's Geopolitical Strategy team has written extensively against underestimating the probability of a hard Brexit, given that polls have not turned definitively to bremorse.6 Thus, if Labour becomes the ruling party, U.K. politicians will continue to pursue Brexit so long as the polls show support for it. Thus, investors should be careful in quickly removing the Brexit risk premium from the pound, especially as EU-U.K. negotiations remain fraught with risks. The Economy The dire economic forecasts made in the direct wake of the 2016 referendum did not come to fruition because the collapse in the pound and the fall in Gilts yields massively eased British financial conditions (Chart I-7), providing an unexpected boon to the economy. This is no longer the case: both the pound and U.K. yields have come back to pre-Brexit levels. The impact of this tightening in monetary conditions is now being felt. Household real consumption growth has fallen to seven-year lows, creating a drag for businesses, as consumer spending represents 66% of the British economy (Chart I-8). Moreover, various measures of the British credit impulse have collapsed, pointing to a continued slowdown in economic activity (Chart I-9). Chart I-8Weak Demand Is Hurting Businesses Weak Demand Is Hurting Businesses Weak Demand Is Hurting Businesses Chart I-9Credit Impulse Points To Downside Credit Impulse Points To Downside Credit Impulse Points To Downside How exactly is Brexit affecting the economy today? Simply put, money is leaving the U.K. Before the referendum, both the basic balance and net FDI stood at 2% of GDP. Today these measures stand at -4% and -3%, respectively. Uncertainty about the exact terms of the Brexit deal and the loss of passporting rights for financial institutions have scared away international capital. The housing market has been especially hit, experiencing its slowest growth rate since 2013, in spite of extremely low mortgage rates (Chart I-10). Foreign capital is a major driver of the U.K.'s real estate market, with academic research suggesting that a 1% increase in foreign residential transactions translates to a 2.1% increase in house prices.7 Hence, as foreign capital continues to flee, the housing market will suffer further. Moreover, the housing market has historically been a key leading indicator of U.K. growth, suggesting that British domestic demand will remain weak (Chart I-11). Chart I-10Low Mortgage Rates Are##br## Not Helping Real Estate Low Mortgage Rates Are Not Helping Real Estate Low Mortgage Rates Are Not Helping Real Estate Chart I-11The Housing Market Points##br## To A Contraction In Demand The Housing Market Points To A Contraction In Demand The Housing Market Points To A Contraction In Demand Inflation Can inflation dynamics trump the lack of growth and force the BoE to tighten policy anyway, supporting the pound in the process? Two opposing forces could determine the path of inflation: the tight labor market and the appreciating pound. A hot labor market like the U.K.'s (Chart I-12) should put upward pressure on wages, pushing up inflation and consequently, rate expectations. However, this ignores the behavior of British inflation over the past 25 years. U.K. core inflation has mostly been driven by previous movements in the currency (Chart I-13). Meanwhile, the labor market has had very little impact on prices, with core inflation staying below 2% from 1996 to 2008, despite an unemployment rate consistently below NAIRU and a global economy firing on all cylinders. Chart I-12U.K. Has A Tight Labor Market... U.K. Has A Tight Labor Market... U.K. Has A Tight Labor Market... Chart I-13...But Inflation Is Determined By The Currency ...But Inflation Is Determined By The Currency ...But Inflation Is Determined By The Currency This kind of tight relationship between inflation and exchange rate fluctuations tends to be associated with EM countries and small open economies, not large service-based economies like the U.K. In fact, the U.K. has to import a larger percentage of its goods and services than other developed countries. Therefore, despite its large service-oriented economy, British import penetration is much more similar to New Zealand and Norway than to the U.S. or Japan (Chart I-14).8 Consequently, core inflation is relatively insensitive to labor market dynamics. Instead, prices of import-sensitive goods and services are the main contributors to variations in core inflation (Chart I-15). Chart I-14Imports Are A Big Share Of U.K. Demand Imports Are A Big Share Of U.K. Demand Imports Are A Big Share Of U.K. Demand Chart I-15Import Prices Determine U.K. Core Inflation Import Prices Determine U.K. Core Inflation Import Prices Determine U.K. Core Inflation Because of this interplay, we do not expect that the labor market tightness will be enough to compensate the depressing impact on inflation from the pound's recent large appreciation. The above dynamics will likely limit how high the BoE will be able to lift interest rates. As a result, we do not expect the pound to buck any rally in the USD this year. Moreover, rising volatility will likely increase the cost of financing the already large current account deficit, which further argues for a weaker pound. We are therefore selling GBP/USD this week. Bottom Line: The combined impact of a likely rollover in inflation, continued soft growth and still-elevated political uncertainty will limit the capacity of the BoE to hike rates. Since the pound's discount to fair value has now melted, the outlook for GBP/USD is now more bearish, particularly as U.S. inflation is set to outperform expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "The Return Of Macro Volatility", dated March 16, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Are Tariffs Good Or Bad For The Dollar?", dated March 9, 2018, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, titled "We Are All Geopolitical Strategists Now", dated March 28, 2018, available at gps.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "In Search Of A Timing Model", dated July 22, 2016, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Special Report, "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com 6 Please see Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update", dated February 14, 2018, available at gps.bcaresearch.com 7 Sa, Filipa. "The Effect of Foreign Investors on Local Housing Markets: Evidence from the UK". King's College London, 2016. 8 It is worth noting that although imports constitute an even higher share of consumption in euro area economies, a lot of this imports are from other EMU countries, therefore the impact of currency fluctuations on prices is more muted on the continent. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Q4 GDP growth was revised up to 2.9%, more than the expectations of 2.7%; Headline PCE came out higher than expected at 1.8%; Core PCE improved to 1.6% from 1.5% but was in line with expectations; Initial jobless claims came in at 215,000, lower than the expected 230,000; The DXY's downward momentum has subsided, and trading has been constrained to a range of around 88.5 to 90.5 for the past two months. Importantly, the DXY is approaching a key downward-sloping trendline which the greenback has not been able to punch above since Q1 2017. As signs are accumulating that global growth may experience a soft patch, the USD may finally be able to punch above this powerful resistance over the coming months. Report Links: Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data has generally been weak: German import prices contracted by 0.6%; Euro area private loans grew by 2.9%, less than the expected 3%; Euro area M3 money supply increased by 4.2%, underperforming expectations of 4.6%; Euro area Business Climate survey fell to 1.34 from 1.48, below the anticipated 1.39; German headline consumer prices came in below expectations of 1.6% annually; German harmonized consumer prices also failed to meet expectations, coming in at 1.5%. Mirroring the DXY, EUR/USD is has lost some of its powerful upward momentum. Net speculative positions are still at all-time highs, but long positions seem to be rolling over. Markets may begin to be concerned about the implications for euro area growth and inflation of a global growth prospects. Investors should be positioned for a short-term correction. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: Both import and export yearly growth underperformed expectations, coming in at 16.5% and 1.8% respectively. Moreover, both the coincident and the leading economic indicators surprised negatively, coming in at 114.9 and 105.6. The Nikkei manufacturing PMI also underperformed expectations, coming in at 53.2 Finally, the National consumer price index also surprised to the downside, coming in at 1.5% Economic data in Japan show that the strength in the currency has started to bite into the Japanese economic outlook. Overall we continue to be bullish on the yen, as this currency doesn't need a strong Japanese economy to rise, instead, it tends to benefit from rising financial market volatility, a rising risk in the current environment. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Both core and headline inflation underperformed expectations, coming in at 2.4% and 2.7% respectively. Moreover, mortgage approvals also underperformed expectations, coming in at 64 thousand. However, average hourly earnings yearly growth surprised to the upside, coming in at 2.8%. GBP/USD has fallen by roughly 2.3% this week. Right now there are two opposing forces that could affect inflation. The first is a very tight labor market, which right is pushing up wages. The second is the pass through from an appreciating pound, which is lowering import prices. Out of these two, the effect of the pound will likely win out, given that imports satisfy a large percentage of demand in the U.K., making inflation less sensitive to labor market dynamics. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Last week's lackluster employment report for Australia continues to weigh down on the Aussie as investors are rightfully reticent to bet on any policy tightening by the RBA. Further hampering the prospects of hikes are the recent developments in the Australian interbank market: Funding costs for Australian banks have increased substantially since the end of last year, with the 3-month Australian bank bill rates gaining 26 bps, and the yield on AUD 3-month implied yield gaining about 50 bps. This is consistent with the increase in the LIBOR-OIS spread. Additionally, this has occurred alongside a flat AUD Swap OIS curve, meaning that no additional rate hikes are being priced in by the market. It will be extremely difficult for the RBA to hike rates alongside these widening spreads, especially when equipped with a slacking economy. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Last Thursday the RBNZ kept its policy rate unchanged at 1.75%. The statement was rather dovish, as governor Graham Spencer stated that "monetary policy will remain accommodative for a considerable period". Moreover Governor Spencer also highlighted that the RBNZ expected CPI to weaken further in the near term due to soft tradable inflation. Overall, we expect that the NZD will outperform the AUD, given that the kiwi economy is less sensitive to a global growth slowdown than the Australian economy. However the kiwi will suffer against the USD or the JPY, given that its positive link with commodity prices and inverse relationship with volatility. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was disappointing: Raw material prices contracted by 0.3% in February; Industrial product prices grew by less than expected, at 0.1% in monthly terms; Monthly GDP was also lackluster, contracting by 0.1%. However, inflation in February was at 2.2%, which is in line with the Bank's target. The fiscal impulse flow-through from the U.S. to Canada is likely to at the very least uphold this inflation figure. This will allow the BoC to stay in line with hike expectations. However, risks such as low wage growth, high debt levels, and NAFTA negotiations were mentioned in the Bank's 2017 Annual Report and need to be monitored carefully when proceeding with hikes. But on the bright side, recent reports that the U.S. is willing to drop its auto-content proposal from NAFTA talks point toward a positive outcome for NAFTA negotiations. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance for February outperform expectations, coming in at 3.138 billion. However, the KOF leading indicator underperformed expectations. EUR/CHF has rallied by roughly 1% this past week. Overall, we expect that this cross will continue to appreciate given that inflation in Switzerland is still very weak. Therefore the SNB will intervene in the currency markets to keep the franc from appreciating. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: The credit indicator underperformed expectations, coming in at 6.1%. Moreover, registered unemployment also surprised negatively, coming in at 2.5%. However it stay flat from last month's reading. USD/NOK has rallied by nearly 2.5% in the past couple days, as the dollar has regained vigor and oil prices have been toppy. Overall, we expect that the Norwegian krone will be one of the best performing commodity currency, as OPEC cuts will help oil outperform other commodities. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Lackluster data continued to come out of Sweden: Consumer confidence dropped to 101.5, underperforming the expected 105; Producer prices contracted 0.5% on a monthly basis, but grew 2.8% on an annual basis; The monthly trade deficit contracted by SEK 3.4 bn; Retail sales disappointed, coming in at 1.5%, less than the expected 1.7%. EUR/SEK has continued to climb on this news flow. It is likely that the SEK received a hit due to Riksbank Deputy Governor Cecilia Skingsley's comments that if the krona appreciates too much, it would jeopardize their inflation outlook. However, she also brought up Sweden's higher inflation relative to the euro area, which means it is "natural" that the Riksbank eventually can start raising rates "a little bit before" the ECB. This will prove to be bullish for the krona this year. Another factor weighing on the SEK today is the rising acrimony in global trade, a risk to which Sweden is very exposed. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio bca.ems_wr_2018_03_29_s1_c1 bca.ems_wr_2018_03_29_s1_c1 Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? bca.ems_wr_2018_03_29_s1_c2 bca.ems_wr_2018_03_29_s1_c2 The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow bca.ems_wr_2018_03_29_s1_c3 bca.ems_wr_2018_03_29_s1_c3 Chart I-4A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over China's Slowdown Is Far From Over China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High U.S. Equities: Median P/E Is At Record High U.S. Equities: Median P/E Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term bca.ems_wr_2018_03_29_s1_c16 bca.ems_wr_2018_03_29_s1_c16 The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR ...And Relative BRL And ZAR ...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart II-1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. Chart II-1At Full Employment, Import Tariffs Raise Rates April 2018 April 2018 The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up, as we discuss in the Overview section. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart II-1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart II-2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart II-2A Replay Of The Nixon Years? A Replay Of The Nixon Years? A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... The two deficits don't always shift in the same direction. In fact, Chart II-3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. Chart II-3Twin Deficits And The Dollar Twin Deficits And The Dollar Twin Deficits And The Dollar The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart II-3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. Chart II-4Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart II-4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next (see the Overview section). (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart II-5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Chart II-5Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart II-6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart II-7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart II-6U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns Chart II-7Composition Of Net International ##br##Investment Position April 2018 April 2018 A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart II-6, top panel). In Chart II-8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart II-8Primary Investment Balance Simulations Primary Investment Balance Simulations Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart II-8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart II-9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart II-9 reveals. Chart II-9U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart II-1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010.

Highlights The 2018 outlook for both economic growth and corporate profits remains constructive for risk assets, although evidence is gathering that global growth is peaking. Some measures of global activity related to capital spending have softened in recent months. Nonetheless, the G3 aggregate for capital goods orders remains in an uptrend, suggesting that it is too soon to call an end in the mini capital spending boom. Our global leading indicators are not heralding any major economic slowdown. The dip in early 2018 in the Global ZEW index likely reflected uncertainty over protectionist trade action. Economic growth in the major countries outside of the U.S. may have peaked, but will remain robust at least through this year. The potential for a trade war is a key risk facing investors. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy. That said, there are hopeful signs that the latest trade skirmish will not degenerate into a full-blown trade war and thereby cause lasting damage to risk assets. Stay overweight equities and corporate bonds. President Trump will announce on May 19 whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Stay long oil and related investments. The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated. EPS growth is peaking in Europe and Japan, but has a bit more upside in the U.S. later this year. Cross-country equity allocation is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. Rising U.S. corporate leverage is not an issue now, but could intensify the next downturn as ratings are slashed, defaults rise and banks tighten lending standards. The bond bear market remains intact, although the consolidation phase has further to run. By Q1 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below NAIRU. Policymakers will then try to nudge up the unemployment rate, but the odds of avoiding a recession are very low. Feature Investors are right to be concerned following the March 23 U.S. announcement of tariffs on about $50 billion of Chinese imports. The President is low in the polls and needs a victory of some sort heading into midterm elections. Getting tough on trade plays well with voters, and the President faces few constraints from Congress on this issue. Trump wants a raft of items from China, including opening up to foreign investment and a crackdown on intellectual theft. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy.1 That said, we do not expect the latest trade skirmish to degenerate into a full-blown trade war. First, China has already signaled it wants to avoid significant escalation. Beijing has offered several concessions, and its threat of retaliatory trade action has been measured so far. On the U.S. side, the fact that the Administration has decided to bring its case against China to the World Trade Organization (WTO) shows that the Americans are willing to proceed through the normal trade-dispute channels. The bottom line is that, while we cannot rule out escalating trade action that causes meaningful damage to the equity market, it is more likely that the current round of tensions will be limited to brief flare-ups. Investors should monitor the extent of European involvement. If Europe joins the U.S. effort to force China to change its trade practices via the WTO, then China will have little choice but to give in without a major fight. In terms of other geopolitical risks, North Korea should move to the back burner for a while now that the regime has agreed to negotiations. Of greater near-term significance is May 19, when Trump will announce whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Oil prices would benefit if the May deadline for issuing waivers on Iran sanctions passes. Trade penalties against Iran would reduce its oil production and exports. The U.S. is also considering sanctions on Venezuela's oil industry. Moreover, Russia and Saudi Arabia are reportedly considering a deal to greatly extend their alliance to curb oil supply. While there are downside risks as well, our base case outlook sees the price of Brent reaching US$74 before year end. Global Growth: Some Mixed Signs Also facing investors this year is the risk that the recent softening in the economic data morphs into a serious growth scare. The 2018 outlook for both the economy and corporate profits remains constructive in our view, but evidence is gathering that global growth is peaking. Investors may begin to question recent upward revisions to the growth outlook for this year and next. Industrial production has softened and the manufacturing PMI has shifted lower in most of the advanced economies (Chart I-1). Bad weather in North America and Europe in early 2018 may be partly to blame, but Korean exports, a leading indicator for the global business cycle, have also softened. The Chinese economy is decelerating and we believe the growth risks are underappreciated. President Xi has cemented his power base and there has been a shift toward accelerated reform. Chinese leaders recognize that leverage in the system is a problem, and the regime is tightening policy on a multi-pronged basis. Structural reforms are positive for long-term growth, but are negative in the short term. The tightening in financial conditions is already evident in the Chinese PMI and the sharp deceleration in the Li Keqiang index (although the latest reading shows an uptick; not shown). A hard landing is not our base case, but the risks are to the downside because the authorities will err on the side of tight policy and low growth. It is also disconcerting that some of our measures of global activity related to capital spending have softened in recent months, including capital goods imports and industrial production of capital goods (Chart I-2). Nonetheless, the fact that the G3 aggregate for capital goods orders remains in an uptrend suggests that it is too soon to call an end in the mini capital spending boom. Consumer and business confidence continues to firm in the major economies. Chart I-1Some Signs Of A Peak In Global Growth Some Signs Of A Peak In Global Growth Some Signs Of A Peak In Global Growth Chart I-2A Soft Spot For Capital Spending A Soft Spot For Capital Spending A Soft Spot For Capital Spending Our global leading indicators are not heralding any major economic slowdown (Chart I-3). BCA's Global LEI remains in an uptrend and its diffusion index is above the 50 line. In contrast, the global measure of the ZEW investor sentiment index plunged in March. We attribute the decline to the announcement of steel and aluminum tariffs and the subsequent market swoon, suggesting that the ZEW pullback will prove to be temporary. Turning to the U.S., retail sales disappointed in January and February, especially considering that taxpayers just received a sizable tax cut. Nonetheless, this probably reflects lagged effects and weather distortions. Our U.S. consumer spending indicator continues to strengthen as all of the components remain constructive outside of auto sales. Household balance sheets are the best that they have been since 2007; net worth is soaring and the aggregate debt-to-income ratio is close to the lowest level since the turn of the century (Chart I-4). Given robust employment growth and the tightest labor market in decades, there is little to hold U.S. consumer spending back. We expect that the tax cut effect on retail sales will be revealed in the coming months, helping to sustain the healthy backdrop for corporate profits. Chart I-3Global Leading Indicators Mostly Positive Global Leading Indicators Mostly Positive Global Leading Indicators Mostly Positive Chart I-4U.S. Consumers In Good Shape U.S. Consumers In Good Shape U.S. Consumers In Good Shape Global Margins Still Rising The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated (Chart I-5). Earnings-per-share surged in the early months of the year in both the U.S. and Japan, although they languished in the Eurozone according to IBES data (local currencies; not shown). Relative equity returns in local currency tend to follow relative shifts in 12-month forward EPS expectations over long periods, and bottom-up analysts have lifted their U.S. earnings figures in light of the fiscal stimulus (Chart I-6). Chart I-5Global Margins Still Rising Global Margins Still Rising Global Margins Still Rising Chart I-6EPS And Relative Equity Returns EPS And Relative Equity Returns EPS And Relative Equity Returns The key question is: can the U.S. market outperform again in 2018 now that the tax cuts have largely been priced in? One can make a compelling case either way. Growth: Global growth will remain robust for at least the next year, and the Eurozone and Japanese markets are more geared to global growth than is the U.S. However, the impressive fiscal stimulus in the pipeline means that economic growth momentum is likely to swing back toward the U.S. this year. GDP growth in Europe and Japan will remain above-trend, but it has probably peaked for the cycle in both economies. Valuation: Our composite measure of valuation suggests that Europe and Japan are on the cheap side relative to the U.S. based on our aggregate valuation indicator, which takes into consideration a wide variety of yardsticks (Chart I-7). That said, one of the reasons why European stocks are on the cheap side at the moment is that export-oriented German exporters are quite exposed to rising international tariffs. Earnings: Previous currency shifts will add to EPS growth in the U.S. in the first half of the year, but will be a drag in Europe and Japan (Chart I-8). However, these effects will wane through the year unless the dollar keeps falling. Indeed, we expect the dollar to firm modestly over the next year, favoring the European equity market at the margin. In contrast, we expect the yen to strengthen in the near term, which will trim Japanese EPS growth. Chart I-7Valuation Ranking Of Nonfinancial ##br##Equity Markets Relative To The U.S. April 2018 April 2018 Chart I-8Impact Of Currency Shifts On EPS Growth Impact Of Currency Shifts On EPS Growth Impact Of Currency Shifts On EPS Growth Chart I-9 updates the forecast from our top-down earnings models. The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up. Narrowing margins are less of a risk in Europe. U.S. EPS growth should be above that of Europe in 2018, but will then fall to about the same pace in 2019. We expect Japanese profit growth to remain very strong this year and next, given Japan's highly pro-cyclical earnings sensitivity. However, this does not incorporate the risk of further yen strength. Earnings expectations will also matter. Twelve-month bottom-up expectations are higher than our U.S. forecast ('x' in Chart I-9 denotes 12-month forward EPS expectations). In contrast, expectations are roughly in line with our forecast for the European market. It will therefore be more difficult at the margin for U.S. earnings to surprise to the upside. Monetary Policy: The relative shift in monetary policies should favor the European and Japanese markets to the U.S. The FOMC will continue tightening, with risks still to the upside on rates in absolute terms and relative to the other two economies. Sector Performance: Sector skews should work in Europe's favor. Financials are the largest overweight in Euro area bourses, while technology is the largest overweight in the U.S. We are constructive on the financial sector in both markets, but out-performance of the sector will favor the Eurozone broad market. Meanwhile, tech companies are particularly sensitive to changes in discount rates, since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening. The Japanese market has a relatively high weighting in industrials and consumer discretionary. The market will benefit if the global mini capex boom continues, but this could be counteracted by softness in global auto sales and further yen strength. It is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. We continue to avoid the Japanese market for the near term because of the potential for additional yen gains. As for the equity sector call, investors should remain oriented toward cyclicals versus defensives. Our key themes of a synchronized global capex mini boom, rising bond yields and firm oil prices favor the industrials, energy and financial sectors. Chart I-10 highlights four indicators that support the cyclicals over defensives theme, the dollar and the business sales-to-inventories ratio. Telecom, consumer discretionary and homebuilders are underweight. Chart I-9Profit Forecast Profit Forecast Profit Forecast Chart I-10These Indicators Favor Cyclical Stocks These Indicators Favor Cyclical Stocks These Indicators Favor Cyclical Stocks We will be watching the indicators in Chart I-10 to time the shift to a more defensive equity sector allocation. Leverage And The Next Recession As the economic expansion enters the late stages, investors are focused on where leverage pressure points may lurk. Last month's Special Report on U.S. corporate vulnerability to higher interest rates and a recession raised some eyebrows. For our sample of 770 companies, we estimated how much interest coverage for the average company would decline under two scenarios: (1) interest rates rise by 100 basis points across the curve; and (2) interest rates rise by 100 basis points and there is a recession in which corporate profits fall by 25% peak to trough. Given all the client inquiries, we decided to delve deeper into the results. We were concerned that our sample of high-yield companies distorted the overall results because it includes many small firms and outliers. We are more comfortable with the results using only the investment-grade firms, shown in Chart I-11. The 'x' marks the interest rate shock and the 'o' marks the combined shock. Nonetheless, the main qualitative message is unchanged. The starting point for interest coverage is low, considering that interest rates are near the lowest levels on record and profits are extremely high relative to GDP. This is the result of an extended period of corporate releveraging on the back of low borrowing rates. Chart I-12 shows that the interest coverage ratio has declined even as profit margins have remained elevated. Normally the two move together through the cycle. Chart I-11Corporate Leverage Will Take A Toll Corporate Leverage Will Take A Toll Corporate Leverage Will Take A Toll Chart I-12The Consequences Of Rising Leverage The Consequences Of Rising Leverage The Consequences Of Rising Leverage The implication is that the next recession will see interest coverage fare worse than in previous recessions. Of course, there are many other financial ratios and statistics that the rating agencies employ, but our results suggest that downgrades will proliferate when the agencies realize that the economy is turning south. Moreover, banks may tighten C&I lending standards earlier and more aggressively because they will also be finely attuned to the first hint of economic trouble given the leverage of the companies in their portfolio. Recovery rates may be particularly low in the next recession because the equity cushion has been squeezed via buybacks, which will intensify widening pressure in corporate spreads. Tighter lending standards would generate more corporate defaults, even wider spreads and a greater overall tightening in financial conditions. Corporate leverage could therefore intensify the pullback in business spending in the next recession. The good news is that we do not see any other major macro-economic imbalances, such as areas of overspending, that could turn a mild recession into a nasty one. As long as growth remains solid, the market and rating agencies will ignore the leverage issue. Indeed, ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart I-13). We remain overweight U.S. investment-grade and high-yield bonds within fixed-income portfolios for now. The European corporate sector is further behind in the leverage cycle (Chart I-14). Europe does not appear to be nearly as vulnerable to rising interest rates. Nonetheless, our European Corporate Health Monitor (CHM) has deteriorated over the past couple of years due to some erosion in profit margins, debt coverage and the return on capital. Meanwhile, the U.S. CHM has improved in recent quarters because the favorable earnings backdrop has temporarily overwhelmed rising leverage (top panel of Chart I-14). For the short-term, at least, corporate health is moving in favor of the U.S. at the margin. Chart I-13Ratings Migration Is Constructive For Now Ratings Migration Is Constructive For Now Ratings Migration Is Constructive For Now Chart I-14Corporate Health Trend Favors U.S. Corporate Health Trend Favors U.S. Corporate Health Trend Favors U.S. The implication is that, while we see trouble ahead for the U.S. corporate sector in the next economic downturn, in the short term we now favor the U.S. over Europe in the credit space. We are watching our Equity Scorecard, bank lending standards, the yield curve and our profit margin proxy in order to time our exit from both corporate bonds and equities (see last month's Overview section). We are also watching for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will get more aggressive in leaning against above-trend growth and a falling unemployment rate. Powell Doesn't Rock The Boat The Fed took a measured approach when reacting to the fiscal stimulus that is in the pipeline. The FOMC lifted rates in March and marginally raised the 'dot plot' for 2019 and 2020. Policymakers shaved the projection for unemployment to 3.6% by the end of 2019. This still appears too pessimistic, unless one assumes that the labor force participation rate will rise sharply. Table I-1 provides estimates for when the unemployment rate will reach 3½% based on different average monthly payrolls and participation rates. Our base case scenario, with 200k payrolls per month and a flat participation rate, sees the unemployment rate reaching 3½% by March 2019. Table I-1Dates When 3.5% Unemployment Rate Threshold Is Reached April 2018 April 2018 The soft-ish February reports for consumer prices and average hourly earnings took some of the heat off the FOMC. Core CPI, for example, rose 'only' 0.2% from the month before. Still, when viewed on a 3-month rate-of-change basis, underlying inflation remains perky; the core CPI inflation rate increased from 2.8% in January to 3% in February (Chart I-15). Inflation in core services excluding medical care and shelter, as well as in core goods, have also surged on a 3-month basis. We expect the latter to continue to pressure overall inflation higher, following the upward trend in import prices. The recent downtrend in shelter inflation should also stabilize due to the falling rental vacancy rate. Chart I-15U.S. Inflation Is Perky U.S. Inflation Is Perky U.S. Inflation Is Perky Moreover, the NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. The ISM manufacturing survey shows that companies are paying more for their inputs and experiencing delays with suppliers. This describes a late-cycle environment marked with rising inflationary pressures. We expect that core inflation will grind up to the 2% target by early next year. By the first quarter of 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below its estimate of the non-inflationary limit. Policymakers will then attempt a 'soft landing' in which they tighten policy enough to nudge up the unemployment rate. Unfortunately, the Fed has never been able to generate a soft landing. Once unemployment starts to rise, the next recession soon follows. Our base case is that the next recession begins in 2020. Bond Bear In Hibernation For Now The bond market showed that it can still intimidate in February, but things have since calmed down as the U.S. mini inflation scare ebbed, some economic data disappointed and trade friction created additional macro uncertainty. Bearish sentiment and oversold technical conditions suggest that the consolidation period has longer to run. Nonetheless, unless inflation begins to trend lower, the fact that even the doves on the FOMC believe that the headwinds to growth have moderated places a floor under bond yields. Fair value for the 10-year Treasury is 2.90% based on our short-term model, but we expect it to reach the 3.3-3.5% range before the cycle is over. Both real yields and long-term inflation expectations have room to move higher. Private investors will also have to absorb US$680 billion worth of bonds this year from governments in the U.S., Eurozone, Japan and U.K., the first positive net flow since 2014 (see last month's Overview). Yields may have to fatten a little in order for the private sector to make room in their portfolios for that extra government supply. In the Eurozone, the net supply of government bonds available to the private sector will still be negative this year, even if the ECB tapers to zero in September as we expect. Some investors are concerned about a replay in the European bond markets of the Fed's 'taper tantrum' of 2013, when then-Chair Bernanke surprised markets with a tapering announcement. The ECB has learned from that mistake and has given several speeches recently highlighting that policymakers will be making full use of forward guidance to avoid "...premature expectations of a first rate rise."2 We think they will be successful in avoiding a similar tantrum, but the flow effect of waning bond purchases will still place some upward pressure on the term premium in Eurozone bonds (Chart I-16).3 Chart I-16ECB: End Of QE Will Pressure Term Premium ECB: End Of QE Will Pressure Term Premium ECB: End Of QE Will Pressure Term Premium The bottom line is that monetary policy will undermine global bond prices in both the U.S. and Eurozone, but we expect U.S. yields to lead the way higher this year. Japanese bond prices will be constrained by the 10-year yield target. Investors with a horizon of 6-12 months should remain overweight JGBs, at benchmark in Eurozone government bonds and underweight Treasurys within hedged global bond portfolios. We recommend hedging the currency risk because we continue to expect the dollar to rebound this year. This month's Special Report, beginning on page 18, discusses the cyclical factors that will support the dollar: interest rate differentials, a rebound in U.S. productivity growth and a shift in international growth momentum back in favor of the U.S. In terms of the longer-term view, the Special Report makes the case that the U.S. dollar's multi-decade downtrend will persist. This does not mean, however, that long-term investors will make any money by underweighting the greenback. The 30-year U.S./bund yield spread of 190 basis points means that the €/USD would have to rise to more than 2.2 to offset the yield disadvantage of being overweight the euro versus the dollar over the next 30-years. Indeed, once it appears that the U.S. yield curve has discounted the full extent of the Fed tightening cycle (perhaps 12 months from now), it will make sense for long-term investors to go long U.S. Treasurys versus bunds on an unhedged basis. Conclusion Recent data releases suggest that global growth is peaking, especially in the manufacturing sector. Nonetheless, we do not believe that this heralds a slowdown in growth meaningful enough to negatively impact the profit outlook in the major countries. Indeed, the major fiscal tailwind in the U.S. will lift growth and extend the runway for earnings to expand at least through 2019. That said, fiscal stimulus at this stage of the U.S. business cycle will serve to accentuate a boom/bust cycle, where stronger growth in 2018/19 gives way to higher inflation a hard landing in 2020. The Fed is willing to sit back and watch the impact of fiscal stimulus unfold in the near term. But by early 2019, the Fed will find itself behind the curve with rising inflation and an overheating economy. The monetary policy risk for financial markets will then surge, setting up for a classic end to this expansion. The consequences of years of corporate releveraging will come home to roost. This year, trade skirmishes will be a headwind for risk assets and will no doubt generate further bouts of volatility. Nonetheless, recent signals from both the U.S. and China suggest that the situation will not degenerate into a trade war. The bottom line is that, while the economic expansion and equity bull market are both in late innings, investors should stay overweight risk assets and short duration for now. Stay overweight cyclical stocks versus defensives, overweight corporate bonds versus governments, overweight oil-related plays, and modestly long the U.S. dollar against most currencies except the yen. Our checklist of items to time the exit from risk is not yet flashing red. We would change our mind if our checklist goes south, our forward-looking indicators turn sharply lower or U.S. inflation suddenly picks up. We are also watching closely the situation in Iran, the U.S./China trade spat and NAFTA negotiations. Mark McClellan Senior Vice President The Bank Credit Analyst March 29, 2018 Next Report: April 26, 2018 1 For more information on why we believe that Sino-American conflict will be a defining feature of the 21st century, please see BCA Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com 2 ECB President Mario Draghi. Speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_1.en.html 3 For more information, please see BCA's Global Fixed Income Strategy Weekly Report "Bond Markets Are Suffering Withdrawal Symptoms," dated March 20, 2018, available at gfis.bcaresearch.com II. U.S. Twin Deficits: Is The Dollar Doomed? In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart II-1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. Chart II-1At Full Employment, Import Tariffs Raise Rates April 2018 April 2018 The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up, as we discuss in the Overview section. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart II-1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart II-2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart II-2A Replay Of The Nixon Years? A Replay Of The Nixon Years? A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... The two deficits don't always shift in the same direction. In fact, Chart II-3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. Chart II-3Twin Deficits And The Dollar Twin Deficits And The Dollar Twin Deficits And The Dollar The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart II-3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. Chart II-4Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart II-4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next (see the Overview section). (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart II-5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Chart II-5Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart II-6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart II-7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart II-6U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns Chart II-7Composition Of Net International ##br##Investment Position April 2018 April 2018 A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart II-6, top panel). In Chart II-8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart II-8Primary Investment Balance Simulations Primary Investment Balance Simulations Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart II-8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart II-9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart II-9 reveals. Chart II-9U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart II-1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010. III. Indicators And Reference Charts The earnings backdrop remains constructive for the equity market. In the U.S., bottom-up forward earnings estimates and the net earnings revisions ratio have spiked on the back of the tax cuts. Unfortunately, many of the other equity-related indicators in this section have moved in the wrong direction. The monetary indicator is shifting progressively into negative territory as the Fed gradually tightens the monetary screws. Valuation in the U.S. market improved a little over the past month, but our composite Valuation Indicator is still very close to one sigma overvalued. Technically, our Speculation Indicator is still in frothy territory, but our Composite Sentiment Indicator has pulled back significantly toward the neutral line. Our Technical Indicator broke below the 9-month moving average in March (i.e. a 'sell' signal). These are worrying signs. Nonetheless, at this point we believe they are a reflection of the more volatile late-cycle period that the market has entered. An equity correction could occur at any time, but a bear market would require a significant and sustained economic downturn that depresses earnings estimates. Our checklist does not warn of such a scenario over the next 12 months. It is also a good sign that our Willingness-to-Pay indicator is still rising, at least for the U.S. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. While this suggests that investor flows remain positive for the U.S. equity market, the WTP appears to have rolled over in both Europe and Japan. This goes against our overweight in European stocks versus the U.S. in currency hedged terms (see the Overview section). Our Revealed Preference Indicator (RPI) remained on its bullish equity signal in March. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. So far, the indicator has not flashed 'red'. Treasurys are hovering on the 'inexpensive' side of fair value, but are not cheap based on our model. Extended technicals suggest that the period of consolidation will persist for a while longer. Value is not a headwind to a continuation in the cyclical bear phase. Little has changed on the U.S. dollar front. It is expensive by some measures, but is on the oversold side technically. We still expect a final upleg this year, before the long-term downtrend resumes. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst