Emerging Markets

Highlights Ongoing monetary tightening in China poses a substantial threat to EM risk assets. Yet financial markets remain highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Business conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The pillars of the EM business cycle are China, commodities, and their own domestic credit cycle, rather than the U.S. and Europe. Continue shorting/underweighting the Malaysian currency, stocks and sovereign credit. Feature Chart I-1China: Ongoing Liquidity Tightening There is one major underappreciated risk in global financial markets: China's gradual yet unrelenting monetary tightening. Though slow and measured, this policy tightening constitutes a significant risk, particularly for emerging markets. The basis is that it could trigger a disproportionally large negative effect on Chinese growth because it is taking place amid a lingering credit bubble in China.1 Mainland interbank rates and onshore corporate bond yields have risen as the People's Bank of China (PBoC) has reduced its net liquidity injections via open market operations (Chart I-1, top panel). The PBoC's monetary tightening is bound to reduce money/credit growth in China. The bottom panel of Chart I-1 demonstrates that changes in the central bank's claims on commercial banks lead by 3 months asset growth at commercial banks. Diminished liquidity injections by the PBoC will soon push commercial banks to reduce the pace of their balance sheet expansion. Asset growth/loan origination among policy banks2 has already slowed (Chart I-2). On top of this, China's regulatory tightening aimed at curbing speculative (high-risk) financial activity will also curtail commercial banks' loan origination. For example, bank regulators are forcing banks to bring off-balance-sheet assets onto their balance sheets. As a result, money/credit growth is set to decelerate meaningfully. This, in turn, will cause another slump in this credit-addicted economy. It is very probable that the mini-business cycle in China has already reached its peak - our credit and fiscal impulse heralds further drop in the manufacturing PMI (Chart I-3). Chart I-2Commercial Banks And Policy ##br##Banks' Loan Growth To Slow Further Chart I-3China's Growth Has Rolled Over While China's monetary tightening is not a direct risk to domestic demand in the U.S. or Europe, it poses an imminent risk to commodities prices and EM risk assets. Consistent with slowing Chinese manufacturing output growth, commodities prices trading in mainland China have lately tanked. Bottom Line: BCA's Emerging Markets Strategy team maintains that ongoing monetary tightening in China poses substantial risks to EM risk assets and commodities. Yet financial markets remain complacent. Perplexing Complacency It is very perplexing that EM risk assets have so far ignored the risks stemming from China's tightening and renewed relapse in commodities prices. It seems portfolio allocation into risk assets, including those in the EM universe, is pushing prices higher irrespective of a major relapse in forward-looking indicators for both China and EM growth. EM stocks, currencies and credit spreads have decoupled from a number of indicators with which they historically had a high correlation: In recent weeks, we have brought to investors' attention that an unsustainable gap has been opening between the commodities currencies index - an equal-weighted average of AUD, NZD and CAD - and both EM exchange rates and EM share prices in local currency terms (Chart I-4A & Chart I-4B). Chart I-4AHeed The Message From Commodities Currencies Chart I-4BHeed The Message From ##br##Commodities Currencies Not only have commodities currencies decisively rolled over, but also commodities prices have begun sliding. Historically, EM risk assets in general and the sovereign credit market in particular have always sold off when commodities prices have drifted lower (Chart I-5). EM equity volatility is back to its lows (Chart I-6). This corroborates reigning complacency in the marketplace. Chart I-5Commodities Prices And ##br##EM Sovereign Spreads Chart I-6A Sign Of Complacency EM sovereign and corporate spreads have also fallen to their narrowest levels in recent years (Chart I-7). Notably, our valuation model for EM corporate bonds - which is constructed based on our EM Corporate Financial Health Index - posits that EM corporate credit is very expensive (Chart I-8). Chart I-7EM Sovereign And Corporate Spreads Chart I-8EM Corporate Credit Is Expensive Finally, EM local currency bond yield spreads over U.S. Treasurys have also dropped a lot, signifying complacency on the part of EM investors (Chart I-9). Chart I-9EM Local Bond Yield Spreads ##br##Over U.S. Treasurys Are Low Bottom Line: EM financial markets are not cheap, and investors are highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Can EM Decouple From China? An oft-asked and relevant question is whether EM ex-China can decouple from China itself. Not for the time being, in our view. On the contrary, as we argued in last week's report titled Toward A Desynchronized World,3 China's slowdown will weigh on the majority of the EM investable equity, currency and credit markets. As a result, growth conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The three pillars of EM ex-China growth are commodities, China and their domestic credit cycles. The primary link is via commodities. As China's growth decelerates and its imports relapse, commodities prices will plunge (Chart I-10). Latin America, Africa, the Middle East, Russia, Malaysia and Indonesia are set to experience negative terms-of-trade shocks as commodities prices deflate. As a result, their currencies will depreciate and growth will suffer. Although Mexico is leveraged to the U.S., oil prices still matter for it. This leaves non-commodities producing economies in Asia and central Europe. The latter is too small to matter for EM benchmarks. Central Europe correlates with Europe's business cycle rather than EM. In emerging Asia, Korea and Taiwan - the largest equity market cap weights after China in the MSCI EM index - sell much more to China than to the U.S. and Europe combined. Korea's shipments to China account for 25% of total exports while those to the U.S. and Europe combined make up 22%. For Taiwan the numbers are 27% and 20%, respectively. Thailand sells to China as much as it does to the U.S. This by and large leaves only three mainstream EM economies that are not substantially exposed to China: India, the Philippines and Turkey (Table I-1). Indian and Philippine stocks are expensive, and these nations confront their own unique problems. Turkey in turn is facing major political, economic and financial predicaments. Chart I-10Industrial Metals Prices To head Lower Table I-1Export To China And U.S. In short, among mainstream EM countries, there are very few plays not exposed to China or commodities and offer a reasonable risk/return profile. Investors also often ask if commodities importing economies in Asia can rally in absolute terms when and as commodities prices drop. Chart I-11 illustrates the Korean and Taiwanese equity indexes have historically (in the past 20 years) been strongly correlated with oil and industrial metals prices. The reason is that commodity price swings partially reflect global growth conditions. Being heavily dependent on exports, Korea and Taiwan are highly sensitive to fluctuations in global growth. We expect global trade to slow down anew, driven by weakness in China/EM imports, even if U.S. and European demand remains resilient. We elaborated on this theme in last week's report.4 Therefore, Korean and Taiwanese export shipments are set to slow as well. We are not bearish on Korean and Taiwanese domestic demand - we are in fact overweight these bourses within the EM equity universe, with a focus on technology and domestic sectors. That said, consumer and business spending in these economies is relatively small in a global context to make a difference for other EM markets. In addition, given these economies' mature phase of development, the pace of their income and domestic demand growth will be moderate. Many EM countries have experienced excessive credit growth in the past 15 years, but their banking systems have not restructured - i.e. banks have not sufficiently provisioned for non-performing loans. Until they do so, domestic loan growth remains at risk of weakening. There has been modest deleveraging in Brazil, Russia and India (Chart I-12). However, there is no evidence that these economies have embarked on a new credit cycle. Chart I-11Korean And Taiwanese Stocks ##br##Correlate With Commodities Chart I-12Some Moderate Deleveraging ##br##In Brazil, Russia And India Case in point are Indian state-owned banks: their experience shows that deleveraging can be more protracted and painful than one might initially expect. The reason is that it takes time for banks to acknowledge non-performing loans, be recapitalized and get ready to boost loan growth again. In addition, Brazil and Russia are still commodities plays at the mercy of commodities price dynamics. Besides, Brazil needs to undergo painful fiscal adjustment/reforms. In other developing countries, bank loan growth remains elevated and bank loan-to-GDP ratios continue to rise (Chart I-13). In these economies, credit retrenchment and even a mild deleveraging has not yet occurred. Prominently, as EM currencies come under downward pressure, interest rates in many economies running current account deficits will be pressured higher. This will lead to a slowdown in bank credit growth and will depress demand. Finally, if it were not for the pick-up in Chinese imports, the EM ex-China business cycle and commodities prices would not have ameliorated in the past 12 months. Notably, excluding China, Korea and Taiwan, developing nations' retail sales volumes and new vehicle sales remain dormant (Chart I-14). Similarly, there has not been much recovery in capital spending and, consistently, imports of capital goods in EM ex-China, Korea and Taiwan (Chart I-15). Chart I-13No Deleveraging In Many EMs Chart I-14EM Ex-China, Korea And Taiwan: ##br##Stabilization But No Revival Chart I-15EM Ex-China, Korea And Taiwan: ##br##Not Much Of Recovery As credit growth slows or fails to pick up in these economies, domestic demand recovery will be tepid, and will certainly disappoint market expectations. Bottom Line: Given budding divergence between U.S./Europe and Chinese growth, EM ex-China growth will fail to recover and will surprise to the downside. The basis is that the pillars of the EM's business cycle are China, commodities and their own domestic credit cycle, rather than the U.S. and Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November, 23 2016, and January 18, 2017, the links are available on page 16. 2 Policy banks are China Development Bank, Agricultural Development Bank and Export-Import Bank of China. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. 4 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. Malaysia: Not Out Of The Woods Arenewed relapse in Chinese growth later this year coupled with lower commodities prices will once again expose Malaysia's vulnerabilities. Notably, 26% of Malaysia's exports are related to commodities - mainly crude oil, natural gas, petroleum products and palm oil. Another downleg in the ringgit's value along with lower commodities prices will cause domestic interest rates to rise. However, Malaysia is in no position to tolerate higher interest rates. Leverage has risen considerably in the past ten years in Malaysia, and is very high (Chart II-1A). Indeed, the country has one of the highest debt-servicing costs in the EM universe, according to BIS data (Chart II-1B). Chart II-1A...And Debt Servicing Costs Chart II-1BHigh Leverage... If the Malaysian central bank attempts to cap interest rates by injecting local currency liquidity into the system, the ringgit will plunge even further. Chart II-2 shows that in recent years local interbank rates have tended to rise when the central bank curtailed its net liquidity injection. If on the other hand the Bank Negara of Malaysia (BNM) does not inject liquidity into the banking/financial system, interest rates will rise as the currency depreciates. Interestingly, despite strong inflows into EM generally, the BNM has continued to inject local liquidity into the economy - albeit at a slower pace than in recent years - to keep local rates tame (Chart II-2). Additionally, despite the significant growth slowdown that has occurred in the past two years in Malaysia, banks' NPLs have not risen much (Chart II-3). As banks start acknowledging loan losses and setting provisions for them, their profitability will decline, capital will be eroded, and loan origination will fall. Chart II-2BNM Has Been Injecting Liquidity ##br##To Control Interest Rates Chart II-3Malaysian Banks Haven't ##br##Acknowledged Enough Losses Yet Meanwhile, even though global trade and commodities prices have picked in the past 15 months, Malaysia's economy has failed to recover. This reflects the country's underlying economic vulnerability as the borrowing/credit spree of the past decade has come to a halt: Commercial and passenger vehicle sales are shrinking. Retail trade and employment are also still anemic. Property sales volumes and housing construction approvals are collapsing (Chart II-4). Capital expenditures are depressed (Chart II-4, bottom panel). On the external side, the semiconductor/electronics sector has boomed in Asia since early 2016, but Malaysia has failed to benefit much. Indeed, the recovery in Malaysia's electronics sector has been weak compared to other technology hubs such as Taiwan and Korea. This confirms why Malaysia has been losing market share in electronics products to Korea, Taiwan and the Philippines (Chart II-5). Chart II-4Cyclical Growth Remains Anemic Chart II-5Malaysia Is Losing Tech Market ##br##Share To Its Asian Competitors Bottom Line: Continue shorting MYR versus the U.S. dollar and the Russian ruble. Equity investors should continue to underweight Malaysian stocks within an EM equity portfolio. Relative value traders should maintain our long Russian / short Malaysia equity trade. Buy/hold Malaysian CDS or underweight this sovereign credit market within an EM credit portfolio. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Dear Client, In addition to an abbreviated Weekly Report that you will receive later tonight, I am sending you this Special Report written by my colleague Mark McClellan of our monthly Bank Credit Analyst publication. Following up on many of the themes discussed in our latest Quarterly Strategy Outlook, Mark makes a convincing case that most of the factors that have suppressed global interest rates since the financial crisis could begin to unwind or even reverse over the coming years. Best regards, Peter Berezin, Chief Global Strategist Highlights The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. Feature In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart 1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart 1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart 2Global Shifts In The Saving And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart 2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart 3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart 3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart 3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart 4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart 2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart 5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart 6). The same is true, although to a lesser extent, in the emerging world. Chart 4Working-Age Population Ratios Have Peaked Chart 5Labor Share Of Income Has Dropped Chart 6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart 7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart 8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart 7Economic Integration And Falling Capital Goods Prices Chart 8Macro Impact Of Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart 9Working-Age Population To Shrink in G7 and China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart 9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart 10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart 10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart 11 presents the data for China and three of the major advanced economies. The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart 11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart 11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. Chart 11Income And Consumption By Age Cohort The results are shown in Chart 12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart 12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Chart 13Demographics And Capex Requirements Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart 13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart 14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart 15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart 14China's Savings Rates Have Peaked... Chart 15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: Table 1Key Secular Drivers The main points we made in this report are summarized in Table 1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook. Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart 16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Another way of looking at this is presented in Chart 17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart 16Market Expects Negative Short-Term Rates For A Long Time Chart 17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 It is true that observed household saving rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3, IMF World Economic Outlook (April 2017). 5 In other words, while the household saving rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e., savings across the household, government, and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014).

Special Report

Highlights Despite Saudi-Iranian tensions, the OPEC 2.0 production-cut deal will survive; Petro-state balance sheets remain under pressure; OPEC 2.0 agreement will backwardate the forward curve, and slow the pace of shale recovery; Aramco IPO will motivate Saudi Arabia to over-deliver on the cuts; In expectation of backwardation, investors should go long Dec/17 Brent vs. short Dec/18 Brent, while also going long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts. Feature Despite cooperating to reduce oil production and drain global oil inventories, the Kingdom of Saudi Arabia (KSA) and Iran still compete at every level for dominance of the Gulf region's economic and geopolitical order. We have maintained that KSA's aggressive push to privatize (or de-nationalize) its state oil company - ARAMCO - is an extension of this battle. Now that a state-led Chinese consortium has emerged as a potential cornerstone investor in the $100 billion Saudi Armco initial public offering (IPO) expected next year, we believe a key element of KSA's strategy in the Persian Gulf's "security dilemma" is falling into place.1 The Interests At Stake By aggressively courting Chinese investors for its potential record-breaking Aramco IPO next year, KSA doesn't just secure funding to pursue its goal of becoming the largest publicly traded vertically integrated oil company in the world. It tangibly expands the number of powerful interests in the world with a deep economic stake in its execution of Vision 2030, the grand plan to diversify away from its near-total dependence on oil revenues. China, too, benefits from this arrangement: By expanding its financial and economic commitments to KSA, it pursues its global investment and technology strategy, and gradually its standing as a "Great Power" with a vested interest in protecting those investments. These states jointly benefit from Aramco's expansion of its refining business into the Asian refined-product markets, which will remain the most heavily contested space in the oil market. It also does not hurt China, where crude oil production has been falling since June 2015 (Chart 1), to be financially invested in a petro-super-state like KSA, which has been supplying on average 14% of its imports over the same period (Chart 2). China's product demand will breach 12mm b/d this year, with gasoline demand growing some 300k b/d, according to the IEA. Overall product demand will grow close to 345k b/d, keeping China the premier growth market in the world for refined products. Investing in the refining system meeting this consumption - and Asia's other growing markets - therefore is attractive to Chinese companies on numerous fronts. Chart 1Chinese Oil Production Falling ... Chart 2... And Imports From KSA Steady Iran has yet to execute on its apparent strategy to attract FDI to its oil and gas sector, where the resource potential is of the same order of magnitude as KSA's. When combined with the development potential of Iraq, a neighboring petro-state, the potential of OPEC's "Shia Bloc" is enormous. Iran has the largest natural gas reserves in the world, and Iraq's oil endowment is second only to KSA's in terms of the vast low-cost, high-quality resource available for development. Yet Iran's success in lining up the investment and technical expertise required to develop its resource endowment as it approaches critical post-sanctions elections next month has been halting at best.2 Aside, that is, from deepening its relationship with Russia, which also is seeking desperately needed FDI in the wake of the oil-price collapse brought about by OPEC's market-share was during 2015 - 16. The KSA-Iran Security Dilemma In Context Before we get into the intricacies of energy geopolitics, a brief recap is in order.3 Chart 3Saudi Spending Binge Raised Oil Breakevens Prior to the lifting of nuclear-related sanctions against Iran beginning in 2015, KSA and OPEC benefited from an undersupplied oil market that kept oil prices above $100/bbl which allowed these states to increase domestic and military spending massively while experiencing few problems in oil exports or development. This can be seen in the evolution of KSA's fiscal breakeven oil prices, which increased dramatically in the lead-up to the 2014 price collapse (Chart 3), as production grew more slowly than spending. As the Saudi Manifa field came online in early 2014, global production expanded from various quarters, and it became apparent that sanctions against Iran would be lifted, KSA led OPEC into a market-share war. Oil prices fell from $100/bbl before OPEC's November 2014 meeting to below $30/bbl by the beginning of 2016. This strategy turned out to be a complete failure.4 We correctly predicted the failed market-share strategy would force an alliance between OPEC and non-OPEC petro-states - led by KSA and Russia, respectively - to cut production in the face of considerable market skepticism in the lead-up to OPEC's November 2016 Vienna meeting and in consultations with the Russian-led non-OPEC petro-states shortly thereafter.5 We remain convinced that this coalition, which we've dubbed OPEC 2.0, will extend its production cuts to the end of this year.6 As a result, OECD commercial inventories will decline by 10% or so, despite rising in Q1.7 Petro-State Balance Sheets Still Under Pressure The oil-price evolution described above buffeted petro-state budgets, particularly KSA's and Russia's. The pressures generated by this evolution hold the key to understanding where oil prices will go next. Finances: While both Saudi Arabia and Russia have managed to weather the decline in oil prices, the pain has been palpable. BCA's Frontier Market Strategy has detailed Saudi fiscal woes in detail.8 Based on their estimates, Saudi authorities will have enough reserves to defend the country's all-important currency peg for the next 18-24 months (Table 1). Without the peg, prices of imports would skyrocket. Table 1Saudi Arabia: Projected Debt Levels And Foreign Reserves Given that Saudi Arabia imports almost all of its consumer staples, such a price shock could lead to social unrest. Beyond the next two years, the government will have to rely on debt issuance to fund its deficits and focus its remaining foreign exchange resources on maintaining the peg. The problem is that this strategy will leave the country with just $350 billion in reserves by the end of 2018, lower than local currency broad money (Chart 4). At that point, confidence among locals and foreigners in the currency peg could shatter, leading to even greater capital flight than is already underway (Chart 5). Chart 4KSA: Forex Reserves Depleting\ Chart 5KSA: Capital Outflows Persist While Russia has weathered the storm much better, largely by allowing the ruble to depreciate, its foreign exchange reserves are down to 330 billion, the lowest figure since 2007 (Chart 6). OPEC 2.0's shale-focused strategy: The market strategy behind the OPEC 2.0 agreement is complex. The roughly 1.8 mm b/d of coordinated production cuts is supposed to draw down global storage by ~ 300 mm bbls by the end of 2017. This should lead to forward curves backwardating - a process that is clearly under way (Chart 7). According to BCA's Commodity & Energy Strategy, a backwardated forward curve is critical in slowing down the pace of tight oil production in the U.S. given the reliance of shale producers on hedging future production prices to lock in minimum revenue.9 Geopolitics: Countries with an unlimited resource like oil tend to be authoritarian regimes (Chart 8). This phenomenon is referred to as the "resource curse," and is well documented in political science. Chart 6Russia: Forex ##br##Reserves Depleting Chart 7Backwardation ##br##Under Way Chart 8Unlimited Resources ##br##Undermine Democracy What does it have to do with geopolitics? Basically, it suggests that the main national security risk to energy-producing regimes is not each other but their own populations. In countries where the political leadership generates its wealth from the sale of natural resources, the citizenry becomes a de facto "cost center" requiring social benefits and security expenditures to ensure the unemployed remain peaceful. By contrast, manufacturing nations benefit from an industrious citizenry that is a "profit center" for government coffers. In this paradigm, the main national security risk for energy-producing regimes is not external, but rather derives from their own under-utilized or restless populations. Thus, when the "unlimited resource" is re-priced for lower demand or greater global supply, the real risk becomes domestic unrest. At that moment, expensive geopolitical imperatives take a back seat to domestic stability. This explains the current détente between, on one side, Russia and the OPEC "Shia Bloc" (Iran and Iraq), and on the other, Saudi Arabia and its OPEC allies. Even with this détente, Saudi Arabia, its allies, and the "Shia Bloc" are finding it difficult to maintain fiscal spending that funds their still-massive social programs with prices trading in the low- to mid-$50/bbl range (Chart 9). Saudi's fiscal breakeven oil price is estimated to be $77.70/bbl this year by the IMF. Iran and Iraq require $60.70/bbl and $54/bbl, respectively, putting them in slightly better shape than their Gulf rival, but still in need of higher prices to sustain the spending required to quell social unrest.10 Given Russia's relatively superior domestic economic situation and political stability (Chart 10), we suspect that Moscow cares a little less about oil market rebalancing than Saudi Arabia. President Vladimir Putin will face reelection in less than a year, but he is unlikely to face a serious challenger. Chart 9Oil Prices Too Low For National Budgets Chart 10Support For Putin Holding Up Even so, Russia still feels the pain of lower energy prices. Oil and gas revenues constituted 36% of state revenues last year, down from 50% in 2014, when prices were trading above $100/bbl. This pushed Russia's budget deficit out to more than 3% of GDP in 2016. According to The Oxford Institute for Energy Studies, "even with planned spending cuts (the deficit) will still be more than 1% of GDP by 2019 ... Russia's Reserve Fund could be exhausted by the end of 2017, on the government's original forecast of an oil price of $40/barrel in 2017."11 Oil-Market Rebalancing Critical For KSA's Aramco IPO For Saudi Arabia, however, rebalancing is critical, which explains why it has over-delivered on the promised production cuts, while Russia and the "Shia Bloc" have dragged their feet (Chart 11 and Chart 12). Not only is the currency peg non-negotiable, but Riyadh's clear interest is oil-price stability in the lead-up to its Aramco IPO. It is not enough to attract a mega investor from China; the entire oil-investment community has to be convinced they are not pouring money into an enterprise that could lose value close on the heels of the IPO. Chart 11Saudis Cut Production More Than Russians ... Chart 12... Or The 'Shia Bloc' To attract foreign capital at reasonable prices for Aramco's massive privatization, KSA must prove it can exert some control over the oil price "floor." As such, the Kingdom's motivation to stick to the OPEC 2.0 agreement is serious. In a joint report done by BCA's Geopolitical Strategy and Commodity & Energy Strategy last January, we argued that three factors are critical to this IPO:12 Moving downstream: Saudi Arabia intends to become a major global refiner with up to 10 million b/d of refining capacity (an addition of about 5 mm b/d of capacity). If realized, this volume of refining capacity would rival that of ExxonMobil's 6 mm+ b/d, the largest in the world. Because OPEC does not set quotas for refined-product exports, Saudi Arabia's shift downstream would allow it to capture higher revenues from international sales of gasoline, diesel, jet fuel, and other refined products. This could eventually mean that Saudi Arabia would fly above ongoing crude oil market-share wars. Instead, it could rely on its access to short-haul domestic supplies and state-of-the-art technology - Aramco's principal endowments - to command massive crack spreads, or the difference between the price of input, crude oil, and output, refined product. FDI wars: With estimates of its value hovering ~ $100 billion, the Aramco IPO expected next year will be the largest ever executed. It is likely to divert FDI that Iraq and Iran desperately need to revitalize their production, transportation, and refining infrastructure. This is a crucial long-term goal for Saudi Arabia. At the moment, its oil production dwarfs that of its "Shia Bloc" OPEC rivals. However, Iran and Iraq are projected to close the gap and potentially export even more oil than the Kingdom in future (Chart 13). Bringing China into the region: The U.S. deleveraging from the Middle East continues. President Donald Trump may have ordered cruise missile strikes against Syria, but he is not interested in getting bogged down in another land war in the region. Chart 14 speaks for itself. As such, Saudi Arabia is largely on its own when facing off against Iran, its regional rival. Appeals to Chinese state energy companies are therefore designed to give Beijing a stake in Saudi energy infrastructure. This would force China to start caring more about what happens to Saudi Arabia, as with Iraq, where it is heavily invested, and Iran, where it has long flirted with investing more. Chart 13Shia Bloc Gaining On KSA Chart 14U.S. Has Deleveraged From Middle East When we first penned our report, we were speculating on the China link. Since then, Beijing has created a consortium consisting of state-owned energy giants Sinopec and PetroChina and banks, led by the country's sovereign wealth fund, to compete in the expected $100 billion equity sale.13 Given the financial, economic, and geopolitical importance of the Aramco IPO, we continue to expect that Saudi Arabia will push to extend the OPEC 2.0 production cut when the group meets in Vienna on May 25. Judging by the commitments to the cuts thus far, the deal appears to be an agreement for Saudi Arabia and its Gulf allies to continue to cut and for Russia and the "Shia Bloc" (Iran and Iraq) not to increase production.14 (Both of the latter states still have a lot of "skin in the game," so to speak.) As such, an extension of the deal is in the interests of KSA, Russia, and their respective allies. And, importantly, it will continue to provide a floor to oil prices. Meanwhile, downside and upside risks to supply continue. In terms of supply increase, the usual suspects -Libya and Nigeria - are working to increase production. In terms of supply decrease, we continue to worry about the dissolution of Venezuela as a functioning state and the potential that supply disruptions may occur. Bottom Line: Geopolitical drivers still support the continuation of OPEC 2.0's efforts to restrain production and draw down global oil stockpiles. As such, our positioning recommendations for an expected backwardation - i.e., long Dec/17 Brent vs. short Dec/18 Brent - and our fade of the option-market skew favoring put - the long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts - remain intact. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 A "security dilemma" refers to a situation in which a state's pursuit of "security" through military strength and alliances leads its neighbors to respond in kind, triggering a spiral of distrust and tensions. Please see BCA Commodity & Energy Strategy and Geopolitical Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com and gps.bcaresearch.com. NB: The $100-billion figure often attached to the estimated size of the IPO, which will seek to float 5% of Aramco, is a placeholder for the moment. There is considerable disagreement over the level at which the market will value Aramco, which some estimates significantly below the value assumed by the $100-billion estimate. We will be examining this in future research. 2 The New York Times provided an excellent summary of post-sanctions development recently in "Even Bold Foreign Investors Tiptoe in Iran," March 31, 2017. 3 For a summary of BCA Commodity & Energy Strategy recommendation performance, please contact your relationship manager. 4 Please see "The Game's Afoot, But Which One," for the consequences of OPEC's market-share war. It was published April 6, 2017, in BCA Research's Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC-Russia Oil Deal On Track To Deliver," dated February 9, 2017, available at ces.bcaresearch.com. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com. 8 Please see BCA Frontier Market Strategy Special Report, "Saudi Arabia: Short-Term Gain, Long-Term Pain," dated February 1, 2017, available at fms.bcaresearch.com. 9 Contango markets - where prices for prompt delivery are less than prices for deferred delivery - favor shale producers when the front of the WTI forward curve is ~ $50/bbl, and - all else equal - incentivizes them to hedge forward so as to lock in future revenues and maximize the number of rigs they deploy. In backwardated markets, however, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. Please see BCA Commodity & Energy Strategy Weekly Report, "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," dated February 16, 2017, available at ces.bcaresearch.com. 10 Please see the IMF, Regional Economic Outlook: Middle East and Central Asia, October 2016, Table 5. 11 Please see "Russia Oil Production Outlook to 2020," Oxford Institute for Energy Studies, February 2017. 12 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. 13 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," Reuters, dated April 19, 2017, available at reuters.com. 14 In "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, we noted, "Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015-16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue." This report is available at ces.bcaresearch.com.

