BCA Indicators/Model

Special Report

Feature Valuations, whether for currencies, equities or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced so far this year, it is always useful to pause and reflect on where currency valuations stand. In this optic, this week we update our set of long-term valuation models for currencies that we introduced In February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 These models cover 22 currencies, incorporating both G-10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning or middle of a long-term currency cycle. Second, by providing strong directional signals, they help us judge whether any given move is more likely to be a countertrend development or not, offering insight on its potential longevity. Finally, they assist us and our clients in cutting through the fog, and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Dollar: Back At Fair Value 2017 was a terrible year for the dollar, but the selloff had one important positive impact: it erased the dollar's massive overvaluation that was so evident in the direct wake of U.S. President Donald Trump's election. In fact, today, based on its long-term drivers, the dollar is modestly cheap (Chart 1). Fair value for the dollar is currently flattered by the fact that real long-term yields are higher in the U.S. than in the rest of the G-10. Investors are thus betting that U.S. neutral interest rates are much higher than in other advanced economies. This also means that the uptrend currently evident in the dollar's fair value could end once we get closer to the point where Europe can join the U.S. toward lifting rates - a point at which investors could begin upgrading their estimates of the neutral rate in the rest of the world. This would be dollar bearish. For the time being, we recommend investors keep a bullish posturing on the USD for the remainder of 2018. Not only is global growth still slowing, a traditionally dollar-bullish development, but also the fed funds rate is likely to be moving closer to r-star. As we have previously showed, when the fed funds rate rises above r-star, the dollar tends to respond positively.2 Finally, cyclical valuations are not a handicap for the dollar anymore. The Euro Chart 2The Euro Is Still Cheap As most currencies managed to rise against the dollar last year, the trade-weighted euro's appreciation was not as dramatic as that of EUR/USD. Practically, this also means that despite a furious rally in this pair, the broad euro remains cheap on a cyclical basis, a cheapness that has only been accentuated by weakness in the euro since the first quarter of 2018 (Chart 2). The large current account of the euro area, which stands at 3.5% of GDP, is starting to have a positive impact on the euro's fair value, as it is lifting the currency bloc's net international investment position. Moreover, euro area interest rates may remain low relative to the U.S. for the next 12 to 18 months, but the 5-year forward 1-month EONIA rate is still near rock-bottom levels, and has scope to rise on a multi-year basis. This points toward a continuation of the uptrend in the euro's fair value. For the time being, despite a rosy long-term outlook for the euro, we prefer to remain short EUR/USD. Shorter-term fair value estimates are around 1.12, and the euro tends to depreciate against the dollar when global growth is weakening, as is currently the case. Moreover, the euro area domestic economy is not enjoying the same strength as the U.S. right now. This creates an additional handicap for the euro, especially as the Federal Reserve is set to keep increasing rates at a pace of four hikes a year, while the European Central Bank remains as least a year away from lifting rates. The Yen Chart 3Attractive Long-Term Valuation, But... The yen remains one of the cheapest major currencies in the world (Chart 3), as the large positive net international investment position of Japan, which stands at 64% of GDP, still constitutes an important support for it. Moreover, the low rate of Japanese inflation is helping Japan's competitiveness. However, while valuations represent a tailwind for the yen, the Bank of Japan faces an equally potent headwind. At current levels, the yen may not be much of a problem for Japan's competitiveness, but it remains the key driver of the country's financial conditions. Meanwhile, Japanese FCI are the best explanatory variable for Japanese inflation.3 It therefore follows that any strengthening in the yen will hinder the ability of the BoJ to hit its inflation target, forcing this central bank to maintain a dovish tilt for the foreseeable future. As a result, while we see how the current soft patch in global growth may help the yen, we worry that any positive impact on the JPY may prove transitory. Instead, we would rather play the yen-bullish impact of slowing global growth and rising trade tensions by selling the euro versus the yen than by selling the USD, as the ECB does not have the same hawkish bias as the Fed, and as the European economy is not the same juggernaut as the U.S. right now. The British Pound Chart 4Smaller Discount In The GBP The real-trade weighted pound has been appreciating for 13 months. This reflects two factors: the nominal exchange rate of the pound has regained composure from its nadir of January 2017, and higher inflation has created additional upward pressures on the real GBP. As a result of these dynamics, the deep discount of the real trade-weighted pound to its long-term fair value has eroded (Chart 4). The risk that the May government could fall and be replaced either by a hard-Brexit PM or a Corbyn-led coalition means that a risk premia still needs to be embedded in the price of the pound. As a result, the current small discount in the pound may not be enough to compensate investors for taking on this risk. This suggests that the large discount of the pound to its purchasing-power-parity fair value might overstate its cheapness. While the risks surrounding British politics means that the pound is not an attractive buy on a long-term basis anymore, we do like it versus the euro on a short-term basis: EUR/GBP tends to depreciate when EUR/USD has downside, and the U.K. economy may soon begin to stabilize as slowing inflation helps British real wages grow again after contracting from October 2016 to October 2017, which implies that the growth driver may move a bit in favor of the pound. The Canadian Dollar Chart 5CAD Near Fair Value The stabilization of the fair value for the real trade-weighted Canadian dollar is linked to the rebound in commodity prices, oil in particular. However, despite this improvement, the CAD has depreciated and is now trading again in line with its long-term fair value (Chart 5). This lack of clear valuation opportunity implies that the CAD will remain chained to economic developments. On the negative side, the CAD still faces some potentially acrimonious NAFTA negotiations, especially as U.S. President Donald Trump could continue with his bellicose trade rhetoric until the mid-term elections. Additionally, global growth is slowing and emerging markets are experiencing growing stresses, which may hurt commodity prices and therefore pull the CAD's long-term fair value lower. On the positive side, the Canadian economy is strong and is exhibiting a sever lack of slack in its labor market, which is generating both rapidly growing wages and core inflation of 1.8%. The Bank of Canada is therefore set to increase rates further this year, potentially matching the pace of rate increase of the Fed over the coming 24 months. As a result of this confluence of forces, we are reluctant to buy the CAD against the USD, especially as the former is strong. Instead, we prefer buying the CAD against the EUR and the AUD, two currencies set to suffer if global growth decelerates but that do not have the same support from monetary policy as the loonie. The Australian Dollar Chart 6The AUD Is Not Yet Cheap The real trade-weighted Australian dollar has depreciated by 5%, which has caused a decrease in the AUD's premium to its long-term fair value. The decline in the premium also reflects a small upgrade in the equilibrium rate itself, a side effect of rising commodity prices last year. However, despite these improvements, the AUD still remains expensive (Chart 6). Moreover, the rise in the fair value may prove elusive, as the slowdown in global growth and rising global trade tensions could also push down the AUD's fair value. These dynamics make the AUD our least-favored currency in the G-10. Additionally, the domestic economy lacks vigor. Despite low unemployment, the underemployment rate tracked by the Reserve Bank of Australia remains nears a three-decade high, which is weighing on both wages and inflation. This means that unlike in Canada, the RBA is not set to increase rates this year, and may in fact be forced to wait well into 2019 or even 2020 before doing so. The AUD therefore is not in a position to benefit from the same policy support as the CAD. We are currently short the AUD against the CAD and the NZD. We have also recommended investors short the Aussie against the yen as this cross is among the most sensitive to global growth. The New Zealand Dollar Chart 7NZD Vs Fair Value After having traded at a small discount to its fair value in the wake of the formation of a Labour / NZ first coalition government, the NZD is now back at equilibrium (Chart 7). The resilience of the kiwi versus the Aussie has been a key factor driving the trade-weighted kiwi higher this year. Going forward, a lack of clearly defined over- or undervaluation in the kiwi suggests that the NZD will be like the Canadian dollar: very responsive to international and domestic economic developments. This gives rise to a very muddled picture. Based on the output and unemployment gaps, the New Zealand economy seems at full employment, yet it has not seen much in terms of wage or inflationary pressures. As a result, the Reserve Bank of New Zealand has refrained from adopting a hawkish tone. Moreover, the populist policy prescriptions of the Ardern government are also creating downside risk for the kiwi. High immigration has been a pillar behind New Zealand's high-trend growth rate, and therefore a buttress behind the nation's high interest rates. Yet, the government wants to curtail this source of dynamism. On the international front, the kiwi economy has historically been very sensitive to global growth. While this could be a long-term advantage, in the short-term the current global growth soft patch represents a potent handicap for the kiwi. In the end, we judge Australia's problems as deeper than New Zealand's. Since valuations are also in the NZD's favor, the only exposure we like to the kiwi is to buy it against the AUD. The Swiss Franc Chart 8The SNB's Problem On purchasing power parity metrics, the Swiss franc is expensive, and the meteoric rise of Swiss unit labor costs expressed in euros only confirms this picture. The problem is that this expensiveness is justified once other factors are taken into account, namely Switzerland's gargantuan net international investment position of 128% of GDP, which exerts an inexorable upward drift on the franc's fair value. Once this factor is incorporated, the Swiss franc currently looks cheap (Chart 8). The implication of this dichotomy is that the Swiss franc could experience upward pressure, especially when global growth slows, which is the case right now. However, the Swiss National Bank remains highly worried that an indebted economy like Switzerland, which also suffers from a housing bubble, cannot afford the deflationary pressures created by a strong franc. As a result, we anticipate that the SNB will continue to fight tooth and nail against any strength in the franc. Practically, we are currently short EUR/CHF on a tactical basis. Nonetheless, once we see signs that global growth is bottoming, we will once again look to buy the euro against the CHF as the SNB will remain in the driver's seat. The Swedish Krona Chart 9What The Riksbank Wants The Swedish krona is quite cheap (Chart 9), but in all likelihood the Riksbank wants it this way. Sweden is a small, open economy, with total trade representing 86% of GDP. This means that a cheap krona is a key ingredient to generating easy monetary conditions. However, this begs the question: Does Sweden actually need easy monetary conditions? We would argue that the answer to this question is no. Sweden has an elevated rate of capacity utilization as well as closed unemployment and output gaps. In fact, trend Swedish inflation has moved up, albeit in a choppy fashion, and the Swedish economy remains strong. Moreover, the country currently faces one of the most rabid housing bubbles in the world, which has caused household debt to surge to 182% of disposable income. This is creating serious vulnerabilities in the Swedish economy - dangers that will only grow larger as the Riksbank keep monetary policy at extremely easy levels. A case can be made that with large exposure to both global trade and industrial production cycles, the current slowdown in global growth is creating a risk for Sweden. These risks are compounded by the rising threat of a trade war. This could justify easier monetary policy, and thus a weaker SEK. When all is said and done, while the short-term outlook for the SEK will remained stymied by the global growth outlook, we do expect the Riksbank to increase rates this year as inflation could accelerate significantly. As a result, we recommend investors use this period of weakness to buy the SEK against both the dollar and the euro. The Norwegian Krone Chart 10The NOK Is The Cheapest Commodity Currency In The G-10 The Norwegian krone has experienced a meaningful rally against the euro and the krona this year - the currencies of its largest trading partners - and as such, the large discount of the real trade-weighted krone to its equilibrium rate has declined. On a long-term basis, the krone remains the most attractive commodity currency in the G-10 based on valuations alone (Chart 10). While we have been long NOK/SEK, currently we have a tactical negative bias towards this cross. Investors have aggressively bought inflation protection, a development that tends to favor the NOK over the SEK. However, slowing global growth could disappoint these expectations, resulting in a period of weakness in the NOK/SEK pair. Nonetheless, we believe this is only a short-term development, and BCA's bullish cyclical view on oil will ultimately dominate. As a result, we recommend long-term buyers use any weakness in the NOK right now to buy more of it against the euro, the SEK, and especially against the AUD. The Yuan Chart 11The CNY Is At Equilibrium The fair value of the Chinese yuan has been in a well-defined secular bull market because China's productivity - even if it has slowed - remains notably higher than productivity growth among its trading partners. However, while the yuan traded at a generous discount to its fair value in early 2017, this is no longer the case (Chart 11). Despite this, on a long-term basis we foresee further appreciation in the yuan as we expect the Chinese economy to continue to generate higher productivity growth than its trading partners. Moreover, for investors with multi-decade investment horizons, a slow shift toward the RMB as a reserve currency will ultimately help the yuan. However, do not expect this force to be felt in the RMB any time soon. On a shorter-term horizon, the picture is more complex. Chinese economic activity is slowing as monetary conditions as well as various regulatory and administrative rules have been tightened - all of them neatly fitting under the rubric of structural reforms. Now that the trade relationship between the U.S. and China is becoming more acrimonious, Chinese authorities are likely to try using various relief valves to limit downside to Chinese growth. The RMB could be one of these tools. As such, the recent strength in the trade-weighted dollar is likely to continue to weigh on the CNY versus the USD. Paradoxically, the USD's strength is also likely to mean that the trade-weighted yuan could experience some upside. The Brazilian Real Chart 12More Downside In The BRL Despite the real's recent pronounced weakness, it has more room to fall before trading at a discount to its long-term fair value (Chart 12). More worrisome, the equilibrium rate for the BRL has been stable, even though commodity prices have rebounded. This raises the risk that the BRL could experience a greater decline than what is currently implied by its small premium to fair value if commodity prices were to fall. Moreover, bear markets in the real have historically ended at significant discounts to fair value. The current economic environment suggests this additional decline could materialize through the remainder of 2018. Weak global growth has historically been a poison for commodity prices as well as for carry trades, two factors that have a strong explanatory power for the real. Moreover, China's deceleration and regulatory tightening should translate into further weakness in Chinese imports of raw materials, which would have an immediate deleterious impact on the BRL. Additionally, as we have previously argued, when the fed funds rate rise above r-star, this increases the probability of an accident in global capital markets. Since elevated debt loads are to be found in EM and not in the U.S., this implies that vulnerability to a financial accident is greatest in the EM space. The BRL, with its great liquidity and high representation in investors' portfolios, could bear the brunt of such an adjustment. The Mexican Peso Chart 13The MXN Is A Bargain Once Again When we updated our long-term models last September, the peso was one of the most expensive currencies covered, and we flagged downside risk. With President Trump re-asserting his protectionist rhetoric, and with EM bonds and currencies experiencing a wave of pain, the MXN has eradicated all of its overvaluation and is once again trading at a significant discount to its long-term fair value (Chart 13). Is it time to buy the peso? On a pure valuation basis, the downside now seems limited. However, risks are still plentiful. For one, NAFTA negotiations are likely to remain rocky, at least until the U.S. mid-term elections. Trump's hawkish trade rhetoric is a surefire way to rally the GOP base at the polls in November. Second, the leading candidate in the polls for the Mexican presidential elections this summer is Andres Manuel Lopez Obrador, the former mayor of Mexico City. Not only could AMLO's leftist status frighten investors, he is looking to drive a hard bargain with the U.S. on NAFTA, a clear recipe for plentiful headline risk in the coming months. Third, the MXN is the EM currency with the most abundant liquidity, and slowing global growth along with rising EM volatility could easily take its toll on the Mexican currency. As a result, to take advantage of the MXN's discount to fair value, a discount that is especially pronounced when contrasted with other EM currencies, we recommend investors buy the MXN versus the BRL or the ZAR instead of buying it outright against the USD. These trades are made even more attractive by the fact that Mexican rates are now comparable to those offered on South African or Brazilian paper. The Chilean Peso Chart 14The CLP Is At Risk We were correct to flag last September that the CLP had less downside than the BRL. But now, while the BRL's premium to fair value has declined significantly, the Chilean peso continues to trade near its highest premium of the past 10 years (Chart 14). This suggests the peso could have significant downside if EM weakness grows deeper. This risk is compounded by the fact that the peso's fair value is most sensitive to copper prices. Prices of the red metal had been stable until recent trading sessions. However, with the world largest consumer of copper - China - having accumulated large stockpiles and now slowing, copper prices could experience significant downside, dragging down the CLP in the process. An additional risk lurking for the CLP is the fact that Chile displays some of the largest USD debt as a percent of GDP in the EM space. This means that a strong dollar could inflict a dangerous tightening in Chilean financial conditions. This risk is even more potent as the strength in the dollar is itself a consequence of slowing global growth - a development that is normally negative for the Chilean peso. This confluence thus suggests that the expensive CLP is at great risk in the coming months. The Colombian Peso Chart 15The COP Is Latam's Cheapest Currency The Colombian peso is currently the cheapest currency covered by our models. The COP has not been able to rise along with oil prices, creating a large discount in the process (Chart 15). Three factors have weighed on the Colombian currency. First, Colombia just had elections. While a market-friendly outcome ultimately prevailed, investors were already expressing worry ahead of the first round of voting four weeks ago. Second, Colombia has a large current account deficit of 3.7% of GDP, creating a funding risk in an environment where liquidity for EM carry trades has decreased. Finally, Colombia has a heavy USD-debt load. However, this factor is mitigated by the fact that private debt stands at 65% of Colombia's GDP, reflecting the banking sector's conservative lending practices. At this juncture, the COP is an attractive long-term buy, especially as president-elect Ivan Duque is likely to pursue market-friendly policies. However, the country's large current account deficit as well as the general risk to commodity prices emanating from weaker global growth suggests that short-term downside risk is still present in the COP versus the USD. As a result, while we recommend long-term investors gain exposure to this cheap Latin American currency, short-term players should stay on the sidelines. Instead, we recommend tactical investors capitalize on the COP's cheapness by buying it against the expensive CLP. Not only are valuations and carry considerations favorable, Chile has even more dollar debt than Colombia, suggesting that the former is more exposed to dollar risk than the latter. Moreover, Chile is levered to metals prices while Colombia is levered to oil prices. Our commodity strategists are more positive on crude than on copper, and our negative outlook on China reinforces this message. The South African Rand Chart 16The Rand Will Cheapen Further Despite its more than 20% depreciation versus the dollar since February, the rand continues to trade above its estimate of long-term fair value (Chart 16). The equilibrium rate for the ZAR is in a structural decline, even after adjusting for inflation, as the productivity of the South African economy remains in a downtrend relative to that of its trading partners. This means the long-term trend in the ZAR will continue to point south. On a cyclical basis, it is not just valuations that concern us when thinking about the rand. South Africa runs a deficit in terms of FDI; however, portfolio inflows into the country have been rather large, resulting in foreign ownership of South African bonds of 44%. Additionally, net speculative positions in the rand are still at elevated levels. This implies that investors could easily sell their South African assets if natural resource prices were to sag. Since BCA's view on Chinese activity as well as the soft patch currently experienced by the global economy augur poorly for commodities, this could create potent downside risks for the ZAR. We will be willing buyers only once the rand's overvaluation is corrected. The Russian Ruble Chart 17The Ruble Is At Fair Value There is no evidence of mispricing in the rubble (Chart 17). Moreover the Russian central bank runs a very orthodox monetary policy, which gives us comfort that the RUB, with its elevated carry, remains an attractive long-term hold within the EM FX complex. On a shorter-term basis, the picture is more complex. The RUB is both an oil play as well as a carry currency. This means that the RUB is very exposed to global growth and liquidity conditions. This creates major risks for the ruble. EM FX volatility has been rising, and slowing global growth could result in an unwinding of inflation-protection trades, which may pull oil prices down. This combination is negative for both EM currencies and oil plays for the remainder of 2018. Our favorite way to take advantage of the RUB's sound macroeconomic policy, high interest rates and lack of valuation extremes is to buy it against other EM currencies. It is especially attractive against the BRL, the ZAR and the CLP. The only EM commodity currency against which it doesn't stack up favorably is the COP, as the COP possesses a much deeper discount to fair value than the RUB, limiting its downside if the global economy were to slow more sharply than we anticipate. The Korean Won Chart 18Despite Its Modest Cheapness, The KRW Is At Risk The Korean won currently trades at a modest discount to its long-term fair value (Chart 18). This suggests the KRW will possess more defensive attributes than the more expensive Latin American currencies. However, BCA is worried over the Korean currency's cyclical outlook. The Korean economy is highly levered to both global trade and the Chinese investment cycle. This means the Korean won is greatly exposed to the two largest risks in the global economy. Moreover, the Korean economy is saddled with a large debt load for the nonfinancial private sector of 193% of GDP, which means the Bank of Korea could be forced to take a dovish turn if the economy is fully hit by a global and Chinese slowdown. Moreover, the won has historically been very sensitive to EM sovereign spreads. EM spreads have moved above their 200-day moving average, which suggests technical vulnerability. This may well spread to the won, especially in light of the global economic environment. The Philippine Peso Chart 19Big Discount In The PHP The PHP is one of the rare EM currencies to trade at a significant discount to its long-term fair value (Chart 19). There are two main reasons behind this. First, the Philippines runs a current account deficit of 0.5% of GDP. This makes the PHP vulnerable in an environment where global liquidity has gotten scarcer and where carry trades have underperformed. The second reason behind the PHP's large discount is politics. Global investors remain uncomfortable with President Duterte's policies, and as such are imputing a large risk premium on the currency. Is the PHP attractive? On valuation alone, it is. However, the current account dynamics are expected to become increasingly troubling. The economy is in fine shape and the trade deficit could continue to widen as imports get a lift from strong domestic demand - something that could infringe on the PHP's attractiveness. However, on the positive side, the PHP has historically displayed a robust negative correlation with commodity prices, energy in particular. This suggests that if commodity prices experience a period of relapse, the PHP could benefit. The best way to take advantage of these dynamics is to not buy the PHP outright against the USD but instead to buy it against EM currencies levered to commodity prices like the MYR or the CLP. The Singapore Dollar Chart 20The SGD's Decline Is Not Over The Singapore dollar remains pricey (Chart 20). However, this is no guarantee of upcoming weakness. After all, the SGD is the main tool used by the Monetary Authority of Singapore to control monetary policy. Moreover, the MAS targets a basket of currencies versus the SGD. Based on these dynamics, historically the SGD has displayed a low beta versus the USD. Essentially, it is a defensive currency within the EM space. The SGD has historically moved in tandem with commodity prices. This makes sense. Commodity prices are a key input in Singapore inflation, and commodity prices perform well when global industrial activity and global trade are strong. This means that not only do rising commodity prices require a higher SGD to combat inflation, higher commodity prices materialize in an environment where this small trading nation is supported by potent tailwinds. Additionally, Singapore loan growth correlates quite closely with commodity prices, suggesting that strong commodity prices result in important amounts of savings from commodity producers being recycled in the Singaporean financial system. To prevent Singapore's economy from overheating in response to these liquidity inflows, MAS is being forced to tighten policy through a higher SGD. Today, with global growth softening and global trade likely to deteriorate, the Singaporean economy is likely to face important headwinds. Tightening monetary policy in the U.S. and in China will create additional headwinds. As a result, so long as the USD has upside, the SGD is likely to have downside versus the greenback. On a longer-term basis, we would expect the correction of the SGD's overvaluation to not happen versus the dollar but versus other EM currencies. The Hong Kong Dollar Chart 21The HKD Is Fairly Valued The troughs and peaks in the HKD follow the gyrations of the U.S. dollar. This is to be expected as the HKD has been pegged to the USD since 1983. Like the USD, it was expensive in early 2017, but now it is trading closer to fair value (Chart 21). Additionally, due to the large weight of the yuan in the trade-weighted HKD, the strength in the CNY versus the USD has had a greater impact on taming the HKD's overvaluation than it has on the USD's own mispricing. Moreover, the HKD is trading very close to the lower bound of its peg versus the USD, which has also contributed to the correction of its overvaluation. Even when the HKD was expensive last year, we were never worried that the peg would be undone. Historically, the Hong Kong Monetary Authority has shown its willingness to tolerate deflation when the HKD has been expensive. The most recent period was no different. Moreover, the HKMA has ample fire power in terms of reserves to support the HKD if the need ever existed. Ultimately, the stability created by the HKD peg is still essential to Hong Kong's relevance as a financial center for China, especially in the face of the growing preeminence of Shanghai and Beijing as domestic financial centers. As a result, while we could see the HKD become a bit more expensive over the remainder of 2018 as the USD rallies a bit further, our long-term negative view on the USD suggests that on a multiyear basis the HKD will only cheapen. The Saudi Riyal Chart 22The SAR Remains Expensive Like the HKD, the riyal is pegged to the USD. However, unlike the HKD, the softness in the USD last year was not enough to purge the SAR's overvaluation (Chart 22). Ultimately, the kingdom's poor productivity means that the SAR needs more than a 15% fall in the dollar index to make the Saudi economy competitive. However, this matters little. Historically, when the SAR has been expensive, the Saudi Arabia Monetary Authority has picked the HKMA solution: deflation over devaluation. Ultimately, Saudi Arabia is a country that imports all goods other than energy products. With a young population, a surge in inflation caused by a falling currency is a risk to the durability of the regime that Riyadh is not willing to test. Moreover, SAMA has the firepower to support the SAR, especially when the aggregate wealth of the extended royal family is taken into account. Additionally, the rally in oil prices since February 2016 has put to rest worries about the country's fiscal standing. On a long-term basis, the current regime wants to reform the economy, moving away from oil and increasing productivity growth. This will be essential to supporting the SAR and decreasing its overvaluation without having to resort to deflation. However, it remains to be seen if Crown Prince Mohamed Bin Salman's ambitious reforms can in fact be implemented and be fruitful. Much will depend on this for the future stability of the riyal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary

While copper prices remain comfortably within the $2.90 to $3.30/lb range they've occupied this year, the rising threat of a Sino - U.S. trade war spilling into the global trading system, along with slowing credit and monetary stimulus in China, will continue to roil copper markets. Refined copper prices - like most commodities - are highly sensitive to the level of world copper demand and EM imports, particularly out of Asia, which are closely tied to income. EM income growth is expected to remain strong; however, a global trade war, or a significant slowing in trade that reduces investment in EM markets and stymies income growth will be bearish for copper prices. Highlights Energy: Overweight. Going into tomorrow's OPEC 2.0 meeting in Vienna, the Kingdom of Saudi Arabia (KSA) and Russia apparently were divided on how much crude oil production needed to be restored to the market. Increases of as little as 300k to 600k b/d and as much as 1.5mm b/d are flying around the market in the lead-up to the meeting.1 Meanwhile, China threatened to impose tariffs on oil imports from the U.S. if President Trump goes ahead with additional tariffs. The increased Sino - American acrimony on trade issues raises the likelihood China will significantly increase oil imports from Iran, in our estimation, which will exacerbate tensions even further. Base Metals: Neutral. Copper treatment and refining charges (TC/RCs) soared at the end of last week following the closure of India's largest smelter. The Metal Bulletin TC/RC index went to an average of $85/MT at the end of last week, up from $82.25/MT. The pricing service also reported China's primary copper-smelting capacity is lower in June due to environmental constraints. Precious Metals: Neutral. Gold prices dropped below $1,300/oz following the FOMC meeting last week, as Fed officials - e.g., Dallas Fed President Robert Kaplan - nodded toward a fourth rate hike this year, even though his base case remained at three. Ags/Softs: Underweight. Grains and beans are down as much as 10% in the past week, on the back of additional tariffs announced by the Trump administration - 10% on $200 billion worth of Chinese imports. The new tariffs were a retaliatory move by the administration, and represent an escalation of tit-for-tat measures by both sides. Feature Chart of the WeekMajor Drivers of Copper Prices Still Supportive Rising EM incomes and expanding world trade volumes, particularly EM imports, have supported base metals prices for the past two years. This was partly aided by expansionary fiscal and monetary policy in China, the world's largest base-metals market, in 2016, which reversed overly restrictive monetary and fiscal policy in the two years prior. For the most part, these supportive underpinnings are still in place for EM commodity growth over the next two years (Chart of the Week). However, their stability increasingly is being threatened by rising Sino - American trade tensions, and the limited room for credit and fiscal expansion in China.2 Global Copper Demand And Trade In its most recent update of global growth, the World Bank is expecting the rate of growth globally to level off this year and next. However, the Bank expects income growth in EM and developing economies - the growth engines of commodity demand - to go from 4.3% last year to 4.5% this year, and 4.7% next year. EM growth will be dominated by South Asia (Chart 2).3 EM GDP growth is of particular importance to commodity markets, since this constitutes the bulk of commodity demand growth generally, particularly in base metals and oil. For the largest EM economies, the income elasticity of demand for copper is 0.70, meaning a 1% increase in income leads to a 0.70% increase in copper consumption. The Bank notes, "The seven largest emerging markets (EM7) accounted for almost all the increase in global consumption of metals, and two-thirds of the increase in energy consumption" over the past 20 years.4 In what the Bank refers to as Low Income Countries (LICs) - a grouping of smaller economies loaded with commodity producers - GDP is expected to grow 6% p.a. on average over the 2018 - 2020 period. Chart 2World Bank Expects Solid EM Growth EM GDP growth fuels copper demand. Since 2000, a 1% increase in global copper consumption ex-China translates into an almost 2% increase in high-grade refined copper prices, based on results of our modeling. When we replace ex-China demand with China, we see a 1% increase in China's consumption translates into a 0.75% increase in high-grade copper prices over the 2000 - 2018 interval. China's growth is expected to slow going forward, in the wake of a managed slowdown, and due to the fact that, as its economy evolves, more of its growth will come from services and consumer demand, which are less commodity intensive. GDP growth also fuels trade, and vice versa. The Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. In our modeling, we've found a 1% increase in EM trade volumes translates into a 1.3% increase in high-grade copper prices, an elasticity in line with post-GFC trade growth. The other key variable in our modeling is the broad trade-weighted USD, which remains a highly important variable for copper prices. In both our global copper-demand and EM import volume models for copper prices, the level of the USD is an important explanatory variable - a 1% increase (decrease) in the USD TWIB translates into ~ 3% decrease (increase) in copper prices since 2000 in our estimates.5 Tight Credit Conditions In China Can Weigh On Copper ... We've been expecting China's managed slowdown in 2H18 to be offset by strong global demand, which, all else equal, would keep copper demand fairly stable.6 While we still do not expect a hard landing in China, the slowdown we've been expecting is showing up in weaker industrial production prints, disappointing retail sales in May, and most significantly, regulatory and liquidity tightening weighing on money and credit. Chinese demand makes up ~ 50% of global metal consumption, these markets would be especially vulnerable in the case of a significant slowdown. The fear of a more serious slump is founded on tighter financial conditions restricting capital spending, and GDP growth. Granger causality tests to determine the direction of causation between Chinese monetary variables and copper prices point to causality running from de-trended levels of all four measures of money and credit to copper prices (Table 1).7 Table 1Chinese Credit And Copper Prices: Evidence Of Causality Furthermore, y/y changes in copper prices are more highly correlated with monetary variables expressed in terms of de-trended levels, than with those same variables expressed as y/y growth rates, or impulses (Chart 3). Across the four credit and money measures, this expression yields an average correlation coefficient of 0.56, compared with 0.38 and 0.37 when expressed as y/y growth rates and impulses as a percent of GDP, respectively. Our modeling also indicates that it generally takes two to three quarters for the full effect of a change in China's credit conditions to be transmitted to copper markets. When we restrict the sample size to the period from 2010 to now we get similar results to our longer intervals (Chart 4). However monetary variables are more highly correlated with copper prices in the shorter sample. Chart 3Chinese Credit Leads Copper Prices By 3 Quarters... Chart 4...A Slightly Longer Lead Time Since 2010 Correlations in the period since 2010 average 0.61, 0.57, and 0.45 for the de-trended levels, y/y growth rates, and impulses, respectively. This can be put down to the fact that China's role as a demand market for copper has been steadily growing over this period. Given that between 2000 and 2017, China's share of global copper demand swelled from 12% to 50%, it is only natural that the impact of its domestic economy on global copper prices also increased (Chart 5). Furthermore, the time lag between Chinese monetary variables and copper markets in the more recent sample increased slightly, with money and credit variables leading prices by 9-10 months, compared to 6-8 months in the full sample. Chart 5China's Growing Role In Copper Markets Bottom Line: De-trended Chinese money and credit variables statistically cause, and are correlated with, y/y changes in copper prices. While these relationships have generally strengthened with China's growing role in the demand side of global copper markets, rolling correlations highlight that there are also extended periods of weak correlations, suggesting fundamental factors can overwhelm the impact of China's credit environment on global copper markets, as has been the case for the past two years. ...But Other Factors Can Take Over In estimating the effect of China's money and credit conditions on copper markets, we find that the relationship can be dominated by supply - demand fundamentals, and overall global macro conditions. More specifically, we find that in periods where DM equity markets outperform EM equity markets, the coefficients in our models with y/y copper prices as the dependent variable are on average 13% lower than the full sample period (Chart 6). Similarly, in periods where EM outperforms DM, the models' credit coefficients are on average 15% higher than the full sample period.8 Our modeling indicates the pre-2005 period as well as the post-2015 intervals as periods during which strong copper demand from growing DM economies weakened the long-term relationship between Chinese money and credit variables and copper prices. Given our expectation that DM demand will remain supportive, this will, to some extent, offset the negative implications of the deteriorating credit environment in China on copper demand and prices. Similarly, in periods characterized by backwardated copper markets, the magnitude of the impact of Chinese money and credit variables on copper prices is on average 35% lower than the full sample (Chart 7). On the other hand, when the copper market is in contango, the magnitude of the impact of Chinese financial variables is on average 13% higher than the full sample period. This highlights the importance of physical fundamentals, and the fact that in cases where they deviate from the direction of the Chinese credit environment - such as during a supply shock - the physical fundamentals weaken historical correlation relationships. Chart 6Credit-Copper Relationship Weakens When DM Outperforms EM ... Chart 7... And When Markets Are Backwardated To rank the top explanatory financial variables in terms of their effect on the evolution of copper prices, we estimated regression models with monetary variables, along with the broad trade-weighted U.S. dollar, and world excluding China copper demand as independent variables (Table 2). Table 2USD Usually Dominates Copper's Evolution The results, which can be interpreted as the y/y percentage point (pp) change in copper prices from a one y/y pp increase in each of the three explanatory variables, indicate that Chinese credit has a similar effect as a one y/y pp increase in world excluding China copper demand, a not-unexpected result, given the rest of the world accounts for 50% of demand. On the other hand, the USD has an outsized effect on the copper market. In our modeling, we've found that, in general, a one pp increase (decrease) in the broad trade-weighted USD translates into a one pp change in copper prices, using y/y models.9 Will Copper Vs. USD Correlations Return To Equilibrium? Our House view calls for a stronger USD going forward. Despite our expectation that DM demand will remain supportive, absent supply-side shocks, a stronger USD along with deteriorating credit conditions in China will weigh on copper prices.10 Ongoing trade disputes will only further bear down on the copper market. Stronger EM GDP growth and the associated increase in copper consumption and trade volumes will offset the strong-USD effects, but a trade war would undermine this support. A caveat to this conclusion is that while credit growth has been generally restrained, the Chinese government - fearful that its policy measures to date are spiraling out of control - may partially reverse its efforts and attempt some easing.11 Bottom Line: The impact of Chinese credit conditions on copper prices is weakened in periods where DM stock prices outperform EM, and when the copper forward curve is backwardated. In terms of the relative magnitude of the effect of China's credit conditions, we find that it has a similar sized effect as the rest of the world's copper demand on the red metal's price, while the USD has a relatively larger effect. This implies that a stronger USD, coupled with tighter financial conditions in China, will compete with expanding EM GDPs and trade growth going forward. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 OPEC 2.0 is the name we've coined for the oil producer coalition lead by KSA and Russia. In November 2016, the coalition agreed to remove 1.8mm b/d of production. We estimate actual production cuts amount to 1.2mm b/d, while as much a 1.5mm b/d of production has been lost to depletion and a lack of maintenance drilling (e.g., infill and other forms of enhanced oil recovery). 2 Our colleague Peter Berezin, writing in this week's Global Investment Strategy, noting slowing industrial production, retail sales and fixed-asset investment, observes, China's "policy response has been fairly muted." Further, unlike 2015, when China stimulated its economy and lifted EM generally, this go-round, there is less room to maneuver owing to high debt levels and overcapacity. Please see BCA Research Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global risk Assets To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 3 Please see "The Role of Major Emerging Markets in Global Commodity Demand" in the Bank's Global Economic Prospects, June 2018, beginning on p. 61. 4 The Bank's EM7 are Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey. They account for ~ 25% of global GDP, and some 60% of global metals consumption. The income elasticities of aluminum and zinc demand for this group are 0.80 and 0.30, respectively. Please see Table SF1.1 on p. 70 of the Bank's June report. 5 The R2 statistic measuring the goodness of fit between actual copper prices and the modeled prices is 94% for the copper-consumption model, and 96% for the EM trade model over the 2000 - 2018 interval. The USD TWIB was used as an explanatory variable in both models. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. 7 Given that in levels, the money and credit variables display a deterministic upward trend, we removed the trend from the data in order to isolate the fluctuations around this trend. This de-trended series is what is significant to copper demand, and thus the evolution of copper prices. 8 We use a threshold OLS model to estimate the y/y model coefficients. The average change in the value of the coefficient is based on the coefficients in the models' outputs of the four money and credit measures. 9 The R2 statistics measuring the goodness of fit between actual y/y changes and those estimated in our models were ~63% in all four models. 10 We discussed this at length last week in BCA Research Commodity & Energy Strategy Weekly Report "Correlations Vs. USD Weaken," dated June 14, 2018, available at ces.bcaresearch.com. 11 Some preliminary signs of potential easing include (1) the PBOC's most recent monetary policy decision in which it did not follow the US Fed's interest rate decision by hiking rates, as it generally does, and (2) a reduction in the reserve requirement ratio. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in

Highlights Fed: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. Credit Cycle: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Emerging Market Debt: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Feature The Federal Reserve meets this week and will deliver the second rate hike of the year, bringing the target range for the federal funds rate up to 1.75% - 2%. With that hike already fully discounted, investors will be more concerned with parsing the post-meeting statement, Summary of Economic Projections, and Chairman Powell's press conference for clues about the future path of rates. We expect only minor changes to the statement, though the Committee could decide to tweak its promise that "the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run". Such a change would simply acknowledge that if gradual rate hikes continue, then the federal funds will move close to most estimates of its neutral (or equilibrium) level within the next 12 months. This touches on an important question for bond investors. Would the Fed actually start to slow the pace of rate hikes once the funds rate reaches its estimated neutral level? Or will it need to see some evidence of decelerating economic growth before slowing the pace of rate hikes below its current 25 bps per quarter pace? Chart 1 shows why this question is important. The shaded boxes in that chart outline a "gradual" rate hike path of 25 bps per quarter. The Fed has been lifting rates at this pace since late 2016. The "x" markings denote the median expected fed funds rate from the Fed's Survey of Primary Dealers, and the "F" markings denote the Fed's own median projections. Notice that there are two "F"s shown at the end of 2018. This is because an equal number of FOMC participants (6) expect a fed funds rate of 2% - 2.25% as expect one of 2.25% - 2.5%. We expect the median will coalesce around the 2.25% to 2.5% range by the end of tomorrow's meeting. Chart 1The Outlook For Rate Hikes Notice in Chart 1 that both primary dealers and the Fed expect to deviate from the quarterly rate hike pace around the middle of next year. This would be consistent with the pace of hikes starting to slow as the fed funds rate approaches its currently anticipated neutral level near 3%. But how confident is the Fed in its estimate of that neutral rate? We would argue that its confidence should be quite low. We are not alone in this assessment. In one of Janet Yellen's final speeches as Fed Chair she warned against placing too much confidence in estimates of the neutral rate.1 [T]he neutral rate changes over time as a result of the interaction of many forces, including demographics, productivity growth, fiscal policy, and the strength of global demand, so its value at any point in time cannot be estimated or projected with much precision. We expect that the current FOMC will heed this warning, and if there are no signs of economic deterioration by the middle of next year, then the Fed will continue to hike rates at a pace of 25 bps per quarter and estimates of the neutral rate will be revised higher. We examined what could potentially make the Fed deviate from its 25 bps per quarter rate hike pace, by hiking either more quickly or more slowly, in a recent report.2 Crucially, Chart 1 shows that not only is the market priced for the Fed to slow its pace of rate hikes as we reach the middle of next year, it is also priced for a slower pace of rate hikes than is expected by the Fed or the primary dealers. This divergence means that below-benchmark portfolio duration continues to make sense on a 6-12 month horizon. Bottom Line: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. A Quick Update On Our Tactical Long Position On May 22 we advised clients with a short-term (0-3 month) horizon to position for lower U.S. bond yields in the near term.3 This call was premised on two catalysts. First, bond market positioning had become excessively net short. That picture now looks more mixed (Chart 2). Net speculative positions in 10-year Treasury futures remain deep in "net short" territory and the Marketvane survey of bond sentiment is still "bearish", but the JP Morgan Duration Surveys for both "all clients" and active clients" have moved somewhat closer to neutral. The second catalyst was that our auto-regressive model pointed to strong odds of a negative reading from the U.S. Economic Surprise Index during the next month (Chart 3). This remains the case, but the reading from our model has moved much closer to the zero line. Chart 2Positioning Now Closer To Neutral Chart 3Surprise Index Still Low Taken together, our two indicators no longer send a resounding "buy bonds" signal. But given the deeply net short Treasury futures positioning and the low level of the surprise index, we are inclined to maintain our tactical buy recommendation for another week. We will re-assess again next week based on trends in the surprise index and the positioning data. The Fed & The Credit Cycle The Powell Fed has so far not been kind to credit spreads. Since February our index of financial conditions has tightened considerably, driven by a combination of falling equity prices, wider quality spreads and a stronger dollar (Chart 4). Yet, the Fed seems relatively unconcerned and is broadly expected to lift rates this week. All in all, the Powell Fed seems less concerned with responding to tighter financial conditions than was the Yellen Fed. Chart 4How Much Pain Can The Fed Take? There is some truth to this observation, though we think the difference has more to do with recent trends in inflation than with any change in approach between the two Fed Chairs. As inflation pressures mount, the Fed is marginally less concerned with responding to weakness in financial markets and marginally more concerned with preventing an inflation overshoot. This is why we will reduce our allocation to corporate bonds once our monetary indicators tell us that inflation expectations are well anchored around the Fed's target. Monetary Indicators Long maturity TIPS breakeven inflation rates are the primary indicators we are monitoring in this regard. When both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%, that will be consistent with past periods of well-anchored inflation expectations and we will start reducing exposure to corporate credit (Chart 5). But we should not rely solely on one indicator. It is conceivable that the financial crisis ushered in a structural shift (possibly due to stricter banking regulations) and that the level of TIPS breakevens consistent with well-anchored inflation expectations is now slightly lower.4 For this reason we also pay attention to the St. Louis Fed's Price Pressures Measure (Chart 5, bottom panel). This model is designed to output the percent chance that inflation will exceed 2.5% during the next 12 months, and we have found that corporate bond excess returns decline significantly when it exceeds 15%.5 It currently sits at 13%. Finally, it's also a good idea to pay attention to core PCE inflation itself. The year-over-year rate of change in core PCE inflation jumped sharply in recent months, but it has not yet returned to the Fed's 2% target (Chart 6). It is therefore still reasonable to expect that inflation expectations are not consistent with target inflation. It is likely that many investors still have doubts about whether inflation will recover to the Fed's target. Chart 5Credit Cycle: Monetary Indicators Chart 6The Fed's Inflation Model Those doubts would probably fade if the year-over-year rate of change in core PCE inflation actually rose to 2% and stayed there for several months. At that point we would have to conclude that inflation expectations are well anchored, whatever the level of TIPS breakeven rates. Incidentally, the recent bounce in core inflation brought it back in line with the reading from Janet Yellen's Phillips Curve model that she presented in a speech from 2015.6 In the context of this model, a continued decline in the unemployment rate will pressure inflation slowly higher, meaning that we expect to receive a signal from our monetary indicators sometime this year. We will pare exposure to corporate bonds at that time. It will be very interesting to hear from Chair Yellen herself when she visits the BCA Conference in September, and we hope to gain insight not only about her inflation forecast but also about how the Fed thinks about its responsiveness to financial markets, and most importantly, about how the Fed is likely to manage the tightening cycle as the funds rate approaches its estimate of neutral. Credit Quality Indicators Outside of Fed policy and the inflation outlook, we are also closely monitoring the relationship between profit growth and debt growth for the nonfinancial corporate sector. Leverage rises whenever debt growth exceeds profit growth and rising leverage tends to coincide with widening credit spreads (Chart 7). Nonfinancial corporate debt grew at an annualized rate of 4.4% in the first quarter, while pre-tax profits actually contracted at an annualized rate of 5.7%. As a result, our measure of gross leverage ticked higher from 6.9 to 7.1. More broadly, profits grew 5.8% in the four quarters ending in Q1 2018, only slightly faster than the 5.2% increase in corporate debt. This does not provide much of a buffer, and it will not take much to send profit growth below debt growth on a sustained basis. In fact, we expect that if labor compensation costs continue to accelerate we will see leverage start to rise more meaningfully in the second half of this year. Our overall Corporate Health Monitor improved noticeably in the first quarter (Chart 8). But this large move will almost certainly reverse in Q2. The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart 8, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (Chart 8, bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. Chart 7Leverage Is Poised To Head Higher Chart 8Tax Cuts Helped Balance Sheets In Q1 Bottom Line: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Still No Opportunity In Emerging Market Debt We pointed out in a recent report that a persistent divergence between U.S. and non-U.S. economic growth was the most likely catalyst that could cause the Fed to slow its pace of rate hikes.7 A divergence between strong U.S. growth and weaker growth in the rest of the world puts upward pressure on the U.S. dollar, and this is a particular problem for many emerging markets that carry large balances of U.S. dollar denominated debt. Our Emerging Markets Strategy service published a Special Report last week that explains in detail this particular problem faced by emerging markets and shows which countries face the most pressing debt concerns.8 For U.S. fixed income investors another important question is whether the recent strength in the U.S. dollar, and weakness in emerging market currencies, has resulted in an opportunity to shift out of U.S. corporate credit and into USD-denominated emerging market sovereign debt. On that note, Chart 9 shows that the average option-adjusted spread for the Baa-rated U.S. Corporate bond index recently dipped below the average spread for the investment grade USD Emerging Market (EM) Sovereign index. However, we think it is still too soon to move into emerging market debt. After adjusting for differences in duration and spread volatility between the two indexes, we come up with a measure of "Months-To-Breakeven". This indicator shows the number of months of spread widening required for each index to lose money relative to U.S. Treasuries. By this measure, U.S. Corporate bonds still look attractive compared to investment grade EM Sovereigns. At the country level, Chart 10 shows the 12-month breakeven spread for the USD-denominated sovereign debt of several major EM countries. It also shows each country's foreign funding requirement, a measure of the foreign capital inflows required in the next 12 months for each country to cover any shortfall in current account transactions and service its foreign currency debt. Chart 9EM Sovereigns Are Still Expensive Chart 10USD-Denominated Emerging Market Debt: Risk/Reward At The Country Level For the Baa-rated countries, Colombia, Mexico and Indonesia all offer spreads similar to what can be found in the Baa-rated U.S. Corporate bond market. The Philippines looks quite expensive, but Russia looks cheap compared to U.S. Corporates and has one of the lowest foreign funding requirements of any EM country. In High-Yield space, Turkey is fairly priced relative to Ba-rated U.S. junk, while Brazil and South Africa both look expensive. Argentina also looks expensive relative to B-rated U.S. junk. Bottom Line: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20170926a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 We explored some possible reasons for such a shift in the U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 7 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Special Report, "A Primer On EM External Debt", dated June 7, 2018, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

The GAA DM Equity Country Allocation model is updated as of May 31, 2018. No significant changes in the model's allocation this month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 111 bps in May, largely driven by Level 2 model which underperformed by 300 bps. The model's largest overweight, Italy, turned out to be the worst performer in May as a result of Italian politics, an event that is difficult for a quantitative model to capture. Level 1 model outperformed by only 7 bps in May. Consequently, since going live, the outperformance of the Level 2 model, which allocates funds among 11 non-U.S. countries, has reduced to 52 bps, while the overall model has performed in line with the MSCI World benchmark. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of May 31, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The largest shift was a move from underweight to overweight in the materials sector, driven by improving momentum. On the other hand, the overweight in energy was reduced by 1.7 percentage points. The aggregate model now has a small overweight on cyclicals versus defensives, although this is entirely in commodity-related cyclicals. The only other overweight sector is utilities, which saw a small decrease in its weight in the model. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com.

Highlights The risk/reward balance for risk assets remains unappealing this month, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The number of items that could take equity markets to new highs appears to fall well short of the number of potential landmines that could take markets down. Tensions vis-à-vis North Korea have eased, but the U.S./China trade war is heating up. Trump's voter base and many in Congress want the President to push China harder. Eurozone "breakup risk" has reared its ugly head once again. The Italian President is trying to install a technocratic government, but the interim between now and a likely summer election will extend the campaign period during which the two contending parties have an incentive to continue with hyperbolic fiscal proposals. The next Italian election is not a referendum on exiting the EU or Euro Area. Nonetheless, the risks posed by the Italian political situation may not have peaked, especially since Italy's economic growth appears set to slow. We are underweight both Italian government bonds and equities within global portfolios. It is also disconcerting that we have passed the point of maximum global growth momentum. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. One reason for the economic "soft patch" is that the Chinese economy continues to decelerate. Our indicators suggest that growth will moderate further, with negative implications for the broader emerging market complex. Dearer oil may also be starting to bite, although prices have not increased enough to derail the expansion in the developed economies. This is especially the case in the U.S., where the shale industry is gearing up. Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. Similar divergences are occurring in the inflation data. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. U.S. inflation is almost back to target and the FOMC signaled that an overshoot will be tolerated. Policymakers will likely transition from "normalizing" policy to targeting slower economic growth once long-term inflation expectations return to the 2.3%-2.5% range. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Feature The major stock indexes are struggling, even though 12-month forward earnings estimates continue to march higher (Chart I-1). One problem is that a lot of good earnings news was discounted early in the year. The number of items that could take markets to new highs appear to fall well short of the number of potential landmines that could take markets down. Not the least of which is ongoing pain in emerging markets and the return of financial stress in Eurozone debt markets. Last month's Overview highlighted the unappealing risk/reward balance for risk assets, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The advanced stage of the business cycle and our bias for capital preservation motivated us to heed the recent warnings from our growth indicators and 'exit' timing checklist. We also were concerned about a raft of geopolitical tensions. Fast forward one month and the backdrop has not improved. Our Equity Scorecard Indicator edged up, but is still at a level that historically was consistent with poor returns to stocks and corporate bonds (see Chart I-1 in last month's Overview). Our 'exit' checklist is also signaling that caution is warranted (Table I-1). Meanwhile, the "global synchronized expansion" theme that helped to drive risk asset prices higher last year is beginning to unravel and trade tensions are escalating. Chart I-1Struggling To Make Headway Table I-1Exit Checklist For Risk Assets U.S./Sino Trade War Is Back? The "on again/off again" trade war between the U.S. and China is on again as we go to press. Investors breathed a sigh of relief in mid-May when the Trump Administration signaled that China's minor concessions were sufficient to avoid the imposition of onerous new tariffs. However, the proposed deal did not go down well with many in the U.S., including some in the Republican Party. The President was criticized for giving up too much in order to retain China's help in dealing with North Korea. Trump might have initially cancelled the summit with Kim in order to send a message to China that he is still prepared to play hard ball on trade, despite the North Korean situation. We expect that U.S./North Korean negotiations will soon begin, and that Pyongyang will not be a major threat to global financial markets for at least the near term. It is a different story for U.S./China relations. Trump's voter base and many in Congress on both sides of the isle want the President to push China harder. This is likely to be a headwind for risk assets at least until the U.S. mid-term elections. The Return Of Eurozone Breakup Risk Turning to the Eurozone, "breakup risk" has reared its ugly head once again. Italian President Sergio Mattarella's decision to reject a proposed cabinet minister has led to the collapse of the populist coalition between the anti-establishment Five Star Movement (M5S) and the euroskeptic League. President Mattarella's choice for interim-prime minister, Carlo Cottarelli, is unlikely to last long. It is highly unlikely that he will be able to receive parliamentary support for a technocratic mandate, given the fact that he cut government spending during a brief stint in government from 2013-14. As such, elections are likely this summer. Chart I-2Italy: No Euro Support Rebound Investors continue to fret for two reasons. First, the interim period will extend the campaign period during which both M5S and the League have an incentive to continue with hyperbolic fiscal proposals. Second, M5S has suggested that it will try to impeach Mattarella, a long and complicated process that would heighten political risk, though it will likely fail in our view. As our geopolitical strategists have emphasized throughout 2017, Italy will eventually be the source of a major global risk-off event because it is the one outstanding major European country capable of reigniting the Euro Area break-up crisis.1 While a majority of Italians support the euro, they are less supportive than any other major European country, including Greece (Chart I-2). Meanwhile a plurality of Italians is confident that the future would be brighter if Italy were an independent country outside of the EU. That said, the next election is not a referendum on exiting the EU or Euro Area. The current conflict arises from the coalition wanting to run large budget deficits in violation of Europe's Stability and Growth Pact fiscal rules. Given that the costs of attempting to exit the Euro Area are extremely severe for Italy's households and savers, and that even the Five Star Movement has moderated its previous skepticism about the euro for the time being, it is likely going to require a recession or another crisis to cause Italy seriously contemplate an exit. We are still several steps away from such a move. Nonetheless, the risks posed by the Italian political situation may not have peaked. Italy's leading economic indicator points to slowing growth, which will intensify the populist push for aggressive fiscal stimulus. We are underweight both Italian government bonds and equities within global portfolios. Global Growth Has Peaked Chart I-3Past The Point Of Max Growth Momentum It is also disconcerting that we have passed the point of maximum global growth momentum, as highlighted by the indicators shown in Chart I-3. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. What is behind this year's loss of momentum? First, growth in 2017 was flattered by a rebound from the oil-related manufacturing recession of 2015/16. That rebound is now topping out, while worries regarding a trade war are undoubtedly weighing on animal spirits and industrial activity. Second, the Eurozone economy was lifted last year by the previous recapitalization of parts of the banking system, which allowed some pent-up credit demand to be satiated. This growth impulse also appears to have peaked, which helps to explain the sharp drop in some of the Eurozone's key economic indicators. Still, we do not expect European growth to slip back below a trend pace on a sustained basis unless the Italian situation degenerates so much that contagion causes significantly tighter financial conditions for the entire Eurozone economy. The third factor contributing to the global growth moderation is China. The Chinese economy surged in 2017 in a lagged response to fiscal and monetary stimulus in 2016, as highlighted by the Li Keqiang Index (LKI) and import growth (Chart I-4). Both are now headed south as the policy backdrop turned less supportive. Downturns in China's credit and fiscal impulses herald a deceleration in capital spending and construction activity (Chart I-4, bottom panel). The LKI has a strong correlation with ex-tech earnings and import growth. In turn, the latter is important for the broader EM complex that trade heavily with China. Weaker Chinese import growth has also had a modest negative impact on the developed world (Chart I-5). We estimate that, for the major economies, the contribution to GDP growth of exports to China has fallen from 0.3 percentage points last year to 0.1 percentage points now.2 Japan and Australia have been hit the hardest, but the Eurozone has also been affected. Interestingly, U.S. exports to China have bucked the trend so far. Chart I-4China Growth Slowdown... Chart I-5...Is Weighing On Global Activity China is not the only story because the slowdown in global trade activity in the first quarter was broadly based (Chart I-5). Nonetheless, softer aggregate demand growth out of China helps to explain why manufacturing PMIs and industrial production growth in most of the major developed economies have cooled. Our model for the LKI is still moderating. We do not see a hard economic landing, but our analysis points to further weakening in Chinese imports and thus softness in global exports and manufacturing activity in the coming months. Oil's Impact On The Economy... Finally, oil prices are no doubt taking a bite out of consumer spending power as Brent fluctuates just below $80/bbl. Our energy experts expect the global crude market to continue tightening due to robust growth and ongoing geopolitical tensions. Chief among these are the continuing loss of Venezuelan crude production and the re-imposition of U.S. sanctions on Iran. At the same time, we expect OPEC 2.0 to keep its production cuts in place in the second half of the year. Increasing shale output will not be enough to prevent world oil prices from rising in this environment, and we expect oil prices to continue to trend higher through 2018 and into early 2019 (Chart I-6). Brent could touch $90/bbl next year. There are a few ways to gauge the size of the oil shock on the economy. Chart I-7 shows the U.S. and global 'oil bill' as a share of GDP. We believe that both the level and the rate of change are important. Price spikes, even from low levels, do not allow energy users the time to soften the blow by shifting to alternative energy sources. Chart I-6Oil: Stay Bullish Chart I-7The Oil Bill The level of the oil bill is not high by historical standards. The increase in the bill over the past year has been meaningful, both for the U.S. and at the global level, but is still a long way from the oil shocks of the 1970s. U.S. consumer spending on energy as a share of disposable income, at about 4%, is also near the lowest level observed over the past 4-5 decades (Chart I-8). The 2-year swing in this series shows that rapid increases in energy-related spending has preceded slowdowns in economic growth, even from low starting points. The swing is currently back above the zero line but, again, it is not at a level that historically was associated with a significant economic slowdown. Chart I-8Oil's Impact On U.S. Consumer Spending Moreover, the mushrooming shale oil and gas industry has altered the calculus of oil shocks for the U.S. The plunge in oil prices in 2014-16 was accompanied by a manufacturing and profit mini recession in the developed countries, providing a drag on overall GDP growth. Chart I-9 provides an estimate of the contribution to U.S. growth from the oil and gas industry. We have included capital spending and wages & salaries in the calculation, and scaled it up to include spillover effects on other industries. Chart I-9Oil's Impact On Consumer Spending And Shale The oil and gas contribution swung from +0.5 percentage points in 2012 to -0.4 percentage points in 2016. The contribution has since become only slightly positive again, but it is likely to rise further unless oil prices decline in the coming months. We have included the annual swing in consumer spending on energy as a percent of GDP in Chart I-9 (inverted) for comparison purposes. At the moment, the impact on growth from the shale industry is roughly offsetting the negative impact on consumer spending. The bottom line is that the rise in oil prices so far is enough to take the edge off of global growth, but it is not large enough to derail the expansion in the developed countries. This is especially the case in the U.S., where the shale industry is gearing up. ...And Asset Prices As for the impact on asset prices, it is important to ascertain whether rising oil prices represent more restrictive supply or expanding demand. A mild rise in oil prices might simply be a symptom of increased demand caused by accelerating global growth. Higher oil prices are thus reflective of robust demand, and thus should not be seen as a threat. In contrast, the 1970s experience shows that supply restrictions can send the economy into a tailspin. In order to separate the two drivers of prices, we regressed WTI oil prices on global oil demand, inventories and the U.S. dollar. By excluding supply-related factors such as production restrictions, the residual of the regression model gives an approximate gauge of supply shocks (panel 2, Chart I-10). This model clearly has limitations, but it also has one key benefit: it estimates not just actual disruptions in supply, but also the premium built into prices due to perceived or expected future supply disruptions. For example, the 1990 price spike appears as quite a substantial deviation from what could be explained by changes in demand alone. Similar negative supply shocks are evident in 2000 and 2008. Chart I-10Identifying Supply Shocks In The Oil Market We then examined the impact that supply shocks have on subsequent period returns for both Treasury and risk assets. We divided the Supply Shock Proxy into four quartiles corresponding to the four zones shown in Chart I-10: strong positive shock, mild positive shock, mild negative shock and strong negative shock; the last of these corresponds to the region above the upper dashed line, which we have shaded in the chart. The performance of risk assets does not vary significantly across the bottom three quartiles of the supply shock indicator (Chart I-11). However, performance drops off precipitously in the presence of a strong negative supply shock. This is consistent with the "choke point" argument: investors are initially unconcerned with a modest appreciation in oil prices. It is only when prices are driven sharply above the level consistent with the current demand backdrop that risk assets begin to discount a more pessimistic future. The total returns to the Treasury index behave in the opposite manner (Chart I-12). Treasury returns are below average when the oil shock indicator is below one (i.e. positive supply shock) and above average when oil prices rise into negative supply shock territory. In other words, an excess of oil supply is Treasury bearish, as it would tend to fuel more robust economic growth. Conversely, a supply shock that drives oil prices higher tends to be Treasury bullish. This may seem counterintuitive because higher oil prices can be inflationary and thus should be bond bearish in theory. However, large negative oil supply shocks have usually preceded recessions, which caused Treasurys to rally. Chart I-11Effect On Risk Assets Chart I-12Effect On Treasurys The model clearly shows that the drop in oil prices in 2014/15 was a positive supply shock, consistent with the oil consumption data that show demand growth was fairly stable through that period. The model indicator has moved up toward the neutral line in recent months, suggesting that the supply side of the market is tightening up, but it is still in "mild positive supply shock" territory. The latest data point available is April, which means that it does not capture the surge in oil prices over the past month. Some of the recent jump in prices is clearly related to the cancelled Iran deal and other supply-related factors, although demand continues to be supportive of prices. The implication of this model is that it will probably require a significant further surge in prices, without a corresponding ramp up in oil demand, for the model to signal that supply constraints are becoming a significant threat for risk assets. A rise in Brent above US$85 would signal trouble according to this model. As for government bonds, rising oil prices are bearish in the near term, irrespective of whether it reflects demand or supply factors. This is because of the positive correlation between oil prices and long-term inflation expectations. The oil bull phase will turn bond-bullish once it becomes clear that energy prices have hit an economic choke point. Desynchronization Last year's "global synchronized growth" story is showing signs of wear. First quarter U.S. GDP growth was underwhelming, but the long string of first-quarter disappointment points to seasonal adjustment problems. Higher frequency data are consistent with a robust rebound in the second quarter. Forward looking indicators, such as the OECD and Conference Board's Leading Economic Indicators, continue to climb. This is in contrast with some of the other major economies, such as the Eurozone, U.K., Australia and Japan (Chart I-13). First quarter real GDP growth was particularly soft in Japan and the Eurozone, and one cannot blame seasonal adjustment in these cases. Chart I-13Growth & Inflation Divergences The divergence in economic performance likely reflects Washington's fiscal stimulus that is shielding the U.S. from the global economic soft patch. Moreover, the U.S. is less exposed to the oil shock and the China slowdown than are the other major economies. Similar divergences are occurring in the inflation data. While U.S. inflation continues to drift higher, it has lost momentum in the euro area, Japan and the U.K. (Chart I-13). Renewed stresses in the Italian and Spanish bond markets have sparked a flight-to-quality in recent trading days, depressing yields in safe havens such as U.S. Treasurys and German bunds. Nonetheless, prior to that, the divergence in growth and inflation was reflected in widening bond yield spreads as U.S. Treasurys led the global yields higher. Long-term inflation expectations have risen everywhere, but real yields have increased the most in the U.S. (prior to the flight-to-quality bond rally at the end of May). This is consistent with the growth divergence story and with our country bond allocation: overweight the U.K., Australia and Japan, and underweight U.S. Treasurys within hedged global portfolios. The dollar lagged earlier this year, but is finally catching up to the widening in interest rate spreads. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. Expect More Pain In EM Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. We do not see the recent selloff across EM asset classes as a buying opportunity since markets have only entered the first stage of the classic final chapter; EM assets underperform as U.S. bond yields and the dollar rise, but commodity prices are resilient. In the second phase, U.S. bond yields top out, but the U.S. dollar continues to firm and commodity prices begin their descent. If the current slowdown in Chinese growth continues, as we expect, it will begin to weigh on non-oil commodity prices. Thus, emerging economies may have to deal with a deadly combination of rising U.S. interest rates, a stronger greenback, falling commodity prices and slowing exports to China (Chart I-14). Which countries are most exposed to lower foreign funding? BCA's Emerging Market Strategy services has ranked EM countries based on foreign funding requirements (Chart I-15). The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-14EM Currencies Exposed To China Slowdown Chart I-15Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. These mostly stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen as it becomes more difficult to service the foreign debt.3 It is too early to build positions even in Turkish assets. Our EM strategists believe that it will require an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms, to create a buying opportunity in Turkish financial instruments. FOMC Expects Inflation Overshoot Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. The FOMC is monitoring stress in emerging markets and in the Eurozone, but is sticking with its "gradual" tightening pace for now (i.e. 25 basis points per quarter). May's FOMC minutes signaled a rate hike in June. However, the minutes did not suggest that the Fed is getting more hawkish, despite the Staff's forecast that growth will remain above trend and that the labor market will continue to tighten at a time when core inflation is already pretty much back to target. Some inflation indicators, such as the New York Fed's Inflation Gauge, suggest that core inflation will overshoot. The minutes signaled that policymakers are generally comfortable with a modest overshoot of the 2% inflation target because many see it as necessary in order to shift long-term inflation expectations higher, into a range that is consistent with meeting the 2% inflation target on a "sustained" basis (we estimate this range to be 2.3-2.5% for the 10-year inflation breakeven rate). The fact that the FOMC took a fairly dovish tone and did not try to guide rate expectations higher contributed to some retracement of the Treasury selloff in recent weeks. Nonetheless, an inflation overshoot and rising inflation expectations will ultimately be bond-bearish, especially when the FOMC is forced to clamp down on growth as long-term inflation expectations reach the target range. As discussed in BCA's Outlook 2018, one of our key themes for the year is that risk assets are on a collision course with monetary policy because the FOMC will eventually have to transition from simply removing accommodation to targeting slower growth. Timing that transition will be difficult, and depends importantly on how much of an inflation overshoot the FOMC is prepared to tolerate. Is 2½% reasonable? Or could inflation go to 3%? The makeup of the FOMC has changed, but we expect Janet L. Yellen4 to shed light on this question when she speaks at the BCA Annual Investment Conference in September. Investment Conclusions The risks facing investors have shifted, but we do not feel any less cautious than we did last month. Geopolitical tensions vis-à-vis North Korea have perhaps eased. But trade tensions are escalating and investors are suddenly faced with another chapter in the Eurozone financial crisis. The major fear in the first and second chapters was that bond investors would attack Italy, given the sheer size of that economy and the size of Italian government debt. That dreadful day has arrived. The profit backdrop in the major economies remains constructive for equity markets. However, even there, the bloom is coming off the rose. Global growth is no longer synchronized and the advanced economies have hit a soft patch with the possible exception of the U.S. While far from disastrous, our short-term profit models appear to be peaking across the major countries (Chart I-16). Chart I-16Profit Growth: Solid, But Peaking The typical U.S. late cycle dynamics are also threatening emerging markets, at a time when investors are generally overweight and many EM countries have accumulated a pile of debt. U.S. inflation is set to overshoot the target, the FOMC is tightening and the dollar is rising. Throw in slowing Chinese demand and the EM space looks highly vulnerable. If the global economic slowdown is pronounced and drags the U.S. down with it, then bonds will rally and risk assets will take a hit. If, instead, the soft patch is short-lived and growth re-accelerates, then the U.S. Treasury bear market will resume. Stock indexes and corporate bond excess returns would enjoy one last upleg in this scenario, but downside risks would escalate once the Fed begins to target slower economic growth. Either way, EM assets would be hit. Our base case remains that stocks will beat government bonds and cash on a 6-12 month horizon. However, the risk/reward balance is unattractive given the geopolitical backdrop. Thus, we remain tactically cautious on risk assets for the near term. We still expect that the 10-year Treasury yield will peak at close to 3½% before this economic expansion is over. Nonetheless, this would require a calming of geopolitical tensions and an upturn in the growth indicators in the developed world. The risk/reward tradeoff for corporate bonds is no better than for equities and we urge caution in the near term. On a 6-12 month cyclical horizon, we still expect corporate bonds to outperform government bonds, at least in the U.S. European corporates are subject to the ebb and flow of the Italian bond crisis, and face the added risk that the ECB will likely end its QE program later this year. Looking further ahead, this month's Special Report, beginning on page 19, analyzes the Eurozone corporate sector's vulnerability to the end of the cycle that includes rising interest rates and, ultimately, a recession. We find that domestic issuers into the Eurozone market are far less exposed than are foreign issuers. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2018 Next Report: June 28, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available on gps.bcaresearch.com 2 This underestimates the impact on the major countries because it does not account for third country effects (i.e. trade with other countries that trade with China). 3 For more information, please see BCA Emerging Market Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018, available on ems.bcaresearch.com 4 Janet L. Yellen, Chair, Board of Governors, Federal Reserve System (2014-2018). II. Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Chart II-7Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in May. We remain cautious, despite the supportive profit backdrop. The U.S. net earnings revisions ratio fell a bit in May, but it remains well in positive territory. Forward earnings continued their ascent, and the net earnings surprise index rose further to within striking distance of the highest levels in the history of the series. Normally, an earnings backdrop this strong would justify an overweight equity allocation within a balanced portfolio. Unfortunately, a lot of good earnings news is discounted based on our Composite Valuation Indicator and extremely elevated 5-year bottom-up earnings growth expectations (see the Bank Credit Analyst Overview, May 2018). Moreover, our equity indicators are sending a cautious signal. Our U.S. Willingness-to-Pay indicator continued to decline in May. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Our Revealed Preference Indicator (RPI) for stocks remained on its 'sell' signal in May, for the second month in a row. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Moreover, our composite equity Technical Indicator is on the verge of breaking down and our Monetary Indicator moved further into negative territory in May. Meanwhile, market froth has not been completely extinguished according to our Speculation Indicator (which is a negative sign for stocks from a contrary perspective). As for bonds, the powerful rally at the end of May has undermined valuation, but the 10-year Treasury is not yet in expensive territory. Our technical indicator suggests that previously oversold conditions are easing, but bonds are a long way from overbought. This means that yields have room to fall further in the event of more bad news on Italy or on the broader geopolitical scene. The dollar has not yet reached overbought territory according to our technical indicator. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Dear Clients, Please note that next week's report will be a joint effort with our geopolitical team, focused on North Korea. The report will be sent to you two days later than usual, on Friday June 8. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights Most episodes of negative relative Chinese equity performance this year have been driven by global stock market selloffs or related to the trade dispute with the U.S. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, we recommend against downgrading China for now, barring hard evidence of a pernicious global slowdown or that severe protectionist action from the U.S. will indeed occur. Our list of charts to watch over the coming months highlights, among several other important points, that monetary conditions are not overly restrictive and that financial conditions are not tightening sharply. This is in spite of a recent clustering in corporate bond defaults that has concerned some investors. Besides broad-based stimulus in response to an impactful trade shock, a sustained pickup in housing construction remains the most plausible catalyst for an acceleration in domestic demand. For now tepid sales volume casts doubt on this scenario, but investors should continue to watch Chinese housing market dynamics closely. Feature There have been several developments affecting Chinese and global stock markets over the past two weeks. On the trade front, Secretary Mnuchin's statement on May 20 that the U.S. would be "putting the trade war" with China on hold was greeted by a material pushback from Congressional Republicans, particularly the administration's plan to ease previously announced sanctions on ZTE Group. The administration's trade rhetoric has since become more hawkish, as evidenced by yesterday's statement from the White House that referenced specific dates for the imposition of tariffs and the announcement of new restrictions on Chinese investment. This uptick in tough language sets the scene for Secretary Ross' Beijing visit this weekend to continue negotiations. More recently, a political crisis in Italy has caused euro area periphery bond yields to rise sharply, roiling global financial markets. The Italian President's rejection of Paolo Savona as proposed finance minister by the anti-establishment Five Star Movement (M5S) and Euroskeptic Lega has led to the installation of a caretaker government until the fall, when new elections are set to take place. The sharp tightening in financial conditions for Italy and Spain over the past week has exacerbated concerns about a potential growth slowdown in Europe, and has fed a relative selloff in emerging market equities that began in late-March. Despite the recent turmoil, our recommendation to investors is to avoid making any major changes to their allocation to Chinese ex-tech stocks within a global portfolio. Unless presented with hard evidence that the slowdown in the global economy is more than a simple deceleration from an above-trend pace, or that protectionist action from the U.S. will occur in a severe fashion, Table 1 suggests that investors should stay overweight Chinese ex-tech stocks (with a short leash). The table highlights that most episodes of negative relative Chinese ex-stock performance since the beginning of the year been driven by global stock market selloffs or related to the trade dispute with the U.S., despite the ongoing slowdown in China's industrial sector that we have repeatedly flagged. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, our interpretation is that investors are well aware of the deceleration in China's economy, but do not yet regard it as a material threat to ex-tech equity prices. Table 1YTD Weakness In Chinese Stock Prices Has Been Driven By Global Events Clearly, however, this assessment on the part of global investors can change, underscoring that the situation in China merits continual re-assessment. With the goal of providing investors with a toolkit to continually monitor the state of the Chinese economy and the resulting implications for related financial asset prices, this week's report presents a list of 11 charts "to watch" across five categories of analysis. In our view these charts span key potential inflection points for the economic and profit outlook, and will serve as an important basis for us to update our view on China over the months ahead. Monetary & Fiscal Policy Chart 1: The Policy Rate Versus Borrowing Rates Chart 1Borrowing/Policy Rate Divergence Should Not Last,##br## But Is Worth Monitoring An interesting divergence has occurred lately between the 3-month interbank repo rate (currently the de-facto policy rate) and both corporate bond yields and the average lending rate. While the repo rate fell non-trivially after it became apparent in late-March that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, corporate bond yields have recently risen sharply and China's weighted-average lending rate ticked higher in Q1. As we highlighted in last week's Special Report, the recent clustering of corporate bond defaults does not (for now) appear to be a source of systemic risk. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. But the possibility remains that the ongoing crackdown on China's shadow banking sector will cause some degree of persistence in the recent divergence between the interbank market and actual borrowing rates, implying that investors should continue to watch Chart 1 over the months for signs of materially tighter financial conditions. Chart 2: The Correlation Between Sovereign Risk And The Repo Rate We noted in a February Special Report that investors could use the rolling 1-year correlation between the 3-month interbank repo rate and the relative sovereign CDS spread between China and Germany as a gauge of whether Chinese monetary policy has become too restrictive for its economy.1 Despite the fact that actual sovereign credit risk in China is extremely low, Chart 2 shows that the relative CDS spread has acted as a good bellwether for growth conditions in the Chinese economy. It shows that the correlation between this spread and the 3-month interbank repo rate was initially positive in late-2016 (representing concern on the part of investors that monetary policy is restrictive), but has since come back down into negative territory. Interestingly, the correlation was consistently positive from mid-2011 to mid-2014, when average lending rates averaged 7% or higher and the benchmark lending rate exceeded the IMF's Taylor Rule estimate by about 1%.2 For now the correlation remains negative (as it was when we published our February report), meaning that it currently supports our earlier conclusion that monetary conditions are not overly restrictive and that financial conditions more generally are not tightening sharply (despite the recent rise in corporate bond yields). Chart 2No Sign Yet That Monetary Policy Is Overly Restrictive Chart 3Watch For Signs Of Fiscal Stimulus Chart 3: The Fiscal Spending Impulse Chart 3 presents the Chinese government's budgetary expenditure as an "impulse", calculated as expenditure over the past year as a percent of nominal GDP. Panel 2 shows the year-over-year change in the impulse. When compared with a similar measure for private sector credit, cyclical fluctuations in China's government spending impulse are relatively small. For this reason, BCA's China Investment Strategy service has not strongly emphasized fiscal spending as a major driver of China's business cycle. However, we also noted in a recent report that fiscal stimulus stands out as one of the "least bad" options available to policymakers to combat a negative export shock from U.S. protectionism, were one to occur.3 The potential for broader stimulus from Chinese authorities in response to an impactful trade shock raises the interesting possibility of another economic mini cycle in China, since the economy accelerated meaningfully in response to the last episode of material fiscal & monetary easing. As such, investors should closely watch over the coming months for signs that fiscal spending is accelerating, particularly if combined with potential signs of easing monetary policy. External Demand Chart 4: Global Demand And Chinese Export Growth Chart 4For Now, Resilient Exports ##br##Are Supporting China's Economy We have noted in several recent reports that a resilient export sector remains the most favorable pillar of Chinese growth. Besides the clear risk to Chinese trade from U.S. protectionism, two other factors have the potential to negatively impact the trend in export growth. The first (and most important) of these risks is a reduction in global demand, which some investors have recently been concerned about given the decline in global manufacturing PMIs. However, Chart 4 highlights that our global PMI diffusion indicator has done an excellent job of leading the global PMI over the past few years, and has barely registered a decline over the past few months. From our perspective, the odds are good that the recent deceleration in the PMI has been caused by sudden caution (even in developed countries) over the Trump administration's protectionist actions, and does not reflect a material or long-lasting slowdown in the global economy. But we will be closely watching the PMI releases over the coming months to rule out a more painful slowdown in global demand. Importantly, we have also highlighted that stronger exports may actually presage a further slowdown in China's industrial sector if it emboldens policymakers to intensify their reform efforts over the coming year. We argued in our May 2 Weekly Report that China's reform pain threshold is positively correlated with global growth momentum,4 meaning that the external sector of China's economy may have less potential to counter weakness in the industrial sector than many investors believe. In this regard, extreme export readings (to the up and downside) should be regarded by investors as a potentially problematic development. Chart 5: The Competitiveness Impact Of A Rising RMB Chart 5 highlights the second non-protectionist risk to Chinese export growth, namely the significant appreciation in the RMB that has occurred since mid-2017. The chart shows the percentile rank of three different trade-weighted RMB indexes since 2014, and highlights that all three are between their 70th & 80th percentiles (with our BCA Export-Weighted RMB index having risen the most). Importantly, the 2015-high shown in Chart 5 represents the strongest point for the currency in over two decades, suggesting that further currency strength may exacerbate the significant deceleration in export prices that has already occurred. Chart 5A Surging RMB Could Undercut Competitiveness Housing Chart 6: Housing Sales Versus Starts We have presented a variation of Chart 6 several times over the past few months, but it is important enough that it deserves to be continually monitored by investors over the coming year. Chart 6 tells the story of China's housing market from the perspective of an investor who is primarily interested in the sector because of its implications for growth. The chart highlights that residential floor space started, our best proxy for the real contribution to growth from residential investment, has fallen significantly relative to sales since 2012-2014. This appears to have occurred because of a significant build up in housing inventories, which has since reversed materially (even though the level remains elevated). To us, this suggests that the gap between housing sales and construction that has persisted for the past several years may finally be over, suggesting that the latter may pick up durably if sales trend higher. For now sales volume remains tepid, but this will be a key chart for investors to watch over the coming year given our view that housing is a core pillar of China's business cycle. The Industrial Sector Chart 7: The BCA Li Keqiang Leading Indicator And Its Components Chart 7 presents our leading indicator for the Li Keqiang index (LKI), which we developed in a November Special Report.5 There are six components of the indicator, all of which are related to changing monetary/financial conditions, and the growth in money and credit. Chart 6Housing Construction Could Accelerate##br## If Sales Pick Up Chart 7A Downtrend In Our LKI Leading Indicator, ##br##Within A Wide Component Range The indicator is at the core of our view, and we have been presenting monthly updates of the series in our regular reports since late last year. However, Chart 7 looks at the indicator from a different perspective, by showing it within a range that identifies the weakest and strongest components at any given point in time. Two points are noteworthy from the chart: While the overall LKI indicator has been trending down since early-2017, there is currently a wide range between the components. This gap is in stark contrast to the very narrow range that prevailed from 2014-2015, when the economy slowed considerably. This could mean that some of the components of the indicator are unduly weak, which in turn could imply that the severity of the slowdown in China's industrial sector will be less intense than the overall indicator would otherwise suggest. At least one component provided a lead on the subsequent direction of the overall indicator from late-2011 to late-2012, the last time that a significant gap existed between the components. This is in contrast to the situation today, in that all of the components are currently in a downtrend (albeit with differing paces as well as magnitudes). The key point for investors from Chart 7 is that all of the components of our indicator are moving in the same direction, which suggests with high conviction that China's economy is slowing. However, the wide range among the components suggests that indicator's message about the intensity of the slowdown is less uniform than it has been in the past, meaning that investors should be sensitive to a sustained pickup in the top end of the range. Equity Market Signals Chart 8: The Beta Of Our BCA China Sector Alpha Portfolio Chart 8 revisits a unique insight that we presented in our May 16 Weekly Report.6 The chart shows the rolling 1-year beta of our BCA China Investable Sector Alpha Portfolio versus the investable benchmark alongside China's performance versus global stocks, and suggests that the former may reliably lead the latter. While we noted in the report that drawing market-wide inferences from the beta characteristics of risk-adjusted performers is a not a conventional approach, finance theory is supportive of the idea. If investors are seeking to maximize their risk-adjusted returns and are engaging in tactical allocation across sectors, then it is entirely possible that beta-adjusted sector returns reflect the risk-on/risk-off expectations of market participants. For the purposes of China-related investment strategy over the coming year, our emphasis on Chart 8 will increase markedly if we see a sharp decline in the beta of our Sector Alpha Portfolio. As we noted in our May 16 report, the model is for now sending a curiously bullish signal, which we see as partial validation of our view that investors should have a high threshold to cut exposure to China within a global equity portfolio. Chart 8Watch For A Decline In The Beta Of ##br##Our Sector Alpha Portfolio Chart 9Decelerating Earnings Growth Could##br## Undermine Investor Sentiment Chart 9: Ex-Tech Earnings Versus The Li Keqiang Index We noted above that predicting the Li Keqiang index (LKI) is at the core of our view, and Chart 9 highlights why. The chart shows that a model based on the LKI closely fits the year-over-year growth rate of Chinese investable ex-tech earnings and, crucially, provides a lead. While the chart does not suggest that an outright contraction in ex-tech earnings is in the cards over the coming year, it does show that earnings growth is about to peak. This is potentially problematic, and warrants close attention, for two reasons: First, our leading indicator for the LKI suggests that it will decelerate further over the coming year, which could push our earnings growth estimate towards or below zero. Second, the peak in earnings growth could dampen investor sentiment towards Chinese ex-tech stocks, especially since bottom up analyst estimates for 12-months forward earnings growth have recently moved higher and are currently above what is predicted by our model. Chart 10: The Alpha Of Chinese Banks By now, the narrative surrounding Chinese banks is well known among global investors. The enormous leveraging of China's non-financial corporate sector is viewed by many as a clear sign of capital misallocation, meaning that a (potentially material) portion of the loan book of Chinese banks will have to be written off as bad debt. The ultimate scope of the bad debt problem in China is far from clear, but these longstanding concerns about loan quality suggest that Chinese bank stocks are likely to materially underperform their global peers if China's shadow banking crackdown begins to pose a significant threat to growth via restrictions on the provision of credit to the real economy. As such, we recommend that investors monitor Chart 10 over the coming year, which shows the rolling 1-year alpha significance for Chinese banks vs their global peers. While the rolling 1-year alpha of small banks has become less positive over the past few weeks, it remains in positive territory, similar to that of investable bank stocks. So, for now, this indicator supports our earlier conclusion that recent divergence between the interbank market and actual borrowing rates highlighted in Chart 1 is not heralding a material tightening in Chinese financial conditions. Chart 10Investors Should Monitor Chinese Bank Alpha ##br##For Significant Declines Chart 11No Technical Breakdown (Yet) In Ex-Tech Relative Performance Chart 11: The Technical Performance Of Ex-Tech Stocks BCA's approach to forecasting financial markets rests far more on top-down macroeconomic assessments than it does on technical analysis. However, technical indicators do contain important information, particularly when our top-down macro approach signals that a change in trend may be imminent. In this regard, technical indicators can provide valuable opportunities to enter or exit a position. To the extent that the technical profile of Chinese ex-tech stocks is informative in the current environment, Chart 11 shows that it is telling investors to stay invested despite the myriad risks to the economic outlook. This message is consistent with that of Table 1, namely that the negative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. From our perspective, a technical breakdown in relative Chinese ex-tech stock performance in response to China-specific news would serve as a strong basis for a downgrade within a global equity portfolio, and we will be monitoring closely for such a development over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Monetary Tightening In China: How Much Is Too Much?" dated January 18, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Question That Won't Go Away", dated April 18, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 6 Please see China Investment Strategy Weekly Report, "The Three Pillars Of China's Economy", dated May 16, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

"Amongst all unimportant subjects, football is by far the most important." - Pope John Paul II From June 14 to July 15, billions of people will tune into the 2018 FIFA World Cup, with untold loss of productivity, working hours, and quality family time as a consequence. At BCA Research, we decided to stop pretending that we are indifferent to the quadrennial sporting pilgrimage - or to our staff hogging bandwidth by live-streaming games during business hours - and instead harness the best young minds of the company to deliver this most eminently unimportant forecast. To our clients who may worry that their hard-earned dollars are subsidizing fleeting research pursuits, we want to assure you that the research herein was produced "off the clock." In our firm's 70-year history, the principal question driving all analysis has been "so what?" Each and every piece of analysis produced at BCA Research is intended to conclude with an investment angle that makes sense of the noise produced by the cacophony of data. We do not intend to evolve out of that genetic material. At the same time, we are passionate about research. Even though this report does not have obvious investment implications, it is an excellent example of our research fundamentals.1 We develop a macro framework through qualitative analysis, enrich it with data manipulated in novel ways, and articulate it through empirical testing. Just as we produced this report "off the clock," we hope that our clients consume it in their down time. The following pages are a respite from President Trump's tweets, elevated equity valuations, prospects of tepid returns, renewed confrontation in the Middle East, and trade wars. It is also the first in a series of in-depth, multi-disciplinary reports that we intend to produce. Stay tuned. This BCA Special Report presents a unique two-step empirical approach to predict the outcome of each World Cup match. Our approach includes micro (player level) and macro (team level) factors to forecast game matches. We present this model in Section I. Section II then introduces several interesting qualitative narratives, focusing on specific teams attending this year's competition. Section III builds on the existing academic literature and our own unique framework to establish whether the World Cup has any market and economic implications. I. Two-Step Model: Forecasting The 2018 FIFA World Cup In this section we introduce a two-step simulation of the upcoming World Cup. Building on academic literature that has shown that teams respond differently to the various stages of the tournament, we develop two separate models for the group and knockout stages of the competition (Box 1).2 Box 1: The World Cup: A Quick Overview The quadrennial World Cup finals will take place in Russia over a period of one month. The tournament is referred to as the "finals" because the actual competition to select the 32 teams began in 2015. The qualification tournament whittled down the 209 FIFA member states (minus the already qualified host, Russia) over the course of three years via continental qualification tournaments. The 32 teams competing in the finals are separated into eight groups. Each team will play one game against each of their group opponents. The top two performers advance to the knockout stage of the competition. In this stage, the World Cup resembles the NCAA March Madness tournament in that teams face immediate elimination. The 2018 FIFA World Cup is the 21st edition of the competition that goes back to 1930. In the history of the competition, only eight nations have won the cup. Brazil has won five times, Germany and Italy four, Argentina and Uruguay twice, and France, England, and Spain once each. We are not the first to attempt to predict the World Cup. In a recent innovative approach, Clemente et al. (2015) use parameters from network analysis to analyze the tournament's matches. More traditional models rely on the FIFA World Ranking, which ranks teams based on past performance.3 Other conventional models draw on economic fundamentals to explain the success and failure of national teams. A literature overview from 2004 of both quantitative and qualitative models found that a simulator running a commercially produced computer game offered the most successful prediction of the World Cup.4 This should not come as a surprise. The computer gaming industry has overtaken Hollywood in terms of total revenue, while production costs of some computer games are running higher than those of blockbuster movies.5 Given that realism is an important feature of sport simulation, it should follow that computer games have a better forecasting track record than humans. In this report, we combine macro and micro variables to develop a unique two-step model. Our micro factors are based on an extensive database consisting of individual player statistics. Inspired by the 2004 study above, we rely on the computer gaming industry for player ranking, modifying it with our own collective soccertise. The list of potential explanatory variables that we considered including in our model is available in Table 1. Table 1Variables Considered And Used For The Models By relying on individual player attributes we believe that we have avoided the pitfalls of more "macro"-oriented models, such as those relying on overall team rankings. Overall team rankings are established on the basis of team performance over a multi-year period of time. We find that this approach overstates team performance over team quality in present time. These models also fail to incorporate tactical analysis into the model. We introduce these macro and qualitative factors - such as reputation and long-term historical performance - in the qualitative part of our evaluation, while letting objective, player- and team-specific data, dominate our model. Data To determine which variables from Table 1 had the highest predictive power we relied on the 192 matches that occurred during the 2006, 2010 and 2014 FIFA World Cups. There are two reasons we focused only on the last three tournaments. The first is data availability. The second is that football has undergone dramatic evolution in strategy in the twenty-first century. Among the 192 matches, 48 took place in the knockout stage of the competition, while the remaining 144 games occurred during the group stages. We rely on the database of player statistics used in Electronic Arts (EA) Sports FIFA computer simulation. The database includes player statistics from August 2004 to present. At the time of the publication of this report, not all 32 teams had made official their final list of 23 players (the lists will be published on June 4th by the FIFA). Therefore, we relied on the most recent World Cup qualifiers, as well as all the friendly matches played year-to-date to come up with the most likely line-ups for these teams. Step One: The Group Stage Model To simulate the 2018 group stage matches, we developed an Ordered Probit (OP) model estimated on past World Cups group stage games. Ordered Probit models are powerful when modeling an ordinal outcome (i.e. the response value has a strictly increasing ordering known prior to the estimation). Football matches can end in either a loss, a draw, or a win, with a well-defined order from loss to win. The Ordered Probit model therefore allows us to use this information, increasing the predictive ability of the model.6 The Ordered Probit model selected is represented using a continuous latent variable yi* that is linearly determined by a set of explanatory variables χι: Where φ is the cumulative normal distribution function and ϒ are arbitrary thresholds selected via log-likelihood maximization.7 Based on our sample of group-stage matches from the past three World Cups, we found that the best explanatory variables are: Team Average Player Rating Average Age - Forwards Average Number of Caps - Defenders Speed Positions Average Rating Group Stage Explanatory Variables Team Average Rating "Talent wins games, but teamwork and intelligence wins championships." Thus said six-time NBA champion Michael Jordan. Our model confirms that the insight from the basketball legend applies to football as well, as average team talent - based on the mean of individual player overall attributes taken from the EA Sports database - is the most significant predictor of game success in both stages of the competition. However, this variable becomes less important in the knockout stages, as the ability to play as a team ("teamwork"), as well as particular tactical matchups ("intelligence"), become paramount in winning the tournament. This is because, in the late stages of the competition, the talent differential between teams narrows substantively. Average Age - Forwards Teams with younger forwards tend to perform better than teams with older forwards due to the highly physical demands of the position. Forwards perform the highest amount of high-intensity efforts (sprinting and sudden changes of direction) and experience the most amount of physical contact among all positions in football.8 Considering that these abilities tend to peak in the early to mid-20's for most professional athletes, it is no surprise that our model gives a premium to youth in this position.9 Moreover, the annals of World Cup history are chock-full of tales of youthful forwards making a name for themselves when it matters.10 Figure 1Position Definitions Average Number Of Caps - Defenders Teams with more experienced defenders will tend to do better than teams with less experienced defenders. The physical demands on defenders tend to be less strenuous relative to other positions, given that they dish out the pain. This means that defenders tend to peak later than any other field position in football and are able to maintain peak performance sometimes well into their 30's. What defenders lack in athleticism they must make up in game IQ, as anticipation, composure, and tactical awareness are all acquired skills that improve with experience. Speed Positions Average Rating Teams with superior talent in their speed positions (full backs and wingers) will perform better in group stages (Figure 1). Academic research has shown that counterattacking football is the most effective tactic against unbalanced defenses.11 Wingers and full backs are crucial for both developing and defending against a counterattack as they cover the least congested part of the pitch, where there is generally the most space to run. Interestingly, this variable becomes less important in the knockout stages. This is most likely due to the fact that teams with skilled and fast wingers can easily exploit the space conceded by the tactically disorganized defenses of easier opponents that populate the early stages of the competition. In the later stages, teams are generally more tactically disciplined. Modeling Group Stage Games For each game, our model uses the spread between Team 1 and Team 2 of each explanatory variable to determine the probability of Team 1 winning the game. Table 2 lists all 32 teams and their descriptive statistics on the four explanatory variables. Table 3 presents how the 32 teams are ranked based on their probability of passing to the next stage inferred by these explanatory variables. Table 2Descriptive Statistics: Group Stage Table 3Group Stage Ranking Our predictive variables were selected based on the results of the 2006, 2010 and 2014 World Cups. The estimated coefficients are then used to produce 1,000 simulations of each game in order to obtain a distribution of the outcome. Table 4Marginal Effect Of Selected##BR##Variables: Group Stage The team average ratings are the core variables in our group stage model. However, due to the high level of multicollinearity in the disaggregated player rating variables, we could not capture the entire set of information from these individual variables. As a result, our final probabilities are derived from the weighted average of two separate estimations, Model 1 and Model 2. This allows our model to capture the importance of the speed positions average rating in predicting the outcome of the group stage matches, which displays the highest marginal impact on the winning probability (Table 4). Therefore, our final model for the probability of winning a game is: Where: Model 1 (M1)=ƒ (Team Average Player Rating, Forward Average Age, Defenders Average Caps) and, Model 2 (M2)= ƒ(Speed Positions Average Rating, Forward Average Age, Defenders Average Caps), and α and (1- α) are the weights given to each models.12 The ultimate product of our modeling is a coefficient we have termed E(points). As a reminder, teams are awarded three points for a win, one point for a draw, and zero points for a loss. The maximum amount of points a team can gain is nine, given that there are three matches (Box 2). BOX 2: E(points) Calculation E(points) allows us to determine which teams have the highest probability of passing to the knockout stages. We caution readers from reading too much into E(points) in terms of which teams move on to the knockout rounds as the competition in each group greatly determines the value. For example, Denmark has a higher E(points) coefficient than Serbia, but that is a function of its relatively easy group (it faces weaker competition). Group Stage: Results Group A Group A was one of the most challenging to forecast (Table 5). First, Uruguay is probably one of the weakest of the group favorites in the competition.13 Second, host Russia and Egypt are separated by few points in terms of overall quality. Table 5Group A Summary Results To make our lives easier, we decided to attribute a significant home advantage bonus to Russia.14 History tells us that hosting the World Cup provides a clear advantage to almost any team (Table 6). One out of every three hosts has won the competition, going back to the first tournament in 1930. A whopping 65% of all hosts have made it all the way to the semi-finals. It pains us to see the "Egyptian King," Liverpool F.C. superstar Mohamed Salah, exit at the group stage. However, history is arrayed against his squad. Russia would have to be only the second host team ever - aside from South Africa in 2010 - to fail to capitalize on its home court in the group stage. And, as history teaches us, you just don't beat Russians on Russian soil. Group B Group B was, by far, the easiest to forecast (Table 7). The two Iberian giants will make it through, a high-conviction view. Portugal will try to become the fourth team to win the European Championship and the World Cup consecutively, joining such great teams as West Germany (Euro 1972, World Cup 1974), France (World Cup 1998, Euro 2000), and Spain (Euro 2008, World Cup 2010, Euro 2012). Our knockout stage model likes Portugal, giving it the fifth-best probability of winning the entire competition. Its performance in the group stage will go far in validating our confidence in the team. Table 6Home Advantage Is Real Table 7Group B Summary Results Group C A pre-tournament favorite, France will look to avenge its stunning loss to Portugal sans Cristiano Ronaldo in the finals of the 2016 Euro. France starts its competition off in one of the weakest groups (Table 8). Group C lacks real competition, with Denmark having only a 25% probability of beating France. This is the lowest probability of success for any second-ranked team in the group stage of the competition. Anything less than 9 points for France would be a concern for the fans of Les Bleus. Table 8Group C Summary Results Group D Argentina and Croatia are the favorites to go through in Group D, but our model likes Nigeria's and Iceland's chances (Table 9). Iceland keeps turning forecasters into fools. As we discuss in Section II, its success in international football is empirical evidence of the divine. Its run in the 2016 Euro Cup, and win against England, may be the greatest upset in any major sporting competition. However, the element of surprise is gone. Table 9Group D Summary Results Nigeria, on the other hand, could be a dark horse. Our model likes their chances, with 31% probability that they advance to the next stage. They have also won only one of their last 12 World Cup matches, which suggests that they may be overlooked coming into the tournament. Group E Brazil is likely to dominate Group E, but the fight for second place, and thus qualification into the knockout round, will be vicious. Switzerland and Serbia represent a real challenge to our model. Their values in the four explanatory factors are tantalizingly close (Chart 1). Serbia gets the narrowest of pushes on three out of the four, but our model assigns identical probabilities of winning (39%) to each team when they face each other head-to-head (Table 10). The model gives the slightest of chances to Switzerland, mainly due to its higher probability of stealing points in its game against Brazil (48% compared to 46% for Serbia). It is a stunning revelation backed by history. Serbia has no luck against non-European competition in the tournament. Other than its impressive win against the eventual finalist Germany in 2010, it has lost to Argentina (by 6-0!), Ivory Coast, Ghana, and Australia. Furthermore, momentum is not on the side of the Orlovi, given that they backed their way into the World Cup with a 3-2 loss to Austria and a nail-biter against Georgia. These results prompted the Serbian federation to replace the head coach months ahead of the World Cup, not a reassuring sign. Chart 1Serbia Vs. Switzerland Table 10Group E Summary Results Group F Germany, the 2014 World Cup winner, will find very little opposition in Group F and should easily avoid the fate of the past two reigning champions who were eliminated early (Table 11). Die Mannschaft was the only team in Europe that won all its qualification games, ending the qualifying tournament with an otherworldly +39 goal difference. Our model likes Mexico over Sweden. This makes sense given that El Tri have progressed past the group stage in the previous six World Cups (only to be promptly eliminated in the first game of the knockout stage every time). Table 11Group F Summary Results Group G Our model finds Group G exceedingly easy to predict. Belgium and England will go through (Table 12). Both teams have a lot in common, starting with quality squads that have failed to make a mark in recent international competitions. Belgium comes to the 2018 World Cup with top quality players in many positions on the field (Table 13). The two squads will find no real competition in this group, but the pressure will be immense on both young squads. How they handle lowly Tunisia and Panama will determine their mental readiness for the knockout stage of the competition. Table 12Group G Summary Results Table 13Top Players In Every Position On The Pitch Group H Group H is by far the most difficult to forecast (Table 14), with all four teams clustered around a similar E(points) value (Chart 2). Poland has the best player - Bayern Münich superstar Robert Lewandowski - and Colombia the best team. However, both Senegal and Japan could surprise. The forecasting error in Group H should have little bearing on further results given the relatively low ranking of all four teams (for example, both Switzerland and Serbia from Group E are ranked as superior teams). However, the top two teams from this group will "cross" against Belgium and England, the two chronic underachievers. As such, winning the group carries considerable upside as the winner would face the young, untested, and skittish England. This means that Colombia, Poland, or perhaps even Senegal and Japan, could end up stunning the world and finishing at least in the top eight. Table 14Group H Summary Results Chart 2Probability Of Proceeding To The Knockout Stage Group Stage Results Table 15 illustrates group stage results. We assign points based on the highest probability outcomes (win, draw, loss) of each game. Table 15Group Stage Results How confident are we of the results? Other than groups E and H, we are highly confident. Box 3 goes over our three most likely "Dark Horses" to go through to the second round. BOX 3: BCA's "Dark Horses" Serbia The Serbian national football team has faced many challenges over the past two decades. Despite these hurdles, Serbia has produced top-class footballers that are integral parts of several European super teams. An experienced defense and aggressive midfield - headlined by one of the world's premier defensive midfielder Nemanja Matic of Manchester United - makes Serbia a hard team to play against. There is little of the Balkan flair on this team that defined Yugoslav football in the 1980s. But perhaps that is a good thing, given that World Cup games are tight, nervous, and often devolve into a defensive slog. Senegal It has been 16 years since Les Lions de la Teranga last appeared in a World Cup - and what a memorable appearance that was. In 2002, Senegal reached the quarter finals, the second African team in history to make it that far in the competition. The 2018 squad shows similar potential. The Lions' forwards pose the kind of threat to opponents' defenses that many of their World Cup rivals would envy. Keep in mind some of these names: Sadio Mané (Liverpool F.C.), Ismaila Sarr (Rennes), and Keita Balde (A.S. Monaco). Peru Peru is our choice for a long shot at this year's tournament. The Peruvian national football team is unbeaten since November 2016, winning eight matches and drawing four, with many coming against elite opposition. Although we do not take overall team rankings into consideration when making forecasts, it is notable that Peru is ranked 11th in the world, according to the ELO index. Peru's path to Russia took it through the South American qualifying tournament, known for being the most competitive in the world. Teams have to play 18 games, many at high altitude or in unforgiving climates, against some of the world's most talented squads. While it is true that they were the last team to qualify, having to beat New Zealand in the intercontinental playoffs, Peru came ahead of Copa America champions Chile and just one and two points behind Colombia and Argentina, respectively. While our model does not believe in the relatively young and unproven Peruvian team, placing it last in the group, the team's excellent coaching and fearless play make it a potential candidate to come out of Group C along with France, especially given that our model may be overstating Denmark's potential. Step Two: The Knockout Stage Model The knockout stage is somewhat easier to model given that the set of possible outcomes is reduced to only {loss; win}. This difference with the group stage is not only relevant for the math behind our model. It is also relevant for the strategy teams employ during the games. Therefore, we simulated this part of our analysis using a probit model estimated on a sample of only knockout stage games from the 2006, 2010 and 2014 World Cups. The binary choice probability of observing a specific outcome becomes: In this stage of the competition, we found the following factors to be the most important: Team Average Player Rating Club Level Synergy Player GINI Coefficient Average Rating - Midfielders Knockout Stage Explanatory Variables Team Average Rating As with the group stage, the overall rating of the team - based on the average of individual rankings from the EA Sports database - is the most powerful explanatory variable. Despite the higher marginal effect of the rating variables in the knockout stage sample, the standard deviation and average of these variables are significantly smaller than in the group stage.15 In other words, the gap in player quality between teams in the group stage is often vast. However, the knockout stage culls the minnows, narrowing the gap in overall player quality between teams. At this stage of the competition, our model has to be supplemented with variables that test for teamwork and synergy. Club Level Synergy Teams with more players playing in the same club tend to perform better in the knockout stages. This is evident from all the World Cup winners in our sample.16 Given the limited practice time that national teams have ahead of the tournament, the year-round experience of playing with teammates in club competition can provide a huge advantage. Especially for football teams from countries with major leagues - such as Germany, Spain and Italy. Their players are more likely to cluster on the major clubs in those leagues, whereas players from smaller footballing nations have to ply their trade in dispersed leagues and teams across the globe. Great Man Theory (Player GINI coefficient) Teams win games, but heroes win World Cups. To test whether superstars are relevant to winning games, we designed a player quality GINI measure. We find that teams with a higher GINI coefficient outperform those with a lower measure. It seems that having a superstar, or two or three, surrounded with role players is a superior strategy to having balanced talent across all positions. This variable only becomes significant in the knockout stages, where the overall talent level between teams narrows. While more skilled teams tend to be more balanced (Chart 3), once we normalize for skill, a higher GINI becomes a predictor of success. Chart 3The Great Man Theory Intuitively we agree with this finding. When the stress and tension of knockout stages peak and the weight of one's entire nation begins to crush a lesser player's shoulders, the Great Man shines through. Exceptional players have the skill, stamina, and otherworldly confidence to unlock the highly disciplined and tactically sound defensive schemes found in the latter stages of the competition. This should be good news for Belgium, Portugal, and Argentina, but really bad news for England. Average Rating - Midfielders Once we decompose the different positions in the field, we find that the midfield is more important to success than other positions in the knockout matches. Research has shown that midfielders, particularly those forming the "spine" of the team, are the most involved in a team's passing play, regardless of the tactics or strategy used.17 Precise and creative passing is key in knockout matches where tactically disciplined defenses are difficult to unlock. Defensive prowess in the midfield is also paramount to prevent the opposition from developing their attack.18 As with the group stage model, the final probabilities for the knockout stage games were derived from the average of two models in order to maximize the information contained in the average midfield player rating variable (Table 16). Table 16Marginal Effect Of Selected Variables: Knockout Stage Therefore, our final probability is: Where: Model 1 (M1) = ƒ(Team Average Player Rating, Club Level Synergy, Player GINI Coefficient) and, Model 2 (M2) = ƒ(Midfielders Average Rating, Club Level Synergy, Player GINI Coefficient), and a and (1 - α) are the weights given to each models.19 Table 17 summarizes the descriptive statistics of each team according to the four variables used to model their performance. Table 17Descriptive Statistics: Knockout Stage Knockout Stage: Results The Round of 16 There were no surprises in the round of 16 (Table 18). The two matches worth paying attention to are England vs. Colombia and Portugal vs. Uruguay. Our model gives the two European teams a 60% chance of winning their respective games. We see the "Great Man Theory" carrying Portugal forward to the quarter-finals. We are essentially willing to bet that Ronaldo is at least worth a quarter-finals berth at the World Cup. Table 18Round Of 16 Summary Results The England-Colombia matchup is essentially a coin toss. The young and untested Three Lions will face a tough challenge in Colombia. However, it is safer to carry England over to the next round as their "conditional probability" of progressing to the quarter-finals is significantly higher than that of Colombia (53% to 17%) (Chart 4). Why the difference? Conditional probability takes into account the original probability of passing the group stage. Given England's easy group, and Colombia's challenging competition, it is mathematically safer to bet on England. Chart 4Probability Of Advancing To The Quarter-Finals Quarter-Finals Making it into the quarter-finals of the World Cup is an extraordinary success reserved for only eight footballing nations. At this point, teams have played four intense and decisive games over three weeks. Fatigue sets in, especially given that the superstars are playing at the end of a grueling club season in what is normally their off-season. Our model bets strongly on the previous two World Cup winners (Table 19), while Brazil and France struggle against their opponents. Belgium and Portugal are left to wonder what might have been, although for Belgium the pain will be greater. Not only will they yet again fail to meet expectations, but also they will waste the highest conditional probability of advancing to the next stage of the four teams that do not advance (Chart 5). Table 19Quarter-Finals Summary Results Chart 5Probability Of Advancing To The Semis France Vs. Portugal: Setting The Record Straight The loss to Portugal in the final of the 2016 Euro, on home soil no less, still stings for France. The loss was particularly painful given that Portugal's superstar, Real Madrid's Cristiano Ronaldo, had to leave the game due to an injury and spent the majority of the game hopping on one leg, yelling instructions to his teammates from the sidelines. Our model gives France a 66% probability of winning the game. The French team is superior in every facet of the game, other than in the speed positions (Diagram 1). France also sports two of the game's best defensive midfielders, Chelsea's N'Golo Kanté and Juventus's Blaise Matuidi, to whom it will fall on to neutralize Portugal's Great Man. French coach Didier Deschamps has also benefited from the overall improvement in the French Ligue 1, calling upon players that play together in the local league. Diagram 1Les Bleus Vs. A Selecao das Quinas Diagram 2A Selecao Vs. The Red Devils We expect a tight match, with intense man-on-man coverage of Ronaldo. France will dominate the ball, slowly building chances against Portugal's defense. In 2016, a young and inexperienced French team wasted a plethora of chances against Portugal's version of the Maginot Line. We do not see history repeating itself. Brazil Vs. Belgium: Red Devils Don't Dance Samba The second tight matchup predicted by our model pits Brazil against Belgium. As with the France-Portugal matchup, the underdog has a solid one-in-three chance of winning the game. What makes Belgium so dangerous is their overall midfielder rating, which we identified as one of the four most relevant factors for winning the game. The problem for Belgium is that it trails Brazil by a lot in other facets of the game (Diagram 2). Its defense is particularly suspect. Belgium has no players ranked in the top five of their defensive position, whereas Brazil sports a fifth of all the best defensive players in the entire tournament. Spain Vs. Argentina: Don't Cry For Me Lionel Our model has no time for La Albiceleste, giving Argentina a paltry 10% chance of defeating Spain. As a reminder, our model is completely ignorant of head-to-head matchups between teams, but it has essentially predicted the 6-1 drubbing that La Roja gave Argentina in a friendly in late March. Granted, Argentina's superstar, and F.C. Barcelona icon, Lionel Messi watched the spanking from the bench. But unless Messi can play defense at the same high level at which he finishes attacks, Argentina is in trouble. Argentina's 2018 squad is essentially the stereotype of every team we have watched from the nation in the last half-century. Its forwards are world class, perhaps the best in the tournament (Diagram 3). Four Argentines are amongst the 15 best forwards in our sample, an extraordinary number (see Table 13). Nevertheless, the rest of the team is subpar relative to other favorites, and particularly against Spain. Germany Vs. England: Hard Brexit Defending champions rarely meet expectations at the World Cup. The tournament is simply too grueling, the pressure too great, and the chasm of time between tournaments too wide to bridge within a single generation. However, Germany faces a young, untested English team in our bracket. Getting to the quarter finals would be seen as a success for England, one upon which to build a winning generation for the 2022 tournament in Qatar. Germany tops England in all facets of the game and across the pitch (Diagram 4). Our model gives England little chance against Die Mannschaft. England has greater chances of extracting a soft Brexit from Berlin than of penetrating Germany's clinical press. Diagram 3La Furia Roja Vs. A Albiceleste Diagram 4Die Mannschaft Vs. The Three Lions Semi-Finals Our model gives Belgium and Portugal decent odds for advancing to the semis, leaving a door open for surprises in the quarter-final round. In the semi-finals, however, the model tightens the odds, snuffing out the chances for an aging Germany and an inexperienced Brazil (Table 20). Brazil's and Germany's chances fall to just 15% and 11%, respectively (Chart 6). Table 20Semi-Finals Summary Results Chart 6Conditional Probability Of##BR##Advancing To The Finals Spain's conditional probability of reaching the finals hovers at an extraordinarily high 54%. France remains at a respectable, and yet uncertain, 41%. France Vs. Brazil: Painful Memories We are not surprised that our model assigns Brazil just a 27% probability against France. France practically coasted to the finals of the Euro 2016, defeating Germany. In terms of quality, the two teams are even on forwards. Brazil takes a big advantage in speed positions and defenders, but France wins where it matters: midfield (Diagram 5). For many years now, Brazil has been known to produce some of the best forwards and defenders, but apart from Ballon d'Or winner Kaka, who retired a couple of years ago, it is difficult to name an outstanding Brazilian midfielder in recent years. Diagram 5Les Bleus Vs. A Selecao The French squad also displays better results on the club synergy variable, the second-best reading for the teams in the knockout stage behind Spain. This is the result of improvements to its domestic league. Meanwhile, Brazil's top players continue to be dispersed across a number of different top clubs. Brazil will avenge its disastrous result from 2014 with a solid showing in Russia. Its pride will be reestablished and memories of the 7-1 drubbing softened. However, it will fail yet again against a European power. Spain Vs. Germany: The Battle Of Champions The other semi-final game will feature the 2010 champion (La Furia Roja) against the 2014 champion (Die Mannschaft). You have to go back all the way to the 1990 World Cup to see the two previous World Cup winners face each other in the semi-finals. Our model is indifferent to Germany's more recent success, giving Spain an overwhelming 85% probability of winning. In 2018, Spain has superior quality across the pitch (Diagram 6). Diagram 6 La Furia Roja Vs. Die Mannschaft In 2010, the year of Spain's last title, the team relied heavily on what made F.C. Barcelona unbeatable in Europe: heavy possession of the ball and gameplay built on crisp passes. This still holds true today, as tiki-taka has become part of Spain's footballing DNA. However, after underperforming in the 2014 World Cup and at the 2016 Euro, new coach Julen Lopetegui has slowly improved overall play. This has particularly involved raising the quality of the Spanish attack. As Spain discovered in the last two major competitions, it is not enough to have possession for 80% of the game if one cannot do anything with the ball. The Finals: Spain Vs. France BCA's Two-Step World Cup model predicts that, on July 15, 2018, the world will see Spain dispatch France in the finals of the world's sporting pilgrimage (Diagram 7). The two teams have the highest conditional probability of traveling down the grueling camino a la gloria eterna, from the group stages to the final (Chart 7). Intriguingly, of the teams knocked out in the quarter-finals, Portugal shows up with a slight conditional probability of winning the tournament. The England-Colombia matchup is essentially a coin toss. Diagram 7Road Map Of The World's Sporting Pilgrimage Chart 7Conditional Probability Of Entering Elysium Our model gives Spain a 59% probability of beating France (Chart 8), large enough to give us confidence, but not an overwhelming figure. It is undeniable that Spain has superior quality across the pitch (Diagram 8). Chart 8Final Matchup Probabilities Diagram 8La Furia Roja Vs. Les Bleus Moreover, Spain clearly excels over France in its defense - it conceded just three goals in its ten qualifier matches - and in its club synergy value, where it scores the highest mark. Five players sampled in our data play for F.C. Barcelona and five play for Real Madrid. What of the game for third place? Surprisingly, it may be the game of the tournament.20 Sure, third place means little. However, this game will mean a lot. If our model is correct, Brazil will face nemesis Germany in a revenge game. The young Brazilian team, completely revamped after the 7-1 Blitzkrieg on home soil, will be playing for the future, for revenge, and for national pride. Our model gives Brazil only a slight edge over Germany (Table 21). This is unsurprising, given that Brazil is, by far, superior in defense, forward, and speed positions, even though it is considerably inferior where it matters: the midfield (Diagram 9). Table 21Third Place Match Summary Results How does our forecast compare with current betting odds? Chart 9 shows that our model gives Spain an extraordinarily high probability of winning the tournament. Spain's 32% odds are double what the bookies' favorites, Brazil and Germany, command. Overall, we think that the betting market is underestimating the odds of a Mediterranean champion, while overstating the odds of both Germany and Brazil. Diagram 9A Selecao Vs. Die Mannschaft Chart 9We Do Not Condone Betting!##BR##(But If You Were Wondering...) II. Teams And Narratives To Watch In Russia: A Qualitative Assessment The World Cup is not just about winning. It is the most watched event - sporting or non-sporting - in the world because it weaves so many narratives and themes together. In this section, we explore some of these narratives and themes. Some are investment relevant, some are geopolitically relevant. Our qualitative assessments are ordered from the lowest-ranked teams to the highest-ranked. South Korea - A New Era Dawns, With The Same Football Results Coming from a country that has imprisoned every former president, including the one it just impeached, it should come as no surprise that South Korea's national team lacks stable leadership. The Koreans had a remarkable coach - the German sweeper Uli Stielike - who had dedicated three years to preparing them for this tournament. They fired him last year, however, due to a handful of losses. He has been replaced with a native son - a known advantage in World Cup football - Shin Tae-yong. Shin Tae-yong threw a special winter training camp for the team in order to establish himself as coach and get to know the squad given such a short time remaining before the tournament. Activities consisted of drinking tiger's blood and hiking up to the Unicorn Lair of Kiringul where, rumor has it, former North Korean dictator Kim Jong Il was conceived. South Korea made it to fourth place when it co-hosted the World Cup in 2002. While it had a lot to do with the Flying Dutchman coach, Guus Hiddink, he was not playing on the field. Rather, it was the insatiable Korean thirst to perform better than their co-host and erstwhile colonial overlord, Japan.21 In 2018, South Korea has a good defense: they seldom have let the ball in the net in recent tournaments. The only problem is that they do not know how to score goals. Young star player Son Heung-min, of Tottenham Hotspurs fame, has shown that he can score multiple goals late in the game - but only when playing against Uzbekistan. Of course, South Korea does have a tremendously compelling national story this year: the war with North Korea is finally over! President Moon Jae-in and his North Korean counterpart, dictator Kim Jong Un, held the third Inter-Korean summit on April 27, and declared for the first time since 1952 that they would stop trying to kill each other, at least formally. Peace is the word of the day. Can the optimism of an era free of war, with potential Korean reunification on the horizon, translate to a morale booster that helps Korean athletes? Probably not. Our model assigns Korea only a 3% chance of making it out of the group stage. The 2018 Winter Olympics were held in South Korea - they even entered the opening ceremony jointly with their communist neighbors. But while the South Koreans did well, winning several golden medals, they did not set a new record. Unlike the South Korean women's hockey team, the South Korean men's football team won't receive an infusion of North Koreans. Nor will they host a North Korean art troupe. Although we doubt that either would help their odds in Russia. Egypt, Morocco, Tunisia, And Saudi Arabia - Renaissance Or Regression? It is now eight long and turbulent years since the Arab Spring ignited with protests in Tunisia. Since then, stagnant regimes have been toppled, hundreds of thousands of people killed in civil wars, and an Islamic State has been created and crushed. Tunisia and Morocco stand out as clear outliers in terms of geopolitics. Since the 2014 parliamentary elections, Tunisia has begun paving the way towards becoming the first country in the Arab world with a functional democracy. Morocco is far from a democracy, but has remained stable over the past decade in stark contrast to the region. King Mohammed VI has enacted a number of reforms that have forestalled, for now, expression of grievances from the public. Saudi leadership has decided to follow the Moroccan example and preempt social unrest by enacting wide ranging reforms from the top. The 33-year old Crown Prince Mohammad Bin Salman has not only pledged to reform the economy, but also to fundamentally change conservative Saudi society. Women have been given the right to drive, the religious police has been regulated into irrelevance, and there is even talk of eliminating public gender segregation. BCA believes that these reforms are genuine and that they will be executed with vigor.22 Saudi leadership is reacting to the reality that the majority of the population is under 30 years of age (Chart 10). Mohammad Bin Salman therefore did not "come out of nowhere," as many commentators claim. He is the regime's response to the socio-economic realities of Saudi Arabia. Chart 10Saudis Are Catering To The Youth In contrast with these three countries, Egypt has stagnated in terms of governance and political reforms. In many ways, the country has regressed back to the military-backed rule that preceded the Arab Spring protests. However, President Abdel Fattah el-Sisi has launched and followed through on some private-sector and macro reforms which should result in marginal improvements for the economy.23 If football is a reflection of socio-economic conditions, then the participation of these four states at the World Cup is a harbinger of a brighter future. In Russia, Arab countries will have the highest number of representatives ever in the World Cup. Given that three of the four countries qualified in the highly competitive African continental qualification tournament, the result is impressive. Our quantitative model gives Morocco, Saudi Arabia, and Tunisia little chance to reach the knockout rounds. Egypt, on the other hand, is only eliminated because we have decided to give Russia a host premium. Since 1930, as a host, only South Africa failed to qualify for the round of 16 in 2010. Egypt has a real chance to be one of the dark horses in this year's tournament. It has the requisite footballing tradition to be able to withstand the pressure of a major tournament. Egypt has won seven African Cup of Nations, the most among its continental peers, and nearly half of its likely squad play in major international leagues. The most important among these is Mohamed Salah, "The Egyptian King," of Liverpool F.C. Salah may be the best forward in the world at the moment and will certainly wreak havoc in the group stage against Russia and Saudi Arabia. These four Arab states have already accomplished a lot by qualifying. But if one of them progresses to the knockout stage, it would be notable. BCA Emerging Markets Strategy research has shown that genuine structural reforms that improve the quality of governance are required for long-term productivity growth, and thus, asset performance.24 But a change in attitude comes first. Confidence is an important part of that change, and seeing Mo Salah and Egypt take on the world's best could light the spark for a Middle East Renaissance. Iceland - A Footballing Black Swan Iceland's football team success is a great reminder to investors that the probability of unexpected events is often greater than the consensus expectation. Iceland has a population of 330,000, just slightly larger than Swansea, Wales' second-largest city and home of "the Swans," the perennial bottom-feeders of the English Premiership League. If one eliminates Iceland's female population, the infirm, and the too old and too young, the pool of available humans for the country's football team is about 40,000. Iceland's qualification for the World Cup is extraordinary. Its success at the Euro 2016, where the country advanced to the last eight teams after defeating England, is nothing short of evidence of the divine. It may be the greatest upset in sports. Ever. Consider that in order to even participate at the Euro 2016, Iceland had to survive a qualification group that included the Netherlands (which failed to qualify!), Czech Republic, Turkey, Kazakhstan, and Latvia.25 Iceland finished second in the group and thus qualified directly for the event. Then, to get to the final eight at the Euro, Iceland had to survive a group made up of Hungary, Portugal, and Austria (where it finished ahead of the eventual Euro champion Portugal!).26 It defeated England in the round of 16 by a score of 2 to 1, only to finally be vanquished by the host nation France.27 What makes Iceland's success so astonishing is statistics, specifically the concept of conditional probability. Because qualification for a major event, such as the Euro, requires successive results, the conditional probability of Iceland getting through to the quarter-finals eventually is close to zero.28 Especially when one considers that there is no element of surprise for a country like Iceland once it shocks the world by qualifying. This is not college basketball, where the knockout nature of the March Madness tournament - and lack of scouting of small universities - creates the potential for upsets. This is international football, played by grown men getting paid millions of dollars to do their job (i.e., not lose to Iceland). What is the secret behind the success of Strákarnir okkar (Our Boys)? Several theories have been advanced: investment in coaching, heated football pitches, "Nordic mentality," "The Breath of Odin," etc.29 To us, all of this smells of the hindsight rationalization that Nassim Taleb identified as the hallmark of Black Swan events.30 Icelandic footballing success is a shock, a rift in the space-time continuum, and unlikely to be replicated. Our model gives Iceland little chance against Argentina, Croatia, and Nigeria. Of course, the whole point of a Black Swan event is that it is impossible to model. So, sit back, relax, and enjoy the Viking War chant!31 Japan - Bad Timing For New Leadership Japan is a nation in ascendancy, having emerged from its "Lost Decades" in recent years to reclaim a leading position among the nations of the world. What stirred the giant from its slumber? A global financial crisis, earthquakes, tsunamis, nuclear meltdowns, debt-deflation, and the revival of its ancient Chinese foe. A new era is dawning. That is fortunate, as it means that Japan's failures in the World Cup will fall under the final year of the outgoing emperor's reign. The problem, once again, is the lack of stable leadership. Just as factions in the ruling Liberal Democratic Party are busy trying to remove the hugely successful Prime Minister Shinzo Abe before a critical party leadership vote, so factions within the Japan Football Association have removed the head coach, Vahid Halilhodzic, just two months ahead of the tournament. Unlike his Korean counterpart, Akira Nishino has not held a winter camp to familiarize himself with the team. Instead, he will rely on the rock-solid supposition that the Japanese would think it ignoble to be led into battle by a foreigner. There is a basis for believing that teams do better under the leadership of a coach who is a national. But there is only so far that ethnic solidarity can go. After all, this is a team that wrestled Haiti and Mali to a draw. To throw its coach under the bus at the last minute is to ensure that Japan's squad remains, in the words of William Durant, "inclined to picturesque suicide". Croatia & Serbia - Strength In Numbers Extrapolating into the future from their vantage point in 1990, leaders of Yugoslav federal republics Slovenia and Croatia made an understandable forecast. First, communism was dead, and it was time for economic and political reforms. Second, "economies of scale" no longer mattered. The future was in global trade and open borders. Therefore, membership in a still-communist federal Yugoslavia dominated by semi-authoritarian Serbia was suboptimal. Looking back at the decision today, it is hard to argue with the results. Slovenia is in the Euro Area with a GDP per capita of $21,304 (2016), while Croatia is close behind, in the EU with a GDP per capita of $12,090 (2016). Meanwhile, their neighbor and aggressive "big brother" Serbia, which fought a war against both to keep them in Yugoslavia, is on the outside looking in. Its GDP per capita ($5,348 in 2016) has only recently recovered to the 1989 Yugoslav levels! There is no argument that Croatia and Slovenia made the right choice, at the time, by choosing secession. But the question is whether they would have still done it knowing everything we know about the present. For one thing, we cannot extrapolate globalization into the future. We are, in fact, at its apex.32 Strength in numbers will matter in a de-globalized, multipolar world of the twenty-first century. And while Croatia and Slovenia are part of a bigger whole - the EU - their size relative to the EU population and economy is laughable relative to their importance in Yugoslavia (Chart 11). Chart 11Small Parts Of A Bigger Whole And then, of course, there is sport. Both Serbia and Croatia are present in Russia. Our model ranks them 14th and 15th respectively. If we combine their rosters into 23 top-ranked players, their ranking jumps to eight, high enough that a semi-final berth becomes a possibility given good luck. This is not the best team that former Yugoslavia could have featured. In 1998, Croatia came third in France with an over-the-hill squad. But in 1994, Serbia and Montenegro (still called Yugoslavia at the time) were banned from competing while that same Croatia was unprepared to compete in the qualifications, which began just after the country's independence. That 1994 team would have featured in-prime Croatian stars33 - who came within two Lilian Thuram goals of the 1998 finals - and a team of Serbian,34 Montenegrin,35 and Macedonian36 players who took Red Star Belgrade to its Champions League title in 1991. Given the relatively weak competition in 1994 (Bulgaria and Sweden made the semi-finals), Yugoslavia could have been crowned World Cup champion in 1994. Of course, if pigs had wings, they would fly. On the other hand, the fact is that Slovenia and Croatia are among the two most Euroskeptic countries in the EU. Clearly, there is some buyers' remorse in both. Perhaps as part of a reformed, democratic, and federal Yugoslavia, both would have enjoyed greater clout in Brussels and thus, greater say in what kind of policies the EU imposed on them. And if that did not work, at least looking at the shiny 1994 FIFA World Cup Trophy would have helped put everything else into perspective. Russia - The World Cup As The Ultimate Lagging Indicator Expectations are low for the Russian national team at the 2018 World Cup. Despite its size, population, relative wealth, and strong tradition of government support for sports, Russia is just not a footballing nation. Its best result at the World Cup was way back in 1966 (fourth place), although it did win a European title in 1960. That was more than half a century ago! As a host, we would expect Russia to get a bump out of its woefully easy group. But from there, the focus will shift away from the Sbornaya to the organization of the tournament. This is the second time Russia is hosting a major international competition, following the 2014 Sochi Winter Olympics, and all eyes will be on the updated infrastructure and tight security measures. The World Cup presents a much greater challenge than the Sochi Olympics because there are 11 venues spread out over a geography the size of Western Europe. Three of the venues - Volgograd, Rostov-on-Don, and Sochi - are also close to the Caucasus region. Russian security forces essentially encircled Sochi in 2014, severely limiting movement into and out of the Black Sea resort town.37 This is unfeasible to do for the country's 11 largest cities. Chart 12Russia - The World Cup As##BR##The Ultimate Lagging Indicator There is an additional problem of limiting hooligan violence. We assume that Russian law enforcement will be much better at limiting the influx of troublemakers than its European neighbors. However, Russia has plenty of domestic hooligans to create violence, which was on clear display at the Euro 2016 clash between English and Russian "fans." All of this brings up the question: Why is Russia organizing the World Cup in the first place? Especially given its semi-pariah status following a spate of controversial geopolitical events thus far in 2018? The answer is that major sporting events are the ultimate lagging indicator of a country's economy, its geopolitics, and market performance. The Sochi selection was made in 2007, amidst an epic commodity bull market and at the peak of the "BRICS are taking over" narrative. The World Cup selection was made in 2010, well before Crimea was annexed, Ukraine was destabilized, and Russia decided to play "peacemaker" in Syria (Chart 12). Just like Brazil in 2014, the World Cup therefore arrives to Russia at an odd time, with the market, economy, and the country's relations with the West hitting rock bottom. Of course, the 2014 World Cup was the bottom for Brazil, with a spate of seismic economic and political changes following. Brazilian equities are up nearly 50% from the closing ceremony of the World Cup to today. Can the same happen in Russia? Mexico - Will Anything Change? Mexican voters will go to the polls on July 1 as its national football team competes in Russia. The election has been dubbed the "biggest election in Mexican history" by the country's National Electoral Institute. We agree. For the first time in Mexico's history, a left-wing, anti-establishment movement has a chance to win (Chart 13). Chart 13The "Biggest Election In Mexican History"? Will Mexico's football team also break with tradition? For the past six World Cups, Mexico has emerged from the group stage only to be promptly eliminated in the knockout stage every time. In 2018, El Tri again have a great chance to emerge from the group. While Germany is a formidable foe, the other European nation in the group, Sweden, barely qualified and is playing without its only top-class footballer, Zlatan Ibrahimovic. As such, Mexico should accomplish the usual feat relatively easily. The question is whether it can do more. Unfortunately, second-place finish in its group will pair it, baring a major surprise, with Brazil. This is where its road will most certainly end. Will politics mirror football? Is Andres Manuel Lopez Obrador (AMLO) just more of the same? We are hopeful that Mexico's left-wing answer to President Donald Trump could actually make some changes for the better. First, the Mexican Congress is unlikely to give AMLO free rein in governing the country. Second, AMLO has moderated his campaign, purposefully hiring centrists and technocrats to signal moderation. Third, AMLO has the charisma and the gravitas to sit down with President Trump and negotiate face-to-face, unlike his predecessor, Enrique Peña Nieto, who never quite got used to Trump's rhetoric and aggressive style. In the end, if AMLO fails to make serious inroads with economic reforms, ongoing drug-related crime, and negotiations with President Trump, at least Mexicans will have one major success to take from 2018. Mexico qualified for the 2018 World Cup, whereas its eternal football rival the U.S. did not! Belgium & Switzerland - The Upside Of Immigration Let us state the facts. Without footballers of immigrant descent, we would not be writing an analysis on the Belgian and Swiss football teams today. Of the 23 call-ups for the international friendlies ahead of the World Cup, 13 were of immigrant background for the Swiss team and 12 for the Belgian. This includes the majority of the stars of both teams, such as Granit Xhaka (Albanian) and Ricardo Rodriguez (Spanish-Chilean) for Switzerland, and Vincent Kompany (Congolese-Belgian), Marouane Fellaini (Moroccan), and Romelu Lukaku (Congolese) for Belgium. In large part, this is a tired topic already well covered by the Belgian and Swiss media. It also draws on the main narrative following the 1998 French World Cup win. Half of the legendary Les Bleus team was made up of players with immigrant backgrounds, including essentially all of its stars. Of the 14 goals scored by the French team, nine came from its multicultural stars Zinedine Zidane, Youri Djorkaeff, Thierry Henry, Lilian Thuram, and David Trezeguet. What separates the 1998 French team from the Belgian and Swiss teams today, however, is the geopolitical context. The 2015 migration crisis in Europe - when the influx of illegal immigrants reached a peak of 220,000 per month in October of that year - still dominates politics on the continent (Chart 14). Although the crisis is now definitively over - the monthly influx figure is below 3,000 - both anti-establishment and establishment parties have swung hard against immigration. Chart 14What Migration Crisis? But wait, are these players really immigrants to begin with? The answer is an obvious and definitive no. Only six Swiss and none of the Belgian players were born outside the country. Even the 1998 French team had only two players who were actually born outside of France (and an additional two were from overseas French territories). This reflects one of the greatest misunderstandings in the political narratives regarding European immigration. There essentially is no longer any non-European immigration to Europe. At least not via legal channels. Players who are visible minorities on these teams are almost universally the children and grandchildren of the post-World War II immigrants from the former colonies (and three of the six foreign-born Swiss players are not visible minorities at all, given that they are from the former Yugoslavia). Several European countries undoubtedly have a problem integrating non-European immigrants. Our colleague Peter Berezin has made a connection between a generous social welfare state and lack of successful integration, with Belgium and Sweden as prominent examples of the connection.38 However, few commentators understand that there is no ongoing large-scale influx of immigrants to Europe, aside from occasional migration crises prompted by wars. The migrations of the 1950s and 1960s, from former colonies, was followed in the 1960s and 1970s by "guest worker" migration. Since then, Europe has progressively tightened its migration policies to all but internal migration from EU member states. What does this mean for Europe's national football teams? Nothing. Football is a sport played by the middle and lower classes almost universally.39 The high proportion of visible minorities on Europe's football rosters is simply a reflection of the fact that many immigrants and their kids grow up in precisely such communities. Eventually, they become French, Belgian, or Swiss. After all, nobody would today doubt Michel Platini's Frenchness. But he is as much a product of immigration as Zinedine Zidane or Zlatan Ibrahimovic. England - A Football Brexit It is well known that the English national team is cursed in World Cup football. If not for the home team advantage, they never would have won their single trophy in 1966. Many commentators in England lament the strength of the English Premier League. Best teams are collections of superstars from other countries who receive the highest wages in football, yet naturally return every four years to play for their mother country. In other words, the English fight wars with mercenaries hired from abroad whose loyalties lie elsewhere. Imagine that! The English national team has chronically underperformed despite having one of the most expensive, and productive, leagues in the world. Like many other U.K. industries, English football leverages the high productivity of extraordinary immigrants. Indeed, the percentage of foreign players in the English Premier League is the highest in the world (Chart 15).40 Chart 15The Most Globalized Labor Market? The immigrant free-for-all, however, almost ended. Just as concerns over immigration prompted Brexit, concerns that English football was being dominated by the non-English almost led to changes to the domestic league Homegrown Player Rule. A proposal to put more stringent rules on foreign players in order to fix the talent pipeline in English football almost took hold under the previous FA chairman, Greg Dyke. Fortunately, the worst effects of the Brexit vote have already passed: The team suffered their worst upset in 66 years at the hands of Iceland in the 2016 Euro Cup, just days after the referendum was held. Remember, there are fewer people in Iceland than there are Sikhs in the United Kingdom. This devastating upset was the first material instance of "Bremorse" in the wake of the referendum. The team is unlikely to suffer such an upset again. Instead, it will perform just like it did in 1066: defeating the likes of the King of Norway and Iceland only to be invaded and enslaved by the King of France. But unfortunately for England, it does not get a rematch with Iceland in group play. Rather, its group of four affords an occasion for an even greater humiliation, perhaps even the crowning humiliation of the entire Brexit saga: a loss to Brussels. Such a loss is likely if only because the signal lesson of British history teaches that Europeans can never successfully invade the island unless it happens to be suffering from deep internal divisions. And with Jeremy Corbyn and a second Brexit referendum on the horizon, such "intestine" divisions are utterly assured. Given all of the above, does it seem likely that this is the year in which England will break a half-century-long curse? No. But our model gives the young team great odds of reaching the knockout stage. Argentina - Promise Vs. Performance Every investor knows the old adage that at the turn of the twentieth century, Argentina was "one of the ten richest countries in the world," ahead of European heavyweights France, Germany, and Italy. And that in 1950, Argentina's GDP-per-capita was six times greater than the likes of South Korea. After half a century of Argentine economic mismanagement and unfulfilled promises, South Korea has today doubled Argentina's national wealth (Chart 16). Chart 16Argentina - Promise Vs. Performance At probably the height of the country's economic and political mismanagement - during the nearly decade-long military rule between 1976 and 1983 - Argentina's football team won two World Cups: 1978 and 1986. Since then, however, it has left behind a legacy of unfulfilled promises and lost opportunities that largely mirror its last thirty years of economic performance. Since the 1990 World Cup in Italy, Argentina has entered every World Cup as one of the favorites. Its fans consider the team one of the world's five greatest footballing nations. To its credit, it has made the finals twice, in 1990 and 2014, and the quarter-finals three other times in that span. But its status as a perennial superpower is under threat. We would argue that Argentina is, in fact, the greatest underperformer in the last three decades of international football. Despite being the fourth highest-ranked team over the past two decades - according to Elo scores, which we interpret to represent the consensus view - the country has failed to lift the World Cup. The greatest threat to Argentina's legacy as a footballing superpower is that, in another twenty years of unfulfilled promises, fans will look back at its past success the way we think of Uruguay's two World Cups, won in 1930 and 1950. One could argue, for example, that its two titles are a product of a single, golden generation, not of eternal status as a superpower. Since Diego Maradona stopped playing, Argentina has only advanced past the quarterfinals once. Coming into the 2018 World Cup, the expectations are once again high. Argentina still has one of the world's top-two players in Lionel Messi. And Elo again ranks it as the fourth-best team, with expectations of at least a semi-final appearance. Our model is more skeptical, dropping it to a sixth-best ranking and predicting yet another quarter-final exit. If Argentina wastes its "Messi generation," the chances that its unfulfilled football promises mirror that of its economy will grow. Portugal - The "Great Man" Theory The "Great Man Theory" posits that a large portion of human history can be explained by the impact of "Great Men" (and women) on global events. Popular from the Greek and Roman classics through the nineteenth century, the theory has been contradicted by post-modern philosophers, sociologists, and historians. BCA's Geopolitical Strategy largely rejects the idea in its methodology. We focus on the constraints to "Great People," rather than their preferences. After all, preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. Enter Cristiano Ronaldo dos Santos Aveiro. Perhaps the greatest footballer ever, Ronaldo is indeed a Great Man. He has willed his teams (whether at club level or internationally) to extraordinary feats. Even in injury, his defeat on the battlefield inspired his teammates to play incredible football in the Euro 2016 final against a superior France. Ronaldo lacks mortal constraints on the football pitch. He has scored 308 goals in 289 appearances for Real Madrid (since 2009), an incredible per-game ratio (Chart 17). In the 2017-2018 season, at the age of 33, he has scored 41 goals in 38 appearances, maintaining a per-goal average of his entire career at the Spanish club. His game appearance total this season is lower than at any other time since 2009-2010, suggesting that he will come into the World Cup fresh and rested. Chart 17The Ronaldo Effect Football, however, is a game played on a wide pitch by 11 players. How can one man, even one as great as Ronaldo, make a difference? Gravity. Ronaldo is such a dangerous player with the ball that defensive midfielders and defenders have to constantly gravitate towards his presence on the pitch. This opens up lanes for his Portuguese teammates to counterattack. And Ronaldo's teammates are not as bad as the consensus thinks. Our quantitative model ranks Portugal seventh, just a few points below Brazil. They are also fortunate to be in a relatively easy group. While the matchup with Spain will be a tense affair, Portugal will easily dispatch Iran and Morocco. And if they come second in the group, they will face the easiest group winner of the next round, Group A's Uruguay. While we do not subscribe to the Great Man theory as a methodology, we respect it. Over the long term, and over a great number of iterations, focusing on great individuals is folly. But when faced with specific events, there is definitely value in thinking about how extraordinary human effort matters. Portugal's path to the quarter finals is easy. Once there, games will become tighter, the pressure unbearable, the stage infinitely larger. It is in these moments that legends play like Great Men, while lesser footballers play like mere mortals. Brazil - Redemption? As host of the last World Cup in 2014, Brazil didn't so much hit rock bottom as descend to the ninth circle of hell. Its merciless 7-1 obliteration by Germany in the semifinals - the sharpest rebuke to home-team self-confidence in history - would have scarred the national psyche even if the country had not proceeded into the worst economic recession in a hundred years. At that point the country's politics became a Shakespearean tragedy in which a handful of corrupt aristocrats slaughtered each other on stage, for all the world to see. Chart 18No Neymar Home "Brazil is back," say the fans - just as the bulls in the financial markets. The argument goes like this: The crisis has proven that the country has resilient institutions. Inflation (read: hubris) has collapsed to the lowest point in years, while the country has tightened its belt (both financially and figuratively), in a long-overdue act of self-discipline. The only difference is that the football comeback, unlike the economic one, is built on firm foundations. The Brazilian squad has made an impeccable run since Dunga stepped down as coach in 2016. It was the first team to qualify for this year's World Cup, going undefeated for quite a stretch of time. Today, the team is coached by Tite, a former player. The least we can say is that he reinvented the way Brazil plays. Brazil's lamentable disappointment under coach Luiz Felipe Scolari ultimately comes down to the need for a new football identity and a new crop of players. That's what they have today. They are a very good team, and freshly humbled. We expect them to go far, though not all the way. It is not certain that all of Brazil's demons have been purged. By way of illustration, the leading presidential candidate is an advocate of military dictatorship, with no pro-market candidate in sight (Chart 18). France - Marchons, Marchons! In 2016, France lost to Portugal in the final of the Euro Cup on home court. This was not the first gut-wrenching loss in the final of a major tournament. In 2006, its aging 1998 generation lost a bitterly fought final against Italy. In Russia, France comes as one of the favorites. Its team is celebrating the 20-year anniversary of its epic 1998 run. Meanwhile, at home, France is marching in lockstep to President Emmanuel Macron's reforms. The economy is booming, cantankerous unions are either defeated or capitulating, and even equity market performance is leaving traditional competitors in the dust (Chart 19). Chart 19France - Marchons, Marchons! Our model sees France reaching the final of the World Cup. However, it also predicts that France will lose this final, a repeat of the 2016 and 2006 performances. Les Bleus will come close, but not light the victory cigar. Football in France is embedded in the cultural fabric; its team is portrayed by the media as a reflection of the contemporary socio-economic narratives. When France won in 1998, for example, the team's multicultural heritage was touted as a model of integration and as a symbol of open-minded, post-colonial France. The 2010 debacle in South Africa, on the other hand, where French players literally went on strike following an altercation with their coach, was presented as a symbol of declining French relevance and growing national impotence. Since 2014, however, positive momentum has been building both on the football pitch and in real life. A young team managed to qualify for the 2014 World Cup, losing to the eventual champion Germany in a closely contested quarter-final game. Two years later, that same team defeated World Champion Germany in a semi-final of the Euro tournament. On the political front, 39-year old Emmanuel Macron swept aside populists and left-wing firebrands, stunning the world by campaigning from a staunchly centrist perspective. The question for France in 2018 is whether it will fall short of victory, yet again. We ask the question both in terms of the performance on the football pitch and in politics. The youthful, energetic, president mirrors the youthful, energetic, squad. But a lot is at stake and second place may not be good enough for either. We remain optimistic that genuine reforms are coming to France.41 And despite our model's preference for Spain in the finals of the World Cup, France has a great chance of repeating the glory from twenty years ago. Spain - Divided It Stands, And Wins On October 1, 2017, 92% of Catalan voters decided that Catalonia should secede from Spain in a referendum deemed illegal by Madrid.42 Soon after, images of old ladies and students being beat up by riot police flooded the internet, as Mariano Rajoy's government signaled its refusal to compromise on the question of independence. Chart 20Catalan Separatism: Overstated Risk Intriguingly, Spain's most independent-minded regions have often produced some of its best footballers. Cesc Fàbregas, Gerard Piqué, Carles Puyol, Xavi Hernandez, and Sergio Busquets are all of Catalan descent and have dutifully defended the Spanish colors in several successful Euro and World Cup campaigns. Meanwhile, the bitter Barcelona-Real Madrid rivalry has been at the heart of Spanish football and deeply embedded in the country's political and socioeconomic history for generations. In other countries, such divisions and rivalries would let politics get in the way. In Yugoslavia, the civil war is famously said to have begun with fan rioting at a 1991 Dinamo Zagreb vs. Crvena Zvezda match. But Spain, somehow, channels the chaos into beautiful, and effective, football. Pro-independence sentiment has begun to waver in Catalonia, as BCA's Geopolitical Strategy predicted (Chart 20).43 This is bullish for the Spanish economy and assets, but also for its football team. Spain conquered the world of football at the height of its economic crisis, in 2010. Will it do so again, on the heels of its political crisis? Our model predicts yes. And we agree. It would seem that Spain's greatest attribute as a nation is to produce diamonds under pressure. III. Investment Implications: Does The World Cup Matter? The FIFA World Cup is the most widely watched sporting event in the world by far (Chart 21). Does all that passion and emotion translate into any economic or market implications? Chart 21World Cup Is The Most Important Unimportant Event In The World Academic literature on the topic is, at best, inconclusive. International football, as an industry, is largely inconsequential. For instance, the wealthiest football club in the world - Manchester United - generates less than 8% of the revenue of the 500th company in the Fortune 500 index. To assess whether the World Cup matters, we take two approaches. First, we explore the implications of hosting the event on the economy of the host nation. Second, we examine the implications of the World Cup on equity markets. Hosting The World Cup Despite the size and the reach of the World Cup, we find little evidence that hosting the event is beneficial to the host's economy. There appears to be little to no effect on either a short or long-term horizon. We found no "World Cup effect" on any of the economic variables one would assume may be impacted. Nonetheless, some patterns are worth highlighting (Table 22). Table 22Is It Worth It? We chose to look at the behavior of each economic variable one year before and after the World Cup, with the exception of core consumer price inflation and the unemployment rate, which we observed on a three-year horizon around the event. The rationale behind this is that the labor market tends to react slowly to changes in underlying economic activity, due to factors such as the rigidity of employment contracts and stickiness of wages. The study starts with the 1990 World Cup hosted by Italy. Interestingly, some patterns are apparent. Out of all the variables we analyzed, inward FDI tends to consistently increase in the host country following the World Cup. Our suspicion is that hosting the event demonstrates, on the margin, that the country meets suitable conditions (governance, return on capital, etc.) to attract foreign capital. On the other hand, we may be capturing a trend already underway, which itself was revealed by the fact that the country was selected to host the World Cup in the first place. As Table 23 illustrates, the selection process lags the actual event, as with any major sporting event (such as the Olympics). Intriguingly, the time-lag is, on average, six years, almost precisely the length of an economic cycle. As such, the decision to award the hosting of the event to a particular country may already take into account the bullish macroeconomic cycle. By the time the event is hosted, the cycle is in full swing and may actually be peaking. Table 23Soccernomic Cycles? Consistently, capital expenditures also tend to increase following the Word Cup. As more foreign capital flows in the country, more investment takes place. Currencies, however, on a one-year horizon, do not react to these FDI flows since the short-term gyrations are dictated by more volatile short-term portfolio flows. As FDI flows in, the unemployment rate falls and tends to continue falling after a World Cup. However, some caution is advised in interpreting these conclusions. Macroeconomic business cycles, commodity prices, and other structural factors are still dominating factors in determining the trend and health of economies. As we indicated in our analysis of Russia in the qualitative section above, the World Cup itself can be considered a lagging indicator of the economy. This certainly appears to be the case with the three members of the BRICS who have hosted the event: South Africa, Brazil, and Russia. As such, hosting the World Cup may signal the top of the bullish cycle, as it certainly did for Brazil. This warrants a few key observations: Brazil did not see a rise in capital expenditure after hosting the World Cup in 2014. In fact, it suffered one of the deepest recessions in the last century. Consistently, unemployment did not fall as it did for other countries as commodities entered a bear market in 2015 and weighed heavily on the economy. Although South Africa did see its unemployment rate fall before the World Cup, the trend did not continue following the event. In the few years leading up to the global financial crisis, the world economy was in the midst of a period of stellar growth. Therefore, it makes sense that Germany was experiencing rising FDI, capital expenditure, and inflationary pressures prior to hosting the event in 2006. In addition, the implementation of the Hartz IV reforms in the early part of the decade put an end to the long-term structural uptrend in the unemployment rate, which has since declined by more than 7%. The year 2002 was an important one for Japan, as the turn of the millennium marked the end of the "lost decade". Subsequently, Japan experienced a falling unemployment rate and rising GDP growth. However, the end of the "lost decade" also saw the beginning of the self-feeding deflationary expectations which have anchored expected inflation levels near zero. As such, consumer prices fell before and after the event. France went through a period of intense reforms in the late 1990s. Prior and subsequent to 1998, growth rates were falling simply because 1998 recorded a higher growth rate of 3.3%, compared to 1.6% in 1997 and 3.1% in 1999. The lowering of the VAT rate, income, and corporate tax by the Chirac government led to real capital expenditure and real household consumption increases during the late 1990s. Furthermore, substantial labor market reforms helped to decrease the unemployment rate. The 1990s were the longest period of economic expansion in U.S. history. In fact, 1994 was the year where the number of jobs created was one of the largest on record, at 3.85 million. As such, real GDP growth and business investment expenditures were high, and the unemployment rate was falling. The prospects of high growth also brought in increased foreign direct investment in the same period in which the World Cup coincided. However, emerging markets were seeing an equally stellar period of growth, which was supported by high capital inflows and appreciating EM currencies, thus leading to a lower U.S. dollar. Although the Federal Reserve began hiking interest rates in 1994, the effect on the dollar was not registered until the beginning of 1995, which also marked the beginning of a dollar bull market. In the 1990s, the Italian government was heavily liberalizing the economy, leading to its eventual inclusion in the Euro Area at the end of the decade. Italian growth during the late '80s and early '90s was high enough for it to surpass Britain and France in terms of GDP growth, consumption and investment growth in 1990 were high. However, the 1990s oil price shock depressed consumer and business activity. Bottom Line: In line with the academic literature, the results of our assessment are at best inconclusive. However, the data does suggest that hosting of the World Cup coincides with some positive macroeconomic developments, particularly in terms of FDI inflows. This, however, may reflect the fact that the decision to host the event is usually made at the beginning of a bullish upcycle, which means that the actual event marks the peak, or top, of the cycle. Equity Market Implications The World Cup may be most relevant, not as a catalyst for market action, but rather as a distraction. The European Central Bank, for example, concluded in a 2012 study that trading volumes dropped considerably during match times.44 The World Cup in Russia could be particularly distracting. Because of Russia's time zone, most matches will be played between 8:00 am and 2:00 pm in New York, and 1:00 pm and 7:00 pm in London. As opposed to the economic impact, there seems to be a general consensus in the academic literature regarding the equity market implications of World Cup matches. For instance, a cross-sectional analysis of 39 countries looking at World Cup and relevant qualifying matches between 1973 and 2004 (that represents 1,162 matches!) concludes that losses have an economically and statistically significant negative effect on the losing country's stock market.45 Furthermore, the study finds that this effect is stronger in small caps, which are disproportionately held by local investors and therefore are more strongly affected by sentiment following a football match. Another study found that being short NYSE and long Treasuries during World Cups would produce a higher return from 1950 to 2007.46 This is due to the decisions taken by foreign investors in U.S. bond and equity markets. During the World Cup, these investors would withdraw capital to invest in their local markets, which would put downward pressures on NYSE prices. Table 24 presents the daily stock return deviation from what one would expect outside of World Cups for all the matches in the past seven World Cups, starting with the quarter-finals (for the period from 1990 to 2014). We report the local equity market movement of the teams playing up to three days after a match took place. Table 24Do World Cup Matches Impact The Local Stock Returns Of The Teams Playing? Several observations can be made: We observe positive "abnormal" returns, i.e., deviations from trend, in the day following the matches, for any of the teams playing, and larger "abnormal" returns when it comes to the winning team. While we observe positive abnormal returns for the winners at t+1, it appears that more than 70% of the daily returns used to compute this average turn out to be negative - implying that, on average, the winners' local equity markets experience small negative returns and, in a few instances, large abnormal positive returns. In line with the literature, we observe negative abnormal returns on t+1 for the losers, regardless of how we define our benchmark. A high number of abnormal daily returns, up to three days after the match, appear to be negative (this is also the case regardless of whether we compare it to the past average, median, or non-World Cup daily returns). Bottom Line: We do not recommend that investors "play" the World Cup. Generally speaking, equity markets react, on average, positively to wins and negatively to losses. However, this is not always the case. 1 There are, however, some less obvious investment implications ... but we do not encourage gambling on sporting events! 2 C. Cotta, A. M. Mora, and J. J. Merelo, "A Network Analysis of the 2010 FIFA World Cup Champion Team Play," Journal of Systems Science 26:1 (2013), 21-42. 3 For instance, please see Gregory T. Papanikos, "Economic, population and political determinants of the 2014 World Cup match results," Soccer & Society 18:4 (2017), 516-532; and Fabian Wunderlich and Daniel Memmert, "Analysis of the predictive qualities of betting odds and FIFA World Ranking: evidence from the 2006, 2010 and 2014 Football World Cups," Journal of Sports Sciences 34:24 (2016), 20176-20184. 4 Please see O'Donoghue et al, "An evaluation of quantitative and qualitative methods of predicting the 2002 FIFA World Cup. Part II: Game activity and analysis," Journal of Sports Sciences 22:6 (2004), 513-514 5 Please see, The Economist, "Why video games are so expensive to develop," September 25, 2014, available at www.economist.com. 6 The OP model makes two critical assumptions: (1) it assumes that the (χ'ι, β, γ) function has the form of a continuous probability distribution function which is the standard normal distribution function of a linear combination of our explanatory variables; (2) it assumes proportional odds between each category in the dependent variable. Assumption (2) was confirmed using the proportional odds Brant test, confirming that the ordered probit is the best suited model for our purpose. Please see Alexander, Carol, Market Risk Analysis: Practical Financial Econometrics (John Wiley & Sons) 2008, 426 pages. 7 Please see EViews 8.1 User's Guide II, pp.259-284. 8 Please see J. Bloomfield, R. Polman, and P. O'Donoghue, "Physical Demands of Different Positions in FA Premier League Soccer," Journal of Sports Science & Medicine 6:1 (2007), 63-70. 9 Please see Seife Dendir, "When do soccer players peak? A note," Journal of Sports Analytics 2 (2016), 89-105. 10 Think 22-year old Mario Götze's stunning game-winner four years ago. 11 Please see H. Sarmento et al, "Match analysis in football: a systematic review," Journal of Sports Sciences 32:20 (2014), 1831-1843. 12 In order to favor our core model (M1), which uses the team average player rating variable, we assigned a weight α = 0.66. 13 We are sure that this is a pure coincidence. Being paired with the host Russia had nothing to do with this. Nothing. 14 A "Novichok bonus" perhaps? 15 Remember that the marginal effect represents the impact of a 1-unit change in the rating variable on the probability of winning. This is why we need to be careful when comparing both stages' marginal effect. A 1-unit change in the rating variable is less frequent, but extremely important in the knockout stage, hence the higher coefficient. 16 In 2006, Italy had 10 players from either Juventus or AC Milan; in 2010, Spain had 12 players from either F.C. Barcelona or Real Madrid; and in 2014, Germany had 11 players from either Bayern Munich or Borussia Dortmund. 17 Please see M. Clemente et al, "Midfielder as the prominent participant in the building attack: A network analysis of national teams in FIFA World Cup 2014," International Journal of Performance Analysis in Sport 15:2 (2015), 704-722. 18 For instance, please see F. M. Clemente et al, "Using Network Metrics in Soccer: A Macro-Analysis," Journal of Human Kinetics 45 (2015), 123-134. 19 In order to favor our core model (M1), which uses the team average player rating variable, we assigned a weight α = 0.66. 20 This would not be the first time that the third place game steals the spotlight. Going back to 1978, the third place game has outscored the final by a considerable margin. Teams usually enter the game with no pressure and therefore commit to a flowing, attacking style of play. Some of the most exciting games in World Cup history were played for third place: think Germany's 3-2 win over Uruguay in 2010, or Turkey's thrilling 3-2 win against South Korea. 21 As well as ... yes, atrocious refereeing. 22 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available from gps.bcaresearch.com. 23 Please see BCA Frontier Market Strategy Special Report, "Egypt: Giving Benefit Of Doubt," dated February 6, 2018, available at fms.bcaresearch.com. 24 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Ranking EM Countries Based On Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 25 The Netherlands has a population 50 times greater than Iceland and a GDP 35 times greater. 26 Portugal has a population 30 times greater than Iceland and a GDP 10 times greater. 27 England has a population 200 times greater than Iceland and a GDP 110 times greater. 28 Just in case any of our Icelandic clients take offense to our premise, we want to point out that the country has competed in a number of Games of the Small States of Europe. Participants at this biannual event includes such sporting powerhouses as Andorra, Cyprus, Liechtenstein, Luxembourg, Malta, Monaco, Montenegro, and San Marino. Iceland actually trails Cyprus in the total tally of medals collected since 1985. 29 Please see Frode Telseth and Vidar Halldorsson, "The success of Nordic football: the cases of the national men's teams of Norway in the 1990s and Iceland in the 2010s," Sport In Society, November 1, 2017. 30 Please see Taleb, Nassim, Fooled By Randomness (New York: Random House), 316 pages. 31 Unless you are a U.S. soccer fan. The U.S. has a population 1,000 times greater than Iceland and a GDP 800 times greater. Please light yourself on fire responsibly. 32 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 33 Robert Prosinecki would have been 25-years old, and at the time one of the highest paid players in the world. In 1998, due to a number of injuries, he was playing for Croatia and largely an afterthought in the team. Davor Šuker and Zvonimir Boban would have also been 25 in 1994 and both at the peak of their careers. 34 Vladimir Jugovic and Sinisa Mihajlovic, were both in their prime in 1994, and both were stars in Italy. 35 The eventual Real Madrid legend Predrag Mijatovic would have been in-prime 25 years of age in 1994 (and unlikely to make the starting 11 of the combined Yugoslav team!), while, by then, the three-time Champions League winner Dejan Savicevic would have already been A.C. Milan's best player. 36 Shout out to Darko Pancev, the 1991 European Golden Boot award winner! 37 For example, for the duration of the 2014 Winter Olympics, only vehicles registered in Sochi, or those with special permission, were allowed through security checkpoints set a 100 kilometers outside the city. 38 Please see BCA Global Investment Strategy Weekly Report, "The End Of Europe's Welfare State," dated June 26, 2015, available at gis.bcaresearch.com. 39 Except in the U.S., which is maybe why it continues to underperform in global competitions. 40 Contrary to most leagues, the Premier League does not have a cap on the number of foreign players a team can have. It just requires eight players to be home grown (three years with an English team before the age of 21). 41 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 42 The turnout of the referendum was a woeful 43%, however. 43 Please see BCA Geopolitical Strategy Weekly Report, "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 44 Ehrmann, M. and Jansen D., "The Pitch Rather Than The Pit: Investor Inattention During FIFA World Cup Matches," European Central Bank, Working Paper 1424, February 2012. 45 Please see Edmans, A., Garcia, D., & Norli, O. "Sports Sentiment and Stock Returns," The Journal of Finance 62:4 (2007), 1967-1998. 46 G. Kaplanski, and H. Levy, "Exploitable Predictable Irrationality: the FIFA World Cup effect on the U.S. Stock Market," Journal of Financial and Quantitative Analysis 45:2 (2010), 535-553. References Alexander, Carol, Market Risk Analysis: Practical Financial Econometrics (John Wiley & Sons) 2008, 426 pages. J. K. Ashton, B. Gerrard, and R. Hudson (2011), "Do national soccer results really impact on the stock market?" Applied Economics, 43:26, 3709-3717. M. H. Berument, and N. B. Ceylan (2012), "Effects of soccer on stock markets: the return-volatility relationship," The Social Science Journal 49, 368-374. J. Bloomfield, R. Polman, and P. O'Donoghue (2007), "Physical Demands of Different Positions in FA Premier League Soccer," Journal of Sports Science & Medicine, 6(1): 63-70. F. M. Clemente, M. S. Couceiro, F. Martins, and R. Mendes (2015), "Using Network Metrics in Soccer: A Macro-Analysis," Journal of Human Kinetics 45/2015, 123-134. M. Clemente et al. (2015), "Midfielder as the prominent participant in the building attack: A network analysis of national teams in FIFA World Cup 2014," International Journal of Performance Analysis in Sport 15(2): 704-722. C. Cotta, A. M. Mora, and J. J. Merelo (2013) "A Network Analysis of the 2010 FIFA World Cup Champion Team Play," Journal of Systems Science 26(1): 21-42. Seife Dendir (2016), "When do soccer players peak? A note," Journal of Sports Analytics, 2: 89-105. A. Edmans, D. Garcia, and O. Norli (2007), "Sports Sentiment and Stock Returns," The Journal of Finance, 62 (4), 1967-1998. J. Geyer-Klingeberg, M. Hang, M. Walter, and A. Rathgeber (2018), "Do stock markets react to soccer games? A meta-regression analysis," Applied Economics, 50:19, 2171-2189. G. Kaplanski, and H. Levy (2010), "Exploitable Predictable Irrationality: the FIFA World Cup effect on the U.S. Stock Market," Journal of Financial and Quantitative Analysis, 45(2): 535-553. Jorge Knijnik (2014), "Playing for freedom: Sócrates, futebol-arte and democratic struggle in Brazil," Soccer & Society, 15:5, 635-654. Christian Koller (2017), "Le football suisse: Des pionniers aux professionnels, " Soccer & Society, 18:4, 597-598 Lindsay Sarah Krasnoff (2017), "Devolution of Les Bleus as a symbol of a multicultural French future," Soccer & Society, 18:2-3, 311-319 S. Kuper, and S. Szymanski (2009), "Soccernomics: Why England Loses, Why Germany and Brazil Win, and Why the U.S., Japan, Australia, Turkey - and Even Iraq - Are Destined To Become the Kings of the World's Most Popular Sport". H. Liu, M.A. Gomez, C. Lago-Peñas, and J. Sampaio (2015), "Match statistics related to winning in the group stage of 2014 Brazil FIFA World Cup," Journal of Sports Sciences, 33:12, 1205-1213. R. Mackenzie, and C. Cushion (2013), "Performance Analysis in Football: A Critical Review and Implications for Future Research", Journal of Sports Sciences 31(6). J.A. Mangan, Hyun-Duck Kim, A. Cruz, and Gi-Heun Kang (2013), "Rivalries: China, Japan and South Korea - Memory, Modernity, Politics, Geopolitics - and Sport," The International Journal of the History of Sport, 30:10, 1130-1152. M. Martiniello, and G. W Boucher (2017), "The colours of Belgium: red devils and the representation of diversity," Visual Studies, 32:3, 224-235. Brank Milanovic (2010), "The World at Play: Soccer Takes on Globalization," YaleGlobal Online. Richard Mills (2009), "'It All Ended in an Unsporting Way': Serbian Football and the Disintegration of Yugoslavia, 1989-2006," The International Journal of the History of Sport, 26:9, 1187-1217. Shakya Mitra (2014), "Spanish football: from underachievers to world beaters," Soccer & Society, 15:5, 709-719. O'Donoghue et al. (2004), "An evaluation of quantitative and qualitative methods of predicting the 2002 FIFA World Cup. Part II: Game activity and analysis," Journal of Sports Sciences 22(6):513-514. Gregory T. Papanikos (2017), "Economic, population and political determinants of the 2014 World Cup match results," Soccer & Society, 18:4, 516-532. Guy Podoler (2008), "Nation, State and Football: The Korean Case," The International Journal of the History of Sport, 25:1, 1-17. Alejandro Quiroga (2017), "Spanish football and social change: sociological investigations," Soccer & Society, 18:1, 160-162. H. Sarmento et al. (2014), "Match analysis in football: a systematic review," Journal of Sports Sciences, 32:20, 1831-1843. B. Scholtens, and W. Peenstra (2009), "Scoring on the stock exchange? The effect of football matches on stock market returns: an event study," Applied Economics, 41:25, 3231-3237. Stefan Szymanski (2010), "The Economic Impact Of The World Cup," Football Economics and Policy 226-235. Taleb, Nassim, Fooled By Randomness (New York: Random House), 316 pages. F. Telseth, and V. Halldorsson (2017), "The success culture of Nordic football: the cases of the national men's teams of Norway in the 1990s and Iceland in the 2010s," Sport in Society. Dag Tuastad (2014), "From football riot to revolution. The political role of football in the Arab world," Soccer & Society, 15:3, 376-388. Scott Waalkes (2017), "Does soccer explain the world or does the world explain soccer?" Soccer and globalization, Soccer & Society, 18:2-3, 166-180. D. Wong, and S. Chadwick (2017), "Risk and (in)security of FIFA football World Cups - outlook for Russia 2018," Sport in Society, 20:5-6, 583-598. F. Wunderlich, and D. Memmert (2016), "Analysis of the predictive qualities of betting odds and FIFA World Ranking: evidence from the 2006, 2010 and 2014 Football World Cups," Journal of Sports Sciences, 34:24, 20176-20184. D. Zec, and M. Paunovic (2015), "Football's positive influence on integration in diverse societies: the case study of Yugoslavia," Soccer & Society, 16:2-3, 232-244.

Special Report

Feature Chart I-1Recent Defaults Have Focused Attention ##br##On Corporate Health The recent spike in defaults on bonds and loans in China, including missed debt repayments by local government financing vehicles (LGFV) and some listed companies, has unsettled investors over the past few weeks.1 The yield spread between 5-year government bonds and 5-year corporate bonds AA minus in China's domestic bond market, has recently hit their widest level in nearly two years (Chart I-1). As a result, some investors are concerned about the possibility of widespread defaults as the Chinese government's deleveraging campaign continues to roll out, and sweeping new rules on shadow banking take effect. Given the report focus on corporate health, this week we are updating our China Industry Watch thematic chartpack to present a visual presentation of the changing situation in China's corporate sector, and its relevance to the broader stock market performance. Overall, the Chinese corporate sector has continued to deleverage and its financial situation has improved modestly. Our Corporate Health Monitor (CHM),2 which is an equally weighted average of net income margin, return on capital, EBIT-to-debt ratio, debt-to-asset ratio and interest coverage ratio, shows that the health of most sectors are improving. Specifically, for steel, construction materials, automobile, food& beverage and tech, our CHMs are in healthy territory. For oil & gas, coal, non-ferrous metals and machinery, CHMs are still below zero but are recovering. In terms of profit growth, it has remained robust for most of the sectors shown in the report. In particular, profit growth has accelerated substantially in the coal and steel sectors, as higher selling prices helped offset the impact of production constraints on revenue and aggressive cost cutting increased gross margins. Firms in the energy sector have also enjoyed higher profit growth as oil prices rebounded. In terms of the leverage picture, the liabilities-to-assets ratio has continued to decline broadly across sectors (Chart I-2). However, in regards of debt sustainability, the interest-to-sales ratio has increased substantially in coal, steel, and non-ferrous sectors, due to dramatic decline in sales resulting from production constraints. The interest coverage ratio in these sector is less problematic because of improving gross margins. For the tech sector, however, there has been a spike in the interest-to-sales ratio and a sharp decline in interest coverage. Looking beyond the fairly broad-based improvement in our overall non-financial CHM, we doubt that a broad-based default wave will occur in response to the crackdown on shadow banking. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. One problem that is worth monitoring is the negative trend in overall industrial enterprises sales, which had a negative growth rate in Q1 relative to the same quarter last year. Part of this negative growth rate is likely due to base effects, given that Q1 2017 itself was abnormally strong. Nevertheless, comparing first three month of the sales this year to that of previous years, it is clear that 2018's value did not reflect an uptrend in the data (Chart I-3). This weak top line performance is somewhat worrisome and we will continue to watch for signs of a further slowdown. Chart I-2A Continued Decline In Debt-To-Assets Chart I-3Tepid Topline Growth Is Worrisome Lin Xiang, Research Analyst linx@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com BCA China Industry Watch includes four categories of financial ratios to monitor a sector's leverage, profitability, growth and efficiency, respectively. Some of these ratios, as shown in Table 1, are slightly tweaked from conventional definitions due to data availability. The financial data in our exercise are from the official statistics on overall industrial firms, of which the listed companies are a subset, but most financial ratios based on the two sets of data are very similar, especially for the heavy industries that dominate the Chinese stock markets - both onshore and offshore. The financial ratios on leverage, growth and profitability are almost identical for some sectors, while some other sectors that are not well represented in the stock market, such as technology, healthcare and consumer sectors, show notable divergences. As the Chinese equity universe continues to expand, we expect that the two sets of data will increasingly converge. Table 1The China Industry Watch 1 More than 10 companies, several of them listed, from a variety of industries have defaulted on 17 bonds worth more than 16.5 billion yuan (US$2.6 billion), according to figures from Choice. 2 Please see China Investment Strategy Special Report, “Introducing The BCA China Industry Watch,” dated February 10, 2016, available at cis.bcaresearch.com. Appendix: China Industry Watch All Firms Chart II-1Non-Financial Firms: Stock Price & Valuation Indicators Chart II-2Non-Financial Firms: Relative Performance Of Valuation Indicators Chart II-3Non-Financial Firms: Leverage Indicators Chart II-4Non-Financial Firms: Growth Indicators Chart II-5Non-Financial Firms: Profitability Indicators Chart II-6Non-Financial Firms: Efficiency Indicators Oil & Gas Sector Chart II-7Oil&Gas Sector: Stock Price & Valuation Indicators Chart II-8Oil&Gas Sector: Relative Performance Of Valuation Indicators Chart II-9Oil&Gas Sector: Leverage Indicators Chart II-10Oil&Gas Sector: Growth Indicators Chart II-11Oil&Gas Sector: Profitability Indicators Chart II-12Oil&Gas Sector: Efficiency Indicators Coal Sector Chart II-13Coal Sector: Stock Price & Valuation Indicators Chart II-14Coal Sector: Relative Performance Of Valuation Indicators Chart II-15Coal Sector: Leverage Indicators Chart II-16Coal Sector: Growth Indicators Chart II-17Coal Sector: Profitability Indicators Chart II-18Coal Sector: Efficiency Indicators Steel Sector Chart II-19Steel Sector: Stock Price & Valuation Indicators Chart II-20Steel Sector: Relative Performance Of Valuation Indicators Chart II-21Steel Sector: Leverage Indicators Chart II-22Steel Sector: Growth Indicators Chart II-23Steel Sector: Profitability Indicators Chart II-24Steel Sector: Efficiency Indicators Non Ferrous Metals Sector Chart II-25Non Ferrous Metals Sector: Stock Price & Valuation Indicators Chart II-26Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Chart II-27Non Ferrous Metals Sector: Leverage Indicators Chart II-28Non Ferrous Metals Sector: Growth Indicators Chart II-29Non Ferrous Metals Sector: Profitability Indicators Chart II-30Non Ferrous Metals Sector: Efficiency Indicators Construction Material Sector Chart II-31Construction Material Sector: Stock Price & Valuation Indicators Chart II-32Construction Material Sector: Relative Performance Of Valuation Indicators Chart II-33Construction Material Sector: Leverage Indicators Chart II-34Construction Material Sector: Growth Indicators Chart II-35Construction Material Sector: Profitability Indicators Chart II-36Construction Material Sector: Efficiency Indicators Machinery Sector Chart III-37Machinery Sector: Stock Price & Valuation Indicators Chart III-38Machinery Sector: Relative Performance Of Valuation Indicators Chart III-39Machinery Sector: Leverage Indicators Chart III-40Machinery Sector: Growth Indicators Chart III-41Machinery Sector: Profitability Indicators Chart III-42Machinery Sector: Efficiency Indicators Automobile Sector Chart III-43Automobile Sector: Stock Price & Valuation Indicators Chart III-44Automobile Sector: Relative Performance Of Valuation Indicators Chart III-45Automobile Sector: Leverage Indicators Chart III-46Automobile Sector: Growth Indicators Chart III-47Automobile Sector: Profitability Indicators Chart III-48Automobile Sector: Efficiency Indicators Food & Beverage Sector Chart III-49Food&Beverage Sector: Stock Price & Valuation Indicators Chart III-50Food&Beverage Sector: Relative Performance Of Valuation Indicators Chart III-51Food&Beverage Sector: Leverage Indicators Chart III-52Food&Beverage Sector: Growth Indicators Chart III-53Food&Beverage Sector: Profitability Indicators Chart III-54Food&Beverage Sector: Efficiency Indicators Information Technology Sector Chart III-55Information Technology Sector: Stock Price & Valuation Indicators Chart III-56Information Technology Sector: Relative Performance Of Valuation Indicators Chart III-57Information Technology Sector: Leverage Indicators Chart III-58Information Technology Sector: Growth Indicators Chart III-59Information Technology Sector: Profitability Indicators Chart III-60Information Technology Sector: Efficiency Indicators Utilities Sector Chart III-61Utilities Sector: Stock Price & Valuation Indicators Chart III-62Utilities Sector: Relative Performance Of Valuation Indicators Chart III-63Utilities Sector: Leverage Indicators Chart III-64Utilities Sector: Growth Indicators Chart III-65Utilities Sector: Profitability Indicators Chart III-66Utilities Sector: Efficiency Indicators Cyclical Investment Stance Equity Sector Recommendations

Highlights 0 To 3 Months: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. 6 to 12 Months: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. Total Return Forecasts: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Feature Chart 1Two Milestones The U.S. bond market reached one noteworthy milestone last week and is quickly closing in on another. The first milestone is that the 10-year Treasury yield decisively broke through the 3% level that had defined its most recent peak (Chart 1). The second milestone is that the market is now close to fully pricing-in the likely near-term path for Fed rate hikes. We noted in a recent report that the Fed's "gradual" rate hike path is quite clearly defined as one 25 basis point rate hike per quarter.1 This equates to 100 bps on our 12-month Fed Funds Discounter, which currently sits at 91 bps, just below this key level (Chart 1, bottom panel). We continue to see upside in Treasury yields on a cyclical horizon. Though tactically, the likelihood of a near-term pullback in yields has increased greatly during the past few days. In this week's report we outline the case for a near-term (0-3 month) pullback in Treasury yields, but also look ahead by introducing a simple framework investors can use to make total return forecasts for all different U.S. bond sectors. The Case For A Near-Term Pullback In addition to the fact that the market is closer to fully discounting the likely near-term path of rate hikes than it has been for some time, there are two other reasons to expect a near-term, temporary pullback in yields. The first is that the below-benchmark duration trade has become the consensus position in the market (Chart 2). Net speculative short positions in 10-year Treasury futures have rarely been greater, and since the financial crisis large net short positions have correlated quite strongly with a decline in the 10-year yield during the subsequent three months. Similarly, positions reported in the JP Morgan Duration Survey are firmly in "net short" territory for both the "all clients" and "active clients" surveys. The Marketvane survey of bond sentiment has also turned bearish for only the fourth time since 2010. Each of the other three times has coincided with a near-term drop in yields. Chart 2Bond Market Looks Oversold But positioning alone would not be enough to convince us that yields might decline in the near-term. Investors also need a catalyst. An excuse to take profits on large net short positions that have been working well. That catalyst is typically a period of worse-than-expected economic data. To judge the trend in economic data relative to expectations we turn to the Economic Surprise Index. Chart 3Economic Surprise Index In a report from last year we demonstrated that if the Economic Surprise Index ends a month below (above) the zero line, it is very likely that Treasury yields fell (rose) during that month.2 Also, we know that the surprise index is mean reverting by its very nature. A long period of positive (negative) data surprises will certainly be followed an upward (downward) revision to investors' economic expectations. Eventually expectations become so elevated (depressed) that they become impossible to surpass (disappoint). The index will then start to mean revert. In that same report from last year we also introduced a simple auto-regressive model of the surprise index, designed to capture its average speed of mean reversion. Based on that model, which is purely a function of the index's own lags, we would expect the surprise index to dip slightly into negative territory in one month's time (Chart 3). Though given the large amount of uncertainty in the model, a fairer assessment would be that it is no longer a given that the surprise index will remain above the zero line in the near-term. Bottom Line: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. Less nimble investors are better off riding out any potential near-term volatility and maintaining below-benchmark portfolio duration on a 6-12 month horizon. The Cyclical Picture Is Unchanged On a 6-12 month investment horizon, we are sticking with the playbook of our Two-Stage Bond Bear Market.3 The first stage is characterized by the re-anchoring of inflation expectations, and here, long-maturity TIPS breakeven inflation rates are still slightly below our target range of 2.3% to 2.5% (Chart 4). We also think bond investors should maintain an overweight allocation to spread product, though the time to trim exposure is approaching. Because the Fed's support for credit markets will weaken as inflation pressures mount, we will start reducing exposure to spread product once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are within our target 2.3% to 2.5% band. The intuition that the credit cycle is long in the tooth is further supported by the fact that the 2/10 Treasury curve is close to 50 bps (Chart 4, bottom panel). In a recent report we showed that while corporate bond excess returns relative to Treasuries usually remain positive until the yield curve inverts, they decline dramatically once the slope dips below 50 bps.4 Valuation also remains tight in the corporate bond market. While investment grade corporate bond spreads have widened in recent months, the junk spread is still close to its post-crisis low, as is the differential between the junk and investment grade spread (Chart 5). Chart 4Inflation Compensation Chart 5Flirting With The Lows The recent widening of investment grade corporate spreads appears to simply reflect a reversion to more reasonable valuation levels, after they had been extremely expensive at the start of the year. Chart 6 shows the 12-month breakeven spread for each investment grade credit tier. We look at the breakeven spread - defined as the spread widening required to lose money versus Treasuries on a 12-month horizon - in order to adjust for the changing duration of the index over time. Chart 6 also shows the breakeven spread as a percentile rank relative to history. In other words, it shows the percentage of time that the breakeven spread has been lower in the past. Notice that earlier in the year investment grade corporate spreads had been approaching all-time expensive levels. They are now closer to the 25th percentile, much more in line with similar spreads for the High-Yield credit tiers (Chart 7). Chart 6Investment Grade Breakeven Spreads Chart 7High-Yield Breakeven Spreads There is no longer a risk-adjusted opportunity in high-yield corporate bonds relative to investment grade. Bottom Line: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. A Simple Framework For Forecasting Total Returns In a recent report we observed that, using a 12-month investment horizon, the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.5 With that in mind, this week we extend that analysis to develop a simple framework for forecasting bond total returns. The framework relies on the fact that the "12-month rate hike surprise" described above is correlated with the 12-month change in Treasury yields. The Appendix to this report shows the historical correlation between the 12-month rate hike surprise and the 12-month change in several different par-coupon Treasury yields. Unsurprisingly, the correlation is very strong for short maturity yields, and gradually weakens as we move further out the curve. This is important because it means that the total return forecasts we generate from this exercise will be more accurate for bond sectors with low duration than for those with high duration. Table 1 shows the total return forecasts we generated for the Bloomberg Barclays Treasury Master Index and for several of its maturity buckets. The results are presented in such a way that readers can impose their own forecasts for the number of Fed rate hikes that will occur during the next 12 months, and then map that forecast to a reasonable expectation for Treasury total returns. Table 1Treasury Index Total Return Forecasts For example, in a scenario where the Fed lifts rates four times (100 bps) during the next year, given current market pricing the rate hike surprise will be modestly negative.6 Using the historical correlations shown in the Appendix, we map that rate hike surprise to changes in the par-coupon Treasury curve and then use the duration and convexity attributes of each individual index to determine how that shift in the Treasury curve will impact index returns. In the scenario described above we would expect the Treasury Master Index to return +2.13% during the next year. While this is a slightly positive number, it is close enough to zero that it does not provide much insulation from changes in long-dated yields that are unrelated to the near-term path for rate hikes. Further, in the four rate hike scenario, investors moving from the Treasury Master Index to the 1-3 year index need only sacrifice 12 bps of expected return to reduce their duration risk by a factor of three. Such a risk/reward trade-off clearly favors a below-benchmark duration stance on a 12-month investment horizon. Table 2 repeats the same exercise but for the major spread sectors of the U.S. bond market. To estimate spread sector total returns we need to forecast both the shift in the Treasury curve and whether spreads will widen, tighten or remain constant. Specifically, we assume that spreads either widen or tighten by the standard deviation of annual spread changes for each index, calculated using a post-crisis interval. Table 2Spread Product Total Return Forecasts The results show that, in a four rate hike scenario, we should expect 12-month investment grade corporate bond total returns of approximately 3.4%, assuming also that spreads stay flat. In a scenario where the average index spread widens by 42 bps, we should expect total returns of only 1%. Bottom Line: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Spread product returns should continue to beat Treasuries for the time being, but the window for outperformance is starting to close. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix Chart 8Change In 1-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 9Change In 2-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 10Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 11Change In 5-Year Yield Vs.12-Month ##br##Fed Funds Rate Surprise Chart 12Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 13Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 14Change In 30-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", dated May 8, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 6 The 12-month rate hike surprise is defined as the 12-month Fed Funds Discounter less the actual change in the fed funds rate during the following 12 months. Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by global risk appetite, as approximated by corporate spreads and commodity prices. For the next six months, the euro has additional downside, while the dollar's rebound could run further. The CAD also looks attractive. Feature In July 2016, in a Special Report titled, "In Search Of A Lost Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline - a sanity check if you will - to our regular analysis. Additionally, these models can help global equity investors manage their currency exposure, having increased the Sharpe ratio of global equity portfolios vis-à-vis other hedging strategies, and also for a host of base-currencies.2 In this report, we review the logic underpinning these intermediate-term models and provide commentary on their most recent readings for the G10 currencies vis-à-vis the USD. UIP, Revisited The Uncovered Interest Rate Parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is the one that will make an investor indifferent between holding the bonds of Country A or Country B. This means that as interest rates rise in Country A relative to Country B, the currency of Country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of Country B. Chart 1Interest Rate Parity: ##br##Generally Helpful, But... There has long been debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. This debate has regained vigor in the past six months as the dollar has greatly lagged the levels implied by 2-year rate differentials (Chart 1). Research by the Federal Reserve and the IMF suggests incorporating longer-term rates to UIP models increase their accuracy.3 This informational advantage works whether policy rates are or aren't close to their lower bound.4 Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements do not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that, as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of indifference of investors between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.5 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from one another. It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials, as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan immediately comes to mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 2Real Rates Work Better Over The Long Run Chart 3Real And Nominal Rate Spreads Can Differ Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real, not nominal, long-term rate differentials. Global Risk Aversion And Commodity Prices Chart 4The Dollar Benefits From Global Stresses Global risk appetite is also a key factor in trying to model exchange rates. Risk-aversion shocks tend to lead to an appreciation in the U.S. dollar, which benefits from its status as the global reserve currency.6 Literature has often focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power with options-adjusted spreads on junk bonds (Chart 4). Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.7 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resource prices constitute a terms-of-trade shock for them. However, this relationship holds up for the euro as well, something already documented by the European Central Bank.8 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe. Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite, approximated by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. The real rates differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com The U.S. Dollar Chart 5Dollar Back In Line With Fundamentals Chart 6More Upside For Now To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss and Swedish real rates, weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. After a short period when it traded below its FITM, the dollar's recent strength has pushed the greenback back to its equilibrium, suggesting the easy gains are behind us. However, the rising risks in EM along with the continued widening in rate differentials between the U.S. and the rest of the world could put upward pressure on the dollar for a few more months (Chart 5). When the trend in the dollar is included, the greenback also trades in line with the ITTM (Chart 6). This confirms the idea that the dollar could experience some more upside for the remainder of 2018, as periods of undervaluation to the ITTM tend to be followed by overshoots. The return of inflation, along with the injection of large amounts of fiscal stimulus in the U.S., could be the narratives that push the greenback up by another 5%. Despite a positive outlook for 2018, we remain concerned about the dollar's longer-term performance. Not only is it still trading at a 16% premium on a PPP basis, European rates have room to increase substantially once euro area economic slack is fully absorbed. We are not there yet, but continued robust growth in the euro area will let the ECB increase rates more aggressively than the Fed beyond 2020. The Euro Chart 7The Euro Is Not A Bargain Anymore... Chart 8...And Has More Downside Before Year End The FITM for EUR/USD continues to point south, dragged down by widening interest rate differentials in favor of the greenback. However, unlike in early 2017, the euro is no longer trading at a big discount to its fair value (Chart 7). As a result, unlike last year, the euro is not able to avoid the downward gravitational pull of a falling FITM. More worrisome for the euro's performance over the coming six months, EUR/USD is still trading at a premium to its ITTM, which adjusts our FITM by taking account of the euro's trend (Chart 8). Currently, the fair value for EUR/USD stands at 1.15, but the euro tends to undershoot its equilibrium after large overshoots such as when EUR/USD traded around 1.25. Moreover, if China's economic slowdown deepens, commodity prices will suffer, which will drag down both the FITM and the ITTM for the euro. We are not yet willing buyers of the euro at current levels. While we espouse a bearish short-term view on the euro, we will be looking to purchase it once it moves to the 1.15-1.10 range. On longer-term metrics, EUR/USD still trades at a significant discount to its fair value. Moreover, long-term rates could rise in Europe relative to the U.S. once investors begin to lift their expectations for future euro area policy rates more aggressively. As such, we continue to closely monitor the slowdown in both euro area and global growth. Once we see signs of stabilization, the euro should again catch a durable bid. The Yen Chart 9A Dovish BoJ Is Pushing Down ##br##The Yen's Fundamentals Chart 10Tactically, The Yen Is At Risk, But Softening Global ##br##Growth Will Limit Its Downside This Year The FITM for the yen is falling fast, and as a result the JPY cannot rally anymore against the dollar (Chart 9). The ITTM provides a very similar message: the yen still trades at a premium to its short-term equilibrium, and is vulnerable to the dollar's strength (Chart 10). Softness in the yen has materialized despite growing stresses in emerging markets and budding signs of a slowdown in global growth - two normally yen-bullish developments - making it clear that the breakdown between USD/JPY and interest rate differentials could not withstand a period of generalized strength in the dollar. While the yen could weaken against the dollar, it is likely to rally further against the euro. Weakness in global growth is likely to limit the yen's downside to the equilibrium implied by its ITTM. Meanwhile, EUR/USD is likely to undershoot this same equilibrium. This contrast points to further weakness in EUR/JPY. The British Pound Chart 11The Pound Is ##br## At Equilibrium Chart 12GBP/USD May Be Dragged Lower By A Falling ##br## EUR/USD, But Cable Is Less At Risk Than The Euro GBP/USD is in a very different position than EUR/USD. While the pound's FITM points south, driven by interest rate differentials, cable trades below its equilibrium level (Chart 11). For the FITM to move up from this point onward, the U.K. economy needs to stabilize. We do think this will happen as British inflation slows, which will support household real incomes, and thus consumer spending. This message is also confirmed by the fact that unlike EUR/USD, GBP/USD does not trade at a premium to the ITTM, which incorporates the trend in the pair (Chart 12). While investors bid up the pound against the dollar as the greenback weakened in 2017 and early 2018, they are still embedding a risk premium in the GBP, a consequence of the murky political outlook that has shrouded the U.K. ever since the Brexit referendum. The models confirm our analysis of two weeks ago: that the pound could experience some downside against the dollar if the euro were to weaken, but that nonetheless cable will suffer less than EUR/USD.9 As a result, EUR/GBP is likely to experience downside as the correction in EUR/USD unfolds. On a longer-term basis, traditional valuation metrics such as PPP suggest that the GBP remains cheap. However, for this judgment to be true, much will depend on the evolution of the negotiations between the U.K. and the rest of the EU. A British exit from the common market will invalidate the message from PPP models, as the economic relationship between the U.K. and its largest trading partner will change drastically, implying that the models are specified over a sample that is not relevant anymore. However, it remains far from clear what form Brexit will ultimately take. The Canadian Dollar Chart 13NAFTA Risk Premia Evident Here... Chart 14...And Here Not only is the loonie trading well below the levels implied by the FITM, but augmented interest rate differential models for the CAD still point north, suggesting its fundamental drivers are currently very supportive (Chart 13). The ITTM for the Canadian dollar confirms this message; even after adjusting for its trend the CAD still trades at a discount to equilibrium (Chart 14). Both formulations of the models highlight that a risk premium has been embedded into the Canadian dollar, reflecting still-possible hazards and setbacks surrounding NAFTA negotiations. However, BCA expects a benign outcome for Canada in the coming weeks, which should help the loonie down the road. Not only does the absence of a major overhaul to NAFTA imply that trade flows between the U.S. and Canada will avoid a major shock, it also means that the Bank of Canada can resume tightening monetary policy. The biggest risk for the Canadian dollar versus the greenback is global growth. So long as global growth has not stabilized, the CAD will find it hard to rally durably against the USD. As a result, we prefer to buy the CAD versus other currencies, the EUR and AUD in particular. The Swiss Franc Chart 15No Evident Deviation From ##br## Fundamentals In The Franc Chart 16Rising EM Stresses And Better Value Will ##br##Help The Swiss Franc Versus The Euro The FITM for the Swissie continues to move upward (Chart 15). In fact, the franc currently trades at a discount to its ITTM. This suggests that downside for the Swiss franc versus the dollar is limited for the remainder of the year (Chart 16). Since the Swiss franc already trades at a discount to the USD, but the euro does not, logically, the EUR/CHF is currently very pricey. Hence, it will be difficult for the euro to rally further against the franc this year. Moreover, the slowdown in global growth and the trouble facing EM assets and currencies are likely to further contribute to the current deceleration in European economic data. As a result, both short-term valuation metrics and economic considerations argue for selling EUR/CHF on a six-month basis. Longer term, the Swiss franc's strength in recent years has contributed to a sharp deterioration in Swiss competitiveness. Since the Swiss economy is very flexible, this has mostly been translated into strong deflationary pressures in the alpine state. As a result, the Swiss National Bank will continue to fight off any appreciation in the franc, maintaining very easy monetary conditions. Thus, long-term investors should not short EUR/CHF, but instead, they should use any weakness in this cross this year to accumulate larger bets on the long side. The Australian Dollar Chart 17AUD Fundamentals At Risk Chart 18AUD Not Cheap Enough To Flash A Buy Signal The FITM for the Aussie is currently in a holding pattern (Chart 17). Meanwhile, AUD/USD trades at a marginal discount to the trend-augmented version of the model, the ITTM (Chart 18). Do not get lulled into a sense of comfort by these observations. First, AUD/USD never stops a move at the ITTM; it tends to overshoot its equilibrium. In fact, undershoots tends to culminate at an 8% discount to the short-term fair value. Additionally, the global economic environment suggests that both the AUD's FITM and ITTM could experience downside in the coming months. Slowing global activity and budding EM stress weigh on commodity prices - key components of the models. They also weigh on Australian interest rate differentials vis-à-vis the U.S. - especially as the Australian economy is replete with slack - keeping wage pressures, inflationary pressures, and consequently the Reserves Bank of Australia at bay. This picture is in sharp contrast to Canada. Canadian labor market conditions are tight and the BoC is likely to resume its hiking campaign once uncertainty around NAFTA dissipates. Since the CAD trades at a much larger discount to both its FITM and ITTM, the relative economic juncture supports being short AUD/CAD. The New Zealand Dollar Chart 19NZD Weaker Than ##br##Fundamentals Imply Chart 20NZD Is Cheap Enough To Warrant ##br## A Buy Versus The AUD As was the case with the Aussie, the FITM for the kiwi has stabilized (Chart 19). However, unlike with the AUD, the NZD trades at a meaningful discount to the ITTM (Chart 20). The NZD has greatly suffered in response to a deceleration in New Zealand economic data and to investors' worries about the Adern government - a coalition of the left-leaning Labour and populist New Zealand First parties. Investors are especially concerned over limitation to immigration on long-term growth, as well as risks to the Reserve Bank of New Zealand's independence. These concerns are real, and warrant taking a cautious stance on the NZD. New Zealand growth has greatly benefited from decades of a large immigration influx and from a staunchly independent central bank. Moreover, slowing global growth and trade as well as rising EM stresses are also likely to exert downward pressure on the NZD's short-term fair-value estimates. We have been taking advantage of the NZD's discount to its FITM and ITTM by selling the Aussie/kiwi cross. AUD/NZD trades at a premium to its relative ITTM. Moreover, the deceleration in global growth and the stress in EM are likely to exact a greater toll on metals than agricultural prices. This represents a greater negative terms-of-trade shock for Australia than New Zealand. Since Australia displays greater labor market slack than New Zealand, this disinflationary shock will bit the larger of the two economies harder. Therefore, interest rate differentials should move against the AUD, pushing the relative ITTM and FITM down. The Norwegian Krone Chart 21NOK Still A Value Play Among ##br## Commodity Currencies... Chart 22...But It Could Experience Further Downside ##br##Against The Dollar This Year The fundamental model for the Norwegian krone remains in an uptrend, established since the beginning of 2016 (Chart 21). This reflects rallying oil prices, the key determinant of Norwegian terms-of-trade and growth. However, the NOK still trades slightly above its ITTM, its fundamentals adjusted for the trend in the currency pair (Chart 22). Over the next six months, the Norwegian krone could experience further downside versus the USD. Corrections in this pair tends to end when it trades 4% below its ITTM. Additionally, the rise in EM volatility and the great sensitivity of the Norwegian krone to USD fluctuations adds an economic impetus to this risk. Moreover, EUR/USD normally exerts a gravitational pull on the NOK/USD. Since we expects the euro to weaken further, this should drag the krone along for a ride. However, we continue to see downside in EUR/NOK as short-term valuations are not attractive, and as oil is likely to outperform the broad commodity complex. In the longer term, we are positive on the NOK. It is cheap based on long-term models that take into account Norway's stunning net international position of 220% of GDP. Moreover, the high inflation registered between 2015 and 2016 is now over as the pass-through from the weak trade-weighted krone between 2014 and 2015 is gone. This means that the NOK's PPP fair value has stopped deteriorating. The Swedish Krona Chart 23The SEK Has Been Clobbered ##br##Beyond Fundamentals... Chart 24...And Is Becoming Attractive,##br## But Beware The Riskbank The Swedish krona's short-term valuations are attractive. As was the case with the krona, the SEK's FITM remains in an uptrend (Chart 23), and the SEK trades at a sizeable discount to its ITTM (Chart 24). Despite this benign picture, we are reluctant to bet on the SEK. To begin with, the SEK displays the greatest sensitivity to the dollar of all the G-10 currencies; our dollar-bullish stance for the rest of the year thus bodes poorly for the krona, pointing to greater undervaluation ahead. Additionally, despite an economy running 2% above potential GDP, the Riksbank still runs an extremely accommodative monetary policy. In fact, recent communications by the Swedish central bank demonstrate a high degree of comfort with the SEK's weakness. It seems as though Riksbank Governor Stefan Ingves wants to competitively devalue the krona. With global growth softening, the Riksbank is likely to encourage further SEK depreciation as the Swedish business cycle is tightly linked to EM growth. We were long NOK/SEK until two weeks ago, when our target level was hit. While we look to re-open this position, the NOK/SEK currently trades at a small premium to its relative ITTM, and thus the corrective episode could run a few more months. Meanwhile, the relative short-term valuation picture suggests that the recent bout of weakness in EUR/SEK could run a bit further. However, weakening global growth and the Riksbank's dovish proclivities suggest that visibility on this cross remains exceptionally low. 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report titled, "Assessing Fair Value In FX Markets", dated February 26, 2018, available at fes.bcaresearch.com and gis.bcaresearch.com. 2 Please see Foreign Exchange Strategy / Global Asset Allocation Special Reports titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors", dated September 29, 2017, and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com. 3 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound", Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 4 Michael T. Kiley (January 2013). 5 Please see Yin-Wong Cheung and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market", CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 7 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 8 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach", Working Paper No.85, European Central Bank (November 2001). 9 Please see Foreign Exchange Strategy Special Report titled, "A Long, Strange Cycle", dated May 4, 2018, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades