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expectations. The divergence between inflation breakevens and real yields seem to suggest that investors have become more concerned about upside risk to inflation but downside risk to growth. Interestingly, this shift in investor sentiment runs counter to incoming data which are painting a picture of benign inflation but growth acceleration. Indeed, wage growth remains lackluster while the Fed’s favorite measure of inflation core PCE has slowed to the lowest level in more than a year (Chart 4). In contrast, both employment data and survey data suggest economic growth is on a tear (Figure 5). The Atlanta Fed’s GDPNow model is currently tracking 2.7% GDP growth for Q1. If it is not the data, what is driving the market’s apparent increased concerns about stagflation? Whatever these concerned may be, are they justified? We seek to answer these two critical questions in this report. Chart 4: Core PCE (3m/3m, SA, AR, %) Chart 5: GDP growth and aggregate hours worked (Q/Q, SA, AR, %) 2.5 . 23 4 2.1 1.9 2 1.7 1.5 0 1.3 14 2 0.9 Mar-10 Jul-11 Nov-12 Mar-14 Jul-15 Nov-16 0.7 S2S®PeOYFT HT NNNMMATH HW HW © = eal GDP growth (AR, %) Boo Ok a Eo eS eet ot Ob ES US hUEDUEU ——_ 9 § § E 3 s 8 3 8 s 3 i: g & E E Es g aggregate hours worked (AR, %) =——— aggregate hours worked, Jan (AR, %) Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research The Trump risk premium Our informal survey of clients in the past two weeks suggests that stagflation concerns are being fed by growing pessimism about the new Trump administration. Clients tell us that their pessimism reflects four main concerns: Downside risk to growth 1. Many investors are concerned that the new administration will get bogged down by its promise to repeal and replace Obamacare, resulting in a significant delay in pushing through fiscal reform 2. This concern is reinforced by the perception that the GOP is divided over the proposed border adjustment tax (BAT), a key element of the tax reform proposal Upside risk to inflation 3. A growing number of investors are worried that potential trade wars with Mexico and China could lead to tariffs and higher prices 4. Many investors are also concerned that the BAT will force retailers to raise prices With many investors having loaded up on Trump trades after the elections (The battle lines are drawn, January 23, their willingness to continue to give the benefit of doubt to the new administration appears to be wearing thin. We would advise patience as there Bankof America <> Merrill Lynch Cause and Effect | 13 February 2017 3 HOUSE_OVERSIGHT_014723