Highlights Despite cooperating to reduce oil production and drain global oil inventories, the Kingdom of Saudi Arabia (KSA) and Iran still compete at every level for dominance of the Gulf region's economic and geopolitical order. We have maintained that KSA's aggressive push to privatize (or de-nationalize) its state oil company - ARAMCO - is an extension of this battle. Now that a state-led Chinese consortium has emerged as a potential cornerstone investor in the $100 billion Saudi Armco initial public offering (IPO) expected next year, we believe a key element of KSA's strategy in the Persian Gulf's "security dilemma" is falling into place.1 Energy: Overweight. We are long the Dec/17 Brent $65/bbl calls vs. short the Dec/17 Brent $45/bbl puts at a net premium of -$0.47/bbl. This new recommendation was down 46.8%, which we initiated last week following our assessment of OPEC 2.0's strategy to reduce global oil inventories. We remain long the Dec/17 Brent vs. short Dec/18 Brent, which is up 94.7%. Our long GSCI position is down 4.5%; we have a 10% stop on this position. Base Metals: Neutral. Copper registered a 51k metric ton physical surplus in January, according to estimates from the International Copper Study Group. Precious Metals: Neutral. Gold retreated going into French elections over the weekend, indicating investors were not as fearful as some pundits. Our long volatility position is down 43.8%. Ags/Softs: Underweight: Reuters reported the Brazilian government will provide up to 500 million reals (~$159mm) to market this year's corn crop. An expected record harvest and weak export volumes prompted the action.2 Feature By aggressively courting Chinese investors for its potential record-breaking Aramco IPO next year, KSA doesn't just secure funding to pursue its goal of becoming the largest publicly traded vertically integrated oil company in the world. It tangibly expands the number of powerful interests in the world with a deep economic stake in its execution of Vision 2030, the grand plan to diversify away from its near-total dependence on oil revenues. China, too, benefits from this arrangement: By expanding its financial and economic commitments to KSA, it pursues its global investment and technology strategy, and gradually its standing as a "Great Power" with a vested interest in protecting those investments. These states jointly benefit from Aramco's expansion of its refining business into the Asian refined-product markets, which will remain the most heavily contested space in the oil market. It also does not hurt China, where crude oil production has been falling since June 2015 (Chart 1), to be financially invested in a petro-super-state like KSA, which has been supplying on average 14% of its imports over the same period (Chart 2). China's product demand will breach 12mm b/d this year, with gasoline demand growing some 300k b/d, according to the IEA. Overall product demand will grow close to 345k b/d, keeping China the premier growth market in the world for refined products. Investing in the refining system meeting this consumption - and Asia's other growing markets - therefore is attractive to Chinese companies on numerous fronts. Chart 1Chinese Oil Production Falling ... Chart 2... And Imports From KSA Steady Iran has yet to execute on its apparent strategy to attract FDI to its oil and gas sector, where the resource potential is of the same order of magnitude as KSA's. When combined with the development potential of Iraq, a neighboring petro-state, the potential of OPEC's "Shia Bloc" is enormous. Iran has the largest natural gas reserves in the world, and Iraq's oil endowment is second only to KSA's in terms of the vast low-cost, high-quality resource available for development. Yet Iran's success in lining up the investment and technical expertise required to develop its resource endowment as it approaches critical post-sanctions elections next month has been halting at best.3 Aside, that is, from deepening its relationship with Russia, which also is seeking desperately needed FDI in the wake of the oil-price collapse brought about by OPEC's market-share was during 2015 - 16. The KSA-Iran Security Dilemma In Context Chart 3Saudi Profligacy Has Continued In 2017 Before we get into the intricacies of energy geopolitics, a brief recap is in order.4 Prior to the lifting of nuclear-related sanctions against Iran beginning in 2015, KSA and OPEC benefited from an undersupplied oil market that kept oil prices above $100/bbl which allowed these states to increase domestic and military spending massively while experiencing few problems in oil exports or development. This can be seen in the evolution of KSA's fiscal breakeven oil prices, which increased dramatically in the lead-up to the 2014 price collapse (Chart 3), as production grew more slowly than spending. As the Saudi Manifa field came online in early 2014, global production expanded from various quarters, and it became apparent that sanctions against Iran would be lifted, KSA led OPEC into a market-share war. Oil prices fell from $100/bbl before OPEC's November 2014 meeting to below $30/bbl by the beginning of 2016. This strategy turned out to be a complete failure.5 We correctly predicted the failed market-share strategy would force an alliance between OPEC and non-OPEC petro-states - led by KSA and Russia, respectively - to cut production in the face of considerable market skepticism in the lead-up to OPEC's November 2016 Vienna meeting and in consultations with the Russian-led non-OPEC petro-states shortly thereafter.6 We remain convinced that this coalition, which we've dubbed OPEC 2.0, will extend its production cuts to the end of this year.7 As a result, OECD commercial inventories will decline by 10% or so, despite rising in Q1.8 Petro-State Balance Sheets Still Under Pressure The oil-price evolution described above buffeted petro-state budgets, particularly KSA's and Russia's. The pressures generated by this evolution hold the key to understanding where oil prices will go next. Finances: While both Saudi Arabia and Russia have managed to weather the decline in oil prices, the pain has been palpable. BCA's Frontier Market Strategy has detailed Saudi fiscal woes in detail.9 Based on their estimates, Saudi authorities will have enough reserves to defend the country's all-important currency peg for the next 18-24 months (Table 1). Without the peg, prices of imports would skyrocket. Table 1Saudi Arabia: Projected Debt Levels And Foreign Reserves Given that Saudi Arabia imports almost all of its consumer staples, such a price shock could lead to social unrest. Beyond the next two years, the government will have to rely on debt issuance to fund its deficits and focus its remaining foreign exchange resources on maintaining the peg. The problem is that this strategy will leave the country with just $350 billion in reserves by the end of 2018, lower than local currency broad money (Chart 4). At that point, confidence among locals and foreigners in the currency peg could shatter, leading to even greater capital flight than is already underway (Chart 5). Chart 4KSA: Forex Reserves Depleting Chart 5KSA: Capital Outflows Persist While Russia has weathered the storm much better, largely by allowing the ruble to depreciate, its foreign exchange reserves are down to 330 billion, the lowest figure since 2007 (Chart 6). OPEC 2.0's shale-focused strategy: The market strategy behind the OPEC 2.0 agreement is complex. The roughly 1.8 mm b/d of coordinated production cuts is supposed to draw down global storage by ~ 300 mm bbls by the end of 2017. This should lead to forward curves backwardating - a process that is clearly under way (Chart 7). According to BCA's Commodity & Energy Strategy, a backwardated forward curve is critical in slowing down the pace of tight oil production in the U.S. given the reliance of shale producers on hedging future production prices to lock in minimum revenue.10 Geopolitics: Countries with an unlimited resource like oil tend to be authoritarian regimes (Chart 8). This phenomenon is referred to as the "resource curse," and is well documented in political science. Chart 6Russia: Forex Reserves Depleting Chart 7Backwardation Under Way What does it have to do with geopolitics? Basically, it suggests that the main national security risk to energy-producing regimes is not each other but their own populations. In countries where the political leadership generates its wealth from the sale of natural resources, the citizenry becomes a de facto "cost center" requiring social benefits and security expenditures to ensure the unemployed remain peaceful. By contrast, manufacturing nations benefit from an industrious citizenry that is a "profit center" for government coffers. In this paradigm, energy-producing states face a primary security risk that is not external, but rather derives from their own under-utilized or restless populations. Thus, when the "unlimited resource" is re-priced for lower demand or greater global supply, the real risk becomes domestic unrest. At that moment, expensive geopolitical imperatives take a back seat to domestic stability. This explains the current détente between, on one side, Russia and the OPEC "Shia Bloc" (Iran and Iraq), and on the other, Saudi Arabia and its OPEC allies. Even with this détente, Saudi Arabia, its allies, and the "Shia Bloc" are finding it difficult to maintain fiscal spending that funds their still-massive social programs with prices trading in the low- to mid-$50/bbl range (Chart 9). Saudi's fiscal breakeven oil price is estimated to be $77.70/bbl this year by the IMF. Iran and Iraq require $60.70/bbl and $54/bbl, respectively, putting them in slightly better shape than their Gulf rival, but still in need of higher prices to sustain the spending required to quell social unrest.11 Chart 8Unlimited Resources Undermine Democracy Chart 9Oil Prices Too Low For National Budgets Chart 10Support For Putin Holding Up Given Russia's relatively superior domestic economic situation and political stability (Chart 10), we suspect that Moscow cares a little less about oil market rebalancing than Saudi Arabia. President Vladimir Putin will face reelection in less than a year, but he is unlikely to face a serious challenger. Even so, Russia still feels the pain of lower energy prices. Oil and gas revenues constituted 36% of state revenues last year, down from 50% in 2014, when prices were trading above $100/bbl. This pushed Russia's budget deficit out to more than 3% of GDP in 2016. According to The Oxford Institute for Energy Studies, "even with planned spending cuts (the deficit) will still be more than 1% of GDP by 2019 ... Russia's Reserve Fund could be exhausted by the end of 2017, on the government's original forecast of an oil price of $40/barrel in 2017."12 Oil-Market Rebalancing Critical For KSA's Aramco IPO For Saudi Arabia, however, rebalancing is critical, which explains why it has over-delivered on the promised production cuts, while Russia and the "Shia Bloc" have dragged their feet (Chart 11 and Chart 12). Not only is the currency peg non-negotiable, but Riyadh's clear interest is oil-price stability in the lead-up to its Aramco IPO. It is not enough to attract a mega investor from China; the entire oil-investment community has to be convinced they are not pouring money into an enterprise that could lose value close on the heels of the IPO. Chart 11Saudis Cut Production More Than Russians ... Chart 12... Or The "Shia Bloc" To attract foreign capital at reasonable prices for Aramco's massive privatization, KSA must prove it can exert some control over the oil price "floor." As such, the Kingdom's motivation to stick to the OPEC 2.0 agreement is serious. In a joint report done by BCA's Geopolitical Strategy and Commodity & Energy Strategy last January, we argued that three factors are critical to this IPO:13 Moving downstream: Saudi Arabia intends to become a major global refiner with up to 10 million b/d of refining capacity (an addition of about 5 mm b/d of capacity). If realized, this volume of refining capacity would rival that of ExxonMobil's 6 mm+ b/d, the largest in the world. Because OPEC does not set quotas for refined-product exports, Saudi Arabia's shift downstream would allow it to capture higher revenues from international sales of gasoline, diesel, jet fuel, and other refined products. This could eventually mean that Saudi Arabia would fly above ongoing crude oil market-share wars. Instead, it could rely on its access to short-haul domestic supplies and state-of-the-art technology - Aramco's principal endowments - to command massive crack spreads, or the difference between the price of input, crude oil, and output, refined product. FDI wars: With estimates of its value hovering ~ $100 billion, the Aramco IPO expected next year will be the largest ever executed. It is likely to divert FDI that Iraq and Iran desperately need to revitalize their production, transportation, and refining infrastructure. This is a crucial long-term goal for Saudi Arabia. At the moment, its oil production dwarfs that of its "Shia Bloc" OPEC rivals. However, Iran and Iraq are projected to close the gap and potentially export even more oil than the Kingdom in future (Chart 13). Bringing China into the region: The U.S. deleveraging from the Middle East continues. President Donald Trump may have ordered cruise missile strikes against Syria, but he is not interested in getting bogged down in another land war in the region. Chart 14 speaks for itself. As such, Saudi Arabia is largely on its own when facing off against Iran, its regional rival. Appeals to Chinese state energy companies are therefore designed to give Beijing a stake in Saudi energy infrastructure. This would force China to start caring more about what happens to Saudi Arabia, as with Iraq, where it is heavily invested, and Iran, where it has long flirted with investing more. Chart 13"Shia Bloc" Gaining On KSA Chart 14U.S. Has Deleveraged From Middle East When we first penned our report, we were speculating on the China link. Since then, Beijing has created a consortium consisting of state-owned energy giants Sinopec and PetroChina and banks, led by the country's sovereign wealth fund, to compete in the expected $100 billion equity sale.14 Given the financial, economic, and geopolitical importance of the Aramco IPO, we continue to expect that Saudi Arabia will push to extend the OPEC 2.0 production cut when the group meets in Vienna on May 25. Judging by the commitments to the cuts thus far, the deal appears to be an agreement for Saudi Arabia and its Gulf allies to continue to cut and for Russia and the "Shia Bloc" (Iran and Iraq) not to increase production.15 (Both of the latter states still have a lot of "skin in the game," so to speak.) As such, an extension of the deal is in the interests of KSA, Russia, and their respective allies. And, importantly, it will continue to provide a floor to oil prices. Meanwhile, downside and upside risks to supply continue. In terms of supply increase, the usual suspects -Libya and Nigeria - are working to increase production. In terms of supply decrease, we continue to worry about the dissolution of Venezuela as a functioning state and the potential that supply disruptions may occur. Bottom Line: Geopolitical drivers still support the continuation of OPEC 2.0's efforts to restrain production and draw down global oil stockpiles. As such, our positioning recommendations for an expected backwardation - i.e., long Dec/17 Brent vs. short Dec/18 Brent - and our fade of the option-market skew favoring put - the long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts - remain intact. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 A "security dilemma" refers to a situation in which a state's pursuit of "security" through military strength and alliances leads its neighbors to respond in kind, triggering a spiral of distrust and tensions. Please see BCA Commodity & Energy Strategy and Geopolitical Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com and gps.bcaresearch.com. NB: The $100-billion figure often attached to the estimated size of the IPO, which will seek to float 5% of Aramco, is a placeholder for the moment. There is considerable disagreement over the level at which the market will value Aramco, which some estimates significantly below the value assumed by the $100-billion estimate. We will be examining this in future research. 2 Please see "Brazil readies $159 million in corn subsidies amid record crop," Reuters, April 19, 2017, available at Reuters.com. 3 The New York Times provided an excellent summary of post-sanctions development recently in "Even Bold Foreign Investors Tiptoe in Iran," March 31, 2017. 4 For a summary of BCA Commodity & Energy Strategy recommendation performance, please contact your relationship manager. 5 Please see "The Game's Afoot, But Which One," for the consequences of OPEC's market-share war. It was published April 6, 2017, in BCA Research's Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC-Russia Oil Deal On Track To Deliver," dated February 9, 2017, available at ces.bcaresearch.com. 8 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com. 9 Please see BCA Frontier Market Strategy Special Report, "Saudi Arabia: Short-Term Gain, Long-Term Pain," dated February 1, 2017, available at fms.bcaresearch.com. 10 Contango markets - where prices for prompt delivery are less than prices for deferred delivery - favor shale producers when the front of the WTI forward curve is ~ $50/bbl, and - all else equal - incentivizes them to hedge forward so as to lock in future revenues and maximize the number of rigs they deploy. In backwardated markets, however, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. Please see BCA Commodity & Energy Strategy Weekly Report, "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," dated February 16, 2017, available at ces.bcaresearch.com. 11 Please see the IMF, Regional Economic Outlook: Middle East and Central Asia, October 2016, Table 5. 12 Please see "Russia Oil Production Outlook to 2020," Oxford Institute for Energy Studies, February 2017. 13 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. 14 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," Reuters, dated April 19, 2017, availableat reuters.com. 15 In "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, we noted, "Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015-16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue." This report is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Bank Credit Analyst

The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The ##br##Saving And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Chart II-6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com.

Bank Credit Analyst

Highlights Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. There are also some worrying signs in our global forward-looking growth indicators for 2018, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. first-quarter economic data. They also went too far in pricing out U.S. fiscal action. It is positive for risk assets that centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. Italian elections could be troublesome, but that is a story for next year. The fact that China finally appears willing to apply pressure to Pyongyang is good news. North Korea might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. Disappointing U.S. Q1 real GDP growth largely reflects weather and seasonal adjustment factors. The deceleration in bank credit growth is also temporary. The window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals remain constructive. Importantly, signs of improving pricing power in the U.S. corporate sector are finally emerging, which should allow margins to expand somewhat in the coming quarters. The bond rally has depressed yields to a level that makes fixed-income instruments highly vulnerable to a reversal of the factors that sparked the rally. Market expectations for the fed funds rate are far too benign. The ECB will announce the next tapering step later this year, and may remove the negative deposit rate. But the central bank will not be in a position to lift the refi rate for some time. Yield spreads will shift in a way that allows one last upleg in the U.S. dollar. The recent pullback in oil prices will not last, as OPEC and Russia manage global stockpiles lower this year. Feature Chart I-1Reflation Trades Returning? Traders and investors gave up on the global reflation story in early April, sending the 10-year U.S. Treasury yield below the year's trading range. Missile strikes, European elections and U.S. saber rattling regarding North Korea lifted the allure of safe havens such as government bonds (Chart I-1). At the same time, the Fed was unwilling to revise up the 'dot plot', doubts grew over the ability of the Trump Administration to deliver any stimulus and U.S. data releases disappointed. The major equity indexes held up well against the onslaught of bad news, but looked increasingly vulnerable as April wore on. The market gloom was overdone in our view, and it appears that financial markets have now returned to a 'risk on' phase. It is difficult to forecast the ebb and flow of geopolitical news so we cannot rule out another bout of risk aversion. Nonetheless, the global economic backdrop remains upbeat and tensions regarding North Korea have eased. President Trump also unveiled his Administration's tax reform plan, raising hopes of a fiscal boost to the economy. Moreover, investors have read too much into the distorted U.S. first quarter data, and our corporate pricing power indicators support our constructive earnings view in 2017. There are clouds hanging over the outlook for 2018, but the backdrop will favor risk assets for most of this year. Investors should remain overweight equities versus bonds and cash, and bullish the dollar. Geopolitics Weigh On Risk Tolerance President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. The fact that China finally appears willing to apply pressure to Pyongyang is good news. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. The safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances. Chart I-2Macron Appears Set For Victory Turning to Europe, investors breathed a sigh of relief following the first round of the French Presidential election. The pre-election polls turned out to be correct, and our Geopolitical Team has no reason to doubt the polls regarding the second round (Chart I-2). We expect Macron to sweep to victory on May 7 because Le Pen will struggle to get any voters from the candidates exiting the race. What should investors expect of a Macron presidency? A combination of President Macron and a right-leaning National Assembly should be able to accomplish some reforms. Several prominent center-right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister. This is positive for the markets as it means that French economic policy will be run by the center-right, with an ultra-Europhile as president. Over in the U.K., the big news in April was Prime Minister Theresa May's decision to hold a snap election, which reduces the risk of a "hard Brexit". The current slim 12-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories who would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservatives are able to increase their seats in Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. U.S. Fiscal Policy: Positive For 2017, But Long-Term Negative Chart I-3Long-Term U.S. Budget Pressures The drama will be no less interesting in Washington in the coming weeks. As we go to press, Congress is struggling to pass a bill to keep the U.S. government running through the end of fiscal year 2017 (the deadline is the end of April). We expect a deal will get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. Both events could see temporary safe-haven flows into Treasurys. However, markets may have gone too far in pricing-out tax cuts or fiscal stimulus. For example, high tax-rate companies have given back all of their post-election equity gains. Even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. "Dynamic scoring" will be used to support the argument that the tax cuts will self-funding through faster growth. We also expect that Trump will get his way on at least a modest amount of infrastructure spending. The so-called Trump trades may wither again in 2018, but we see a window this year in which the stock-to-bond total return ratio lifts as growth expectations rebound. Looking further ahead, it seems likely that the U.S. budget deficit is headed significantly higher. Health care and pension cost pressures related to population aging are well known (Chart I-3). A recent Special Report by BCA's Martin Barnes highlighted that "it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlement programs and preventing a massive rise in the budget deficit."1 There is simply not enough non-defense discretionary spending to cut. Larger U.S. Federal budget deficits could lead to a widening fiscal risk premium in Treasury yields, although that may take years to show up. Perhaps more importantly, the U.S. government sector will be a larger drain on the global pool of available savings in the coming years. We highlight in this month's Special Report, beginning on page 20, that there are several key macro inflection points under way that will temper the "global savings glut" and begin to place upward pressure on global bond yields. A Temporary Soft Patch Or Something Worse? The first quarter GDP report for the U.S. is due out as we go to press, and growth is widely expected to be quite weak. The retail sales and PCE consumer spending data have fed concerns that the U.S. economy is running out of gas, despite the surge in the survey data such as the ISM. We believe that growth fears are overdone. Financial markets should be accustomed to weak readings on first quarter GDP. Over the past 22 years, the first quarter has been the weakest of the four on 12 occasions, or 55% of the time. Second quarter GDP growth has been faster than Q1 growth 70% of the time. A large part of the depressed Q1 GDP growth rate and lackluster "hard data" readings likely reflect poor seasonal adjustment and weather distortions. The "soft" survey data are more consistent with the labor market. Aggregate hours worked managed to increase by 1.5% at an annualized rate in Q1. If GDP growth really was barely above zero, this would imply an outright decline in the level of labor productivity. Even in a world where structural productivity growth is lower than it was in the past, this strikes us as rather implausible. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have pulled back from their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in the weather-impacted "hard" data in May and June. What about the slowdown in commercial and industrial loan growth and corporate bond issuance late in 2016 and into early 2017? This is a worry, but it partly reflects the lagged effects of the contraction in capital spending in the energy patch. C&I loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that the defaults have waned, this process will soon go into reverse. Higher profits more recently have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 bn in issuance in Q1, the highest level on record (Chart I-4). The rest we chalk up to uncertainty surrounding the U.S. election. The recent spikes in the political uncertainty index correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November. There has been a close correlation between these spikes and the deceleration in C&I loan growth. CEOs are also holding back on capex in anticipation of new tax breaks from Congress. The good news is that bond issuance has rebounded strongly in January and February of this year (Chart I-5). The soft March U.S. CPI release also appeared to be quirky, showing a rare decline in the core price level in March (Chart I-6). However, the March reading followed two months of extremely strong gains and it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart I-4U.S. Bank Credit Slowdown Is Temporary Chart I-5U.S. Corporate Bond Issuance Is Rebounding Chart I-6U.S. Inflation: Sogginess Won't Last Global Economic Data Still Upbeat For the major industrialized economies as a group, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4½% in February on a year-over-year basis (Chart I-7). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession that was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart I-8). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the six months to March (Chart I-9). Chart I-7Global Pick-Up On Track Chart I-8Manufacturing Rebound Is Not About Energy Chart I-9U.S.: Non-Energy Production Surging The weak spot on the global data front has been capital goods orders (Chart I-7). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart I-7, third panel). Improving CEO sentiment, accelerating profit growth and activity surveys all suggest that capital goods orders will catch up in the coming months. That said, one risk to our positive capex outlook in the U.S. is that the Republicans fail to deliver on their promises. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital spending. As for China, the economic data are holding up well and deflationary pressures have eased. Fears of a debt crisis have also ebbed somewhat. That said, fiscal and monetary stimulus is fading and it is a worrying sign that money and credit growth have decelerated because they tend to lead production. Our China experts believe that growth will be solid in the first half of the year, but they would not be surprised to see a deceleration in real GDP growth in the second half that would weigh on commodity prices. Bond Market Vulnerable To Fed Re-Rating A rebound in the U.S. activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A May rate hike is unlikely, but we would not rule out June. The bond market is vulnerable to a re-rating of the path for the fed funds rate because only 45 basis points of tightening is priced for the next 12 months. This is far too low if growth rebounds as we expect. The FOMC also announced that it intends to start shrinking its balance sheet later this year by ceasing to reinvest both its MBS and Treasury holdings. Our bond strategists do not think this by itself will have much of an impact on Treasurys because yields will continue to be closely tied to realized inflation and the expected number of rate hikes during the next 12 months (Chart I-10). Fed policymakers are trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. It is a different story for mortgage-backed securities, however, where spreads will be pressured wider by the lack of Fed purchases. All four of our main forward-looking global economic indicators appear to have topped out, except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past (Chart I-11). Nonetheless, all four are still consistent with robust growth. They would have to weaken significantly before they warned of a sustained bond bull market. Chart I-10Shrinking Fed Balance Sheet: ##br##Bearish For Bonds? Chart I-11Leading Indicators: ##br##Some Worrying Signs The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is the most concerning at the moment. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The bottom line is that global bond yields have overshot on the downside: underlying U.S. growth is not as weak as the Q1 figures suggest; market expectations for the fed funds rate are too benign; the Republicans will push ahead with tax cuts and infrastructure spending; the global economy has healthy momentum, and the majority of the items on our Duration Checklist suggest that the bond bear market will resume; the ECB will announce another tapering of its asset purchase program this autumn, placing upward pressure on the term premium in bond yields across the major markets; and the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. We recommend keeping duration short of benchmarks within fixed-income portfolios. One Last Leg In The Dollar Bull Market Chart I-12ECB In No Hurry To Lift Rates While we see upside for the money market curve in the U.S., the same cannot be said in the Eurozone. The economic data have undoubtedly been robust. The composite PMI is booming and capital goods orders are in a clear uptrend. Led by gains in both manufacturing and services, the composite PMI rose from 56.4 in March to 56.7 in April, a six-year high. The current PMI reading is easily consistent with over 2.0% real GDP growth (Chart I-12). This compares favorably to the sub-1% estimates of trend growth in the euro area. Private sector credit growth reached 2½% earlier this year, the fastest pace since July 2009. Despite this good news, the ECB is in no rush to lift interest rates. The central bank will taper its asset purchase program further in 2018, but ECB President Draghi has made it clear that he will not raise the refi rate until well after all asset purchases have been completed, which probably will not be until late 2019 at the earliest (although the ECB could eliminate the negative deposit rate to ease the pressure on banks). Unemployment is still a problem in Spain and Italy, while core CPI inflation fell back to just 0.7% in March. The euro could strengthen further in the near term if Macron wins the second round of the French elections, easing euro break-up fears. Nonetheless, we expect the euro to trend lower on a medium-term horizon versus the dollar as rate expectations move further in favor of the greenback. Some real rate divergence is already priced into money and currency markets, but there is room for forward real spreads to widen further, possibly pushing the euro to parity versus the dollar before this cycle is over. We are also bullish the dollar versus the yen for similar reasons. On a broad trade-weighted basis, we still expect the dollar to rally by another 10%. Positive Signs For U.S. Corporate Pricing Power Chart I-13U.S. Corporations Gaining Pricing Power Turning to the equity market, it is still early days for Q1 U.S. earnings, but the results so far are positive for a pro-risk asset allocation. After a disappointing Q4, positive Q1 earnings surprises for the S&P 500 are on track to match their highest level in two years, with revenue surprises also materially higher than previous quarters. At the industry level, banks and capital goods companies stand out: the former registered an earnings beat of nearly 8%, and it was nearly 12% for the latter. We highlighted the positive 2017 outlook for U.S. corporate profits in our March 2017 Monthly Report. Earnings growth is in a catch-up phase following last year's profit recession, which was related to energy prices and a temporary slowdown in nominal GDP growth relative to aggregate labor costs. Proprietary indicators from our sister publication, the U.S. Equity Sectors Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart I-13). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly-based across industries (as shown by the diffusion index in the chart). As a side note, the Profit Proxy provides some evidence that recent softness in core CPI inflation will not last. Second, the upward march of wage growth appears to be taking a breather (Chart I-13). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching perpetually-optimistic bottom-up estimates for 2017 (Chart I-14). Many companies have supported per share profits in this expansion via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart I-15 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same is true for GDP. Chart I-14U.S. Profit Model Is Very Upbeat Chart I-15U.S. Corporate Finance Cycle Comparison Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity issuance since 2009, which includes the impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions (positive values shown in Chart I-15 represent net equity withdrawals). CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Nonetheless, buybacks have boosted EPS growth by almost 2% over the past year according to our proxy (Chart I-16). We expect this tailwind to continue given the positive reading from our Capital Structure Preference Indicator (third panel). Firms have a financial incentive to issue debt and buy back shares when the indicator is above zero. Stronger global growth should continue to power an acceleration in corporate earnings outside the U.S. over the remainder of the year. Chart I-17 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Our profit indicators remain constructive for the U.S., Eurozone and Japan. Chart I-16Incentive To Buy Back ##br##Stock Remains Strong Chart I-17Global Profit ##br##Growth On The Upswing It is disconcerting that the rally in oil prices has faltered in recent days as investors worry that increased U.S. shale production will thwart OPEC's plans to trim bloated inventories. A breakdown in oil prices could spark a major correction in the broader equity market. Indeed, commercial oil inventories finished the first quarter with a minimal draw. The aim of last year's agreement between OPEC and Russia to remove some 1.8mn b/d of oil production from the market in 2017 H1 was to get visible inventories down to five-year average levels. They are well short of that goal. Without trimming stockpiles to more normal levels, storage capacity remains too close to topping out, which raises the risk of another price collapse. This is an extremely high-risk scenario for states like Saudi Arabia, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. This is the reason why our commodity strategists expect the OPEC/Russia production cuts to be extended when OPEC meets on May 25. This will significantly raise the odds that OECD commercial oil stocks will be drawn down to more normal levels. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. Investment Conclusions Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. Admittedly, some of the U.S. data have been disappointing given the extremely upbeat survey numbers. There are also some worrying signs in our global forward-looking growth indicators, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. economic data in the first quarter. They also went too far in pricing out U.S. fiscal action. As for European political risk, centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. There are legitimate reasons to be concerned about the economic and profit outlook in 2018. Nonetheless, we believe that the window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals are constructive. The passage of market-friendly fiscal policies in the U.S. later in 2017 will be icing on the cake. Perhaps more importantly, we are finally seeing signs that pricing power in the U.S. corporate sector is improving, allowing margins to expand somewhat in the coming quarters. Our profit models remain upbeat for the major advanced economies and for China. It has been frustrating for those investors looking for an equity buying opportunity. Despite the surge in defensive assets such as gold and Treasurys, the major equity bourses did not correct by much. Value remains stretched in all of the risk asset classes. Nonetheless, investors should stay positioned for another upleg in the stock-to-bond total return ratio in the coming months. Perhaps the largest risk lies in the bond market. The rally has depressed yields to a level that makes bonds highly vulnerable to a reversal of the factors that sparked the rally. Within an underweight allocation to fixed-income in balanced portfolios, investors should overweight investment- and speculative-grade corporate bonds in the U.S. and U.K. We are more cautious on Eurozone corporates as the ECB's support for that sector will moderate. Looking ahead to next year, our bond strategists foresee a shift to underweight credit given the advanced nature of the releveraging cycle in the U.S. corporate sector. Our other recommendations include: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. in currency-hedged terms. Continue to favor defensive over cyclical equity sectors in the U.S. for now, but a shift may be required later this year. Overweight the dollar versus the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market. Recent underperformance is a buying opportunity. Value has improved and cyclical conditions favor small caps. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst April 27, 2017 Next Report: May 25, 2017 1 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies and Fantasies," dated April 5, 207, available at bca.bcaresearch.com II. Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The Saving ##br##And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Chart II-6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The modest correction in April did not improve equity valuation by much in any of the major markets. Our U.S. valuation metric is still hovering just below the +1 sigma mark, above which would signal extreme overvaluation. Measures such as the Shiller P/E ratio are flashing red on valuation, but our indicator takes into consideration 11 different valuation measures. Technically, the U.S. equity market still has upward momentum, while our Monetary indicator is neutral for stocks. The Speculation index indicates some froth, although our Composite Sentiment indicator has cooled off, suggesting that fewer investors are bullish. The U.S. net revisions ratio is hovering near zero, but it is bullish that the earnings surprise index jumped over the past month. First-quarter earnings season in the U.S. has got off to a good start, while the global earnings revisions ratio has moved into positive territory for the first time in six years (see the Overview section). Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little 'dry power' left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. April's rally in the U.S. bond market dragged valuation close to neutral. However, we believe that the market is underestimating the amount of Fed rate hikes that are likely over the next year. Now that oversold technical conditions have been absorbed, this opens the door the next upleg in yields. Bonds typically move into 'inexpensive' territory before the monetary cycle is over. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, the dollar has shifted down this year to meet support at the 200-day moving average and overbought conditions have largely, but not totally, been worked off. We still believe there is more upside for the dollar, despite lofty valuation readings, due to macro divergences. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China

Highlights China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Continued demand strength in DM will not prevent a relapse in EM/China growth. EM is much more leveraged to China than to DM. Higher bond yields in DM, a stronger U.S. dollar and weak China/EM domestic demand are bearish for commodities and EM risk assets. A new equity trade: short KOSPI / long Nikkei. Feature In our recent reports1 we have argued that China's growth is likely to relapse again in the second half of this year based on its aggregate credit and fiscal impulse. Chart I-1 illustrates that this impulse leads Korean, Taiwanese, Japanese, German and U.S. aggregate exports to China by six months, and this indicator is reinforcing the message that shipments from these economies to the mainland have peaked and will stumble. Consistently, the bottom panel of Chart I-1 reveals that Chinese imports of capital goods are set to decelerate significantly and probably contract anew by the end of this year or early 2018. If markets are forward looking, they should begin discounting a potential growth slump very soon. Chart I-2 demonstrates that there is a tight correlation between each of these countries' shipments to China and the mainland's credit and fiscal impulse. Chart I-1Chinese Imports To Relapse Chart I-2Exports To China To Weaken In this context, a relevant question is whether the expansion of U.S. and European imports will be sufficient to safeguard the recovery in EM and global trade as China's imports tumble. Our analysis substantiates that domestic demand strength in the U.S. and Europe will boost these economies but will likely not preclude another downturn in EM/Chinese growth and global trade. In brief, China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Our basis is that EM and China trade much more with one another, and as such the DM business cycle has become a less important driver. If DM demand holds up as China's imports tumble anew, EM share prices and currencies will underperform their DM counterparts. In this context, our negative view on EM is contingent on a deceleration in China's business cycle rather than a major relapse in DM domestic demand. In the near term, higher bond yields in DM due to strong domestic demand combined with weakness in EM/Chinese growth will reverse the EM rally. EM Is Much More Leveraged To China Than To DM Chart I-3EM Is Leveraged To China Much More Than DM Chart I-3 shows that the relative performance of EM versus DM stocks typically fluctuates with the relative import volume trend between China and DM. This supports our thesis that the EM world is much more leveraged to China than DM. The following considerations certify China's greater importance for EM economies compared to the U.S. and Europe: Table I-1 shows the share of exports going to China and to the U.S. for individual EM countries. The mean for exports to China is 14.6% of total, and 11.3% for shipments to the U.S. These numbers corroborate the fact that developing countries sell more to China than to the U.S. Chart I-4 is constructed using the numbers from Table I-1. It demonstrates that Korea, Taiwan, Chile and Peru are more exposed to China while India, Turkey, and the Philippines are more leveraged to the U.S. We did not include Mexico and central Europe in this chart because the former trades with the U.S. and the latter predominantly with European countries due to their geographical proximity. Table I-1Export To China And U.S. Chart I-4Exposure To China And Exposure To The U.S. Chinese demand is critical for commodities, particularly for industrial metals prices. China consumes 6-7-fold more industrial metals than the U.S. Unsurprisingly, the mainland's credit and fiscal impulse leads industrial metals prices (Chart I-5). At this moment, we are negative on both metals and oil prices, as we view the 2016 rally as a mean-reverting rally in a structural bear market. As commodities prices drop again, commodities-producing nations will suffer from a negative terms-of-trade shock. This is regardless of which countries they export commodities to. There is one global price for each commodity, and when it deflates commodity producing nations are the ones that get hurt - irrespective of whether they sell that commodity to China, the U.S., Europe or the rest of the world. Countries like Korea and Taiwan do not sell commodities, but their largest export destination is still China (Chart I-6). The latter accounts for 25% of Korean and 27% of Taiwanese exports Chart I-5China's Credit And Fiscal##br## Impulse And Industrial Metals Chart I-6Korea And Taiwan: The ##br##Composition Of Exports. Even if we assume that 30% of goods exported to China by Korea and Taiwan are assembled and then re-exported to other countries, the mainland's domestic absorption of Korean and Taiwanese goods is still considerable. Notably, the recovery in Korean, Taiwanese and Japanese exports has been driven more by China than the rest of the world (Chart I-7). Therefore, China's business cycle is also important for some non-commodity producing countries like Korea, Taiwan and others in Asia. China itself has become much more reliant on its credit origination and fiscal spending than on exports in general and exports to DM in particular (Chart I-8). Chart I-7Asia's Exports Recovery Has Largely ##br##Been Driven By China's Demand Chart I-8China Has Become Reliant ##br##On Stimulus Not Exports Finally, Table I-2 exhibits the product structure of Chinese imports. By and large, China imports three categories of goods: various commodities, capital goods and some luxury goods. All three are at risk of a slowdown because they are leveraged to the nation's credit cycle. Table I-2Composition Of Chinese Imports Bottom Line: China's imports are critical not only for commodity producers (Latin America, Russia, Africa, the Middle East and Indonesia) but also for non-commodity economies in Asia. Altogether this comprises most of the EM universe. EM/China's Importance In Global Trade EM/China account for much larger global trade flows than advanced economies. In short, global trade will relapse again if global shipments to China and the rest of the EM universe slump. EM including Chinese imports (but excluding the mainland's imports for re-exports) in U.S. dollars are equal to imports by the U.S., EU and Japan combined (Chart I-9). Chinese imports for processing - imports that are used to manufacture goods for exports - are excluded from the calculation of this chart. Only Chinese imports for domestic consumption are accounted for. Also, this EM aggregate excludes Mexico and central European countries because their manufacturing is intertwined with the ones in the U.S. and EU. Exports to EM countries account for 25%, 28% and 17% of German, Japanese and U.S. exports, respectively. As a share of GDP, exports to vulnerable EM economies stand at 2%, 5% and 5% of U.S., German and Japanese GDP, respectively (Chart I-10). Chart I-9EM Imports Are Equal To Combined##br## Imports Of U.S., EU And Japan Chart I-10Japan And Germany Are More ##br##Exposed To EM Than The U.S. Japan and Germany are much more vulnerable to an EM/China slowdown than the U.S. and the rest of Europe (Europe ex-Germany). China's exports are exposed more to EM than DM. Chart I-11 shows that 45% of Chinese exports are shipped to Asia ex-Japan, 18% to Latin America, Russia, the Middle East, Africa, Australia and Canada and only 18% to the U.S. and 16% to the EU. Capital spending in China and EM ex-China makes up 5% and 5% (together 10%) of global GDP in real terms (Chart I-12). By comparison, EU and U.S. capital expenditures are 5% and 4.5% of world GDP in real terms. Hence, EM and especially China's investment outlays are big enough to matter for the global economy. Chart I-11China Sells More To EM Than DM Chart I-12EM/China Capex Is Large As Chart I-1 indicates, China's imports of industrial goods will soon tumble. Capital goods imports for EM ex-China have revived, but as their bank loan growth slumps the recovery in capital goods imports is likely to be short lived. Bottom Line: Two-pronged trade flows between EM and China are considerable for their own economies as well as global trade flows. Continued demand strength in DM countries will not prevent a relapse in EM/China growth. Market Observations And Conclusions Our conviction is that China's imports are set to dwindle in the second half of this year. This is bearish for commodities producers and Asian economies selling to China. If markets are forward looking, they should begin discounting this now. Moreover, bank deleveraging in EM/China has further to run. Altogether, this leads us to maintain the strategy of underweighting EM risk assets relative to their DM counterparts, and maintaining a negative stance on EM in absolute terms. Furthermore, it appears the U.S. dollar and U.S. bond yields have recently bounced from their technical support levels, and odds are they will rise further (Chart I-13). DM bond yields will move higher for now before the EM/China slowdown becomes visible later this year. For the time being, rising U.S. bond yields and a stronger greenback (versus EM, Asian and commodities currencies) will weigh on EM risk assets. Remarkably, Chinese interest rates are rising and corporate bond prices are plunging as the People's Bank of China continues along a gradual tightening path (Chart I-14). Chart I-13The U.S. Dollar And U.S. Bond Yields To Rise Chart I-14China: Borrowing Costs Are Rising As long as economic data from China and DM remain positive, financial regulators in Beijing are determined to curb leverage and speculative activities in China's credit system. Higher interest rates and regulatory tightening amid the lingering credit bubble are bound to cause meaningful stress in China's financial system and lead to a deceleration in credit growth. EM risk assets are very complacent about this risk. Interestingly, the commodities currencies index - an equal-weighted average of the Australian, New Zealand and Canadian dollars - has already halted its rally and begun depreciating even versus safe-haven currencies like the Swiss franc (Chart I-15). Such poor showing by commodities currencies should be taken seriously because it has occurred at a time when the U.S. dollar has been soft and global share prices have been well bid. As such, we read this message from the commodities currencies as a harbinger of a major top in commodities prices and EM risk assets. There is no reason why EM ex-China currencies should diverge from the commodities currency index this time around (Chart I-16). Chart I-15Commodities Currencies Versus ##br##Safe-Haven Currency Chart I-16EM Currencies ##br##To Tumble In short, we are reiterating our bearish strategy on EM currencies and recommend shorting a basket of the following currencies: ZAR, TRY, BRL, CLP, COP, MYR and IDR versus the U.S. dollar or a basket of the U.S. dollar and the euro. The main risk to our downbeat view on EM risk assets is not EM/China fundamentals but the rally in DM share prices. That said, DM stocks and credit markets were well bid in 2012-2014 yet EM stocks and currencies did very poorly during that period. This could be repeated again in the next couple of months before fundamental problems/weaker growth in China/EM become evident and stem the rally in DM equities too, as occurred in 2015. A New Equity Trade: Short KOSPI / Long Nikkei We have identified a tactical opportunity for a relative equity trade: short Korean / long Japanese stocks, currency unhedged. The Korean won is overvalued versus the Japanese yen, according to the relative real effective exchange rate based on unit labor costs (Chart I-17). This will provide a competitive advantage to Japanese manufacturers and will dent performance of the KOSPI versus the Nikkei. Even though the won could still appreciate versus the yen, equity prices in Japan will still fare better than their Korean counterparts in common currency terms. Japan's more competitive positioning is also reflected in its manufacturing PMI, which is much stronger than Korea's (Chart I-18). This should lead to outperformance of Japanese manufacturers versus their Korean peers. Chart I-17The Korean Won Is Expensive ##br##Versus The Yen Chart I-18Manufacturing PMI: ##br##Korea And Japan Korea is much more exposed to China than Japan. Exports destined to China make up 25% and 18% of Korean and Japanese exports, respectively. In the meantime, combined exports to the U.S. and EU account for 22% of Korea's total exports and 31% of Japan's total exports (Chart I-19). Provided our view that China's growth will disappoint relative to U.S. and EU growth pans out, Japan is in better position than Korea. Japanese policymakers continue to be much more aggressive in reflating their economy than Korean policymakers. Bank loan growth is accelerating in Japan but is slowing in Korea, albeit from a higher level (Chart I-20). Finally, the technical profile of relative performance between Korean and Japanese share prices favors the latter (Chart I-21). Chart I-19Japan And Korea: Structure Of Exports Chart I-20Bank Loan Growth Is Stronger In Japan Than Korea Chart I-21Short KOSPI / Long Nikkei Bottom Line: Short KOSPI / long Nikkei, currency unhedged. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Reports titled, "A Time To Be Contrarian", dated April 5, 2017, "Signs Of An EM/China Growth Reversal", dated April 12, 2017 and "EM: The Beginning Of The End", dated April 19, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights It is difficult to judge how much of the recent unwind of the Trump Trades has been due to data disappointments versus rising geopolitical tensions. We do not believe that an attack on North Korea is imminent. Rather, U.S. military muscle-flexing is designed to force the rogue state to the negotiating table. On the economic front, the U.S. "hard" data have disappointed surveys in Q1. However, we believe this largely reflects weather and seasonal adjustment distortions. The Leading Economic Indicator and our new Beige Book Monitor support this view. Our profit growth model is very bullish for earnings this year, and is supported by our proxies for corporate pricing power. The latter is improving relative to wage growth recently, suggesting that there is more upside for margins this year. Returning cash to shareholders has not been particularly strong in this expansion relative to past expansions, contrary to popular belief. Nonetheless, buyback activity will continue to boost EPS growth by about 2 percentage points. Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. Feature Treasury yields fell to their lowest level last week since just after the U.S. Presidential election. The solid start to the Q1 earnings reporting season was not enough to offset the disappointing economic reports and geopolitical fears, leaving U.S. equity prices mostly lower on the week (Chart 1). We thought that the "hard" data would improve to meet the accelerating "soft" data, but that clearly didn't occur last week. Unusual weather in March may have been a factor. We will return to the outlook for the economy and corporate profits later in the report. Chart 1Q1 Growth Disappoints It is difficult to judge how much of the bond rally has been due to data disappointments versus rising geopolitical tensions. President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances.1 The market's political focus will likely turn back to Washington this week. Congress has until April 28 to pass a bill to keep the U.S. government running through the end of fiscal year 2017. Our Geopolitical Strategy Service continues to expect a deal to get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. While the negotiations surrounding both of events could weigh on Treasury yields in the near term, our view is that they are unlikely to prevent an uptrend in yields over the coming 6-12 months. As for North Korea, the safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. But, near term, this situation is a huge wildcard. We cannot rule out another wave of risk aversion in financial markets. As this week's publication goes to press, the results of the first round of the French presidential election are being tabulated. Please consult BCA's Daily Insight on Monday, April 24, 2017 for our first take on the election results. A Temporary Soft Patch Or Something Worse? In last week's report, we wrote that the weak readings from the "hard" economic data would soon catch up with the surging "soft" economic data. In fact, the opposite has occurred since mid-April. Is this the start of a prolonged weak patch in the U.S. economy? Or is the softness perhaps related to weather and poor seasonal adjustment? We favor the later explanation for now. The first quarter GDP report is due out this Friday, April 28. The Bloomberg consensus is looking for just a 1.2% gain in the quarter after the 2.1% increase in Q4 2016. The Atlanta Fed's "GDP Nowcast" puts Q1 GDP at just 0.5% (Chart 1). The New York Fed's "Nowcast" is at 2.7%. Both estimates have been moving consistently lower since early March, dragging down 10-year Treasury yields (with U.S. stock prices along for the ride). Financial markets should be used to weak readings on first quarter GDP by now. Between 1950 and 1996, Q1 GDP was the weakest quarter of the year in just 14 of 47 years, or 30% of the time (Table 1). Q2 growth was stronger than Q1 growth about half the time. This is just about what you would expect if the U.S. Bureau of Economic Analysis' (BEA) seasonal adjustment program was functioning properly. But something has gone awry since 1997, despite the government statisticians' recent attempts to correct the problem. Over the past 20 years, the first quarter has been the weakest GDP reading of the year 10 times, or 50% of the time, and Q2 GDP growth has been faster than Q1 growth 70% of the time. Table 1The Gap Between GDP Growth In Q1 And Q2 Has Widened In The Past 20 Years A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this anomaly are in the private investment and government consumption components of GDP. More specifically, the Cleveland Fed cites defense spending as the key driver of the weakness in Q1 GDP relative to other quarters. We'll expand on this theme in next week's U.S. Investment Strategy report, but for now our view remains that the weakness in U.S. economic growth is temporary. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have backed off of their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in weather-impacted "hard" data like retail sales, housing starts and industrial production. The April update of our Beige Book Monitor, which we introduced last week, confirms that the economy is stronger than the GDP data suggest (Chart 2). The Monitor is simply the difference between the percentage of "strong" versus "weak" descriptors for growth in the document. Chart 2BCA Beige Book Monitor Upbeat For Growth The Monitor edged higher in April to 65%, from 51% in the March reading. "Weather" was mentioned 18 times, after just 6 mentions in March. More than two thirds of the 18 mentions of weather in April cited it as having a negative impact on economic activity. This supports our view that weather had a non-negligible impact on the hard data in March. Thus, if the weather in the first three weeks of April persists into the final week of the month, the stage is set for a noticeable improvement in U.S. economic data released in May. All else equal, this should temper fears that the U.S. economic expansion has lost momentum, supporting stock prices and allowing the recent bond rally to unwind (depending on geopolitics). The soft March CPI also appeared to be quirky, revealing that the core measure actually contracted in March (Chart 3). We note, however, that the weak March reading followed two months of extremely strong gains. In addition, it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Our "inflation words" indicator based on the Beige Book remains in an uptrend (Chart 2). Chart 3Has U.S. Inflation Peaked? A rebound in the activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A rate hike in next month is unlikely, but we would not rule out June if the economic data firm as we expect. Positive Signs For U.S. Corporate Pricing Power Another 82 S&P 500 companies report first quarter results this week, making it the busiest week of the season. The consensus for Q1 earnings growth remains near 10% on a 4-quarter trailing basis. That forecast is likely to be met. We highlighted the positive 2017 outlook for U.S. corporate profits in the April 10, 2017 Weekly Report. The U.S. experienced a profit recession in 2016 that did not coincide with an economic recession. Oil prices were part of the story, but we have seen this pattern occur several time since the late 1990s; nominal GDP growth (a proxy for top line growth) decelerates temporarily relative to labor compensation growth. Margins get squeezed but, since the economy manages to avoid a recession, nominal GDP growth subsequently rebounds relative to labor compensation. This resulted in a 'catch up' phase when earnings-per-share growth accelerated sharply and equity returns were favorable. We believe that U.S. earnings are in the same type of catch-up phase now, which has been accentuated by the rebound in oil prices. Proprietary indicators from our sister publication, the U.S. Equity Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart 4). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly based across industries (as shown by the diffusion index in the chart). As a side note, the Proxy provides some evidence that softness in core CPI will not last. At the same time, the upward march of wage growth appears to be taking a breather (Chart 4). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching (perpetually optimistic) bottom-up estimates for 2017 (Chart 5). Chart 4Corporate Sector Gaining ##br##Some Pricing Power Chart 5Profit Model##br## Is Very Bullish Companies have supported per share profits in this expansion in part via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart 6 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same has been true for GDP growth. Chart 6Comparison Of Corporate Outlays Across Four Economic Expansion Phases Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity withdrawal since 2009, which includes the net impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions. Bottom Line: CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Buyback Tailwind To Continue How important are buybacks to EPS growth? Chart 7 (second panel) presents a rough proxy for the historical impact of equity withdrawal that is based on the S&P 500 divisor. It is the difference between EPS growth and growth in total dollar earnings. When the line is above zero, it means that EPS growth has been lifted above dollar earnings growth via equity withdrawals. Chart 7Buybacks Adding Almost ##br##2 Percentage Points To EPS Growth This proxy must be taken with a grain of salt due to the manner in which the divisor is calculated. Nonetheless, it suggests that buybacks have boosted EPS growth by 2 percentage points in the year to 2016Q4. We expect that buyback activity will continue to be a mild tailwind in the coming quarters given the positive reading from our Capital Structure Preference Indicator (Chart 7, third panel). This Indicator is defined as the equity risk premium minus the default adjusted high-yield corporate bond yield. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Bottom Line: Buybacks have not had an outsized impact on EPS growth in this cycle, but the good news is that this tailwind is likely to continue. Capitalization Strategy: Stick With Small Caps The relative performance of U.S. small vs large cap stocks surged following the November election, but has since retraced about two-thirds of its post-election gains and has recently been trading below its 200-day moving average. Small cap stocks have been one of several "Trump trades" that have waned over the past three months, but our view is that several positive tailwinds for small cap relative performance continue to warrant an overweight stance: Panel 1 of Chart 8 highlights that our cyclical capitalization indicator has moved sharply into positive territory following the election, and has remained positive despite the recent weakness in small cap relative performance. Small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (panel 2), which argues for a bullish stance given our overweight positions in U.S. equities versus bonds. Our relative valuation indicator for U.S. small caps has moved back towards neutral valuation territory, which is a significant change from the conditions that prevailed in the early part of the U.S. economic recovery. Chart 9 shows that the indicator was consistently elevated from 2009 until early-2015, but has since fallen back to zero. While relative prices have accounted for some of this adjustment, the relative (trailing) earnings trend for small cap stocks remains in an uptrend and has recently risen to an all-time high, despite a disappointing Q1. Chart 10 highlights one risk to the small cap trade that will be important to monitor. The chart shows the NFIB's outlook survey along with the percentage of respondents citing "red tape" as the most important problem facing their business. The consistent rise in concerns about red tape under the Obama administration, especially the strong rise that began in 2010, suggests that small firms have found elements of the Affordable Care Act to be particularly burdensome for their business. This suggests that a portion of the sharp rise in the outlook for small businesses following the election has occurred due to expectations that the ACA will be repealed, in turn implying that confidence may wither following the failure of the American Health Care Act (AHCA) to even be subjected to a vote in the House. Chart 8Beta And The Cycle Argue ##br##For Small Caps Chart 9Small Caps Are##br## No Longer Expensive Chart 10Watch The Change Of A "Trump Slump" ##br##In Small Business Sentiment While several planned policies of the Trump administration have indeed been delayed due to the failure of the AHCA, we remain of the view that a legislative agenda that at least appears to be pro-business remains in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation that we noted above. Bottom Line: Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. The failure of the AHCA may cause a near-term pullback in small business confidence, but we doubt that this will be sustained over the coming 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 2 "Lingering Residual Seasonality in GDP Growth," Federal Reserve Bank of Cleveland, March 28, 2017.

Highlights Commercial oil inventories finished the first quarter with a minimal draw. This was largely due to a surge in production and sales by Gulf producers and Russia at the end of 2016 and earlier this year, as well as slightly lower demand. Despite reports floating storage and more opaque inventories - e.g., Caribbean storage - drew significantly, OPEC 2.0 remains well short of its goal to get visible oil stocks down to five-year-average levels by year-end. If drawing storage down to more normal levels remains OPEC 2.0's goal, then the production-cutting deal negotiated by Saudi Arabia and Russia will have to be extended when OPEC meets next month. We expect this to happen. Even so, risk-reversals in options markets indicate investors and hedgers are willing to pay more for downside put protection than upside call exposure. We recommend fading this bias, and buying out-of-the-money calls and selling out-of-the-money puts using Dec/17 options. Energy: Overweight. We closed our long Dec/17 WTI vs. short Dec/18 WTI position last Thursday with a 583.3% gain. We remain long Dec/17 Brent vs. short Dec/18 Brent, which is up 242.1%. Our long GSCI position is down 1.3%. We are recommending a long Dec/17 Brent $65/bbl call vs. a short Dec/17 Brent $45/bbl put, which we will put on at tonight's close. This is driven by our analysis of the need to extend OPEC 2.0's production-cutting deal into the end of the year to reduce OECD commercial oil inventories. We continue to expect Brent and WTI prices to trade on either side of $60/bbl by year-end. Base Metals: Neutral. Copper traded lower this week, on the back of news Freeport McMoRan is poised to resume exports from its Indonesian facilities. Precious Metals: Neutral. Gold traded higher, but remains range-bound. Our long volatility gold options play is up 2.9%. We will leave this trade on as a hedge, going into the French elections. Ags/Softs: Underweight: Despite heavy rains, grains (excluding rice) and beans were well offered this past week. Feature The surge in oil production and sales by Gulf producers and Russia at the end of last year and earlier this year, along with a reported slowing of demand - down ~ 100k b/d from our March estimates - combined to leave estimated supply and demand roughly balanced for 2017Q1 (Chart of the Week). These dynamics left visible OECD inventories above year-end 2016 levels (Chart 2). Chart of the WeekVisible Inventories Barely Budge In 2017Q1, ##br##As Supply Surge And Lower Demand Collide Chart 2Visible Inventories Will Reach 5-year Average##br## If OPEC 2.0 Production Cuts Are Extended Less-visible floating storage, along with oil stockpiles in China and Japan, drew more than 70mm barrels (bbls), according to Morgan Stanley, while Caribbean storage fell by some 10 - 20mm bbls during the last quarter.1 In addition, major trading companies are actively looking for buyers to take unwanted physical storage capacity off their hands. Nonetheless, OPEC 2.0 - the states banded together under the leadership of the Kingdom of Saudi Arabia (KSA) and Russia to remove some 1.8mm b/d of oil production from the market in 2017H1 - remains well short of its goal to get visible inventories down to five-year-average levels. Failure to reduce inventories almost surely requires producers allied in the production-cutting deal to extend their pact into 2017H2. We think they will, given the oft-stated desire of the Saudi and Russian energy ministers, Khalid Al-Falih and Alexander Novak, to see inventories continue to draw. Their desire was re-stated recently at a hastily called news conference in Houston last month.2 This message has remained constant from other OPEC leaders as well. The Logic Of Extending OPEC 2.0's Deal To 2017H2 Reducing the global storage overhang is imperative for the OPEC 2.0 coalition. It is the driving force behind the unlikely alliance KSA and Russia forged at the end of last year. Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015 - 16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector.3 After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue. Entering the second quarter of this year, KSA and its allies continue to over-deliver on their pledges to cut ~ 1.2mm b/d of production. Markets are expecting Russian cuts to increase to ~ 300k b/d, in line with their pledges under the OPEC 2.0 production-cutting Agreement negotiated last year (Chart 3 and Chart 4). Chart 3KSA Continues To Over-Deliver; ##br##Russian Cuts Expected to Increase Chart 4KSA Allies Continue to Deliver;##br## Iran And Iraq Continue To Under-Deliver However, if the OPEC 2.0 production deal to remove ~ 1.8mm b/d of production is not extended beyond its end-June deadline, storage levels will remain uncomfortably high for the KSA - Russia alliance. By our reckoning, allowing the deal to expire without extending it would only reduce visible OECD inventories by a little over 170mm barrels by year-end. This can be inferred from our assessment of balances (Chart of the Week). Not extending OPEC 2.0's deal leaves OECD commercial oil inventories close to 130mm barrels above the targeted 300mm-barrel drawdown required to return OECD inventories to more normal (i.e., five-year average) levels. With U.S. shale production coming on strong, this could be precarious for OPEC 2.0 next year. Extending the OPEC 2.0 production-cutting deal to the end of 2017H2 will reduce visible commercial inventories in the OECD by slightly more than the 300mm barrels being targeted (Chart 5). This should put storage levels back at more normal, five-year average levels, and give OPEC 2.0 some breathing room to craft a strategy to contain U.S. shale production going forward.4 For this reason, extending the 1.8mm b/d production cuts to end-2017 is almost a foregone conclusion for us, particularly as KSA needs to clean up the market, so to speak, ahead of the IPO of Saudi Aramco next year. Among other potential investors with a keen interest in the potential $100 billion floatation is a state-led consortium of Chinese banks and oil companies.5 We Think Upside Risks Dominate Oil Markets The logic of extending the OPEC 2.0 deal is compelling. But the market does not share this view. Oil speculators have significantly reduced their net long position as a percent of total open interest in the dominant crude-oil futures markets, WTI and Brent (Chart 6). This, after the specs were chastened following their huge increase in upside exposure earlier this year. Chart 5Extending OPEC 2.0'S Production Deal Reduces ##br##OECD Oil Stocks By 300mm+ Barrels By End-2017 Chart 6Specs Are Retreating From Oil We can also see a lack of conviction in oil options markets. Option markets provide a useful gauge of fear and greed called "skew," which is nothing more than the difference between implied option volatilities (IOV) for puts and calls.6 When the skew favors puts - shown by a negative number in the risk-reversal shown in Chart 7 - markets are signaling they value downside protection more than upside exposure, and vice versa when call IOVs exceed put IOVs. Chart 7Option Skew Favors Downside Puts ##br##Over Upside Call Exposure Given the logic we laid out above, we are recommending investors fade the put skew in the options markets. Specifically, we are getting long out-of-the-money Dec/17 $65/bbl Brent calls and selling out-of-the-money Dec/17 $45/bbl Brent puts against them, to express our view. We will be doing so at the close of trading today, and will report our strikes and net premium in next week's publication.7 Bottom Line: We expect the OPEC 2.0 production deal to be extended when OPEC meets on May 25 in Vienna. This will significantly raise the odds OECD commercial oil stocks will be drawn down to more normal levels, giving the OPEC 2.0 petro-states more breathing room to develop a strategy to regain a modicum of control over prices. This is critical for KSA, which still is on track to IPO Saudi Aramco next year. Given our expectation, we are recommending investors buy out-of-the-money Dec/17 $65/bbl Brent calls and sell out-of-the-money Dec/17 $45/bbl Brent puts. This allows investors to fade what appears to be a consensus - given put skews and spec positioning - and capitalize on what we believe is an all-but-certain extension of the OPEC 2.0 production deal. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. As has been mentioned often, our level of conviction in that forecast is low beyond 2018, given the large capex cuts for projects that would have been funded between 2015 and 2020 absent the 2014 - 2016 oil-price collapse. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "OPEC's Barkindo Sees Progress in Oil Cuts as Stockpiles Drop," and "Oil Traders Drain Hidden Caribbean Hoards as OPEC Cuts Bite," published by Bloomberg.com on April 2 and 3, 2017, respectively. 2 Please see "Saudi Arabia, Russia Offer United Front on Oil Supply Cuts," published by Bloomberg.com on March 7, 2017, and "Saudi energy minister says oil market fundamentals improving," published by reuters.com on the same day. 3 BCA Research's Commodity & Energy Strategy examined this in our feature article published on September 8, 2016, entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." It is available at ces.bcaresearch.com. 4 We discuss this at length in "KSA's, Russia's End Game: Contain U.S. Shale Oil," and "The Game's Afoot In Oil, But Which One," published by BCA Research's Commodity & Energy Strategy Weekly Report April 6 and March 30, 2017, Both are available at ces.bcaresearch.com. 5 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," published by Reuters.com on April 19, 2017. We speculated on just such an event in "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," published by BCA Research's Commodity & Energy Strategy and its Geopolitical Strategy January 14, 2016. We noted, "While inviting Western investors and energy firms to take a stake in Aramco would make obvious sense for Saudi Arabia, we would speculate that the real target for the IPO will be Chinese state-owned enterprises (SOEs). China has overtaken the U.S. as the main importer of crude from Saudi Arabia ... but it continues to free-ride on Washington's security guarantees and commitments in the region. By giving China a stake in Saudi Arabia's energy infrastructure, Riyadh would force Beijing to start caring about what happens in the region." 6 "Implied option volatility" is market jargon for the standard deviation of expected returns. It is used as an input for option-pricing models. The "implied," as it's known colloquially in markets, solves an option-pricing model like Fischer Black's, once the option's premium is discovered via trading. Market participants can determine whether puts (i.e., the right, but not the obligation, to sell) are more highly valued than calls (the right to buy) in relative terms by differencing the implied volatilities of puts and calls that are equidistant from at-the-money options. This is referred to as the options' "skew." We use the IOVs for puts and calls that both change by $0.25/bbl for every $1.00/bbl move in oil futures (i.e., 25-delta puts and calls) to calculate skew. Please see Fischer Black's seminal article, "The Pricing of Commodity Contracts," in the Journal of Financial Economics, Vol. 3, (1976), pp. 167-79. 7 We employed a similar strategy in March 2016 - getting long Dec/16 Brent $50/bbl calls vs. selling $25/bbl puts, which registered a 103.5% gain between March 3 and April 14, following a rally in Brent prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Special Report

Dear Client, I am travelling in Asia talking to investors and doing some field research. As such, there will be no CIS report next week. The next report will be sent to you on May 5th. Best regards, Yan Wang, Senior Vice President China Investment Strategy Feature A special report I co-authored with my colleagues Arthur Budaghyan and Peter Berezin, and the webcast we all participated in with Caroline Miller late last month, focused on China's debt situation - a critical global macro issue that has been heatedly debated around the globe as well as within BCA.1 Economists rarely agree with one another, and financial markets are constant battles between buyers and sellers with diametrically opposed views. Similarly, it is not possible for senior research staff within BCA to always have uniform opinions. Our intention was to bring an internal debate on a critical global macro issue in front of clients in a straightforward and comprehensive way, which hopefully can enhance clients' own understanding of the topic. Our report and webcast received higher-than-normal questions and feedback. This week's report serves as a follow-up to clarify some of the more common questions we received. But It Is The Rapid Pace Of Increase In China's Debt-To-GDP Ratio That Is Alarming!! Even for clients that agree with Peter and myself and view Chinese debt from the savings investment identity perspective, a common pushback is that the pace of increase in China's debt-to-GDP ratio is alarmingly rapid, which is bound to create misallocations and financial risks (Chart 1). My arguments emphasizing the micro debt situation within the corporate sector and cross-country comparisons of efficiency ratios were reassuring, but not enough to alleviate all the concerns on the apparently rapid increase in debt relative to economic output in recent years. A few further points are in order: Chart 1The GDP Factor In China's Rising ##br##Debt-To-GDP Ratio First, the rapid increase in debt reflects the rapid increase in capital spending, which means the economy has become more capital intensive compared with before - i.e. it takes more capital to produce one unit of GDP. This could indicate declining efficiency in capital spending in terms of generating "growth." It could also mean the Chinese economy may have arrived at a much more capital intensive phase in its economic development curve. Dramatic improvement in the country's transportation infrastructure and urban development in recent years are tell-tale signs. Accumulating capital stock is the ultimate way for a developing country to improve productivity and lift living standards. China's growth path should be viewed as a norm rather than an anomaly. Second, the Chinese economy has directed massive financial resources toward infrastructure investment post the global financial crisis, largely undertaken by state-owned corporate entities such as state-owned enterprises and local government financing vehicles. These investments are not much different from the massive increase in fiscal deficits in other countries to finance social spending programs and welfare expenditures, as both were designed to support domestic demand during an economic downturn. The difference is that China's social welfare system is poorly developed and not large enough to make a meaningful contribution in supporting aggregate demand- and therefore the state sector must explicitly ramp up capex. Another important difference is that government expenditures on social benefit programs distributed to households in most other countries are ultimately consumed, whereas in China, state investment in infrastructure occurs on an accumulated physical asset. This is a key reason why I believe focusing only on the liabilities side of the balance sheet misses an important big-picture point. Finally, the apparently alarming increase in China's debt-to-GDP ratio is also partially attributable to how this ratio itself is calculated, in which the slowdown of China's nominal GDP growth rather than its increase in debt has played a much bigger role. Chinese nominal GDP growth dropped from almost 20% in 2010-'11 to close to 6% in 2015-early 2016. In a division calculation in mathematics, a falling denominator (nominal GDP) increases the result exponentially, while a rising numerator (debt) increases the result linearly. If nominal GDP growth had stayed stable, the pace would have been a lot less alarming. This also suggests that the best way to bring down the "debt-to-GDP" ratio is to increase the denominator - i.e. boosting growth either in real or nominal terms. In fact, Chinese nominal GDP expanded by 11.8% in the first quarter from a year ago, as reported early this week - the gap between credit growth and nominal GDP growth has already narrowed significantly. Has China Ever Delevered, And How To Delever Going Forward? In our joint report, Arthur cautioned that China in the past has had periods of deleveraging, and warned that a similar episode would be inevitable going forward, in which the Chinese authorities would have to rein in credit growth below nominal GDP growth, leading to a lower credit-to-GDP ratio (Chart 2). In my view, this diagnosis is misguided, and the policy prescription is dangerous. Chart 2Deleveraging Versus Inflation First, it is worth noting that China's credit-to-GDP ratio has been on an ever-rising trend ever since the data became available, which in my view reflects the accumulation of capital stock through savings and investments. There have indeed been a few short-lived periods when the ratio has declined, as Arthur pointed out, or the economy appeared to "delever," such as in the late 1980, early 1990s, early 2000s and prior to the global financial crisis. However, it is immediately clear that the periods of "deleveraging" in the 1980s and 1990s were both mainly due to massive increases in inflation, which artificially boosted nominal GDP growth. An inflation outbreak is hardly an ideal way to delever that policymakers should aim for. Inflation also picked up between 2003 and 2008, but not nearly as much as the previous two episodes, and the Chinese economy was characterized as experiencing "low inflation boom". However, it is important to note that the country's current account surplus jumped from 2% in 2003 to as high as 10% in 2007. This means Chinese savers collectively did not lend to domestic companies, and therefore debt was not accumulated within the country and shown in the debt-to-GDP ratio. Rather, they lent to foreign entities, such as the U.S. government, in the form of increased holdings of U.S. Treasurys. By the same token, after the global financial crisis, China's current account surplus tumbled back to 2% of GDP, which indicated a significant reduction in the pace of increase in foreign lending but simultaneously a sharp increase in domestic investment and credit. This is precisely what one would expect from the savings-investment identity in conceptualizing China's debt dynamics. In fact, the only period in which China's corporate sector indeed "delevered" in the "classic" textbook sense was the early 2000s, amid aggressive reforms of state-owned enterprises and the banking system. Mass bankruptcies of state-owned firms unleashed by the SOE reform efforts led to mounting losses in the banking sector. The government set up state-owned asset management companies as "bad banks" to take over the non-performing loans of commercial banks - financed by the issuance of special-purpose government bonds. Therefore, the government essentially engineered a "debt swap" in which corporate sector debt was exchanged for government debt - but the country's overall total outstanding debt hardly dropped. It is also noteworthy that the overall economy remained reasonably resilient throughout the "deleveraging" process, even though it was also hit by multiple severe external shocks such as the tech-bubble bust, terrorist attacks in New York City and the SARS crisis. In other words, the playbook of the early 2000s suggests that "deleveraging" will not necessarily hurt growth. In my view, "deleveraging" solely for the purpose of it is not only ineffective, but also counterproductive. Aggressive credit constraint intensifies deflationary pressures, creating a double-whammy on nominal GDP growth through both lower real growth and a falling GDP deflator - which makes it a lot harder to achieve a lower credit-to-GDP ratio. It goes without saying that irresponsible lending and investment behavior should be punished by market forces. However, as shown by "too big to fail" dilemma policymakers in the west had to deal with at the height of the global financial crisis, it is always a delicate balancing act, and it is overly dogmatic to suggest or expect Chinese policymakers to do otherwise. In fact, I have repeatedly argued that the much-touted "Likonomics"2 efforts named after the incumbent Chinese premier a few years ago that appeared to favor harsh "deleveraging" was one of the key reasons behind China's sharp growth slowdown in previous years. Chinese policymakers have since taken a more realistic approach in dealing with the corporate sector debt issue. The government embarked on a new debt-swap program in 2015 to deal with the existing debt load of local government financing vehicles.3 Some provincial "bad bank" asset management companies have been established to absorb regional banks' loan losses - both of which were taken from the early 2000s playbook. Furthermore, policy reflation has significantly eased deflationary pressures and lifted nominal GDP growth, which has narrowed the gap with the pace of credit expansion. In addition, the pace of IPOs in the domestic equity market has quickened notably - i.e. more domestic savings are being channeled into the economy via equity financing as opposed to bank loans. All of these measures in my view are the correct steps to lower the corporate debt-to-GDP ratio, rather than some "short term gain, long term pain" myopic fixes. China's Interbank Rate And The PBoC Liquidity Management Arthur argued in our report that the People's Bank of China (PBoC) in recent years has moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money), which effectively accommodates commercial banks' credit creation binge by injecting massive amounts of liquidity, as evidenced by the much-lowered volatility in China's interbank market since 2016 - with an explosion of PBoC direct lending to financial institutions (Chart 3). I doubt there is a connection between this point and China's loan growth. The PBoC's direct lending to commercial banks only began to increase in earnest starting in early 2016, while bank loan growth peaked six years before that. If anything, the recent change reflects the PBoC's more flexible and sophisticated management of the country's interbank liquidity compared with previously primitive and blunt measures. It is easy to spot the dramatic volatility in China's interbank rates before 2016 compared with other major economies. Chinese interbank rates routinely had sharp spikes, underscoring dramatic changes in interbank liquidity, which were both extremely rare and potentially damaging in other countries. Hong Kong's interbank rates showed similar spikes during the Asian Crisis in the late 1990s, when its currency peg was under furious speculative attack (Chart 4). U.S. interbank rates spiked amid the "Lehman shock" that marked a dramatic escalation of the global financial crisis. In "normal times" interbank rates closely track the policy interest rates of respective monetary authorities in major economies. Sharp spikes in interbank rates could easily tilt a country's financial institutions into a liquidity crisis, even without any solvency issues, and a central bank should seek all means to avoid such an event as the lender of last resort. Chart 3No Connection Between The PBoC Lending ##br##And Commercial Bank Loan Growth Chart 4Interbank Rates: Experiences In Other Countries In other words, the PBoC was effectively playing with fire in the past by allowing extreme swings in interbank liquidity. The impact on the country's banking system was not as dramatic as one would have expected, mainly because Chinese banks are heavily reliant on retail deposits for their loanable funds rather than on wholesale funding through the interbank market, as in other countries. Meanwhile, most Chinese banks are state-owned, which also reduces "perceived" counterparty risks. There were episodes in which some banks failed to honor their liquidity obligations during periods of extreme liquidity crunch, or technically defaulted, which in the west could well have triggered bankruptcies and a massive chain reaction. In China, these features, ironically, have made its banking sector more "resilient" to what effectively are central bank failures. Chart 5RRR Is Still Elevated The key reason was that the PBoC mainly relied on reserve requirement ratio (RRR) adjustments to manage interbank liquidity, which are by definition blunt and hard to adjust in a timely manner - the very reasons why other central banks have mostly abandoned it. More recently, the PBoC has been utilizing new liquidity tools, such as various lending facilities and open market operations. This is the sole reason behind the apparently steep increase in the PBoC's claims on commercial banks, shown in Chart 3. In fact, rather than providing massive liquidity relief, the PBoC still keeps the RRR at near historically high levels (Chart 5). Therefore, all the items on the PBoC's balance sheet should be cross-checked to assess its liquidity operations, rather than focusing on one item. In my view, what's happening is that PBoC has more recently been learning and experimenting with modern central banking, rather than accommodating/encouraging commercial banks' lending behavior. All in all, the debate on China's debt situation will likely stay, and its evolvement over time will be closely studied by policymakers and academia, which is probably irrelevant to most investors. From investors' point of view, the important point is that the market has been focusing on China's debt and leverage for many years, which means it is likely already priced in. Moreover, from a macro point of view, it is highly unlikely that such a well-known issue will cause a major risk event - black swans, by definition, are unheard of and unpredictable. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, ""Likonomics": Off To A Rocky Start," dated July 10, 2013, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Game Changer?" dated March 11, 2015, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations