Financial Markets

Special Report

The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing. Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017. Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes. It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't. While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise. During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing. In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product. Testing The Golden Rule's Performance Chart 1 on page 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash. Chart 1The Golden Rule's Track Record If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case. Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1). Chart 2Treasury Index Excess Return & ##br##Fed Funds Rate Surprises (1990 - Present) Chart 3Treasury Index Price Return & ##br##Fed Funds Rate Surprises (1990 - Present) Table 112-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present) Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise. Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order. The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step. Learning From Failures While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components: Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns. The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises. This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession. Chart 4When The Golden Rule Doesn't Work The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year. Chart 5The 2017 Example The 2017 Episode Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower. At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike. The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year. Forecasting Total Returns One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index. First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher. Chart 6Market Has Underestimated ##br##The Fed In Recent Years We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps. With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(ΔY2) E(ΔY2) = 1-year trailing estimate of yield volatility In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.60% for the Treasury Master Index. Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.37%. Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors. Table 2Treasury Index Total Return Forecasts Spread Product Total Return Forecasts With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten. Table 3Spread Product Total Return Forecasts For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.9%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix A Chart 7Change In 1-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 8Change In 2-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 9Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 10Change In 5-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 11Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 12Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 13Change In 30-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Appendix B Chart 14Corporate Bond Spread Scenarios Chart 15Government-Related Spread Scenarios Chart 16Structured Product Spread Scenarios

Highlights Global Yields: Flattening government yield curves in the developed world have raised concerns about a potential future growth slowdown. Yet real policy rates will need to move into positive territory before monetary policy becomes truly restrictive and curves invert. This means global bond yields have not yet peaked for this cycle. UST-Bund Spread: The U.S. Treasury-German Bund spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). UST Technicals: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains bearish. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Feature In most years, investment professionals can look forward to taking some well-deserved time off in July to hit the beach and read a good book. This year, those same investors are forced to keep an eye on their Bloombergs while responding to the public musings of Donald Trump. The president made comments late last week that threatened the independence of the Federal Reserve, while also accusing China and Europe of currency manipulation. While those headlines can briefly move markets on a sunny summer day, they represent more Trump-ian bluster than any potential change in the conduct of U.S. monetary or currency policy. Chart of the WeekCan Policy Be Truly "Tight"##BR##With Negative Real Rates? The underlying dynamic remains one of mixed global growth (strong in the U.S., slowing almost everywhere else) but with low unemployment and rising inflation in most major economies. That means that independent, inflation-fighting central bankers must focus on their inflation mandates. In the U.S., that means more Fed rate hikes and a firm U.S. dollar, regardless of the desires of President Trump - the author of the large fiscal stimulus, at full employment, which is forcing the Fed to continue hiking rates. In other countries, however, the economic backdrop is leading to varying degrees of central banker hawkishness. That ranges from actual rate hikes (Canada) to tapering of bond buying (Europe, Japan) to merely talking up the potential for rate increases (U.K., Sweden, Australia). The aggregate monetary policy stance of the major developed market central banks is now tilted more hawkishly. So it is no surprise that global government bond yield curves have been flattening and returns on risk assets have been underwhelming (Chart of the Week). Yet the reality is that all major global curves still have a positive slope, even in the U.S. and Canada where central banks have been most actively tightening, while real policy interest rates remain below zero. It would be highly unusual for yield curves to invert before real rates turned positive, especially if central bankers must move to an outright restrictive stance given tight labor markets and rising realized inflation. This implies that there is more scope for global bond yields to rise over the next 6-12 months. We continue to recommend that investors maintain a defensive overall duration stance ... and to focus more on that good book on the beach and less on Trump's Twitter feed. Where To Next For The Treasury-Bund Spread? Chart 2A Pause In The Rising Yield Trend,##BR##Not A Reversal The rise in bond yields in both the U.S. and euro area seen in the first quarter of 2018 has been partly reversed since then. One of the culprits has been a stalling of the rally in oil markets, which has prompted a pause in the rise of inflation expectations on both sides of the Atlantic (Chart 2). Yet another factor has been the larger decline in real bond yields, which have fallen around 20bps in the both the U.S. and euro area since the peak in mid-May (bottom two panels). A potential driver of those lower real yields is the growing concern over the potential hit to global growth from rising trade tensions between the U.S. and China (and Europe, Canada, Mexico, etc). This comes at a time when China's economic growth was already slowing and acting as a drag on global trade activity and commodity prices. There has been significant weakness in China's currency and equity market of late, which raises the specter of another broader global selloff as occurred during the Chinese turbulence of 2015/16. Yet the declines in industrial metals prices and emerging market corporate debt have been far more modest so far in 2018 (Chart 3). A big reason for that has been the more subdued performance of the U.S. dollar this year, unlike the massive surge in 2015/16 that crushed risk assets worldwide (Chart 4). A more likely driver of the recent drop in real yields in the U.S. and core Europe was the slump in euro area economic data earlier in 2018. That move not only drove yields lower, but also pushed out the market-implied timing of the first ECB rate hike (Chart 5) and drove the spread between U.S. Treasuries and German Bunds to new wides. In our last Weekly Report, we updated our list of indicators in the U.S. and euro area that we have been monitoring to assess if our below-benchmark duration stance was still appropriate.1 The conclusion was that the underlying trends in growth and inflation on both sides of the Atlantic still supported higher bond yields on a cyclical basis, although the pressures were greater in the U.S. Yet at the same time, the gap between U.S. and euro area government bond yields has remained historically wide, with the 10-year Treasury-German Bund spread now sitting at 255bps - the highest level since the late 1980s. Chart 3Slowing Growth##BR##In China... Chart 4...But Not Yet Enough To Threaten##BR##Global Financial Stability Monetary policy differences have historically been the biggest driver of that spread. Today, the Fed is well into an interest rate hiking cycle that began nearly three years ago, and is now in the process of unwinding its balance sheet. Meanwhile, the ECB has been keeping policy rates at or below 0% while engaging in large-scale bond buying (Chart 6). Chart 5A Turn In European Yields##BR##On The Horizon? Chart 6Wide UST-Bund Spread Reflects##BR##Monetary Policy Divergences When looking at more typical fundamental drivers of the Treasury-Bund spread, many of the cross-regional differences are already "in the price". The spread appears to have overshot relative to the three main factors that go into our Treasury-Bund spread valuation model (Chart 7): The gap between Fed and ECB policy rate The ratio of the U.S. unemployment rate to the euro area equivalent The gap between headline inflation in the U.S. and euro area The Fed's rate hikes have now widened the policy rate differential versus the ECB equivalent (the short-term repo rate) to 200bps. At the same time, the rapidly improving situation in the euro area labor market now means that the unemployment ratio has been constant over the past couple of years, while euro area inflation has also caught up a bit toward U.S. levels in recent months. Adding it all up together in our Treasury-Bund valuation model - which also includes the sizes of the Fed and ECB balance sheets to quantify the impact on yields of bond-buying programs - and the conclusion is that the current spread level of 255bps is 50bps above "fair value" (Chart 8). Chart 7UST-Bund Spread Overshooting Fundamentals Chart 8UST-Bund Spread Looks Wide On Our Model Importantly, fair value is still rising, primarily because of the widening policy rate differential. We have consistently argued that the true cyclical peak in the Treasury-Bund spread will occur when the Fed is done with its rate hike cycle. Yet there are opportunities to play that spread more tactically, based on shorter-term indicators. For example, the gap between the data surprise indices for the U.S. and euro area has been a correlated to the momentum of the Treasury-Bund spread, measured as the 13-week change of the level of the spread (Chart 9). Data surprises are now bottoming out in the euro area while they continue to drift lower in the U.S. As a result, the Treasury-Bund spread momentum has begun to fade, right in line with the narrowing of the data surprise differential. Also from a more technical perspective, the deviation of the Treasury-Bund spread from its 200-day moving average is at one of the more stretched levels of the past decade. Combined with the extended spread momentum, this suggests that the Treasury-Bund spread should expect to see a period of consolidation in the next few months (Chart 10). Chart 9Relative Data Surprises No Longer##BR##Support A Wider UST-Bund Spread Chart 10UST-Bund Spread Momentum##BR##Got To Stretched Extremes We have been recommending both a structural short U.S./long core Europe position in our model bond portfolio for over a year now. We also entered into a trade that directly played for a wider 10-year Treasury-Bund spread in our Tactical Trade portfolio. We initiated that recommendation on August 8th, 2017 when the spread was at 162bps. With the spread now at 255bps, we are now closing out that recommendation this week, taking a profit of 7% (inclusive of the gains from hedging the Bund exposure into U.S. dollars).2 At the same time, we feel that it is too early to position for a narrowing of the Treasury-Bund spread. The large U.S. fiscal stimulus will continue to put upward pressure on U.S. bond yields over the next year, both through higher U.S. inflation and the associated need for tighter Fed policy. Already, the Treasury-Bund spread reflects both the relatively larger dearth of spare capacity in the U.S. economy (Chart 11) and the expected widening of the U.S. federal budget deficit compared to reduced deficits in the euro area (Chart 12). Much like the rise in the fair value of the Treasury-Bund spread, this suggests that there is limited downside for the spread on a more medium-term basis. Chart 11UST-Bund Spread Narrowing Will Be##BR##Limited By Faster U.S. Growth... Chart 12...The Result Of Looser##BR##U.S. Fiscal Policy We are taking profits on our tactical spread based on our read of all of our relevant indicators. There is a good chance, however, that we could consider re-entering a spread widening trade on any meaningful narrowing of the spread or adjustment in our indicators. Bottom Line: The fundamental drivers of the 10-year U.S. Treasury-German Bund spread continue to point to the spread staying wide over the next 6-12 months. Yet the spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). A Quick Update On U.S. Treasury Market Technicals One of the overriding aspects of the U.S. Treasury market over the past few months has been the stretched technical backdrop. The combination of oversold price momentum, bearish sentiment and aggressive short positioning have helped keep yields in check, even as U.S. growth and inflation accelerate and the Fed continues to signal more future rate hikes. Back in March, we presented a study of previous episodes of an oversold U.S. Treasury market since the year 2000.3 Our goal was to determine how long it typically took for a resolution of oversold Treasury market conditions. Unsurprisingly, we concluded that the longest episodes of oversold Treasuries occurred when U.S. economic growth and core inflation were both accelerating, and vice versa. At the time of that report, all of the technical indicators that we looked at were signaling that Treasury bearishness was deeply entrenched (Chart 13). Now, four months later, there has been some change in those indicators: Chart 13UST Technical Indicators##BR##Are More Mixed Now The 10-year Treasury yield relative to its 200-day moving average: then, +43bps; now, +18bps The trailing 26-week total return of the Bloomberg Barclays U.S. Treasury index: then, -4.3%; now, -0.6% The J.P. Morgan client survey of bond managers and traders: then, very large underweight duration positioning; now, positioning is neutral The Market Vane index of bullish sentiment for Treasuries: then, near the bottom of the range since 2000; now, still near that same level The CFTC data on speculator positioning in 10-year U.S. Treasury futures: then, a large net short of -8% (scaled by open interest); now, still a large net short of -11%. Therefore, the message from the technical indicators is more mixed now than in March. Price momentum and duration positioning is now neutral, while sentiment and speculative positions remain stretched. The former suggests that there is scope for Treasury yields to begin climbing again, while the latter implies that there may still be room for some counter-trend short-covering Treasury rallies in the near term. In our March study, we defined the duration of each episode of an oversold Treasury market by the following conditions: The start date was when the 10-year Treasury yield was trading at least 30bps above its 200-day moving average and the Market Vane Treasury bullish sentiment index dipped below 50; The end-date was when the yield declined below its 200-day moving average. The details of each of those episodes can be found in Table 1. This is the same table that we presented back in March, but we have now added the current episode. At 150 days in length, this is already the fourth longest period of an oversold Treasury market since 2000. Yet perhaps most surprising is the fact that Treasury yields are essentially unchanged since the start date of the current episode (March 20th, 2018). There is no other period in our study that where yields did not decline while the oversold market resolved itself. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market Perhaps this can be interpreted as a sign that there is still scope for a final short-covering Treasury rally before this current oversold episode can truly end. Yet as we concluded in our March study, it took an average of 156 days for an oversold market to be fully corrected if U.S. growth was accelerating (i.e. the ISM manufacturing index was rising) and core PCE inflation were both rising at the same time - as is currently the case (Chart 14). Chart 14U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing The longest such episode in 2003/04 lasted for 203 days before the 10-year yield fell below its 200-day moving average. Yet the second longest episode (196 days) occurred in 2013/14, and Treasury yields ended up climbing to a new cyclical high before eventually peaking. Given the underlying positive momentum in both U.S. economic growth and inflation, but with a mixed message from the technical indicators, we suspect that this current oversold episode may have further to run. Yet as we concluded back in March, and still believe today, it will prove difficult to earn meaningful returns betting on a counter-trend decline in yields this time, as any such move will likely be modest in size and lengthy in duration. Bottom Line: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains very bearish and there are large speculative short positions. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Trendless, Friendless Bond Market", dated July 17th 2018, available at gfis.bcaresearch.com. 2 The return on this trade is calculated using the Bloomberg Barclays 7-10-year government bond indices for the U.S. and Germany, adjusted for duration differences between the indices. The German return is hedged into U.S. dollars, as this trade was done on a currency-hedged basis. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering From Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Please note that our next publication will be a joint special report with BCA’s Geopolitical Service that will be published on Wednesday, August 1st instead of our usual Monday publishing schedule. Further, there will be no publication on Monday, August 6th. We will be returning to our normal publishing schedule thereafter. Highlights We continue to explore a cyclical over defensive portfolio bent, and the capex upcycle along with higher interest rates are our key investment themes for the remainder of the year. A number of sentiment indicators have broken out (Chart 1), and our sense is that the SPX will also hit fresh all-time highs in the coming quarters. While buybacks vaulted to uncharted territory in Q1/2018 (Chart 2), our profit growth model suggests that EPS will continue to expand at a healthy clip for the rest of the year (Chart 3) and 10% EPS growth is achievable in calendar 2019. Positive macro forces remain in place with the ISM - manufacturing and non-manufacturing - surveys reaccelerating. Beneath the surface, the new-orders-to-inventories ratio is gaining traction and even the trade-related subcomponents (new export orders and imports) are ticking higher. High backlogs also suggest that SPX revenue growth will remain upbeat (Chart 4). Non-farm payrolls are expanding on a month-over-month basis for 93 consecutive months, a record (Chart 5), at a time when the real fed funds rate remains near the zero line (Chart 6). As a result, the economy is overheating. Corporate selling price inflation is skyrocketing, according to our gauge, with our diffusion index catapulting to multi-decade highs. This represents a positive margin backdrop as wage inflation remains muted (Chart 7). While at first sight, valuations appear dear, a simple thought experiment suggests that soon they will deflate1 (Chart 8). And, on a forward price-to-earnings-to-growth (PEG) basis, valuations have sunk to one standard deviation below the historical mean (Chart 9). Two key risks that we are closely monitoring that can put our cyclically positive equity market view offside are: a sustained rise in the U.S. dollar infiltrating profit growth (Chart 10), and corporate balance sheet degradation short-circuiting the broad equity market (Chart 11). Chart 1Sentiment Is Breaking Out Chart 2Buybacks Are Soaring Chart 3Earnings Growth Hasnt Slowed... Chart 4...And Backlogs Suggest They Wont Chart 5Record Jobs Growth... Chart 6...And Still-Loose Monetary Policy Chart 7Wage Growth Is Trailing Chart 8The Market Is Not That Expensive... Chart 9...By Several Measures Chart 10A Strong Dollar Is A Risk Chart 11Corporate Sector Leverage Is Too High Feature S&P Industrials (Overweight) While our industrials CMI remains very near 20-year highs, it has lost its upward momentum this year due almost entirely to the strength of the U.S. dollar, though sliding global PMI surveys have also started to weigh (second panel, Chart 13). Combined with heightened fears of a trade war, the internationally geared S&P industrials have come under pressure. Chart 12S&P Industrials (Overweight) Chart 13Positive Industrial Growth Backdrop Still, demand growth has been resilient and continues to soar as the capex upcycle has not yet run its course and the implications for top line and profit growth are unambiguously positive (third and bottom panels, Chart 13). Should some let up emerge from the current break down of international trade, we would expect earnings to resume their role as the fundamental driver for industrials. Our valuation gauge has rapidly declined this year as extreme bearishness is not reflected by the strong profit backdrop. From a technical perspective, S&P industrials have been the most oversold since the Great Recession. S&P Energy (Overweight, High-Conviction) Our energy CMI has continued to push higher from the extremely depressed levels of 2016 and 2017. Still, the much better cyclical environment has started to get reflected in relative share prices with the S&P energy index besting all other GICS1 sectors in Q2. We recently refined our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterated its high-conviction status. We believe the steep recovery in underlying commodity prices, which the market has thus far failed to show much confidence in, has started to restore some semblance of normality in the exploration & production (E&P) stocks space (top panel, Chart 15). Chart 14S&P Energy (Overweight, High Conviction) Chart 15A Capex Boom As Oil Reignites Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (second panel, Chart 15). Accordingly, we raised the S&P oil & gas E&P index to an overweight stance. Simultaneously, weakening crack spreads (third panel, Chart 15) and rising gasoline inventories (bottom panel, Chart 15) have given us cause for concern for refiners. As a result, we trimmed the S&P oil & gas refining & marketing index to underweight, though this did not shake our high-conviction overweight position on the broad S&P energy index. Our Valuation Indicator (VI) remains near deeply undervalued territory, and indicates an attractive entry point for fresh capital. Our Technical Indicator (TI) has fully recovered from oversold levels and now sends a neutral message. S&P Financials (Overweight) The pace of improvement in our financials cyclical macro indicator (CMI) has not abated. However, the usual tight correlation between the CMI and the relative performance of the S&P financials index has broken down. An important culprit has been the heavyweight S&P banks sub-index and its transition from a correlation with the 10-year UST yield and toward the 10/2 yield curve slope earlier this year (top and second panels, Chart 17). While the former is still up year-over-year, the latter has continued to flatten and the result is likely a squeeze on banks' net interest margins, a key profit driver; we recently booked gains of 6% and removed it from the high-conviction overweight list, and the S&P banks index is currently on downgrade watch. Chart 16S&P Financials (Overweight) Chart 17Growth And Credit Quality Offset A Flat Yield Curve Still, our key three reasons for being overweight the S&P financials index remain unchanged. Rising yields and the accompanying higher price of credit are a boon to financials and a core BCA theme for 2018 remains higher interest rates. The global capex upcycle, another of BCA's key themes for 2018, has paused for breath, though it has been replaced by soaring U.S. demand. This exceptional willingness of U.S. CEOs to expand their balance sheets should mean capital formation will proceed at well above-trend pace, and further underpin C&I loan growth (third panel, Chart 17). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 17). Market bearishness has more than offset the positive fundamentals and the S&P financials index has underperformed in 2018; the result has been a steep fall in our VI to nearly one standard deviation below normal. The bearishness is also reflected in our TI which has recently collapsed into oversold territory. S&P Consumer Staples (Overweight) Our consumer staples CMI has moved sideways since our last update, near a depressed level. This is reflected in the share price performance; defensives in general and staples in particular have been woefully unloved this year. However, we believe positive macro undercurrents have made bargain basement prices in consumer staples an exceptional deal, particularly for investors willing to withstand short term volatility for a long-term investment gain. We recently pointed out that, while non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. The bearish read on this would be that this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (top panel, Chart 19). Chart 18S&P Consumer Staples (Overweight) Chart 19Staples Are Poised For A Recovery Meanwhile consumer staples exports are flying in the face of a rising U.S. dollar, which has typically presaged relative earnings gains (second panel, Chart 19). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 19). Both our VI and TI concur; as they are both more than a standard deviation below fair value. S&P Health Care (Neutral) Earlier this month, we lifted the S&P pharma and biotech indexes to neutral and, given that these sectors command roughly a 50% weighting in the S&P health care sector, these upgrades also lifted the health care sector to a neutral portfolio weighting. Sentiment has moved squarely against the sector and the bar for upward surprises has been lowered enough to create fertile ground for upside surprises. As shown in the second panel of Chart 21, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how our VI has remained under pressure and our TI has sunk. Chart 20S&P Health Care (Neutral) Chart 21Peak Pessimism In Health Care Still, our health care CMI has been treading water at relatively low levels, but our S&P health care earnings model suggests that at least a bottom in profit growth has formed (bottom panel, Chart 21). S&P Technology (Neutral) We lifted the S&P technology index to neutral earlier this year to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel, Chart 23).2 Software and tech hardware & peripherals are the two key sub-indexes we prefer and have also put on our high-conviction overweight list. Chart 22S&P Technology (Neutral) Chart 23A Capex Upcycle Should Sustain High Valuations There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel, Chart 23). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel, Chart 23). The technology CMI has also turned positive this year after falling for the previous three, though an appreciating dollar and higher interest rates continue to suppress an otherwise exceptionally robust macro environment. Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is in overbought territory, though it has been at this high level for several years. S&P Utilities (Neutral) Our utilities CMI appears to have found a bottom, arresting the linear downtrend of the previous decade. Declining earnings have steadied out as the industry has found some discipline; new investment has declined and turbine & generator inventories have ticked up (second panel, Chart 25). The result of declining investment has been a slight improvement in capacity utilization, albeit still at a relatively low level (third panel, Chart 25). Chart 24S&P Utilities (Neutral) Chart 25Earnings Are Looking For A Bottom The uptick in capacity utilization has driven a surge in industry pricing power, despite flat natural gas prices which have historically been the industry price setter; this could be the precursor to a recovery in sector earnings (bottom panel, Chart 25). Still, as with other defensive sectors, utilities have underperformed cyclical sectors in the last year; this has been exacerbated by utilities trading as fixed income proxies. Our VI does not provide much direction as it has been in the neutral zone for the past year, underscoring our benchmark allocation recommendation. Our TI fell steeply earlier this year, though it has recovered and offers a neutral reading. S&P Materials (Neutral) The materials CMI has come under pressure as the Fed has continued to tighten monetary policy. A further selloff in bonds remains the BCA view for 2018, implying rising real rates will weigh on the sector for at least the remainder of the year. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher (real rates shown inverted, top panel, Chart 27). Chart 26S&P Materials (Neutral) Chart 27This Time Is Different For Chemicals On the operating front, chemicals sector productivity has made solid gains over the past year and the sell-side bearishness for much of the past decade has finally reversed (second panel, Chart 27). Further, overcapacity, the usual death knell of the chemicals cycle, seems to be a thing of the past as the industry has massively scaled back on capital deployment on the heels of a mega global M&A cycle (third panel, Chart 27). Net, operating improvements might offset macro headwinds. Our VI echoes this neutral message and sits on the fair value line. Our TI is somewhat more bullish and is edging toward an oversold position. S&P Real Estate (Underweight) Our real estate CMI looks to have found a bottom earlier this year, though the only time it has been worse was during the Great Financial Crisis. Real estate stocks are continuing to behave like fixed income proxies, as they have since the overhang from the GFC gave way to a yield focus (top panel, Chart 29). In the context of a tightening monetary backdrop, we would need compelling operating or valuation reasons to maintain even a benchmark allocation in the sector; these are both absent. Chart 28S&P Real Estate (Underweight) Chart 29Dark Clouds Forming On the operating front, the commercial real estate (CRE) sector is waving a red flag. The occupancy rate has clearly crested and rents are headed down with it, warning of declining sector cash flows (second panel, Chart 29). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel, Chart 29). We recently initiated a trade to capitalize on relative CRE weakness by going long the S&P homebuilding index/short the S&P REITs index.3 Such overwhelming bearishness would suggest the sector would be relatively cheap, but our VI suggests that REITs are fairly valued. Our TI is has been unwinding an oversold position and is now in neutral territory. S&P Consumer Discretionary (Underweight) In early March, we identified three key factors that we expected to weigh on the consumer discretionary sector: a rising fed funds rate, quantitative tightening and higher prices at the pump. As highlighted in Chart 31, all of these factors remain intact and underlie the two-year decline in the consumer discretionary CMI. Chart 30S&P Consumer Discretionary (Underweight) Chart 31The Amazon Effect Further, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (fed funds rates shown inverted, top panel, Chart 31). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 31). Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents nearly a quarter of its market value, and about to get even larger in the upcoming introduction of the Communications Services GICS1 sector, but only comprises 3% of this sector's net income. Our TI agrees with our VI and is well into overbought territory. S&P Telecommunication Services (Underweight) Our telecom services CMI, bounced off its 30-year low earlier this year, but not nearly enough for a bullish position to be established. Rather, our bearish thesis remains unchanged: A combination of still-tepid pricing power weighing on earnings (second panel, Chart 33), weak consumer spending (bottom panel, Chart 33) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel, Chart 33), should all keep relative performance suppressed. Chart 32S&P Telecommunication Services (Underweight) Chart 33Pricing Power Is Still On Hold Valuations have fallen significantly - our VI continues to touch new lows - and our TI has been indicating a persistently oversold position, but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Despite the neutral CMI reading, we downgraded small caps earlier this year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 35). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Chart 34Size Indicator (Favor Large Vs. Small Caps) Chart 35Small Cap Leverage Is Critical Our call has thus far been slightly offside as small caps have been outperforming: investors have sought the trade-friction free shelter that small caps offer compared with internationally exposed large caps. Extreme optimism also reigns throughout the small cap world (third panel, Chart 35). However, we continue to think a turn is merely a matter of time; the NFIB's "good time to expand" reading is at its highest level in the history of the survey (bottom panel, Chart 35) which means small cap CEOs are more likely to push their already-stretched balance sheets closer to the breaking point. Our TI is telling us that small caps are overbought, but the VI continues to offer a neutral message. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "How Expensive Is The SPX?" dated July 6, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Buying Opportunity," dated April 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

Highlights Many investors remain overweight equities; BCA recommends a neutral stance. Investors should position portfolios for rising rates. Fed Chair Powell weighed in last week on yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. More evidence of trade policy-related uncertainty, rising labor costs and deteriorating margins in the latest Beige Book. Feature The S&P 500 finished the week little changed, as investors braced for a wave of Q2 earnings reports this week and next. The S&P financials sector, which tends to lead the overall market, rose more than 1% last week, as the banks reported healthy Q2 results. The dollar sold off late last week after President Trump grumbled about the Fed's rate policy. BCA's view is that Fed Chair Powell will ignore Trump's comments on monetary policy and adhere to the central bank's mandate of low and stable inflation and full employment. Gold fell 1% on the week. BCA recommends monitoring the price of gold for clues about the neutral rate of interest. Fed Chair Powell's semiannual policy testimony to Congress dominated the headlines last week. Powell discussed trade policy, the yield curve, the neutral rate and financial stability. The week's economic data was robust, suggesting that Q2 GDP will be well above the Fed's view of potential GDP. Housing starts were soft in June, but the weakness was due to supply issues, not tepid demand. Widespread supply constraints were prevalent in the Fed's latest Beige Book. The strong economic data, along with a 23-year high in the number of inflation words in the Beige Book pushed the 10-year Treasury yield up 6 bps to 2.88%. BCA's U.S. Bond Strategy team notes that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%. In late June, BCA downgraded its 12-month recommendation on global equities and credit from overweight to neutral. We still expect that the U.S. stock-to-bond ratio will grind higher in the next year, as U.S. stocks move sideways and Treasury yields climb. We recommend that investors put proceeds from the sale of equity positions into cash. Not all investors are being risk averse. The National Association of Active Investment Managers (NAAIM) says that active managers have increased their equity risk tolerance since the start of the year (Chart 1). At 89%, the average exposure of institutional investors is close to the cycle high reached in March 2017, which was the greatest since the S&P 500 zenith in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated (Chart 2). Moreover, the asset allocation survey from AAII shows that investors' allocation to equites (at 69% in June) are in line with the 2007 market top (Chart 3). However, equity holdings based on this survey were higher before the peak in equity prices in 2000. Moreover, consumers' expectations for stock price returns in the next 12 months remain close to cycle highs (U of Michigan) and near 24-year extremes based on the Conference Board surveys (Chart 4). Despite the optimism, individual sentiment toward equities remains muted in some surveys (Chart 4, panel 3). Chart 1Active Managers Have Increased Equity Exposure This Year Chart 2Equity Speculation##BR##Is Elevated Chart 3Equity Allocations##BR##On The Rise... Chart 4Households Expect Higher Stock##BR##Prices In The Next 12 Months Individuals, banks and other financial institutions hold more equities today than at the height in 2007. However, insurance companies and pension funds' holdings of equites are not as elevated as they were in 2007 (Table 1). Somewhat surprisingly, households' cash positions are below the 2007 level and at a cycle low. However, the cash positions of financial institutions are four times as large as in 2007, partly due to the Fed's vigilance on financial stability. Pension funds and insurance companies have roughly the same allocation to cash today as earlier in the cycle (2012) and in 2007, just before the financial crisis. Table 1Asset Allocation: Comparison With Early 1990s Bottom Line: BCA's view is that the risk/reward balance for holding equities is much less attractive than it was at the start of the bull market in 2009. The economy is in the late stages of an expansion and is running beyond full employment. The Fed is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (not shown). The good news is already priced into the equity market. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early in 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily moving our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months. This shift would also be favored if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. 10-Year Treasuries: An Update BCA's U.S. Bond Strategy service recommends that investors remain below benchmark in duration. However, at 2.84%, the 10-year Treasury yield is 27 bps below its 2018 zenith of 3.11%, which was reached in mid-May. Chart 5 shows that the drop in yields since that time reflects both slower economic growth prospects and weaker inflation. Investors are concerned about the impact of Trump's trade policies on global growth and those fears have been stoked by the recent run of poor economic data in the U.S. Oil prices and inflation breakevens moved up in tandem earlier this year, and both are currently rolling over (not shown). U.S. inflation is back to the Fed's 2% target and the central bank remains on course to raise rates two more times in 2018 and another four times next year. The market is pricing in only three more hikes in the next 18 months. The economy is at full employment. Moreover, at 3.6%, the average of the New York Fed and Atlanta Fed's Nowcasts for Q2 GDP growth implies that the GDP expanded well above the Fed's projection of potential GDP (1.8%) in the first half of the year (Chart 6). Moreover, the lagged effect of easier financial conditions suggests that GDP growth in the second half of the year will also be far above potential (Chart 7). Chart 5Inflation Breakevens##BR##Rolling Over Again Chart 6U.S. Economy Poised For Above##BR##Potential Growth in 2018 Inflation breakevens (Chart 5) are falling again despite mounting inflation pressures. The New York Fed's Underlying Inflation Gauge (Chart 8, panel 4) climbed to 3.33% in June, its highest point since 2005. Moreover, wage inflation is trending up and the economy is beset with shortages and constraints.1 Chart 7Lagged Effect Of Easier Financial##BR##Conditions Will Boost Growth Chart 8Inflation Is##BR##Accelerating Bottom Line: Investors should position their portfolios for escalating rates. Global growth should bottom in the second half of the year and the U.S. economic activity reports will begin to outpace lower expectations. Moreover, with inflation at the Fed's target and mounting, inflation breakevens will adjust upward. BCA's position is that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current forward rates.2 Leading The Way S&P Financials provide a long lead time for market peaks. Table 2 shows that since the mid-1970s, a peak in the Financials sector relative to the S&P 500 occurs an average of 16 months before a peak in the overall index. The Bank (Industry Group) sector provides a similar warning (18 months), while the Investment Banking index's relative performance peaks 20 months before the S&P 500 tops out (Chart 9). Note that the leads times are slightly shorter in the last 15 years than in the 1976-2000 period (Table 2). Table 2Financial Stocks' Relative Performance Provides Early Warning Of Market Tops Chart 9Financials Lead The Broad Market In a recent report,3 BCA's U.S. Equity Strategy service noted that cyclicals and interest rate-sensitive sectors, including financials, perform well when U.S. fiscal policy is loose and monetary policy is tight. Furthermore, our equity strategists found that rising rates boost top-line growth for banks, while the impact of fiscal stimulus via lower taxes should support business and consumer demand for capital. Moreover, our U.S. Equity Strategy team examined sector performance in late cycles, defined as the period between the peak in the ISM Manufacturing Index and the next recession.4 Financials outperform the S&P 500 in late-cycle environments; in the early stages (peak in the ISM's index to peak in the S&P 500) financials underperform the broad market, but they outperform after the peak in the S&P 500 and the next recession. Bottom Line: Our equity strategists recommend that investors remain overweight financials relative to the S&P 500. The late-cycle environment, along with the favorable regulatory climate, suggest that financials still have some room to run. The implication is that the peak in the overall U.S. equity market is still over a year away. Until then, the Fed will continue to remain vigilant on the financial sector and financial stability. Staying The Course At his semiannual Congressional testimony last week, Fed Chair Powell reaffirmed that the Fed will maintain its gradual pace of rate hikes. Following his presentation, Powell met with legislators and discussed the yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. Powell repeated his June statement that the yield curve can be considered an indicator of monetary stance. Like Powell, BCA's position is that a steep curve signals that policy is stimulative and short-term rates will need to climb. The opposite holds if the yield curve inverts. A flat yield curve indicates that the policy stance is neutral. The 2/10-year curve has flattened to about 25 bps. Our view is that if the curve inverts with a few more Fed rate hikes, it would suggest that the neutral rate is lower than what the Fed believes and policy is becoming restrictive. Furthermore, BCA's U.S. Bond Strategy team anticipates that curve flattening will occur as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations at a higher level. On tariffs, Powell stated that "in general, countries that have remained open to trade, that haven't erected barriers including tariffs, have grown faster. They've had higher incomes, higher productivity." He added that more and broader tariffs are bad for the economy. Furthermore, Powell said that the FOMC has not yet seen evidence that the trade uncertainty has affected wages, but he noted that the central bank is concerned that capital spending plans may be at risk. The latest Beige Book (see next section of this report) finds that the business community is increasingly apprehensive about trade policy. BCA's Geopolitical Strategy service anticipates that trade-related uncertainty will remain in place at least until the U.S. mid-term elections in November.5 BCA views financial stability as a third mandate for the central bank,6 along with low and stable inflation, and full employment. Powell stated last week that financial stability vulnerabilities were "moderate right now," but he remarked that "we keep our eye on that very carefully after our recent experience." Chart 10 presents several indicators that the FOMC uses to assess financial vulnerabilities. Powell acknowledged the prominent status of financial stability when asked about the Fed's role. The central bank's Monetary Policy Report,7 released on July 13, has an entire section dedicated to financial stability. Powell spoke about the shape of the yield curve, saying it can relay a message about longer run neutral interest rates. BCA also recommends monitoring the price of gold for clues about the neutral rate of interest. Chart 11 shows that when the Fed funds rate is above its neutral or equilibrium rate, the 2/10 curve is flat (panel 3). Moreover, gold tends to appreciate when the stance of monetary policy is more accommodative and then the metal depreciates when the stance becomes more restrictive (panel 4). The steep decline in the gold price between 2013 and 2016 preceded downward revisions to the Fed's estimate of the neutral rate. An upside price breakout would signal that we should bump up our estimate of the neutral rate. Conversely, a large decline in gold prices would imply that monetary policy is turning restrictive. Gold prices recently headed lower. Chart 10FOMC Is Closely Monitoring##BR##Financial Stability Chart 11The 2/10 Curve,##BR##Gold And The Neutral Rate Bottom Line: The Fed will continue with gradual rate hikes until it believes policy has returned to near neutral. The yield curve and gold will help to indicate when that point is reached. Widespread Chart 12Inflation Words At A 23 Year High The Beige Book released last week ahead of the FOMC's Jul 31-August 1 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in June and July. The Fed's business and banking contacts mentioned either tariffs (31) or trade policy (20) a total of 51 times, an increase from 34 in May and 44 in April. In March, as President Trump announced the first round of proposed tariffs, there were only three mentions of trade or tariff-related uncertainty. Moreover, uncertainty arose nine times in July (Chart 12, panel 4); all were related to trade policy. A recent study by the Federal Reserve Bank of St. Louis8 found that GDP per capita, wages and the investment-to-GDP ratio, all decline after tariffs are implemented (Chart 13). The study covered tariffs in 14 countries from 1980 through 2016. Importantly, the researchers noted that while the data showed that past tariff increases are followed by persistent decreases in economic activity, this evidence does not necessarily mean that higher tariffs triggered these changes. It is possible that other economic events may have driven tariff increases and ensuing recessions. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book, despite the recent rise in the greenback. The report also finds widespread concern about profit margins. Chart 12, panel 2 shows that at 81% in July, BCA's Beige Book Monitor ticked up from May's 67% reading. The July reading was the highest since early 2016. The recent low in November 2017 at 53% was when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book hit an 18 -year low in July. On the other hand, the number of strong words climbed in July to a 30-month high. The 2017 Tax Cut and Jobs Act was noted 5 times in the latest Beige Book, up from 3 in May, but still far below 15 mentions in March and 12 in April. The legislation was cast in a positive light in three of the five mentions. The implication is that most of the good news related to the tax bill has already been discounted by businesses. BCA's stance is that the dollar will move up modestly in 2018. The trade-weighted dollar has climbed by 6% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the handful of references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be a meaningful issue for corporate profits in Q2 2018. We will provide an update on Q2 S&P 500 earnings in next week's report. The dearth of recent dollar references is in sharp contrast with a flood of comments during 2015 and early 2016 (Chart 12, panel 3). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The disagreement on inflation between the Beige Book and the Fed's preferred price metric widened in July as the number of inflation words surged (Chart 12, panel 1). Mentions of inflation in July's Beige Book were the greatest since at least 1995. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that core PCE may still rise. Chart 13The Economic Consequences Of Trade Wars Moreover, July's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. Furthermore, several districts stated that a lack of workers was impeding growth. In addition, "widespread", which is part of BCA's inflation word count, was used 14 times in July to describe both labor shortages and swelling input costs, up from 11 times in May. We discussed the impact of escalating labor and input costs on margins in last week's report.9 The Beige Books released this year suggest that concerns about deteriorating margins is more prevalent in 2018 versus 2017. Only 57% of comments about margins in the first five Beige Books of 2017 noted deteriorating margins. In the 2018 Beige Books, 85% of references to margins indicated concern about higher labor, interest and raw materials costs. Bottom Line: July's Beige Book supports our stance that rising inflation pressures will result in at least two more Fed rate hikes by year-end and four next year. Moreover, the Beige Book confirms that labor shortages are restraining output of goods and services in some economic sectors. Furthermore, rising input costs are pervasive and will continue to pressure corporate profit margins. BCA expects both corporate profit growth and margins to peak later this year. The nation's tax policy still gets high marks from the business community, but the impact is fading. Ongoing uncertainty over trade policy will restrain growth. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Aailable at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Bond Bear Still Intact", published June 5, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Special Report "Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening", published April 16, 2018. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Special Report "Portfolio Positioning For A Late Cycle Surge", published May 22, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," published July 24, 2017. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf 8 https://research.stlouisfed.org/publications/economic-synopses/2018/04/18/what-happens-when-countries-increase-tariffs 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Available at usis.bcaresearch.com.

Special Report

Highlights Chart 1Corporate Health: Improving Everywhere, ##br##Down In The U.S. Dollar bull markets are often accompanied by positive returns for the S&P 500. While a strong dollar hurts the earnings outlook for the S&P 500, it supports an expansion of multiples by putting downward pressure on rates and elongating the U.S. business cycle. The dollar and stocks are most positively correlated when the U.S. yield curve slope is between zero and 50-basis points, and flattening. Today's environment fits this bill. BCA is neutral on U.S. in a balanced portfolio. While the USD's strength should be associated with rising U.S. equity prices, the quality of U.S. stock returns is deteriorating. This warrants a certain degree of de-risking relative to our former overweight stance. Feature For the past two weeks, we have warned investors that the dollar rally was over-extended, and that a correction was likely to ensue. However, we also argued that this correction was likely to prove a countertrend move, and that the dollar was likely to end the year at higher levels. BCA has a neutral stance on equities on both a cyclical and tactical horizon. BCA is also neutral on U.S. equities within a global equity portfolio. For investors, it becomes important to understand whether a stronger dollar constitutes an additional downside risk for stocks. This is especially relevant in the U.S., where equity valuations are comparatively elevated, and where corporate health is deteriorating relative to the rest of the world (Chart 1). In this report, we built on the research of our colleague Anastasios Avgeriou, who spearheads BCA's U.S. Equity Sector Strategy service, who has shown that the dollar and the S&P often do rise in unison.1 Ultimately, while the dollar can have an impact on the relative performance of the U.S., it is generally not a strong determinant of the trend in the S&P 500. Strong Dollar And The S&P: Good Friends Indeed A picture is worth a thousand words. As Chart 2 illustrates, a strong dollar has never really been enough to slay a bull run in the S&P 500. Between late 1978 and early 1985, the real trade-weighted dollar rallied by 45%, yet the S&P 500 was able to advance by 102%. Between 1995 and 2002, the real trade-weighted dollar increased by 33% but rallied by nearly 92%. If one were to confine their observations to 1995 to August 2000 window, the dollar would have been up 16.5% and the S&P an outstanding 223%. Finally, from its most recent cyclical bottom in 2011 to the end of 2016, the trade-weighted dollar rallied by 22%, but the S&P 500 managed to rise by another impressive 68%. It is true that the magnitude of the strength of U.S. equities in the face of a strong dollar has decreased over time. This essentially reflects the fact that in the early 1980s, 20% of S&P 500 revenues were garnered outside the U.S. versus roughly 40% today, which in turn has increased the drag on earnings created by a stronger dollar. This problem is illustrated by the negative relationship present between the dollar and U.S. earnings revisions (Chart 3). Chart 2Strong Dollar, No Problem Chart 3Dollar Is Dangerous For The Earnings Outlook Yet, despite this negative link between earnings revisions and the dollar, the S&P can still rise when the dollar increases. What explains this seeming paradox? The answer is almost tautological: It is multiples. A strong dollar tends to be associated with a rising P/E ratio. This is because a strong dollar has a dampening impact on inflation. As a result, when the dollar rises, the Federal Reserve can keep interest rates lower than would otherwise be the case, fomenting periods of declining bond yields (Chart 4). Thanks to lower bond yields, not only do multiples get a boost, but additionally the domestically driven U.S. economic cycle also gets elongated. This further helps stocks in the process. Another more international dimension helps explain the positive correlation between stocks and the dollar. The dollar tends to experience its strongest rallies when U.S. growth is superior to that of the rest of the G-10. As Chart 5 illustrates, the bulk of the early 1980s dollar rally, of the late 1990s rally, and of the 2011 to early 2017 rally materialized when U.S. economic activity was outperforming. In all these instances, the relative strength of the U.S. economy attracted funds from abroad. This also meant that foreign funds flowing into the U.S. economy bolstered liquidity in the U.S. economy. Not only did this liquidity support economic activity, thereby counterbalancing the drag created by a stronger dollar, these funds also found their way into asset markets, generating higher multiples in the U.S. in the process. Chart 4Strong Dollar Hurts Yields Chart 5Growth Differentials Matter For The Dollar Bottom Line: A strong dollar in and of itself has never been enough to derail a bull market in the S&P 500. While a strong dollar creates a hurdle for foreign earnings accruing to U.S. firms, higher multiples often compensate for this negative. Essentially, a higher dollar causes downside to bond yields, warranting lower hurdle rates and higher valuations. Moreover, a stronger dollar diminishes inflationary pressures in the U.S., warranting easier Fed policy than would otherwise be the case. Since the U.S. economy is domestically driven, this elongates the business cycle, helping stocks in the process. Correlation And The Yield Curve Slope While a strong dollar does not seem to be a death threat for the equity market, are there environments when the dollar and the S&P 500 are more correlated than others? Table 1Dollar Versus S&P 500 Correlation: ##br##A Function Of The Yield Curve The answer to this question is yes. As Table 1 illustrates, the correlation between the dollar and the S&P 500 fluctuates significantly based on both the slope of the yield curve and whether the yield curve is flattening or not. Interestingly, when the yield curve is steep (defined as greater than a 50-basis-point spread between 10-year and 2-year Treasury yields), the dollar and U.S. stock prices tend to move in opposite directions. However, when the yield curve is flatter but before it has yet to invert (a yield curve slope of between zero and 50 basis points), the correlation between the dollar and the S&P 500 changes: it becomes positive. In fact, the time at which the correlation between stocks and the dollar is the highest is when the yield curve slope is in that zone and is also flattening. This is surprising, but at the same time it makes sense. We know that when the yield curve is flat but not inverted, the stock market tends to still rally (Chart 6). However, this flattening yield curve indicates that monetary conditions are not as accommodative as they once were. Interestingly, while the dollar performs poorly in the early innings of a monetary tightening campaign, it performs much better when monetary conditions are not so easy anymore that they juice up global growth, but they are not yet tight enough to cause an imminent recession in the U.S.2 This corresponds to a an environment with a flatter yield curve that has yet to invert, such as the one in place today. In light of these observations, the close correlation between the S&P 500 and the dollar in this environment should not be very surprising. Chart 6Flat And Flattening: No Problem For Stocks Bottom Line: The dollar and the stock market are not always positively correlated. However, when the U.S. yield curve slope stands between zero and 50 basis points and is flattening, the positive correlation between the S&P 500 and the dollar is at its strongest. This defines today's environment. Investment Implications BCA thinks the U.S. dollar has ample downside on a long-term basis. After all, the U.S. dollar trades at a significant premium to its PPP fair value, and this kind of overvaluation historically indicates significant downside for the greenback on a multi-year time horizon (Chart 7). Moreover, the Trump administration's fiscal policy is likely to result in a widening of both the fiscal and current account deficits. While a twin deficit rarely impacts the dollar negatively, so long as U.S. real rates rise relative to the rest of the world, it nonetheless often ends up being a harbinger of long-term weakness in the greenback.3 It is hard to make any inference for the S&P 500 based on a bearish long-term dollar view as historically, during a structural dollar bear market, the relationship between the greenback and the S&P has been rather ambiguous. However, BCA also thinks the 2018 dollar rally is not over. As Chart 8 shows, when U.S. rates are in the top of the distribution of interest rates among G-10 economies, the dollar tends to perform well. The U.S.'s status as the global high-yielder is currently unchallenged. This suggests the dollar has a natural advantage over other currencies through the remainder of the year. Chart 7Long-Term Downside For The Dollar... Chart 8...But 2018 Rally Is Not Over Moreover, as the U.S. economy is less exposed to the global industrial cycle than the rest of the world is, the U.S. dollar will benefit from the softening global economic environment. This is even truer, given that the U.S. economy was already set to outperform other G-10 economies even before the soft patch in global trade began. As a result, long-term flows into the U.S. are strong, which is generating a basic balance-of-payments surplus (Chart 9). American investors are not blind to this reality; the higher expected rate of returns on U.S. projects along with U.S. corporations bringing earnings back home to take advantage of the Trump tax cuts is generating outsized repatriation flows into the country, historically a good correlate of a strong dollar (Chart 10). This phenomenon is likely to remain alive through the remainder of the year. Chart 9Money Is Making Its Way Into The U.S. Chart 10Americans Like Their Dollar Since the U.S. yield curve slope currently stands between zero and 50 basis points while it is flattening in response to the Fed's interest rate hikes, we are in the part of the cycle where the dollar and stocks are positively correlated, and where they in fact often rise together. This suggests the S&P 500 has more upside ahead for the rest of the year as well. It is important to note that the tech sector is now the most at risk from the dollar strength as it has the largest percentage of foreign sales (Chart 11). However, BCA is neutral on stocks on a cyclical horizon. This is not because stocks will not be able to eke out some positive returns; it is because we are acutely aware that we stand close to the end of the bull market. Moreover, the end of an equity bull market is often marked by a pick-up in volatility. Accordingly, risk-adjusted returns for U.S. equities are declining. Hence, while an underweight stance on stocks is not yet warranted, a neutral stance is appropriate as we believe that it is better to be early and leave some money on the table than to be late.4 There remains a big risk that could cause the dollar to rally and stocks to fall, despite where we stand in the cycle: trade disputes. As Chart 12 illustrates, since May, tariff announcements and protectionist pronouncements have buoyed the dollar. However, the same announcements ultimately represent a real risk to profits as they create a real danger for global supply chains and imply higher cost of goods sold by U.S. corporations. Investors should monitor these risks closely. Chart 11S&P 500: Aggregate Sector International Revenue Exposure (%) Chart 12While Tariffs Can Help The Dollar, ##br##They Will Not Help Stocks Bottom Line: BCA anticipates the dollar to be able to rise over the course of the next six to nine months, as U.S. rates are in favor of the greenback and domestic growth outperformance will continue to favor inflows into the U.S. This bullish view on the U.S. dollar currently does not constitute a reason to downgrade stocks to underweight. In fact, at this stage of the cycle, U.S. stocks and the dollar tend to rise in unison. However, since the quality of the equity gains is likely to deteriorate as equity volatility is on an uptrend, BCA prefers to maintain a neutral cyclical stance on equities within a balanced portfolio rather than an overweight stance. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Sector Strategy Insight Report, titled "Can the S&P 500 Continue Rising Alongside the U.S. Dollar?", dated October 13, 2016, available at uses.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different," dated May 25 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card," dated February 23 2018, available at fes.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report, titled "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated June 28, 2018 available at bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Chart 11Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Chart 13Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The 2016-2017 China/EM recovery was not the beginning of a new economic and financial cycle. We view it as a mid-cycle recovery, or hiatus, in an unfinished downtrend that began in 2011. Our basis: In EM at large and especially in China, the excesses and "deadwood" left from the 2009-2011 credit boom were not cleansed. Easy money masked the negative fundamentals in 2016-2017. Yet as Chinese money and credit growth continues to fall and the Federal Reserve steadily shrinks its balance sheet, cracks are re-surfacing in EM and China. In Thailand, continue overweighting equities, currency and fixed-income market versus their respective EM benchmarks. Feature The most striking difference between our view on EM and that of the overwhelming majority of investors and experts is as follows: Most investors and commentators view the 2016-2017 EM recovery as the beginning of a new economic and financial cycle. Hence, the narrative goes that both the EM economic expansion and the rally in EM financial markets are still at an early stage, and barring severe tightening from the U.S. Federal Reserve, it is unlikely that EM growth will slump much. BCA's Emerging Markets Strategy team regards the 2016-2017 revival in EM economies in general and China in particular as a mid-cycle recovery, or hiatus, in an unfinished downtrend that began in 2011. This is why we were reluctant to turn bullish after EM financial markets rallied in 2016-2017. China is more important to EM than the U.S. In our opinion, it was only a matter of time before China's and the Fed's tightening would lead to a considerable relapse in EM financial markets. In brief, the rally of last year was nothing more than a bull trap. In this week's report we highlight where EM and China are in their respective economic cycles, and elaborate on why we believe their pre-2016 downturns and adjustments remain incomplete.1 EM/China Cycles Chart I-1 presents the best way to visualize the EM/China cycles. Chart I-1Where Are EMs & Commodities In The Cycle? Following the devastating crises of 1997-'98, the new structural bull market in EM began in 1999-2001. By the early 2000s, crises-hit EM banks had recognized and provisioned for their bad assets, and were in the process of restructuring. In turn, companies had considerably ameliorated their financial health by restructuring debt (including foreign debt), and cutting capital spending and employment, thereby boosting their free cash flows. By 2004, China completed aggressive structural reforms, such as shutting down unprofitable SOEs, tolerating massive layoffs and allowing market forces to play a greater role in the economy (Chart I-2, top panel). The Middle Kingdom also joined the WTO in 2001, which opened global markets for Chinese exports (Chart I-2, bottom panel). The structural reforms of the late 1990s and the WTO accession created fertile ground for China's structural growth boom in the 2000s. Chart I-2China Implemented Structural ##br##Reforms In Late 1990s China's nominal manufacturing output growth - depicted on the top panel of Chart I-1 on page 2 - accelerated throughout the 2000s, reaching a 20% annual growth rate in 2007. Consistently, commodities prices and EM share prices were in a structural bull market over that period (Chart I-1, bottom panel). The U.S. credit crisis in 2008 compelled a vicious, but relatively brief, bust in commodities and EM equities. Following the Lehman crash that year, China and many other developing nations injected considerable monetary and fiscal stimulus into their economies. As a result, Chinese and EM domestic demand boomed well before the DM recovery in the second half of 2009. It was in 2009-2011 that EM and China were in the late cycle phase. This period was characterised by booming credit and capital spending, strong income growth, capacity shortages, and a surge in inflation across many economies. Starting in 2011-2012, China and EM economies entered a major downtrend. Consistently, the bear market in commodities began in 2011.2 In 2015, the downtrend escalated, and the selloff became vicious. In the second half of 2015, Chinese policymakers became unnerved and, once again, injected enormous amounts of credit and fiscal stimulus into the mainland economy. These reflationary efforts led to a revival in China's economy, which in turn lifted commodities prices in 2016-2017. China's growth impulse boosted many EM economies that are more leveraged to China than to the U.S. It is this 2016-2017 mid-cycle revival in EM/China/commodities'- that we refer to as a hiatus in a bear market. Chart I-3Chinese Money Growth ##br##Points To More Downside Recognizing the long-run unsustainability of this easy money-based growth model and the need to manage escalating financial risks (China's official code word for "bubbles") motivated Chinese policy makers to begin tightening in late 2016. Consequently, money/credit have decelerated, and with a time lag, the business cycle has rolled over (Chart I-3, top panel). In turn, EM risk assets and commodities have been suffering since early 2018 (Chart I-3, bottom panel). Diagnosis Of EM Fundamentals Like doctors examining and diagnosing patients in regard to their medical conditions and prescribing medicines to cure them, the global investment community attempts to diagnose the health of economies and companies, and predict their outlook. In turn, a forecast of the future will have higher odds of being right if the diagnosis it relies upon is correct. Applying this reasoning to EM and the Chinese economies, we need to diagnose their conditions: Have the hangovers following their respective credit/easy money booms dissipated? What are the productivity trends in these economies, and are they in a position to embark on a structural growth trajectory? Our hunch has been and remains that EM economies have not sufficiently dealt with their excesses and are therefore not ready to embark on a new structural growth trajectory for the following reasons: First, China's credit and money excesses remain enormous (Chart I-4). Mild deleveraging has been occurring only in the past 12 months. Importantly, the consequence of this deleveraging is that the current growth slowdown will deepen. Domestic credit has tightened somewhat in the past 12 months, but Chinese companies' and banks' foreign indebtedness has surged (Chart I-5, top panel). Remarkably, external debt repayments and interest payments due in 2018 amount to $125 billion (Chart I-5, bottom panel). This presents a risk to the value of the yuan. Chart I-4China: Not Much Deleveraging So Far Chart I-5China: A Lot of Foreign Debt Is Due In 2018 Second, the mainland's economy recovered in 2016 due to exceptionally soft budgets for SOEs and local governments as well as easier access to credit for the private sector. Notably, consistent with skyrocketing credit, money supply has been exploding in China. Chart I-6 illustrates that broad money in China has expanded by RMB 170 trillion (equivalent to $28 trillion) in the past 12.5 years - which is equal to the entire money supply in the U.S. and the euro area combined, i.e., the same as the money created by the U.S.'s and euro area's respective banking systems over their entire history. Chart I-6Helicopter Money' In China The overwhelming majority of commentators mistakenly believe that China's money and credit excesses are due to households' high savings rates. We have documented - in a series of Special Reports3 on money, credit and savings - that banks do not need savings to originate loans - i.e., there is no relationship between the savings rate of a nation and the rate of deposits growth in the banking system (Chart I-7). Banks create money (deposits) out of thin air when they originate loans or buy assets from non-banks. This is true for any country, regardless of income level and type of economic system. Chart I-7No Link Between Savings And Deposits In short, the enormous money boom in China is just the mirror image of the gigantic credit bubble. The bottom panel of Chart I-6 illustrates that money growth in China has hugely exceeded money growth in countries that have undertaken QE programs. Hence, one can argue that China has done more than QE - it is fair to say the Middle Kingdom has dropped "helicopter money." And if the supply of money has any relevance to its price, the RMBs value is set to drop relative to other countries. The behavior of mainland households corroborates that there is an oversupply of local currency. Eagerness among households in China to exchange their RMBs for foreign currency and assets confirms that they are very concerned about preserving the purchasing power of their savings. This pent-up demand for dollars from mainland firms and banks due to forthcoming foreign debt servicing obligations - see Chart I-5 on page 5 - along with lingering pent-up demand for foreign assets among households and companies will weigh on the RMB's value. On top of that, the narrowing interest rate differential between China and the U.S. also points to further yuan depreciation (Chart I-8). Do the authorities hold enough international reserves to satisfy Chinese individuals' and companies' demand for foreign currency? Chart I-9 reveals the central bank's foreign exchange reserves including gold (about US$3 trillion) are equal to 10% and 14% of broad money (M3) and total deposits, respectively. In brief, the US$3 trillion foreign exchange reserves are not sufficient to back up the enormous deposit base which has been created by banks out of thin air. Chart I-8More RMB Weakness Ahead Chart I-9China: FX Reserves Are Thin ##br##Relative RMB Deposits Importantly, these money excesses and ultimately Chinese households' willingness to hold RMBs - with the exchange rate acting as the litmus test - represent a major constraint on policymakers to indefinitely stimulate the economy. Third, the mainland's real estate market bubble has in recent years moved from coastal areas to third- and fourth-tier cities. Consistently, construction activity has recovered in the past two years, but the sustainability of the revival is dubious. The decline in inventories in third- and fourth-tier cities has been achieved via the monetization of excess housing inventories. The central bank has been funding "slum" development in smaller cities via cheap and direct financing. Since the start of 2014, the PSL program has injected RMB 3 trillion into housing and construction in tier-3 and smaller cities. In brief, the authorities have extended the property cycle by a few more years by conducting outright monetization of housing stock. In the process, property developers' leverage has continued surging, while their net cash flows have more recently deteriorated (Chart I-10). In short, the adjustment in the real estate market has been delayed, and imbalances have become larger. Fourth, consistent with easy money policies and soft budget constraints for government entities, efficiency and productivity continue to deteriorate in China (Chart I-11). Chart I-10Chinese Property Developers: ##br##Leverage And Cash Flow Chart I-11China: Declining Efficiency ##br##And Productivity In any economy, easy money leads to less productivity. Other EMs are no different (Chart I-12). Fifth, easy money in China finds its way into many other developing economies via mainland imports. As such, slower Chinese growth will translate into weaker mainland imports of commodities, materials and industrial goods. As a result, EM ex-China trade balances will deteriorate. In turn, EM corporate profits are at major risk of plunging due to a slowdown in China. Chart I-13 illustrates that the mainland's money/credit cycle leads EM corporate profits. This is why we spend ample time understanding and discussing China's cycle and fundamentals. Chart I-12EM Ex-China: Weak Productivity Growth Chart I-13EM Corporate Earnings Are At Risk Remarkably, EM non-financial companies' return on assets and profit margins are at levels that prevailed at the height of previous major downturns/crises (Chart I-14). If they relapse from these levels, this would entail very poor corporate profitability, and investors may question the multiples they are paying for EM equities. Finally, there has been little deleveraging in EM ex-China, Korea and Taiwan: External debt and debt servicing in 2018 remains elevated (Chart I-15). Chart I-14EM Non-Financials: Return On Assets Are ##br##At Levels Seen In Major Downturns Chart I-15EM Ex-China: External Debt And Servicing Local currency debt has been reduced in the Brazilian, Russian and Indian corporate sectors only. There has been little deleveraging outside of these segments. In Brazil, loan contraction in the banking system has been offset by a surge in public debt. Public debt dynamics in Brazil are unsustainable - the result will be either the monetization of public debt or severe fiscal contraction and renewed recession. We will discuss the outlook for Brazil in a Special Report next week. More importantly, banking systems not only in China but in most EM countries, have not provisioned for non-performing loans (NPLs). NPL recognition and provisioning are very low relative to the magnitude of preceding credit booms. Notably, with nominal GDP growth relapsing in many EM economies, their NPL provisions should rise, as demonstrated in Chart I-16A and Chart 16 I-B (nominal GDP growth is shown inverted in this chart). Chart I-16AEM Banks' Provisions Are Set To Rise Chart I-16BEM Banks' Provisions Are Set To Rise Bottom Line: In EM at large and in China above all, the excesses and "deadwood" of 2009-2011 were not cleansed during the 2011-2015 downturn. Specifically, credit excesses have gotten larger - not smaller - in China while the property market has become even more bubbly. Likewise, the misallocation of capital, inefficiencies and speculative behavior in both the financial system and real economy have proliferated. Easy money masked all these negatives in 2016-'17. Yet, as money and credit growth in China have plunged and the Fed steadily shrinks its balance sheet, these negatives are now re-surfacing. EM And The Fed Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary driver of EM economies are their domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-17). On this chart, we shaded the periods when EM stocks rallied despite a rising fed funds rate. Chart I-17EM Share Prices And Fed Funds Rate: Mixed Correlation The episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Importantly, EM stocks, credit markets and currencies did well during periods of rising fed funds rate in 1988-1989, 1999-2000, and 2017, as illustrated in Chart I-17. Presently, the Fed's policy is bullish for the U.S. dollar, and, hence bearish for EM currencies. When EM currencies depreciate, their equities, credit and local bond markets typically sell off. As the Fed is shrinking its balance sheet, commercial banks' reserves at the Fed are also declining. In recent years, changes in banks' excess reserves have been inversely correlated with the dollar (the dollar is shown inverted in the chart) (Chart I-18). Furthermore, U.S. dollar liquidity is also relapsing, which is a bad omen for EM risk assets (Chart I-19). Chart I-18Fed Balance Sheet And U.S. Dollar Chart I-19U.S. Dollar Liquidity Is Bearish For EM Bottom Line: Rising U.S. interest rates in of themselves are not a sufficient condition for EM to sell off. Only in combination with poor EM fundamentals or a weakening global business cycle are rising U.S. borrowing costs negative for EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Thailand: Will It Be A Low-Beta Market? 19 July 2018 Thai equities have been selling off in absolute terms and have lately begun to underperform the emerging markets (EM) equity benchmark (Chart II-1, top panel). Meanwhile, the currency has also been weakening (Chart II-1, bottom panel). Chart II-1Thai Financial Markets It is very unlikely that Thai share prices and the currency will decouple from their EM peers. Hence, given our negative outlook on EM stocks and currencies, odds are that Thai stocks and the baht will weaken further in absolute terms. However, we believe that Thai financial markets will act defensively amid the ongoing EM selloff. The basis on which we are reiterating our overweight stance on both Thai equities and the baht relative to their EM peers, is founded on the relative resilience of this country's macro fundamentals: Thailand runs a very large current account surplus of 10% of GDP and this provides the baht with a significant cushion. Further, Thai exports are not susceptible to a rollover in commodities prices and a downtrend in Chinese demand. Thailand's main exports are electronics, semiconductor chips, and autos - all of which account for about 40% of total exports. These categories are facing less downside risks than industrial metals and oil prices from weaker Chinese demand. Importantly, exports to China make up 12% while shipments to the U.S. and EU account for 12% and 11% of Thai total goods exports, respectively. We are less negative on the outlook of exports to the U.S. and EU than to China. Thailand has the lowest levels of foreign debt servicing obligations and foreign funding requirements among EM countries (Charts II-2). This stands in stark contrast to the onset of the Asian financial crisis when Thailand had the highest level of external debt. Accordingly, low external debt will limit Thai baht selling by local companies looking to hedge their foreign debt liabilities. Finally, foreign ownership of local government bonds is relatively low (15%). This will limit potential outflows. Chart II-2FX Debt Vulnerability Ranking: Foreign Debt Service Obligations (FX Debt Service In Next 12 Months) Remarkably, domestic demand in Thailand is beginning to improve. Chart II-3 shows that loan growth is picking up noticeably. In turn, growth in manufacturing production and consumption is starting to turn upwards (Chart II-3, middle panel). Passenger vehicle sales are also growing robustly (Chart II-3, bottom panel). Improving domestic demand will continue to be supported by low and stable domestic rates. In the recent months, interest rates have risen in many South East Asian countries but not in Thailand (Chart II-4). This is a critical difference that places Thailand apart from many of its peers. The Bank of Thailand (BoT) is in no rush to raise its policy rates even if the currency depreciates further. Thai core inflation remains slightly below target and the currency depreciation can in fact be viewed as a positive reflationary force. In a nutshell, the enormous current account surplus, low public debt/fiscal deficit and structurally low inflation provide Thailand with the ability to maintain low interest rates amid the ongoing EM storm. This will in turn fortify domestic demand resilience to a negative external shock. Chart II-3Thai Growth Is Firming Up Chart II-4Policy Divergence A quick comment on political risks is warranted. The Thai military junta and political institutions have begun preparations to hold elections sometime next year (likely February to May) that will return the country to civilian rule. A transfer of power from the currently stable military rule to a more uncertain civilian rule will likely trigger a period of rising volatility. However, the junta's economic management has been fairly successful. Growth is strong and, crucially, public debt is low at 33% of GDP and the fiscal deficit is manageable. The junta has the capacity to continue to appease rural voters - who traditionally vote for the populist, anti-junta Pheu Thai party - by increasing government spending. Moreover, the junta has rewritten the constitution, which was approved in a popular referendum and ratified in 2017, to influence both the electoral system and parliament in its favor. Nevertheless, the opposition Pheu Thai Party, which has won every election since 2001, retains the edge in popular opinion. Our colleagues from the Geopolitical Strategy team believe that in the 20%-30% chance scenario where the elections enable the opposition to form a government, policy uncertainty will spike. Yet, this will only occur next year and in the meantime macro factors still make Thailand immune to external shocks. Importantly, uncertainty over the transition period, and the outcome of the elections has probably caused an exodus of foreign investors from this bourse (Chart II-5). However, foreigners' diminished holdings of Thai stocks will limit the downside in the months ahead and allow this market to outperform the EM equity benchmark. Chart II-5Foreigners Have Bailed Out of Thai Stocks Bottom Line: We recommend EM dedicated portfolios keep an overweight position in Thai equity, currency and fixed income markets. Macro factors make Thailand more immune to external shocks vis a vis other EM economies. Political risks by themselves do not justify this bourse's underperformance versus the EM benchmark. In turn, the Thai baht should outperform other EM currencies amid the ongoing weakness in global growth. In line with this view, we maintain the long 5-year Thai bonds / short 5-year Malaysian bonds trade. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Where Are EMs In The Cycle?," dated May 3, 2018, available on page 20. 2 Industrial metals prices began falling and oil prices peaked in 2011 even though oil prices stayed flat till 2014 when they crashed. 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, available on page 20. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration Checklist: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A below-benchmark overall portfolio duration stance is still warranted - even after our recent move to downgrade spread product exposure. Canada: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Feature Chart of the WeekStagflation Keeping Yields Afloat Developed market bond yields are lacking direction at the moment, pulled by competing forces. Overall global economic activity has lost some momentum and is now less synchronized. Yet the majority of major countries in the developed world are still growing at an above-potential pace that is keeping unemployment low and slowly boosting wages. This is helping underpin inflation, both realized and expected, while keeping government bond yields elevated despite increasing concerns about the future path of the global economy (Chart of the Week). The growing worries about a potential "U.S. versus the world" trade war are weighing on growth expectations, although not yet by enough to cause a meaningful pullback in global equity markets which remain supported by current solid earnings growth. Credit spreads have increased for both developed market corporate debt, but are still at historically narrow levels suggesting that investors are not overly concerned about default/downgrade risk. Emerging market (EM) debt has seen more significant spread widening in recent months, with a stronger U.S. dollar playing a large role there, but there has been little spillover from weaker EM markets into developed market credit valuations. We recently downgraded our recommended allocation to global corporate debt to neutral, while also upgrading our weighting on government bonds to neutral. Yet we maintained our below-benchmark overall duration stance, given our view that bond markets were still underpricing the potential for faster global inflation and tighter monetary policies given the persistent underlying strength of economic growth (especially in the U.S.). In light of that change in our view, an update of one of more reliable tools over the past eighteen months - our Duration Checklist - is timely. The Duration Checklist Is Still Bearish We have maintained our strategic below-benchmark stance on duration exposure for some time now, dating back to January 2017. Shortly afterward, we introduced a list of indicators to monitor going forward to determine if that defensive duration posture on U.S. Treasuries and German Bunds was still justified.1 We called that list our "Duration Checklist", and it contains elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The Checklist is meant to be a purely objective read on the data and how it relates to the likely future path of bond yields. We last updated the Checklist back on January 30th of this year.2 The conclusion was that the underlying economic and inflation backdrop was still indicating more upside for yields on a 6-12 month horizon in both the U.S. and Europe. There was a risk, however, that the bond selloff could pause given heightened bullishness on risk assets and extremely oversold conditions in government bond markets. Since that last update of the Checklist, the 10-year U.S. Treasury yield is higher (2.86% vs. 2.72%) while the 10-year German Bund yield is lower (0.36% vs. 0.70%). Although yields in both markets did climb to even higher levels - 3.12% and 0.78%, respectively - in February and March before pulling back to current levels. As we update the Checklist once again this week, we see that the backdrop is still conducive to rising bond yields in the U.S. and Europe, but with differing risks compared to six months ago (Table 1). Note that the Checklist was designed to assess if we should maintain our duration tilt, thus we apply a checkmark ("check") to any indicator that points to potentially higher bond yields, and an "x" to any element that could signal a bond market rally. Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds Global growth momentum is decelerating. The OECD's global leading economic indicator (LEI) is in a clear downtrend, having fallen for five consecutive months (Chart 2). That weakening is broad based, as shown by the depressed level of our LEI diffusion index. The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has been falling sharply since March of this year and now sits at the lowest level since January 2012. The Citigroup Global Data Surprise index peaked at the beginning of 2018 and has fallen steadily to below zero, although it may be in the process of bottoming out. Meanwhile, our global credit impulse - a reliable leading indicator of global growth - has noticeably slowed. We are giving an "x" to all these elements of our Duration Checklist, indicating that the current "soft patch" of global growth represents a risk to the performance of our below-benchmark duration stance. U.S. growth remains solid, but Europe is cooling a bit. The U.S. economy is firing on all cylinders at the moment (Chart 3). The ISM manufacturing index is near 60, while both consumer and business confidence are above the mid-2000s peak of the previous business cycle. Corporate profits are growing around 20% and our models suggest that this trend can continue over the rest of 2018. All these indicators earn a "check" on the U.S. side of our Duration Checklist. Chart 2Global Growth Indicators Are##BR##No Longer Bond Bearish Chart 3U.S. Growth##BR##Remains Strong The growth story is mixed in the euro area, however (Chart 4). The manufacturing PMI has been steadily falling since February of this year, but still remains well above the 50 line indicating an expanding economy. Consumer and business confidence are both at cyclical highs, but the upward momentum has stalled. Corporate profits are growing at a robust pace, but our models suggest that earnings should slow over the remainder of this year. In our Duration Checklist, the momentum of the growth indicators is the relevant measure and not the level. So we are now placing an "x" on the manufacturing PMI, which is giving a clear signal on slowing growth, while maintaining a "check" next to confidence and profit growth but with a question mark given that both may be in the process of rolling over. Inflation pressures are strengthening on both sides of the Atlantic. Back in January, the inflation elements of the Checklist were providing the most mixed signals. That is no longer the case (Charts 5 & 6). Oil prices are accelerating in both U.S. dollar and euro terms, which suggests upside risks on headline inflation in the U.S. and euro area. Unemployment rates are now below the OECD estimates of full employment, and wage inflation is accelerating, in both regions. Thus, all the inflation components of our Duration Checklist earn a "check". Chart 4Is Euro Area Growth Peaking? Or Just Cooling? Chart 5U.S. Inflation Backdrop Is Bond Bearish Chart 6Euro Area Inflation Backdrop Is Bond Bearish Both the Fed and European Central Bank (ECB) are biased to tighten monetary policy. The Fed continues to signal that additional rate hikes are coming given the underlying strength of the U.S. economy and rising trend in U.S. inflation. The ECB has announced that it will taper its net new bond purchases to zero by year-end in its asset purchase program, and has provided forward guidance on the timing of a first rate hike in 2019. Both policies are credible given falling unemployment and rising core inflation rates in both the U.S. and euro area. Thus, we are keeping the "check" on both sides of the policy portion of the Checklist. Investor risk appetite has grown more cautious. This element of our Checklist was a potential headwind to our below-benchmark duration stance back in January, but is much less of an impediment to higher yields now (Charts 7 & 8). Chart 7U.S. Investor Risk Appetite##BR##Has Cooled Off A Bit Chart 8European Investor Risk Appetite##BR##Has Also Cooled Off The cyclical advances of both the S&P 500 and EuroStoxx 600 have stalled, and both indices are now back close to their 200-day moving averages, suggesting that equity markets are not overstretched (and, therefore, ripe for a correction that could drive down bond yields in a risk-off move). The VIX and VStoxx volatility indices remain at low levels, even after the spike that occurred in early February and the more modest volatility shock in the aftermath of the Italian election in May. This implies that investors still prefer owning risky assets over risk-free government bonds. These elements warrant a "check" on both sides of our Duration Checklist. Corporate bond spreads, however, have widened over the past few months, suggesting that investors are pricing in some increased uncertainty over future creditworthiness. While the overall level of spreads is still historically low, the rising trend justifies an "x" in our Checklist as a possible headwind to rising Treasury and Bund yields from waning investor risk appetite. Treasuries and Bunds are not as oversold compared to January, but large short positions remain an issue. The 10-year U.S. Treasury yield is now trading just above its 200-day moving average, while the deeply oversold price momentum seen earlier in the year has eased up a bit but remains negative (Chart 9). The combined signal is a neutral one but, in our Checklist framework, neither of these measures is stretched enough to suggest that yields cannot move higher. Thus, we are giving a weak "check" to both momentum elements on the U.S. side. There is still a large short position in 10-year Treasury futures according to the CFTC data, however, and this remains an impediment to higher Treasury yields - we are keeping the "x" for this piece of the Checklist. For Bunds, yields are now trading just below the 200-day moving average while price momentum has turned slightly positive (Chart 10). While neither indicator is stretched from an historical perspective, they are not sending a message that Bunds are oversold. Thus, we are giving a weak "check" to both technical elements on the European side of our Checklist (note that due to a lack of available data, we exclude investor positioning when evaluating the technical backdrop for Bunds). Chart 9USTs Not Oversold,##BR##But Large Short Positions Remain Chart 10Bund Technicals##BR##Are Neutral The majority of indicators in our Duration Checklist continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, we conclude that a continued below-benchmark duration stance is warranted for both markets. Not all of the news is bond bearish, however. The cooling of global growth indicators, the euro area manufacturing PMI, the widening of corporate credit spreads and the persistent short position in the Treasury market remain potential headwinds to a renewed period of rising bond yields. Yet without evidence that U.S. or European capacity constraints are loosening up, triggering a dovish shift from the Fed and ECB, the upward trend in inflation will prevent any meaningful decline in yields from current levels. Bottom Line: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A continued below-benchmark overall portfolio duration stance is warranted - even after our recent move to downgrade spread product exposure. Canada Delivers Another Rate Hike, With More To Follow Chart 11The BoC & The Fed: Follow The Leader The Bank of Canada (BoC) hiked its policy rate last week by 25bps to 1.5%, once again delivering a tightening in lagged response to U.S. rate increases over the past year. The hike was not a surprise, as the Canadian economy is operating at full capacity and core inflation is at the midpoint of the BoC's 1-3% target band. Overnight Index Swap (OIS) markets are now pricing that both the BoC and the Fed will raise rates by another 75bps over the next twelve months, and we see the potential for even more increases than that - even with the Canadian economy cooling from the very rapid growth seen last year (Chart 11). The current spread between 2-year government bond yields in the U.S. and Canada is the widest since 2008, which is weighing on the level of the Canadian dollar versus the greenback (3rd panel). The latter is helping to ease financial conditions in Canada (bottom panel), especially at a time when the country is benefitting from the positive terms of trade impact of strong oil prices. The loonie is also being impacted by worries about future U.S. trade policy. The Trump administration has already imposed tariffs on Canadian steel and aluminum exports and is demanding serious concessions in the renegotiation of the North American Free Trade Agreement (NAFTA). In their latest Monetary Policy Review (MPR) that was released after the BoC policy meeting last week, the central bank provided an estimate of the impact of the steel and aluminum tariffs that went into effect on June 1st. The conclusion was that the 25% tariff on U.S. imports of Canadian steel, and 10% levy on U.S. aluminum imports, would have little net impact on the Canadian economy once the Canadian response was factored in. The BoC concluded that the level of total real Canadian exports would be reduced by -0.6% by year-end, but that Canadian real imports would also decline by a similar amount as the Canadian government slapped its own tariffs on U.S. exports of steel, aluminum and various consumer products. This neutral view on U.S.-Canada trade tensions appeared throughout the BoC's updated economic forecasts, as its projections on the growth of Canadian exports, imports and U.S. real GDP growth (the critical driver of Canadian trade) were all increased from the previous MPR published in April. That may be an overly optimistic assessment of the potential impact of a trade dispute with the U.S. Yet the BoC did admit that it can only estimate the impact of tariffs once the precise details are known, thus it cannot adjust its forecasts based on what might happen in the NAFTA negotiations. The BoC can only base its forecasts on what they can observe now, which is that Canada's overall economy remains in decent shape, even though the composition of growth is shifting. The BoC's latest Business Outlook Survey indicates that Canadian firms continue to see robust demand and are facing increasing capacity constraints. This is boosting hiring plans and keeping capital spending intentions reasonably firm even with the uncertainties over NAFTA that is causing some firms to delay investment (Chart 12). The BoC is projecting that overall Canadian real GDP will only grow by 2% in 2018, even with a smaller contribution to growth from consumer spending and housing. The year-over-year rate of change in retail sales volumes has already dipped into negative territory and is now at the lowest since the end of 2009 (Chart 13). The BoC has attributed this to some slowing in interest-sensitive spending in response to tighter BoC monetary policy. At the same time, household debt growth has been slowing and house price inflation has plunged over the past year (although most of this decline occurred in the overheated Toronto market). The BoC is not concerned about the impact of its rate hikes on the interest burden for households, despite the high level of household debt, given the accelerating pace of wages and income growth. The BoC is likely happy to see a shift away from overheating consumption fueled by speculative increases in house prices, but there is a risk that additional rate hikes could finally trigger the long-awaited bursting of the Canadian housing bubble. Chart 12Canadian Businesses Are Optimistic,##BR##Even With Trade Worries Chart 13Higher BoC Rates##BR##Do Have An Impact (On a related note - the topic of housing bubbles will be discussed at the upcoming BCA Investment Conference in Toronto on September 23-25 by Hilliard Macbeth of Richardson GMP, who has written several books on the topic of global asset bubbles and has some particularly strong views to share on Canadian housing.) Yet the BoC will have to take the risk that additional rate increases could cause a bigger shakeout in the Canadian housing market, given that Canadian inflation is trending higher. Headline CPI inflation is now above the midpoint of the BoC's 1-3% target band, while all the various measures of core inflation that the BoC monitors are hovering around 2% (Chart 14). The BoC estimates that the output gap in Canada is now closed, and that the tight labor market will continue to boost inflation. Chart 14Inflation On The Rise In Canada Chart 15Market Is Underpricing The BoC Already, the average hourly earnings measure of wage inflation is growing close to 4% on a year-over-year basis, although the BoC has noted in recent research that other measures of labor costs are not growing as fast.3 Nonetheless, with 10-year inflation expectations in the Canadian inflation-linked government bond market now trading just below the BoC's 2% target (bottom panel), and with a high number of Canadian businesses reporting increasing difficulties in sourcing quality labor, the inflationary message sent by the surging rate of average hourly earnings growth will likely prove to be correct. Even though the Canadian OIS curve is now discounting another 75bps of rate hikes over the next year, that would only take the BoC policy rate to 2.25% - still below the central bank's estimate of the neutral policy rate, which is between 2.5-3% (Chart 15). Given the likely need for the BoC to eventually move to a restrictive stance to cool off an overheating economy and keep inflation around the 2% target, we see more potential upside for Canadian bond yields, especially with very little increase currently priced in the forwards. Stay underweight Canada in hedged global bond portfolios. Bottom Line: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th, 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Some Thoughts On The Treasury-Bund Spread", dated January 30th, 2018, available at gfis.bcaresearch.com. 3 https://www.bankofcanada.ca/wp-content/uploads/2018/01/san2018-2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Firming crude oil prices and recovering capex budgets suggest that energy E&P stocks are in a sweet spot and primed for outperformance. Decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Recent Changes Lift the S&P oil & gas exploration & production index to overweight today. Downgrade the S&P oil & gas refining & marketing index to underweight today. Table 1 Feature Equities broke out of their recent trading range last week on the eve of earnings season despite protectionist rhetoric. While Q2/2018 EPS euphoria may serve as a catalyst to catapult the SPX to fresh all-time highs in the coming months, especially given the collapse in stock correlations (CBOE implied correlation index shown inverted, Chart 1), sell-side analysts have now revised down Q1/2019 EPS growth estimates by 300bps to 7%. We view Q1/2019 earnings as critically important, as they will give us the first clean read on trend EPS growth. By that time the one-off impact of tax reform will be filtered out of the data. At present, Q1/2019 EPS estimates are likely suffering for two reasons: delayed P&L FX translation effects from a year-to-date rise in the U.S. dollar and difficult year-over-year comparisons with a blowout Q1/2018 quarter. In recent research, we have been flagging the currency as the single biggest risk to our sanguine equity market view. In other words, a sustainable breakout in equities requires a sideways-to-lower move in the greenback (trade-weighted U.S. dollar shown inverted, Chart 2). Chart 1All-Time Highs Ahead... Chart 2...But Watch The Greenback Drilling beneath the surface, Charts 3 & 4 show net earnings revisions (NER) per sector as a four week average and Chart 5 summarizes the latest data points for an easier comparison. Industrials NER have taken a hit on the back of Trump's tariff rhetoric and recent implementation. Nevertheless, the tech sector shows no signs of infiltration either from a rising currency or Trump's protectionist actions. As a reminder, the IT sector garners 60% of its sales from abroad and remains the most important sector to monitor for any broad market EPS inflection points.1 Chart 3Sector... Chart 4...Net EPS Revisions On the economic front, a softening U.S. dollar would be synonymous with a reacceleration in global growth. We are currently in the seventh month of the economic soft patch and there are high odds that by early fall the tide will turn. The global non-manufacturing PMI is already signaling that a pick up in growth is forthcoming. Historically, the global services PMI has been an excellent leading indicator of its sibling, the global manufacturing PMI, and the current message is to expect an end to the global growth deceleration sometime in the autumn (Chart 6). Chart 5Watch Tech Stocks Chart 6Longest Uninterrupted Payrolls Expansion On Record!!! In the U.S., the ISM manufacturing survey reaccelerated last month despite Trump's protectionist rhetoric with both trade subcomponents of the survey - new export orders and imports - rising smartly. Even the latest employment report came in above expectations, and confirmed that the U.S. economy is firing on all cylinders and remains a key global growth engine. Importantly, non-farm payrolls have been expanding on a month-over-month basis for the longest period on record hitting 93 consecutive months as of June (Chart 7). Similarly, the yield curve has remained positively sloped for a record 134 straight months (please see Chart 2 from our April 16th Special Report titled 'Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening'). Tack on China's recent easing in monetary conditions, as evidenced by both a depreciating currency (steepest month-over-month depreciation since 1994) and falling interest rates (Chart 8), and the likelihood of additional easing measures in the pipeline, and the world's two largest economies will likely lead global growth out of its recent mini-slump. Chart 7Can Services Pull Up Manufacturing? Chart 8China Is Easing Monetary Conditions This week we are refining our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterate its high-conviction status. E&P Is Flaring Up... Exploration & production (E&P) stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 9). There are high odds that a catch up phase looms and we recommend to boost exposure to this late-cyclical energy sub-index to overweight. Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on E&P stocks along with a bottleneck-induced steep shale oil price discount to WTI. Keep in mind that as oil prices were collapsing during the global manufacturing recession of late-2015/early-2016, the U.S. E&P industry went through a clean-up phase where a plunge in free cash flow (FCF) caused a spike in bankruptcies on the back of extreme balance sheet degradation (Chart 10). Chart 9Most Vulnerable Gap Has To Be Filled Chart 10Balance Sheets Getting Repaired Chart 11No Longer Stressed In more detail, E&P FCF got squashed, dropping by 66% from peak to trough as net debt ballooned by 30% during the same time frame. And, in response, independent energy producers' junk bond spreads skyrocketed to over 20%, surpassing even the Great Recession peak (Chart 11). Nevertheless, the steep recovery in underlying commodity prices along with the forgiving debt and equity markets that lent a helping hand to this extremely fragmented industry, has restored some semblance of normality in the E&P space. The second panel of Chart 9 shows that shale oil production is rising at a healthy clip following a long bottoming phase on the heels of reaccelerating WTI crude oil prices. Not only is OPEC 2.0 supporting oil price gains, but sustained domestic inventory draws are also underpinning crude prices. BCA's Commodity & Energy Strategy service remains positive on the oil price backdrop with oil price risks skewed to the upside. The upshot is that the recovery in E&P cash flow growth will continue in the coming months (second & third panels, Chart 10). Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (middle panel, Chart 12). Rising oil prices are conducive to additional energy-related investments (bottom panel, Chart 9). Importantly, there is a sizable divergence between the oil & gas rig count and relative share prices that will likely narrow via a catch up phase in the latter (top panel, Chart 12). National data confirm the Baker Hughes weekly rig count that has been in a V-shaped recovery. Energy related investment has doubled from the depths of the manufacturing recession (bottom panel, Chart 12), and if oil prices even stand pat at current levels, additional drilling will most likely take place in the biggest shale plays (Permian, Eagle Ford, Marcellus and Bakken) where breakeven costs are roughly 30% lower. All of this suggests that U.S. producers will continue to pump oil at a brisk pace, and earnings will likely overwhelm. Sell side analysts have taken notice and relative EPS estimates are following crude oil prices higher. Similarly, S&P oil & gas E&P net EPS revisions are also in positive territory (Chart 13). Chart 12Capex Upcycle Beneficiary Chart 13Following Oil Higher Adding it up, there are high odds that E&P stocks will continue to outpace the broad energy complex and the SPX on the back of firming capex budgets and sustained oil inflation. Bottom Line: We are boosting the S&P oil & gas E&P index to an overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, DVN, CXO, MRO, APA, HES, NBL, EQT, COG, XEC and NFX. ...But Refiners Are Flaming Out While we are warming up to the S&P oil & gas E&P index, the opposite is true for the pure play S&P oil & gas refining & marketing index, and recommend to trim exposure below benchmark. Refiners have taken it to the chin over the past six weeks underperforming both the SPX and the broad energy complex, and deteriorating industry fundamentals signal that more pain lies ahead. The middle panel of Chart 14 shows that crack spreads have given way recently, and as the Brent/WTI crude oil spread closes in on the zero line, refining margins will remain under intense downward pressure. Already, margins are contracting on a six-month rate of change basis and that will continue to weigh on relative share prices (bottom panel, Chart 14). This is an ominous sign for relative profits that will likely follow crack spreads lower. The refining supply/demand backdrop is also waning. Refined products consumption has sunk recently, and the year-to-date steep momentum reversal of 13 percentage points suggests that relative profits will underwhelm (top & middle panels, Chart 15). Not only is demand faltering, but the news is equally grim on refining inventories. In fact, there is no apparent supply side offset: gasoline stocks are rising (gasoline inventories shown inverted, bottom panel, Chart 15). This supply/demand backdrop will weigh on industry profitability. Worrisomely, the sell side's analyst community is extremely optimistic with regard to 12-month forward relative EPS growth estimates (north of 20%, not shown). On a 5-year forward relative EPS basis Wall Street's exuberance is unprecedented: analysts expect refiners to double the SPX's 16% long-term EPS growth rate (Chart 16). We would lean against these great expectations. Chart 14Refiners Rally Has Cracked Chart 15Mind The Supply/Demand Backdrop Chart 16Too Much Optimism Adding insult to injury, relative valuations do not offer any cushion in case of any profit mishaps as they are hovering near previous cyclical peaks and significantly higher than the historical mean (bottom panel, Chart 16). Netting it out, decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Bottom Line: Trim the S&P oil & gas refining & marketing index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Investors are too complacent about the risks of a trade war. Standard economic models understate the potential economic damage that a trade war could cause. Global equities would suffer mightily from a trade war. Deep cyclical sectors would be hardest hit. Financial equities would also fare poorly. Regionally, European and EM stock markets would underperform. A trade war would benefit Treasurys and other safe-haven government bonds. A contained trade war would likely be somewhat dollar-bearish. In contrast, a full-out war could send the greenback soaring. Feature From Phony War To Real War? After months of posturing, Trump's trade war is starting to heat up. The U.S. imposed tariffs of 25% on $34 billion of Chinese goods last Friday. Tariffs on another $16 billion of goods are set to go in effect on July 20th. China has stated that it will retaliate in kind. On Tuesday, Trump further upped the ante, announcing that he will levy a 10% tariff on an additional $200 billion of Chinese imports by August 31. He also threatened tariffs on another $300 billion on top of that if China still refuses to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than what China exported to the U.S. last year! China is not the only country in Trump's crosshairs. The Trump administration levied tariffs of up to 25% on steel and aluminum from the EU, Canada, Mexico, and other U.S. allies on June 1, 2018. The affected regions have retaliated with their own tariffs. As Marko Papic, BCA's chief geopolitical strategist, has repeatedly stressed, there is little reason to think that trade tensions will ease over the coming months. Protectionism is popular with the American public (Chart 1). Trump ran on a protectionist platform and now he is trying to fulfill his campaign promises. It does not help that Trump is accusing foreign governments of doing things they are not doing. Chart 2 shows that U.S. tariffs are actually higher than in most other G7 economies. As we have argued in the past, the U.S. runs a persistent current account deficit because it has a higher neutral real rate of interest - otherwise known as r-star - than most other countries.1 Standard interest rate parity equations imply that a country with a relatively high neutral rate will have an "overvalued" currency that is expected to weaken over time, whereas a country with a low neutral rate will have an "undervalued" currency that is expected to strengthen over time. Intuitively, this must happen because investors will only hold low-yielding bonds if they expect a currency to strengthen. The result is a current account deficit for countries with overvalued currencies such as the U.S., and a current account surplus for regions with undervalued currencies such as the euro area (Chart 3). Chart 1Free Trade Is Not In Vogue In The U.S. Chart 2Tariffs: Who Is Robbing The U.S.? Chart 3Interest Rates And Current Account Balances The Economic Costs Of A Trade War How much damage could a trade war do to the global economy? As it turns out, this is a surprisingly difficult question to answer. Standard economic theory offers little guidance on the matter. By definition, global exports are always equal to imports. In a conventional Keynesian model, countries with trade deficits would gain some demand from a trade war, while countries with surpluses would lose some demand. However, the contribution of net exports to global demand would always be zero. Granted, there would be some efficiency losses, but in the standard Ricardian model of comparative advantage, they would not be that large. As Box 1 explains, the deadweight loss from a tariff can be computed as one-half times the change in the tariff rate multiplied by the percentage-point decline in imports that results from the tariff. Suppose, for example, that a trade war leads to a 10% across-the-board increase in U.S. tariffs, which causes U.S. imports to fall by 30%.2 Given that imports are 15% of U.S. GDP, the resulting deadweight loss would be 0.5*0.1*0.3*15=0.225% of GDP. That's obviously not a lot. The True Cost Of A Trade War Is Likely To Be High Our sense is that the true cost of a trade war would be much greater than these simple models suggest. There are at least six reasons for this: Most simple models assume that labor and capital are completely fungible and that the economy is always at full employment. In practice, it is doubtful that workers could easily move to companies that would benefit from tariff protection from those that would suffer from retaliatory measures. Workers have specialized skills. Likewise, a piece of machinery that is useful in one sector of the economy may be completely useless in another. Industries are often concentrated in particular regions. As such, a trade war could severely degrade the value of the existing stock of human and physical capital. This would result in lower potential GDP. It would also result in temporarily higher unemployment as workers, laid off from firms which have been adversely affected by tariffs, are forced to scramble for a new job elsewhere. Comparative advantage is not the only source of trade gains. Arguably more important are economies of scope and scale. A firm that has access to a global market can spread fixed costs over a larger quantity of output, thus lowering average costs (and ultimately prices). The existence of large global markets also allows companies to offer niche products that might not be worthwhile to develop for smaller markets. Modern trade is dominated by the exchange of intermediate goods within complex supply chains (Chart 4). This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. U.S. firms are particularly vulnerable to supply-chain disruptions because the Trump administration has dotardly chosen to levy tariffs mainly on intermediate and capital goods (Chart 5). This stands in contrast to China and the EU, which have raised tariffs mainly on final goods in a politically strategic manner (agricultural products in Trump-supporting rural areas and Harley Davidson bikes, which are manufactured in Paul Ryan's home district in Wisconsin). Chart 4Trade In Intermediate Goods Dominates Chart 5The U.S. Is Not Very Smart In ##br## Implementing A Protectionist Agenda Uncertainty over the magnitude and duration of a trade war could cause companies to postpone new investment spending. A vast economic literature pioneered by Avinash Dixit and Robert Pindyck has shown that firms tend to defer capital expenditure decisions when faced with rising uncertainty.3 Furthermore, as I discussed in an academic paper which was published early on in my career, business investment is typically higher when firms have access to larger markets.4 Higher tariffs could lead to an implicit tightening in fiscal policy. If the U.S. raises tariffs by an average of ten percentage points across all imports, a reasonable estimate is that this would imply a tightening in fiscal policy by around 1% of GDP - enough to wipe out the entire stimulus from Trump's tax cuts. Of course, the tariff revenue could be injected back into the economy through more tax cuts or increased spending. However, given the possibility that gridlock will increase in Washington if the Republicans lose the House of Representatives in November, it is far from obvious that this would happen. A trade war would lead to lower equity prices and higher credit spreads. This would translate into tighter financial conditions. Historically, changes in financial conditions have been highly correlated with changes in real GDP growth (Chart 6). Changes in financial conditions have, in turn, led the stock market. The S&P 500 index has risen at an annualized pace of 10% since 1970 when BCA's Financial Conditions Index (FCI) was above its 250-day moving average, while gaining only 1.5% when the FCI was below its 250-day average (Chart 7). Given today's elevated valuations across many asset markets, the risk is that a trade war triggers a sizable correction in asset prices. Chart 6Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Chart 7The Link Between Financial Conditions ##br##And The Stock Market Protecting Your Equity Portfolio From A Trade War We think investors are understating the risks of a trade war. This, along with a host of other reasons, prompted us to downgrade global risk assets from overweight to neutral on June 20.5 As bad as a trade war would be for Main Street, it would be even worse for Wall Street. The mega- cap companies that comprise the S&P 500 have a lot more exposure to foreign markets and global supply chains than the broader U.S. economy. The "beta" of corporate profits to changes in GDP growth is also quite high (Chart 8). Chart 9 shows how U.S. equity sectors performed during days when the S&P 500 suffered notable losses due to heightened fears of protectionism. We identified seven separate days, including Wednesday's selloff, which was spurred by Trump's threat to impose tariffs on another $200 billion of Chinese imports. Chart 8Profits Are Much More Volatile Than GDP Chart 9This Is How Markets Trade When They Are Worrying About Trade Wars The chart shows that deep cyclical sectors such as industrials, materials, and energy fared badly during days of protectionist angst. Financials also underperformed, largely because such days saw a flattening of the yield curve. Tech, health care, and telecom performed broadly in line with the S&P 500. Consumer stocks outperformed the market, but still declined in absolute terms. Utilities and real estate were the only two sectors that saw absolute price gains. Considering that the sector composition of European and EM bourses tends to be more tilted towards cyclicals than the U.S., it is not surprising that the former have underperformed during days of increased protectionist worries. Bonds: Yields Likely To Rise, But A Trade War Is A Risk To That View In contrast to equities, a trade war would benefit Treasurys and other safe-haven government bonds. Admittedly, the imposition of tariffs would push up import prices. However, the effect on inflation would be temporary. Just as the Fed tends to disregard one-off increases in commodity prices, it will play down any transient boost to inflation stemming from a trade war. Instead, the Fed will focus on the growth impact, which is likely to be negative. To be clear, trade jitters are not the only thing affecting bond yields. Judging by numerous business surveys, the U.S. economy is starting to overheat (Chart 10). Last week's employment report does not alter this conclusion. While the unemployment rate rose by 0.2 percentage points, this was mainly because of a jump in the participation rate. Considering that the number of workers outside the labor force who want a job is near a record low, the ability of the economy to draw in additional workers is limited (Chart 11). Chart 10The U.S. Economy Is Overheating Chart 11A Small Pool Of People Want ##br##To Jump Into The Labor Market Historically, continuing unemployment claims have closely tracked the unemployment rate over time (Chart 12). The fact that continuing claims have dropped by 9% since the end of January, while the unemployment rate has dipped by only 0.1 percentage points, suggests that the unemployment rate will fall further over the coming months. On balance, we continue to maintain our bearish recommendation on Treasurys, but acknowledge that a trade war is a risk to that view. Trade Wars And Currencies Unlike safe-haven bonds, whose yields are likely to decline in proportion to the magnitude of the trade war, the impact on the dollar is more difficult to predict. On the one hand, a modest trade dispute is likely to be somewhat dollar bearish, inasmuch as it hurts U.S. growth and forces the Fed to slow the pace of rate hikes. Since most other major central banks are not in a position to cut rates, expected rate differentials between the U.S. and its trading partners would narrow. On the other hand, a severe trade war would probably be dollar bullish. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. still tend to attract capital inflows into the safe-haven Treasury market. The U.S. is a fairly closed economy, and hence would be relatively less affected by a breakdown in global trade. Commodities are also likely to suffer if trade flows decline (Chart 13). Lower commodity prices tend to be bullish for the greenback. Moreover, as we discussed in our latest Strategy Outlook, a tit-for-tat trade war with China could force the Chinese government to devalue the yuan. That would have a knock-on effect on other emerging market currencies. Chart 12Unemployment Can Fall Further Chart 13Commodities Are A Potential Victim Of Trade War Notably, the greenback has fared better recently than it did earlier this year during days when protectionist rhetoric intensified. On Wednesday, the broad trade-weighted dollar gained 0.3% while the DXY picked up 0.6%. This supports our view that the dollar will strengthen over the remainder of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 2 This assumes an elasticity of import demand of 3, which is broadly consistent with most academic estimates. 3 Avinash K. Dixit, and Robert S. Pindyck, "Investment Under Uncertainty," Princeton University Press, (1994). 4 Peter Berezin, "Border Effects Within A Dynamic Equilibrium Trade Model," The International Trade Journal, 14:3 (2000), 235-282. 5 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. BOX 1 The Deadweight Loss From A Trade War Box Chart 1Tariffs Increase Budget Revenues, But Lead To A Bigger Loss In Consumer Surplus In the simplest models of international trade, an increase in tariffs leads to higher prices, resulting in a loss of consumer surplus. This is depicted by the blue region (ABCE) in Box Chart 1. The government collects revenue from the tariff shown by the red-colored rectangle (ABDE). The difference between the loss in consumer surplus and the gain in revenue - often referred to as the "deadweight loss" from a tariff - is depicted by the green-colored triangle (BCD). Arithmetically, the area of the triangle can be calculated as: Deadweight loss = 0.5 x Tariff x (Pre-tariff level of imports - Post-tariff level of imports) If one divides both sides by GDP, the formula reduces to: Deadweight loss/GDP = 0.5 x Tariff x Percentage Point Change In Import Share of GDP Resulting From Tariff There are many things in the real world that are not captured by this equation. For example, if the country that imposes the tariff is sufficiently large, this could push down the international price of the goods that it imports. The country would then benefit from an improvement in its terms of trade. As Robert Torrens showed back in the 19th century, if a country has any degree of market power (i.e., it is not a complete price-taker on international markets), there will always be a level of tariffs that makes it better off. The caveat is that this "optimal tariff" only exists if other countries do not retaliate. If everyone retaliates against everyone else, everyone will be worse off from a trade war. Moreover, as discussed in the main text, there are many factors that this simple model does not capture which could result in significant economic damage from raising tariffs even when retaliation does not take place, especially in cases where the tariffs are imposed on intermediate and capital goods. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades