Financial Markets

The GAA DM Equity Country Allocation model is updated as of January 31, 2018. The model has made large shifts in country allocations. The U.S. is upgraded to neutral from previously the largest underweight, driven largely by technical conditions. It seems dramatic, but as shown in Chart 2, the model did have similar large shifts in the past as well. Canada also has received a large increase to overweight driven by extremely attractive valuation. To fund these upgrades, the previously largest overweight in Italy is cut in half (mainly driven by liquidity and valuation) and Australia is back to underweight (trading places with Canada). As a result, the model now is overweight the Netherlands, Italy, Germany, Canada and Spain, neutral on the U.S. and underweight Japan, the U.K., France, Australia and Sweden as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 99 bps in January, largely driven by the Level 2 model which outperformed by 207 bps, thanks to the underweights in the U.K., Japan and Canada vs. the overweights in Italy, the Netherlands and Germany. Since going live in January 2016, the overall model has outperformed the benchmark by 190 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 570 bps. The Level 1 model has performed in line with the MSCI world benchmark. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 31, 2018. The model continues to be bullish on global growth as seen by a 10% aggregate overweight in the cyclical sectors. The model continues to hold equal underweights in consumer staples, health care, telecom and utilities stocks. Looking forward, we believe improving global growth dynamics, and rising equity markets will help us maintain an aggregate cyclical pro-growth bias. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Watch Inflation Expectations How much longer can this go on? Global equities were up 6% in January alone (the 15th consecutive month of positive returns), and investors are increasingly asking how much further this bull market has to run. There are no signs we can see that suggest it will end imminently. Our watch-list of key recession indicators (decline in global PMIs, inverted yield curve, rise in credit spreads - Chart 1) is sending no warning signals. U.S. GDP growth was a little weaker than expected in Q4, at 2.6% QoQ annualized, but this was mainly due to inventories and strong imports: final private demand, a better guide to future growth, was strong at 4.3%. Fed NowCasts for Q1 growth point to 3.1-4.2%. The euro zone grew even faster than the U.S. last year, and even Japan probably saw 1.8% GDP growth. Corporate earnings expectations have accelerated sharply over just the past few weeks - particularly in the U.S. as a result of the tax cuts (Chart 2) - with analysts now expecting 16% EPS growth for the S&P 500 this year. BCA U.S. Equity Strategy service's earnings models suggest that this forecast may still be too cautious (Chart 3). Recommended Allocation Chart 1No Recession Signals Flashing Chart 2A Dramatic Rise In Earnings Forecasts... Chart 3...But Forecasts May Still Be Too Cautious While it is true that equity valuations are stretched, particularly in the U.S. (with BCA's Composite Valuation Index having just tipped into the "Extremely Overvalued" zone - Chart 4), valuations are not usually a good timing tool. Investor euphoria seems not yet to have reached the extremes that usually characterize a bull-market peak. The message we hear consistently from wealth managers is that their clients who missed last year's rally are now looking to get into risk assets. The American Association of Individual Investors' latest weekly survey shows 45% bulls to 24% bears - not especially optimistic by past standards (Chart 5). Flows into equity funds have started to accelerate, but have been weaker than bond flows over the past year (Chart 6). Chart 4U.S. Equities Now 'Extremely Overvalued' Chart 5Investors Are Not Particularly Bullish Chart 6Flows Into Equities Starting To Accelerate Chart 7Key: Inflation Expectations Getting to 2.5% We think the key to timing the top lies in inflation expectations. With the U.S. economy at full capacity and unemployment at 4.1%, well below the NAIRU of 4.6%, the Fed believes that a pick-up in inflation is just a matter of time - an analysis we agree with. The market has started to come round to this view too, with implied inflation rising by about 40 BPs over the past two months (Chart 7). The market has now priced in a 65% probability of the Fed's projected three rate hikes this year, and even a 27% probability of four. Inflation expectations hitting 2.5% (which would be compatible with the Fed's 2% PCE inflation target - CPI inflation is typically 50 BPs higher) could be the tipping-point. This is because it would remove the Fed put - with inflation expectations elevated, the Fed would no longer be able to back off from tightening in the event of a global risk-off event such as a stock-market correction or a slowdown in China. Such a rise in inflation expectations would also push the 10-year U.S. Treasury yield above 3%, which would increase the attraction of fixed income, and represent a threat to highly indebted borrowers, especially in emerging markets. This is how bull markets typically end: with the Fed having to raise rates to choke off inflation, and either making a policy mistake or tightening monetary policy enough to slow growth. But all this is probably quite a few months away. We expect to turn more defensive perhaps late this year, ahead of a recession that we have for some time now penciled in for the second half of 2019. Given how advanced the cycle is, conservative investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now. But investors focused on quarterly performance should ride the bull market until some of the warning signals mentioned above begin to flash. For now, therefore, we continue to recommend an overweight in equities relative to bonds on the 12-month investment horizon, and mostly pro-risk and pro-cyclical tilts. Equities: We continue to prefer developed over emerging equities. EM will be hurt by the slowdown likely in China (where money supply and credit growth have fallen in response to the authorities' tighter policies - Chart 8), rising U.S. interest rates, sluggish productivity growth, and valuations that are no longer particularly cheap (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which should benefit from their higher beta, more cyclical earnings, still accommodative monetary policy, and cheaper valuations than the U.S. Our sector bets are tilted to late-cycle value sectors such as financials, industrials and energy. Chart 8Tighter Monetary Conditions in China Chart 9EM No Longer Cheap Fixed Income: Rising inflation expectations should push the 10-year U.S. Treasury bond yield up to 3% this year, with German Bunds rising by a similar amount. We recommend an underweight on duration, and a preference for inflation-linked over nominal bonds, in these markets. In the U.K. and Australia, however, central banks are unlikely to tighten as quickly as futures markets have priced in and so we prefer their government bonds. While the expansion continues, spread product should continue to outperform in the fixed-income bucket. The default-adjusted spread on U.S. high-yield bonds remains over 200 BP and, though we see little further spread contraction, carry alone makes this attractive. Currencies: BCA was correct last year to predict a widening of interest-rate differentials between the U.S. and the euro zone, but wrong to conclude that this would lead to a stronger dollar (Chart 10). The drivers of currencies can undergo regime shifts, and it seems now that valuation (both the euro and yen are cheap compared to their purchasing power parity, 1.32 and 99 to the U.S. dollar respectively), current account surpluses (3.3% for the euro zone and 3.7% for Japan), and other factors have become more important. Tactically, the euro, in particular, looks very overbought. Speculative investors are very long euros, the ECB is likely to remain dovish relative to the Fed, and the strong euro could put some downward pressure on growth in the short-term. However, if the dollar were to rebound by 5% or so we would be likely to end our dollar bull call. Chart 10Rate Differentials No Longer Moving Currencies Chart 11Oil Supply To Increase In 2019 Commodities: Oil prices have risen on the back of strong global demand, OPEC discipline, and a lag in the response of U.S. shale oil producers. We forecast an average of $67 a barrel for Brent crude this year, with spikes to as high as $80 in the event of disruptions in producer countries such as Venezuela. However, with one-year forward crude prices around $62, shale producers (whose marginal costs average about $52 a barrel) are likely to pick up production soon. OPEC, too, should be happy with crude around $50-60. Our energy team forecasts a pick-up in supply next year (Chart 11), which should bring the crude price down to an average of $55 in 2019. Industrial commodities are a product of Chinese demand, global growth, and the U.S. dollar. These drivers look likely to be mixed over the coming months and so we remain neutral. Gold has risen, in the face of rising interest rates, because of the weak dollar - it remains an excellent hedge against inflation, recession, and geopolitical risks and so should be a modest part of any balanced portfolio. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation

Highlights The German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3% would be a trigger to downgrade equities and upgrade bonds... ...especially as the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. On a 6-9 month horizon, upgrade Airlines to overweight. Downgrade Banks to underweight. Upgrade Germany (DAX) to neutral. Downgrade Italy (MIB) and Spain (IBEX) to underweight. Feature Where has the equity market cycle gone? Since 2012, the stock market's 6-month returns have generated an unprecedented consistency, with only a brief breakdown - at the end of 2015 - into negative territory (Chart of the Wesk and Chart I-2). Chart of the WeekSince 2012, The Equity Market ##br##Cycle Has Disappeared Chart I-2Much Less Cyclicality In Equities ##br##Than In Commodities The disappearance of the equity market cycle brings to mind the concept of the "Great Moderation", a term coined in 2002 to describe the big drop in business cycle volatility during the 1990s. In 2004, Ben Bernanke suggested that "improvements in monetary policy, though certainly not the only factor, probably were an important source of the Great Moderation." Today's Great Moderation 2.0 refers to the equity market cycle - or rather, its disappearance. And in finding a reason for the Great Moderation 2.0, Bernanke's attribution to monetary policy might be right on the money. Stick With TINA, Or Flirt With TIA? For many years, ultra-accommodative monetary policy has provided a consistent and substantial uplift to world stock market valuations. Since 2012, our preferred measure of equity market valuation - world stock market capitalisation to GDP - has almost doubled. This inexorable and relatively trouble-free rise has even spawned its own acronym: TINA - There Is No Alternative (to owning equities.) However, the uplift to stock market valuations has happened in a less obvious way than you might realise. Based on the excellent predictive power of stock market capitalisation to GDP, the prospective 10-year annualised return from world equities has collapsed from 9% in 2012 to 1.5% now (Chart I-3). Over the same period, the global 10-year bond yield has compressed from 3% to 1.5%. Hence, the collapse in prospective equity returns is not due to the decline in bond yields per se. It has happened mostly because the excess return offered by equities over bonds - the so-called 'equity risk premium' has compressed from 6% to zero (Chart I-4). Chart I-3World Equity Market Cap To GDP Implies##br## A Feeble Prospective 10-Year Return Chart I-4Prospective Equity Returns ##br##Have Become 'Bond Like' Ultra-accommodative monetary policy has caused the disappearance of the equity risk premium. The simple reason is that at low bond yields, the risk of owning bonds becomes similar to the risk of owning equities. Chart I-5Below A 2% Yield, 10-Year Bonds Have ##br##More Negative Skew Than Equities When bond yields approach their lower bound, bond prices have little upside but they have a lot of downside. This ratio of an investment's potential losses relative to its potential gains is the risk that most frightens investors,1 and is known as negative skew. At yields below 2%, bond returns become as negatively skewed as equity returns, or even more negatively skewed than equities (Chart I-5). As the risk of bonds increases to become 'equity-like', the prospective return from equities must compress to become 'bond-like'. Which is to say, equity valuations become substantially richer. All well and good - so long as the global 10-year bond yield stays low. Above a 2% yield, the negative skew on bond returns disappears, and equities once again require an excess prospective return over bonds. More colloquially, investors would dump TINA and start flirting with TIA (There Is an Alternative). In essence, a big threat to the Great Moderation 2.0 comes the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3%. Any moves towards these thresholds would be a trigger to downgrade equities and upgrade bonds - especially as we now explain why the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. The Equity Sector Cycle Is Alive And Well For the stock market in aggregate, the cycle has been moribund. But for equity sector relative performance, the cycle is very much alive and well. In The Cobweb Theory And Market Cycles 2 we showed and explained the existence of mini-cycles in economic and financial variables. To summarise, a lag between the demand for credit and its supply necessarily creates mini-cycles in both the price of credit (the bond yield) and the quantity of credit (the global credit impulse). Thereby it also creates mini-cycles in GDP growth. The useful point is that these cycles are very regular with half-cycles averaging 6-8 months. Which makes their turning points and phases predictable. Given that the global credit impulse cycle has been in a mini-upswing phase since last May, it is highly likely to turn into a mini-downswing phase through the first half of 2018. The latest data point, showing a tick down, seems to corroborate such a turning point. From an equity sector perspective, Banks versus Healthcare has closely tracked the phases of the credit impulse mini-cycle (Chart I-6). In all five of the last five mini-downswings, Banks have underperformed Healthcare, and we would expect no difference in the next mini-downswing. Hence, on a 6-9 month horizon, downgrade Banks to underweight. Unsurprisingly, exactly the same pattern applies to Basic Materials (and Energy) versus Healthcare (Chart I-7). Hence, on a 6-9 month horizon, stay underweight Basic Materials and Energy versus Healthcare. Also unsurprisingly, the performance of European Airlines is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost (Chart I-8). As an aside, this also somewhat insulates the European Airlines against a strengthening euro, given that this variable cost is priced in dollars. Hence, on a 6-9 month horizon, upgrade European Airlines to overweight. Chart I-6Banks Vs. Healthcare Tracks The ##br##Credit Impulse Mini-Cycle Chart I-7Materials Vs. Healthcare Tracks The##br## Credit Impulse Mini-Cycle Chart I-8European Airlines Relative Performance Is A##br## Mirror-Image of The Oil Price Cycle Country Allocation Just Drops Out Of Sector Allocation Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-9 and Chart I-10). Chart I-9Italy = Long Banks Chart I-10Spain = Long Banks Therefore, the key consideration for European equity country allocation is always: how to allocate to the vital few equity sectors that feature most often in the skews: Banks, Healthcare, Energy and Materials. To reiterate, our 6-9 month recommendation is to underweight Banks, Materials And Energy versus Healthcare, and to overweight Airlines versus the market. Then to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown in Box I-1. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Box I-1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands. Underweight: Italy, Spain, Sweden and Norway. In terms of change, it means upgrading Germany (DAX) to neutral and downgrading Italy (MIB) and Spain (IBEX) to underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities", January 28, 2018 available at eis.bcaresearch.com. 2 Please see the European Investment Strategy Weekly Report "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* There is a lot of optimism already priced into the South African rand, making it vulnerable to a countertrend reversal. Therefore, this week's recommended trade is to go long USD/ZAR with a profit-target of 6% and a symmetrical stop-loss. In other trades, short S&P500/long Eurostoxx50 hit its stop-loss, while short Japanese energy and short palladium moved comfortably into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights Even though our baseline scenario calls for four rate hikes out of the Fed this year - more than markets have priced in - gold will be supported by increasing inflation and inflation expectations, heightened geopolitical risks, and greater volatility in equity markets. Further out, we expect gold will provide a good hedge against a likely equity downturn, as the bull market turns into a bear market in 2H19. For now, keep gold as a strategic portfolio hedge. Energy: Overweight. After popping above $70 and $66/bbl last week, Brent and WTI prices retreated ~ $2.00/bbl on the back of a stronger USD and increased rig counts in the U.S. shales, particularly in the prolific Permian Basin, where 18 rigs were added. We continue to expect Brent and WTI prices to average $67 and $63/bbl this year. Base Metals: Neutral. Spot copper continues to trade on either side of $3.20/lb on the COMEX. We remain neutral, given our view upside risk - chiefly supply-side disruptions at the mine and refined levels - will be balanced on the downside by a stronger USD and a slowdown in China. Precious Metals: Neutral. Gold will draw support from rising inflation and inflation expectations this year and next (see below). Ags/Softs: Underweight. NAFTA negotiations ended this week in Montreal with the U.S. rejecting proposals from Canada to advance the talks. However, the U.S. side stated it would seek "major breakthroughs" at the next round of negotiations in Mexico City beginning February 26, according to agriculture.com. Feature Gold Price Risks Skewed To The Upside Price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here. Higher inflation and inflation expectations, which normally would be bullish for gold, will be countered by Fed policy-rate hikes, which will boost the USD and lift real rates in our base case (Chart of the Week). Inflation's Revival Would Support Gold ... Despite above-trend global growth last year, subdued inflation limited the Fed's willingness to proceed with interest rate normalization in earnest. However, we do not put this down to structural forces, and instead expect core inflation to be near its bottom.1 In fact, inflation's soft readings are typical of the expected 18-month lag between U.S. economic growth and a pick-up in inflation, and as our Global Investment Strategists point out, several key indicators including the ISM manufacturing index, the New York Fed's Inflation Gauge, as well as BCA's proprietary pipeline inflation index are already moving in this direction (Chart 2).2 Chart of the WeekInflation And U.S. Financial Variables Matter Chart 2Signs Of Life In U.S. Inflation Inflation tends to pick up once the unemployment rate falls below the 5% mark. With the latest unemployment reading coming in at 4.1%, the U.S. economy has reached the steep end of the Phillips Curve - a workhorse model used by the Fed, which depicts the trade-off between unemployment and inflation. Indeed, BCA's Global Investment Strategists expect the U.S. unemployment rate to continue falling to a 49-year low of 3.5% by year-end. These further declines in the unemployment rate will push up wages, pressuring service inflation (Chart 3). At the same time, we expect the lagged impact of the weak USD will begin to show up in goods price inflation, along with higher energy prices. While some components of the Fed's preferred inflation gauge may face a slowdown in price pressure - most notably rent - this will likely be mitigated by accelerating prices in other components, such as health care, which we expect will return to its historic trend. In fact, U.S. inflation expectations - supported by higher energy prices and a strong December core CPI reading - have already started to increase (Chart 4). As our U.S. Bond Strategists point out, by the time core inflation returns to the Fed's target, the 10-year TIPS breakeven inflation rate will be between 2.4% and 2.5%.3 Chart 3At The Steep End Of The Philips Curve Chart 4A Breakout In Inflation Expectations Thus the 2018 inflation outlook is showing signs that it is in the process of bottoming, and will soon begin its ascent. We expect core PCE inflation, the Fed's preferred gauge, to reach the central bank's 2% target by year-end. This pick-up in inflation and inflation expectations is positive for gold, which we've shown to be an attractive hedge against rising prices. However, inflation's comeback will likely embolden the Fed to proceed more aggressively with its hiking cycle. ... But A Hawkish Fed Counters Inflation ... While our modelling showcases an inverse relationship between real rates and gold prices, what is crucial to our outlook is our expectation of how the Fed will proceed with its interest rate normalization process this year. Given that gold's correlation with inflation is strengthened during periods of low real rates, the ideal condition for gold would be for the Fed to stay behind the inflation curve. But we are not expecting that just yet.4 Rather than waiting to see the "whites of inflation's eyes," our expectation is the Fed will tighten ahead of inflation. This has in fact already materialized with three hikes in 2017 amid muted inflation. Upward surprises in U.S. growth, coupled with an upward trend in inflation will keep the Fed on its normalization path with greater confidence. We expect four rate hikes in 2018 - above both market expectations and what is implied by the "dot plot". Net, the pre-emptive Fed rate hikes we expect will lead to higher real rates, and will limit gold's upside this year. ... As Does A Stronger Greenback An increase in U.S. real rates vis-à-vis other economies, as well as a shift in the composition of global growth to favor the U.S., will support the USD. In addition to higher real rates, this would also limit gold's upside in 2018. Stronger growth ex-U.S. last year weakened the USD. This year, we expect the U.S. economy to outperform. Financial conditions have eased in the U.S. relative to the rest of the world, while fiscal policy is expected to be comparatively more favorable in the U.S. The U.S. surprise index has reflected this shift in comparative growth, outperforming most regions (Chart 5).5 While the Euro has been exceptionally resilient, the fallout from a stronger currency will eventually begin to show up in slower growth. The EUR/USD cross has diverged from the spread in expected policy rates, leaving the euro looking expensive (Chart 6). Since the beginning of the year, spreads have widened in favor of the dollar, while the USD has weakened. Although we do not expect the ECB to hike until mid-2019, our expectation of four Fed rate hikes this year will support the greenback. This will push spreads back in line. Such decoupling is not the norm, and we expect a 5% appreciation in the dollar in broad trade weighted terms.6 Chart 5Economic Surprises Favor The U.S. Chart 6EUR Looks Expensive Still, The Fed Could Surprise, And Tilt Dovish Chart 7A Policy Change Would##BR##Tolerate Higher Inflation A risk to our base case outlook is a change in the Fed's monetary policy framework. Here we note an increasing number of statements advocating the exploration of an alternative policy framework have been emerging from the Fed. This line of attack observes the Fed's current 2% inflation target is unsatisfactory, as it is too close to the zero-lower bound on interest rates, thus constraining the Fed's ability to exercise expansionary monetary policy when rates are low.7 Alternative policy proposals include price-level targeting, as well as an increase in the inflation target. Additionally, former Fed Chair Bernanke recently proposed a temporary price level target be implemented during low-rate periods.8 The net effect of these alternatives would be a higher inflation rate - above the current 2% target (Chart 7). If the Fed were to adopt a new monetary policy framework, it will likely occur before the next recession - in order to allow it to better respond to economic weakness. While we do not expect a regime change this year, these discussions and an eventual shift, may make the Fed more dovish this year, and more likely to tolerate higher inflation in the future. This would be an upside risk to gold, as it would assume its role as a store-of-value against higher inflation. The net effect of such a policy change - were it to occur - would be higher inflation expectations, lower real rates, and a weaker USD, all of which would bid up the gold market. Bottom Line: The revival of U.S. inflation and inflation expectations will bolster gold. However, our expectation that the Fed will continue hiking ahead of a realized uptick in inflation, and more aggressively than is currently priced in the market, will increase real rates and limit gold's upside potential. A stronger USD on the back of higher real rates, as well as a shift in global growth in favor of the U.S., will work against gold this year. Geopolitical Risks: Understated In 2018 We expect geopolitical risks to support gold prices this year. Gold's safe-haven attributes will be highlighted by a combination of events spread across the calendar year, which we believe will put a floor under the metal's price (Chart 8).9 Political and economic policy uncertainty will remain elevated this year (Chart 9). Our Geopolitical Strategists see this year's gold-relevant risks stemming from two main factors: (1) U.S. political risks, and (2) Exogenous tail risks. The former is likely to be a more significant source of upside pressure. Chart 8Gold Outperforms During##BR##Geopolitical Crises Chart 9Elevated Policy Uncertainty##BR##Supports Gold U.S. Foreign Strategy Risks Will Keep Gold Bid U.S. political risks are rooted in President Trump's strategic decisions, and boil down to two mutually exclusive schemes ahead of the midterm elections: Domestic Strategy or Foreign Strategy (Table 1). Our Geopolitical strategists note: "... policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy."10 Trump's propensity to take on a more aggressive stance in foreign policy - which would be boosted by an unfavorable outcome in the immigration bill - will set the stage for a volatile year, supporting gold via its ability to hedge against geopolitical risks (Chart 10). Table 1Trump's Two-Level Game Chart 10Trump Will Look To Revive His Political Capital In addition to the U.S. political risks, many low-probability high-impact risks will keep volatility elevated this year and could support gold as a strategic portfolio hedge in 2018. Most notable are the following: A meaningful slowdown in China would have a negative impact on the global economy, as well as increase the risk of a monetary policy mistake in the U.S. The Fed's monetary policy decision is important for EM growth, while EM growth contributes to U.S. inflation, this feedback system makes the expected slowdown in Chinese growth relevant to the U.S. monetary stance. If China slows more than expected, this would reduce the global demand for commodities and goods, diminishing U.S. inflation expectations, potentially forcing the Fed to reassess its rate hike pace. If no adjustments are made, the Fed risks overshooting the equilibrium interest rate, increasing the risk of an equity correction. A downward rate hike adjustment, would keep the USD and real rates at low levels. A global oil-supply disruption caused by a collapse of the Venezuelan economy would lead to a short-lived spike in oil prices (Chart 11). In low-spare-capacity environments - as we are in today - oil prices become more responsive to supply shocks. Based on our simulations, a 600k b/d drop in Venezuelan oil supply in 2018 could spike oil prices by ~$10/bbl, leading to higher cost-push inflation. Our modelling shows U.S. CPI is highly responsive to oil price variation. This spike in headline inflation would push gold prices higher. Chart 11Cost-Push Inflation Risk From Venezuela Collapse In addition to U.S.-Iran tensions, we see other potential catalysts to instability in the Middle East - mainly regarding a severe deterioration of the U.S.-Turkish relationship, and Iraqi-Kurdish clashes ahead of Iraqi elections. Lastly, Europe: Italian elections and Euro-skepticism are a longer-term risk; however, news around the Italian elections in March has the potential to fuel talk of a potential breakup, which could lift gold.11 Bottom Line: Increased tensions due to Trump's controversial foreign strategy (China and Iran), as well as exogenous tail risks throughout the year will keep risks elevated in 2018, supporting gold prices. In fact our geopolitical strategists believe risks are understated this year, increasing the utility of gold's ability to hedge against political turmoil. Gold Outperforms In Equity Bear Markets In addition to its ability to hedge against rising inflation and increased geopolitical risks, gold outperforms during equity downturns and amid market volatility.12 Specifically, during periods of negative equity returns, gold outperformed the S&P500 79% of the time, with an average excess return of 3.7%. Furthermore, gold outperforms equities 60% of the time in periods of rising VIX with an average excess monthly return of 1.6% in these periods, and only 30% of the time in decreasing VIX periods with an average monthly excess return of -1.8% (Chart 12).13 We expect the equity bull market to remain intact throughout 2018. An equity downturn is not expected before 2H19. Nevertheless, we expect volatility to increase this year as investors fret about the sustainability of the bull market, and amid heightened geopolitical tensions. Moreover, domestic U.S. developments - e.g., the evolution of Special Counsel Robert Mueller's investigation; a larger-than-expected Democrat win in the midterm elections or a Fed policy mistake - could affect investor sentiment and trigger a rise in volatility and a temporary sell-off in S&P 500. In our view, consumer confidence is a key contributor to the current equity bull market and currently stands at very elevated levels (Chart 13). Thus, any meaningful disappointment could derail this high-confidence environment. Chart 12Gold Outperforms Amid##BR##Volatility & Equity Downturns Chart 13High Confidence##BR##Environment At Risk Therefore, we believe the larger-than-expected tail risks and the monetary and political risks in the U.S. are not fully reflected in the gold market (Chart 14). The above risks assessment would suggest a fatter right tail in out-of-the-money gold options. Chart 14Rising Volatility Will Support Gold Chart 15Understated Geopolitical Risks This Year Bottom Line: While geopolitical risks were overstated in 2017, they are understated this year (Chart 15). Thus we do not expect a repeat of last year's low-VIX high-confidence environment. Rather gold will gain support from increased equity volatility this year. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see BCA Research The Bank Credit Analyst Special Report titled "The Impact of Robots on Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 2 Please see BCA Research Global Investment Strategy Weekly Report titled "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy Weekly Report titled "It's Still All About Inflation," dated January 16, 2018, available at usbs.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report titled "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Global Investment Strategy Weekly Report titled "The Indefatigable Euro," dated January 26, 2018, available at gis.bcaresearch.com. 7 Please see "Fed Officials See Benefits In Letting Inflation Run Above Target," dated January 19, 2018, available at Bloomberg.com. 8 Please see https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ 9 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research Geopolitical Strategy Weekly Report titled "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 11 For a comprehensive analysis of this issue, please see BCA Research Geopolitical Strategy Special Report titled "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 12 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 13 Excess returns = (Gold - S&P 500) monthly returns. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

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

Highlights Duration Checklist: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. UST-Bund Spread: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Feature Chart of the WeekUST-Bund Gap Still##BR##Reflects Policy Differences With the 10-year yield on both U.S. Treasuries and German Bunds hitting new cyclical highs on an intraday basis yesterday (2.72% and 0.70%, respectively), it is clear that the backdrop for global government bond markets is still bearish. The yield differential between the two markets remains quite wide, however, with the cyclical European economic performance rapidly catching up to that in the U.S. This is raising the odds that European Central Bank (ECB) will have to soon begin signaling a move to a less accommodative policy stance that will raise European bond yields further away from historically low levels. The continued strength of the Euro versus the U.S. dollar is a sign that investors are already expecting a big compression in U.S. bond yields versus European equivalents (Chart of the Week). Should investors position now for an eventual tightening of the Treasury-Bund spread? Or is it possible that the spread widens even further, thus providing a better entry point to profit from a spread tightening move? In this Weekly Report, we investigate the drivers of the Treasury-Bund spread to provide some clues as to its future direction. Our conclusion is that, from a medium-term strategic perspective, a narrowing of the Treasury-Bund spread is highly probable, but there is still potential for widening in the next few months. Checking In On Our Duration Checklist: Still Bearish, But With No Big Signal For U.S.-German Spreads In early 2017, we introduced a list of indicators to monitor in order to determine if our strategic below-benchmark duration stance on U.S. Treasuries and German Bunds should be maintained.1 This list, which we dubbed our "Duration Checklist", contained elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The vast majority of indicators in the Checklist have accurately pointed to a cyclical backdrop for rising yields throughout the past year, despite the surprising drop in global inflation witnessed in 2017 (Table 1). Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds With bond yields hitting fresh cyclical highs this week, it is a good time to provide another update of our Duration Checklist to see how conditions have changed since our last update in September. Specifically, we are looking for any differences in the individual U.S. and European components of the Checklist that can inform our view on the UST-Bund spread. Global growth momentum is accelerating to the upside. The global leading economic indicator (LEI) continues to climb steadily higher, even with global growth already in a solid uptrend (Chart 2). The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has started to accelerate. The Citigroup Global Data Surprise index is at the highest level since 2004 (!), while our global credit impulse indicator has picked up sharply - both of which should keep global bond yields under upward pressure. We are giving a "check" to all these elements of our Duration Checklist, indicating that a defensive stance on overall duration exposure should be maintained. The only indicator in the "global" section of our Duration Checklist that is not pointing to higher bond yields is our global LEI diffusion index, which has fallen to just below the 50 line. This suggests a potential narrowing of the breadth of the current global upturn, which warrants an "x" in the Checklist. Domestic economic growth in both the U.S. and Euro Area remains solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe remain high and are rising, as is consumer and business confidence on both sides of the Atlantic (Charts 3 & 4). Corporate profit growth is solid both in the U.S. and Europe, with our models suggesting that earnings should expand at a double-digit pace again in 2018. All these indicators earn a "check" in our Duration Checklist. Chart 2Majority Of Global Growth Indicators##BR##Still Pointing To Higher Yields Chart 3U.S. Growth##BR##Remains Solid Chart 4A Booming European##BR##Economy Is Bearish For Bunds Inflation signals are mixed both in the U.S. and Europe. This remains the portion of our Checklist that has the greatest number of conflicting signals. While the rapid rise in oil prices over the past several months is putting upward pressure on headline U.S. inflation (Chart 5), the equally fast increase in the EUR/USD exchange rate is helping offset much of that increase in the Euro Area (Chart 6). Unemployment is below the OECD's estimate of the full employment NAIRU rate in the U.S., yet both Average Hourly Earnings growth and the Atlanta Fed Wage Tracker are decelerating. Unemployment in the Euro Area is now back to the OECD'S NAIRU level for the first time since the Great Recession, but wage inflation has only risen modestly. Chart 5U.S. Inflation Still Subdued,##BR##Despite Higher Oil & Low Unemployment Chart 6A Puzzling Lack Of##BR##Euro Area Core Inflation For the U.S. inflation side of our Checklist, we are giving a "ü" to the accelerating oil price (in U.S. dollar terms) and the unemployment gap, but an "x" to decelerating wage inflation. In the Euro Area, we give a "check" to the unemployment gap and a weak "check" to wage inflation which is in a mild uptrend. The stable momentum in the Euro-denominated Brent oil price earns an "x" in the Checklist, however. Both the Fed and ECB Are Looking To Tighten Monetary Policy. The Fed remains in a tightening cycle and with U.S. growth strong, core inflation bottoming out and the labor market still tight, there is no reason why the Fed should not deliver on its projected three rate hikes in 2018. The ECB just reduced the size of its monthly asset purchases in response to the robust Euro Area economic growth and modest pickup in inflation. The latest comments from various ECB officials suggests that, if core inflation rebounds after the recent unusual dip, then additional moves to less accommodative monetary policy (tapering first, rate hikes later) should be expected. So for both the U.S. and Europe, we place a "check" in this portion of the Duration Checklist. Investors risk appetite remains strong. The surge in global stock markets seen so far in 2018 has definitely played a role in the backup in global bond yields, as investors have been allocating out of fixed income into equities. Within our Duration Checklist framework, a bearish signal for bonds occurs if the percentage deviation of equity indices from their 200-day moving average is positive but is not yet at 10% - a stretched level that has typically preceded significant equity corrections. The S&P 500 index is now 14% above its 200-day average, and thus earns an "x" in that element of the Duration Checklist. The other parts of the U.S. side of the Checklist - tight corporate bond spreads and a low level of the VIX volatility index - both warrant a "check" as an indication of intense investor risk appetite that lessens the appeal of government bonds (Chart 7). In the Euro Area, the Stoxx 600 index is only 4% above its 200-day moving average, but with tight credit spreads and a low level of the VStoxx volatility index (Chart 8). All these elements earn a "check" in our Duration Checklist. Chart 7High Risk Appetite In the U.S.,##BR##But Risk Assets Look Stretched Chart 8Still A Pro-Risk Bias##BR##Among Euro Area Investors Bond market momentum is not overly stretched, although short positioning is an issue. In the U.S., the 10-year Treasury yield is only 35bps above its 200-day moving average, well below the 90-100bps levels seen at previous yield peaks (Chart 9). Price momentum for the 10-year is right on the zero line, suggesting no stretched extreme that would precede a reversal. Both of those indicators earn a "check" in the Checklist. Positioning is a problem in the U.S., however, with the CFTC data on Treasury futures showing a net short position on the 10-year contract among speculators. From the point of view of our Duration Checklist, a big net short is a bullish signal for bonds from a contrarian perspective. Thus, positioning warrants an "x" in the U.S. side of the Checklist. In Europe, the 10-year Bund yield is now 22bps above its 200-day moving average. This is below the previous peaks around the 50bps level. Price momentum is also hovering just above the zero line and is no impediment to a move higher in yields (Chart 10). Both of these pieces of the Duration Checklist score a "check". Note that due to a lack of available data, we do not include a positioning component on the European side of the Checklist. Chart 9USTs Not Oversold,##BR##But Positioning Getting Stretched Chart 10Bunds Not Yet At##BR##Oversold Extremes The net conclusion from our Duration Checklist is that the majority of indicators continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, a below-benchmark duration stance is still warranted for both markets. There are only a few potentially bullish signals in the Checklist. The overshoot in U.S. equity markets and the large net short position in Treasury futures are both sending a more positive signal for Treasuries, while the more stable momentum in the Euro denominated oil price is also a positive for Bunds. None of those is enough to prompt a change in our recommended below-benchmark duration stance. At the same time, there is not enough of a difference between the U.S. and European sides of the Checklist to provide a signal for the future direction of the Treasury-Bund spread. For that, we must dig a bit deeper into the drivers of that spread, which we cover in the next section. Bottom Line: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. How To Play The Treasury-Bund Spread - Tactically Wider, Structurally Narrower The Treasury-Bund spread, like most cross-country bond yield spreads, is driven mostly by economic growth and inflation differentials. In the past, the U.S. and European economic cycles have rarely been in sync, which creates gaps in growth, inflation and monetary policy between the two regions. This usually leads to the Fed and ECB (and the Bundesbank before it) rarely having interest rates at similar levels, or moving at a similar pace, thus creating large cyclical swings in the Treasury-Bund spread. At the moment, however, the 200bp gap between 10-year Treasuries and German Bunds mostly reflects the 4.6 percentage point gap between the unemployment rates in the U.S. and Europe. The spread has been far less correlated to the difference in inflation rates between the two economies. Reported headline inflation in the U.S. is only 30bps above the same measure in Europe, with core inflation only 60bps higher in the U.S. (Chart 11). The latter may be more critical for the future direction of the Treasury-Bund spread, however. The dip in Euro Area core inflation back below the 1% level at the end of 2017 was a surprise given the strength of European growth last year, with real GDP reaching a well-above potential pace of 2.8%. Core inflation must rise from the current 0.9% level for the ECB to consider any move to a tighter monetary policy stance, as this would give the central bank confidence that its 2% inflation target would be reached in the medium-term. The markets seem to be pricing in a recovery of Euro Area core inflation in the coming months. Our Euro Area months-to-hike indicator, which measures the number of months until the first full 25bp rate hike is priced into the EUR Overnight Index Swap (OIS) curve, is now down to 17 months. As the interest rate markets have pulled forward the date of the next ECB rate hike to June 2019, the currency markets have followed suit with the euro rallying to a 3-year high last week (Chart 12). Chart 11Big Gaps Between Yields & Unemployment,##BR##Small Gaps In Inflation Chart 12Markets Are Acting Like##BR##Core Inflation Will Rebound In Europe A rebound in Euro Area core inflation is the first step towards seeing a convergence of the Treasury-Bund spread. The key is how the ECB responds to that move. Looking across the full spectrum of maturities, the moves in the yield gap between U.S. Treasuries and German government bonds have historically occurred alongside changes in relative inflation expectations (Chart 13). This makes sense, as to the extent that inflation expectations were climbing at a faster rate in the U.S. than in Europe, the market would price in a higher future Fed funds rate relative to European policy rates and, thus, widen the Treasury-Bund spread (and vice versa). That correlation between relative inflation expectations and the Treasury-Bund spread has broken down in recent years. The specific timing of that breakdown can be traced back to the August 2014 speech given by Mario Draghi at the Fed's Jackson Hole conference, marked by the vertical line in Chart 13. In that speech, Draghi introduced the idea that the ECB could begin buying government bonds to fight deflation pressures in Europe. That sent a powerful signal to the markets not to expect any movement in European policy rates for some time - the typical response seen in recent years to an announcement by a central bank that it was ramping up asset purchases. If Euro Area core inflation begins to rise in the coming months, the ECB's "forward guidance" can start to work in reverse. The ECB will be forced to signal further reductions in its asset purchases, likely all the way to zero in a full taper scenario. Markets will then begin to price in both higher inflation expectations and ECB rate hikes, resulting in a normalization of the Treasury-Bund spread through higher Bund yields. Until that inflation upturn happens in Europe, however, it will be difficult to get much of a tightening of the Treasury-Bund spread. In Chart 14, we present the spread versus the difference between policy rates in the U.S. and Europe (top panel), the ratio of the U.S. and Euro Area unemployment rates (middle panel), and the gap between U.S. and European headline inflation (bottom panel). At the moment, the Treasury-Bund spread is being held at an elevated level by the relative unemployment rates, with the spread looking wide versus the inflation differential. The much lower U.S. unemployment rate, which is driving the Fed to continue slowly hiking interest rates while the ECB keeps policy rates near zero, is preventing any meaningful decline in the Treasury-Bund spread. Chart 13UST-Bund Spread Has Divorced##BR##From Inflation During ECB QE Chart 14UST-Bund Spread Reflects Policy##BR##& Unemployment Differentials We have combined these three variables into a simple econometric model to explain the Treasury-Bund spread (Chart 15). We also added the size of the balance sheets of the Fed and ECB as separate variables, to account for the impact of bond purchases from each central bank. This model shows that a) the predicted value of the spread continues to steadily rise and b) the current spread is below one standard deviation away from that predicted value - a level equal to 237bps on the spread. That implies that there is still room for Treasury yields to climb higher versus Bunds before the spread becomes "too wide". Additional spread widening will be much harder to come by in the near-term, however. The gap between data surprise indices between the U.S. and Euro Area - which correlates well to the momentum in the Treasury-Bund spread - is relatively stretched, at a time when U.S. bond managers are already very underweight duration exposure (Chart 16). Yet with the forward curves already pricing in some mild tightening over the next year (top panel), betting on Treasury-Bund spread widening is a positive carry trade. One final point in favor of a wider Treasury-Bund spread is that the spread momentum is not yet close to the extremes seen in previous cycles (Chart 17). The big cyclical peaks in the spread typically occur when spreads are 50bps above the 200-day moving average, which is well above current levels. Chart 15Our New Model Suggests##BR##UST-Bund Spread Not Overstretched Chart 16Relative Data Surprises & UST##BR##Positioning May Limit Additional Spread Widening Chart 17UST-Bund Spread Momentum##BR##Not Yet At Stretched Extremes Our conclusion after looking at all these indicators is that the major cyclical peak in the Treasury-Bund spread is not yet on the immediate horizon, but is likely to unfold later this year - after one final move higher in Treasury yields versus Bunds. Bottom Line: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy A stable China, a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth signal that the industrials complex, especially the most cyclical part, remains on a solid footing. Deteriorating profit prospects warn that investors should refrain from paying a premium valuation for industrial machinery; take profits and move to the sidelines. Recent Changes S&P Industrial Machinery - Book profits of 4% and downgrade to neutral today. S&P Construction Machinery & Heavy Truck - Stop triggered last week, remove from the high-conviction list for a 10% gain. Small Caps / Large Caps - Downgrade alert in a recent Insight. Table 1 Feature The S&P 500 smashed through the 2,800 mark last week, as corporate profits continued to deliver, the U.S. dollar took a dive and global economic data releases held their own. Stars could not be more aligned for a euphoric blow off phase, with equity bourses the world over already registering annual-like returns in but a few short weeks. While stocks have more room to run, especially versus bonds, on a cyclical time frame, tactically the likelihood of a short-term healthy pullback is increasing. Last week we identified five indicators we are closely monitoring that are signaling an overstretched market.1 This week we update our Complacency-Anxiety Indicator that also catapulted to all-time highs and breached the one standard deviation above the historical mean mark (Chart 1). This confirms that a Q1 setback remains likely, and our strategy since December 18 has been to monetize gains in tactical trades and institute stops to the high flyers in our high-conviction call list. Were a 5-10% correction to materialize, we would "buy the dip" as we do not foresee a recession in the coming 9-12 months. While consumer price inflation is nowhere to be found, corporate selling prices are climbing at a brisk pace. The U.S. dollar debasement and related commodity reflex rebound, especially in oil prices, are the culprits, and the latter will likely assist even the CPI basket and morph into an inflationary impulse as we posited in late-November (please see the bottom two panels of Chart 1B). Already, inflation expectations are headed higher. Chart 2 updates our corporate sector pricing power proxy and our diffusion index. It also updates the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. The middle panel of Chart 2 shows the Atlanta Fed Wage Growth Tracker and that measure of wage inflation has converged down to the AHE reading, suffering a 100bps drop in the past year. Chart 1Complacency Reigns Chart 2Margin Expansion Phase Is Intact Corporate pricing power is upbeat at a time when wages are decelerating. Taken together, our margin proxy indicator suggests that the ongoing profit margin expansion phase has more upside (bottom panel, Chart 2). Table 2 shows our updated industry group pricing power gauges, which we calculate from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter-term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 78% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-September update. The outright deflating sectors dropped by two to 13 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, or 5 fewer than our most recent report. Impressively, deep cyclicals/commodity-related industries dominate the top ranks, occupying 8 out of the top 10 slots (top panel, Chart 3). A softening greenback and rising global end demand explain the commodity complex's sustained ability to increase prices. In contrast, tech, telecom and consumer discretionary sectors populate the bottom ranks of Table 2. Netting it out, accelerating corporate sector pricing power will continue to bolster top line growth in 2018. Tack on high operating leverage kicking into higher gear at this stage of the cycle and still muted wage inflation and profit margins and EPS growth will remain upbeat. With regard to cyclicals versus defensives, diverging pricing power (Chart 3) and wage growth trends (Chart 4) suggest that cyclicals continue to have the upper hand compared with defensives (Chart 5). Chart 3Deep Cyclicals... Chart 4...Have The Upper Hand... Chart 5...Vs. Defensives This week we update our view on a deep cyclical sector and modestly tweak our intra-sector positioning. Industrials And China We lifted the S&P industrials sector to an above benchmark allocation in early October via boosting the S&P construction machinery & heavy truck sub index to overweight.2 Synchronized global growth, a capex upcycle, firming capital goods final demand, and the U.S. dollar's fall coupled with the commodity price rebound all pointed to a bright outlook for U.S. capital goods producers. Currently, all these forces remain in play and continue to bolster industrials stocks' profit prospects. However, the emerging market (EM)/Chinese economic backdrop deserves closer scrutiny. Why? Because the most cyclical parts of the industrials complex are levered to the EM in general and China in particular. These high operating leverage businesses also drive relative profit and stock performance, signaling that China's economic growth might or ails determine the overall fortunes of U.S. capital goods producers. While Chinese economic data are currently a mixed bag and we take them with a big grain of salt, global high-frequency financial market data are emitting an unambiguously positive signal. First, BCA's FX strategist, Mathieu Savary, brought to our attention that the extremely economic-sensitive Canadian TSX Venture Exchange Index is in a V-shaped recovery.3 Highly speculative basic resources issues dominate this Index and help explain the tight positive correlation with Chinese output (top panel, Chart 6). Second, the ultimate economic-sensitive indicator, Dr. Copper, is also in a violent upswing, heralding that China will be, at least, stable in 2018 (middle panel, Chart 6). Third, high-beta Australian materials stocks have been in an upward trajectory since the early 2016 trough both versus the MSCI All-Country World Index and the broad Australian market, sniffing out improving Chinese-related commodity demand (bottom panel, Chart 6). Similarly, upbeat non-Chinese economic data suggest that China's economic prospects are far from faltering. Australia's close economic ties with China signal that taking a pulse of the Australian economic juggernaut reveals the state of China's economic affairs. Down Under employment growth has been brisk of late, with annual job creation running at a 3.3% clip, a rate last hit in the mid-2000s when China's economy was roaring and the commodity super-cycle was in full swing (second panel, Chart 7). Australian CEO confidence as well as consumer confidence are pushing decade highs, and the manufacturing PMI survey recently shot to a 16 year high (third panel, Chart 7). Chart 6China Is##BR##Alright Chart 7Australian Indicators Confirm:##BR## China Is Stable All of this suggests that China will likely remain stable in 2018, barring a policy mistake a la the August 11, 2015 currency devaluation. The upshot is that industrials EPS and equities have more room to run. On that front, both our Cyclical Macro Indicator and our profit growth model corroborate that the path of least resistance for relative share prices is higher (Chart 8). U.S. dollar debasing is synonymous with capital goods producers' top line growth acceleration, as a large part of total revenues are sourced from abroad. The near 20 percentage point fall in the trade-weighted U.S. dollar since 2015 suggests that more global market share gains are in store for U.S. industrials (Chart 9). Global growth is also joined at the hip with the greenback's depreciation. Synchronized global growth along with our derivative coordinated global capex growth 2018 theme, will likely serve as catalysts for a sustained breakout in relative share prices (Chart 10). Chart 8EPS Model And CMI Flash Green Chart 9Industrials Love A Cheap Greenback Chart 10Levered To Global Growth Adding it up, a stable China is music to the ears of industrials executives. Tack on a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth and the most cyclical parts of the industrials complex will continue to lead the pack. Bottom Line: Stay overweight the S&P industrials index, but selectivity is warranted. Take Profits In Industrial Machinery We outlined above that the most cyclical parts of the S&P industrials index with high foreign sales content would benefit disproportionately from our stable-to-mildly sanguine EM/China view. While the broad machinery index fits the bill, the industrial machinery sub index less so, and we recommend monetizing gains of 4% since inception and moving to the sidelines. Chart 11 shows the relative performance of the two key drivers of the S&P machinery index: industrial machinery and construction machinery & heavy truck sub-indexes. While these indexes moved hand-in-hand since the mid-1990s, early this decade this tight positive correlation fell apart. One key determinant of the relative move of these indexes is the U.S. dollar. The greenback troughed in 2011 and since then the more "defensive", less globally-exposed S&P industrials machinery index left their brethren in the dust (bottom panel, Chart 11). Now that the U.S. dollar has peaked, the catch up phase in the S&P construction machinery & heavy truck index that is already underway will likely gain momentum (top panel, Chart 11). Beyond the depreciating currency, at the margin, softening S&P industrial machinery operating metrics argue for pruning exposure in this index. Both the Empire and Philly Fed new orders surveys have petered out, suggesting that industry new order growth will likely continue to lose steam (middle panel, Chart 12). In fact, a weak industrial machinery new orders-to-inventories ratio is also warning that sell-side analysts' relative profits forecasts are too optimistic (bottom panel, Chart 12). Chart 11Catch Up Phase Chart 12Waning End-Demand Drilling deeper into industry operating metrics is revealing. While shipments have held their own and moved mostly sideways similar to new orders, inventory accumulation is worrying. Industry inventories have risen by over 30% during the past three years (Chart 13). Simultaneously, industrial machinery backlogs have drifted steadily lower. Given the supply build up, any hiccup in demand, even a minor one, could prove very deflationary and heavily weigh on industry profitability. With regard to valuations, Chart 14 shows that both on a relative trailing price-to-sales and relative forward price-to-earnings ratio basis, the index is trading one standard deviation above the historical mean. The moderating industry demand backdrop suggests that relative valuations are expensive. Chart 13Inventory Liquidation Risk Chart 14Why Pay A Premium? Adding it all up, deteriorating profit prospects warn that investors should refrain from paying a premium valuation for the S&P industrial machinery index. Bottom Line: Book profits of 4% in the S&P industrial machinery index and downgrade to a benchmark allocation. We also recommend redeploying profits from our downgrade in the S&P industrial machinery index to their more cyclical machinery siblings the S&P construction machinery & heavy truck index, thus sustaining the overall overweight exposure in the broad S&P industrials sector. Housekeeping Last week we instituted a risk management tool for our 2018 high-conviction list: setting a stop once a call has cleared the 10% return mark.4 This past week, the S&P construction machinery & heavy truck index hit the trailing stop at the 10% mark, and thus we are booking gains and removing this index from the high-conviction list. While our confidence is not as high as in late-November given the parabolic move in this index and rising chance of a tactical overall equity market pullback, from a cyclical perspective we continue to recommend a core overweight in this industrials sector powerhouse. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Earnings Take Center Stage," dated October 2, 2017, available at uses.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, "Health Care Or Not, Risks Remain," dated March 24, 2017, available at fes.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report co-authored by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst, and Brian Piccioni of Technology Sector Strategy. Mark and Brian argue that the deflationary impact of robot automation will not prevent inflation from rising as the labor market tightens. I hope you will find their report interesting and informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Our cyclically overweight stance on global equities/underweight stance on bonds is working. Stick with it. U.S. Treasury Secretary Mnuchin's comments about the dollar are unlikely to have any lasting effects. EUR/USD has decoupled from terminal rate expectations since the start of this year. Tactical trade recommendation: Go short EUR/USD while simultaneously going long 30-year U.S. Treasurys/short 30-year German bunds. Feature Global Equities Enter A Blow-Off Phase Valuations do not matter on the way up, but they sure do matter on the way down. Once the market reaches that Wile E. Coyote moment - the one where the poor sap runs off the cliff, pauses in mid-air, looks down, and sees the ground below - all hell will break loose. On every valuation measure, U.S. stocks, and increasingly global stocks, have become very expensive (Chart 1). Chart 1AU.S. Stocks Are Expensive... Chart 1B...While Global Stocks Are Getting There That moment, however, is unlikely to arrive until the global economy and earnings growth begin to stall out. As we have argued in past reports, this probably will not happen until late next year. Historically, it has not paid to get defensive until six months before the start of a recession (Table 1). This suggests that stocks could continue to rally right through 2018. Beep beep. Table 1Too Soon To Get Out Granted, the timing of our recession call could turn out to be wrong, which is why we are watching a wide number of leading variables for signs that a slowdown is around the corner (Chart 2). In the U.S., these include credit spreads, the slope of the yield curve, financial conditions, business and consumer confidence, ISM new orders minus inventories, building permits, core capital goods orders, and initial unemployment claims. We have consolidated these variables and dozens of others into our MacroQuant model. The model is still pointing to a reasonably rosy cyclical outlook for stocks (Chart 3). Chart 2Leading Cyclical Data Still Strong Chart 3Cyclical Outlook For Stocks Is Still Rosy The Dollar Takes A Pounding While our cyclical bullish view on stocks and bearish view on bonds has paid off this year, our expectation that the dollar would recoup some of last year's losses has not worked out. Time will tell if December 2016 marked the beginning of a secular dollar bear market. The dollar tends to suffer when global growth accelerates. This happened last year. The dollar also tends to weaken when the composition of growth shifts away from the United States. That also happened in 2017. The remainder of this year could be different. We expect global growth to remain solidly above-trend in 2018, but ease from the torrid pace of 2017. This is already being foreshadowed by the decline in our Global LEI diffusion index to below 50%, a slowdown in Korean and Taiwanese exports, a deceleration in the Chinese Li Keqiang Index, and the loss of momentum in EM carry trades (Chart 4). Meanwhile, the composition of global growth should shift back in favor of the U.S. The fact that the U.S. Economic Surprise index has recovered in recent months relative to other economies suggests that this reversal of fortunes is already underway (Chart 5). The end result for asset markets could be slightly reminiscent of the late 1990s, a period when both equities and the dollar rallied. Chart 4Global Growth Will Remain Above-Trend ##br##But Ease From Blistering Pace Chart 5Composition Of Global Growth Will Shift ##br##Back In Favor Of The U.S. Talk Is Cheap Chart 6Trade-Weighted Dollar No Longer Pricey We do not put much weight on the remarks concerning the dollar made by Treasury Secretary Steven Mnuchin at Davos this week. While Mnuchin did say that "obviously a weaker dollar is good for us as it relates to trade and opportunities," he added that "longer term, the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and it continues to be the primary currency in terms of the reserve currency." More importantly, history suggests that verbal interventions in currency markets are only effective beyond the near term when backed by a supporting change in monetary policy. Many people remember the success that then-Treasury Secretary James Baker had in driving down the dollar following the Plaza Accord in 1985, but what is often forgotten is that the Federal Reserve steadily cut rates from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year interest rate differential fell by 454 bps against Japan, 630 bps against the U.K., and 407 bps against Germany over this period. It is also worth noting that the Fed's real broad trade-weighted dollar index is now 27% below its 1985 peak and 3% below its long-term average (Chart 6). This makes any effort to talk down the dollar all the more difficult. ECB Sending Mixed Messages About The Euro Chart 7Market Has Brought Forward ECB Rate Hikes ECB officials continue to send mixed messages about the resurgent euro. Earlier this month, ECB Vice President Vitor Constâncio and Bank of France Governor François Villeroy both expressed concern about the euro's strength, as did Ewald Nowotny, the fairly hawkish President of Austria's central bank. In contrast, Mario Draghi refused to wade into the debate during yesterday's press conference. The lack of angst in his tone sent the euro higher. Draghi's reluctance to say anything concrete about the euro was partly motivated by the desire to avoid the sort of "beggar thy neighbor" criticism that greeted Mnuchin's remarks. Like other central banks, the ECB gives a lot of weight to financial conditions in setting monetary policy. A stronger currency has tightened euro area financial conditions. This is something that must concern the ECB, at least behind closed doors. Ultimately, any effort by the ECB to knock down the euro will only work if it convinces the market to soften its expectations about the future pace of rate hikes. The likelihood of such an outcome is certainly higher now than it was in 2016. Our "months to hike" measure for the ECB has plummeted from over 60 months in mid-2016 to 19 today (Chart 7). Given that the ECB has made it clear that it intends to delay raising rates for some time after asset purchases end later this year, it is hard to see the central bank hiking rates before the summer of 2019. That is not far from where market pricing now stands. In contrast, if euro area growth were to surprise meaningfully on the downside or if core inflation in the peripheral economies continues to fall - it is already close to zero in Italy - the ECB could be forced to bide its time longer than the market currently expects. A Safer Way To Short EUR/USD Chart 8EUR/USD And Rate Decoupling ##br##Will Not Last Long Still, the euro has a lot going for it. Unlike the U.S., the euro area is running a current account surplus. This means the region does not need to attract foreign capital for there to be excess demand for euros. All it needs to do is keep net capital outflows roughly below 3% of GDP. The ability of the euro area to retain and attract fresh capital has become easier as political risk has ebbed and the ECB's pledge to do "whatever it takes" to preserve the euro has solidified. The euro's share of global central bank reserves currently stands at 20%, well below the 60% share enjoyed by the U.S. dollar. If capital continues to gravitate towards the region, the euro could strengthen further. All this makes shorting the euro a risky bet. With that in mind, investors should consider hedging short EUR/USD positions by wagering that the terminal rate spread between the euro area and the U.S. will narrow. Chart 8 shows that the spread in expected policy rates ten years out has decoupled from EUR/USD since the start of the year. The same is true for the 30-year spread between Treasurys and bunds - another good proxy for the terminal rate spread. While spreads have widened in favor of the dollar, the greenback has nonetheless plunged. Such decoupling rarely lasts long, which makes this a highly attractive trade. With that in mind, we are going short EUR/USD as a tactical trade while hedging the risk of a stronger euro by going long 30-year Treasurys/short 30-year bunds (a bet on further spread compression). Given that the first leg of the trade is more volatile than the second, we are scaling up the latter by a factor of 1.5. We will aim to close the trade for a gain of 5% (EUR/USD of about 1.18), assuming no change in the current spread of 160 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Bank Credit Analyst

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