Financial Markets

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist Highlights The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on mainland growth. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets, including commodities and EM. The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. A narrowing interest rate differential between China and the U.S. will continue exerting downward pressure on the RMB's value versus the dollar. Our credit stress test on Turkish banks suggests their stocks are not yet cheap assuming the non-performing loan ratio rises to 15%. Stay short banks and the lira. Feature China's economic slowdown, ongoing trade wars and accumulating U.S. inflation pressures will continue propping up the U.S. dollar, thereby sustaining a perfect storm for EM financial markets. This is taking place amid the poor structural fundamentals in the developing economies and the existing overhang of investor positions in EM. Altogether this argues for more downside in EM financial markets. A strong dollar is also a bad omen for developed markets' stock indexes. The reason being that the dollar is a countercyclical variable, and the greenback's rallies usually coincide with global trade downturns that are bearish for global cyclical equity sectors (Chart I-1). Needless to say, tariffs on imports are ultimately negative for global trade, and will exacerbate the global growth slowdown that has been occurring since early this year. In fact, there is anecdotal evidence that global trade has so far temporarily benefited from mounting expectations of tariffs.1 Companies have ordered more inputs and shipped more goods in advance of higher tariffs coming into effect. This is why global shipments and manufacturing production have so far held up reasonably well, while business expectations have plummeted (Chart I-2). Consequently, global trade and manufacturing production will likely record considerable weakness later this year. Since markets are typically forward looking, asset prices will adjust beforehand. Chart I-1Global Industrial Stocks And U.S. Dollar Chart I-2Global Trade Is Heading South We are maintaining our negative stance on EM stocks, currencies, credit markets and high-yielding local bonds. China Is Easing Liquidity, But Don't Hold Your Breath Chart I-3Chinese Interest Rates And EM Stocks: ##br##Positively Correlated China's softening industrial data, growing anecdotal evidence of a worsening credit crunch in the economy, U.S. tariffs, and plunging domestic share prices have been sufficient for the authorities to ease liquidity conditions in the Chinese banking system. Not surprisingly, many investors are wondering whether the worst is over for Chinese stocks and China-related financial markets worldwide, including those in EM. At the current juncture, liquidity easing by the PBOC is a necessary but not sufficient condition to turn positive on this nation's industrial cycle as well as EM risk assets. We have the following considerations on this topic: First, China's risk-free interest rates - government bond yields - led the selloff in both EM and Chinese stocks (Chart 3). These bond yields have plunged since November, foreshadowing the slowdown in China's growth and the carnage in EM/Chinese financial markets. By and large, there has been a positive correlation between EM share prices and China's local bond yields and interbank rates as illustrated on Chart I-3. For example, EM stocks, currencies and credit markets rallied substantially in 2017 in the face of rising interest rates in China. Likewise, they dropped in the second half of 2015 as bond yields and money market rates in China plunged. The rationale behind the positive correlation between EM risk assets and Chinese interest rates is that the latter rise and EM risk assets rally when the mainland economy is improving. The opposite is also true. At the moment, Chinese risk-free bond yields will likely continue to drop as additional slowdown in growth is in the cards. This heralds a further drop in EM financial markets. Second, any major stimulus will constitute a retraction of the Chinese government's policy of deleveraging and containing financial risks. The latter is the code phrase Chinese authorities use to stop fueling bubbles and speculative excesses. Hence, any policy stimulus will for now be measured and insufficient to boost growth this year. China is saddled with massive debt and money overhangs and a bubbly property market. Ongoing enormous expansion in money supply (i.e., RMB deposits)2 (Chart I-4) and a narrowing interest rate differential over the U.S. will continue exerting downward pressure on the RMB's value (Chart I-5). Chart I-4'Helicopter Money' In China Chart I-5The RMB Will Depreciate Further Even though capital controls have tightened since 2015, the capital account is not perfectly closed. As such, shrinking interest rate deferential versus the U.S. warrants further yuan depreciation. In short, the authorities cannot reduce interest rates further and expand money/credit growth at a double-digit rate without tolerating sizable currency deprecation. If the Chinese authorities opt for a large fiscal and credit stimulus again, the nation's structural imbalances will grow further. In this scenario, the Middle Kingdom's secular growth outlook will deteriorate, and policymakers' manoeuvring room to stimulate in the future will narrow. Chart I-6China: The Industrial Cycle Is Slumping Crucially, China's enormous money and credit creation are entirely unrelated to its high savings rate. Money and credit in China have been driven by speculative behavior of Chinese banks and borrowers not households' high savings rate. We have discussed these issues in detail in our past special reports3 and will not expand on them here. Third, there has been money/credit tightening on three fronts in China - liquidity, regulatory and anti-corruption. Even though liquidity conditions in the banking system are now ameliorating, as evidenced by the plunge in interbank rates, the regulatory clampdown on the shadow banking system as well as the anti-corruption campaign targeting the financial industry are still underway. The latter policy initiatives will continue to curb credit creation by suppressing banks' and shadow banking institutions' ability and willingness to finance the real economy. In fact, it is not inconceivable that the regulatory clampdown and anti-corruption campaign will have a larger impact on credit supply than the decline in borrowing costs. Finally, policy easing and tightening works with a time lag. China's business cycles and related financial markets do not always respond swiftly to changes in policy stance. Specifically, monetary and fiscal policies were easing substantially from the middle of 2015, yet EM/China-related risk assets continued to plummet for six months until February 2016. Conversely, policy was tightening in China throughout 2017, yet EM/China-related asset markets did well in 2017. In brief, there could be a long lag between a change in policy stance and a reversal in financial markets. For now, we reckon that the cumulative effect of policy tightening of the past 18 months will continue to seep through the Chinese economy till the end of this year. Chart I-6 demonstrates that various industrial cycle indicators continue to deteriorate. Bottom Line: The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on Chinese growth and China-related risk assets, including commodities and EM. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets. More Downside The indicators that have been useful in foretelling the turmoil in EM financial markets this year are signaling that a negative stance is still warranted: One indicator that gave an early warning signal for the current EM selloff was EM sovereign and corporate bond yields. At the moment, the average of EM dollar-denominated corporate and sovereign bond yields continues to presage lower EM stock prices, as demonstrated in Chart I-7 - bond yields are shown inverted in this chart. Chart I-7Rising EM Borrowing Costs Are Bearish For Their Stocks Notably, EM share prices display lower correlation with U.S. bond yields and U.S. TIPS yields than with EM corporate and sovereign bond yields (Chart I-8). Why are EM share prices exhibiting a stronger correlation with EM bond yields rather than with U.S. Treasury yields? The basis is that EM equities are sensitive to EM - not U.S. - borrowing costs. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate and sovereign U.S. dollar bond yields - i.e. EM borrowing costs in dollars - will decline, and EM share prices will rally (Chart I-7). But when EM corporate (or sovereign) yields rise - irrespective of whether because of rising U.S. Treasury yields or widening EM credit spreads - EM borrowing costs in dollars rise, and consequently equity prices come under considerable selling pressure. In other words, a drop in U.S. bond yields on its own is not enough for EM share prices to advance, and conversely, a rise in U.S. bond yields is not sufficient for EM stocks to drop. It is movements in EM U.S. dollar bond yields, which are comprised of U.S. Treasury yields and EM credit spreads, that matter for the direction of EM equity prices. Regarding local bond yields, EM share prices typically exhibit a strong negative correlation with EM domestic government bonds yields - the latter are shown inverted on this chart (Chart I-9). Since we expect EM currencies to depreciate further and, given the negative correlation between EM currency values and their local bond yields, the latter will continue rising. Chart I-8EM Stocks And U.S. Rates: ##br##Mixed Relationship Chart I-9EM Equities And Local Bond Yields: ##br##Strong Correlation The risky-to-safe-haven currency ratio4 continues to fall after experiencing a major breakdown early this year (Chart I-10, top panel). Historically, this ratio has been correlated with EM share prices and currently heralds further downside (Chart I-10, bottom panel). This ratio also is agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the general trend in the greenback. Hence, this indicator answers the question of the direction of EM share prices, regardless of the dollar's trend. Finally, key to EM performance has been corporate profits. Presently, the outlook for EM corporate profits is still negative, as suggested by the negative readings on China's money and credit (Chart I-11). Chart I-10Are Risk Assets In A Bear Market? Chart I-11EM Corporate Profits Will Likely Shrink Bottom Line: EM risk asset will continue selling off and underperforming their DM counterparts. Stay short/underweight EM risk assets. The Dollar's Trend Is Still Up The U.S. dollar is instrumental to EM financial market trends. We expect the dollar rally to persist for now - at least through the end of this year. The underlying inflation gauge measure calculated by New York Fed points to further acceleration in U.S. consumer price inflation (Chart I-12). Furthermore, America's job market is continuing to tighten. In brief, U.S. domestic demand will stay robust even as global trade slumps. These will limit the Federal Reserve's ability to back off from tightening, even if EM financial markets continue to sell off. Chart I-12U.S. Inflation Risks Are To The Upside Remarkably, a strong U.S. exchange rate is needed to cap America's growth and inflation and to boost growth in the rest of the world, especially in Asia. Given the widening growth momentum between the U.S. and Asia, the dollar will likely need to rally significantly to reverse the growth differential currently moving in favor of America. This will be especially true if more trade tariffs are imposed. Odds are that the RMB will depreciate further given the backdrop of lower interest rates in China - discussed above. That will cause a downturn in emerging Asian currencies. A strong dollar, a slowdown in Chinese/EM demand for commodities and large net long positions by investors in oil and copper all argue for a considerable drop in commodities prices in the months ahead. This is bearish for Latin American and many other EM exchange rates. Bottom Line: The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. With respect to currency positions, we recommend investors to continue to short a basket of EM currencies such as BRL, ZAR, TRY, MYR and IDR versus the dollar. CLP and KRW are also among our shorts given our bearish outlook for copper prices, global trade and Asian currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkish Banks: A Bargain Or Value Trap? 12 July 2018 Turkish bank stocks have now fallen by 40% in local currency terms and by 55% in U.S. dollar terms since their peak early this year (Chart II-1), prompting the question whether they have become a bargain or are still a value trap. Banks represent 30% of the Turkey MSCI index and are integral to the performance of this bourse. Although Turkish banks appear to be cheap with their price-to-trailing earnings ratio at 4.5 and their price-to-book value ratio at 0.62, they are still vulnerable to a substantial rise in non-performing loans (NPL) and ensuing provisioning, write-off and equity dilution. Turkey has been experiencing an enormous credit binge for years and its interest rates have risen by 600 basis points since the start of the year. Yet, current NPLs and provisions stand at a mere 3% and 2.3% of total outstanding loan, respectively (Chart II-2). Chart II-1Turkish Stocks: A Long-Term Perspective Chart II-2Turkish Banks Are Underprovisioned The creditworthiness of debtors is worse when one takes into account that Turkish companies have large foreign currency debt and a record amount of foreign debt obligations due in 2018 (Chart II-3). In our credit stress test, we assume that in the baseline scenario the non-performing credit assets (NPCA) ratio will rise to 15% (Table II-1). Taking into account that the NPL-to-total loan ratio reached 18% in 2002 after the 2001 currency crisis, we believe 15% is a reasonable estimate. Chart II-3Turkey: Record High Foreign Debt Obligations Table II-1Credit Stress Test For Turkish Banks To put this number further into perspective, India - one of the very few countries within the EM universe to have somewhat fully recognized its NPLs - currently has an NPL ratio of 15% on its public banks. Chart II-4Turkish Equities: ##br##A Cyclically-Adjusted P/E Ratio If we assume that Turkish bank stocks at the end of this cycle will trade at a price-to-book ratio of 1 after adjusting for all credit losses, then banks' stock prices are currently about 17% overvalued in the baseline scenario of 15% NPCA (Table II-1, the middle row). In all three scenarios, we assume a recovery rate of 40%. With regards to the overall equity market, Chart II-4 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is currently around 5, compared to the historical average of 8. For the bourse's CAPE ratio to drop to two standard deviations below its mean, share prices have to fall by another 20-25%. This is plausible given the outlook for more populist economic policies following the recent elections. Besides, corporate profits will contract considerably because of the monetary tightening that has occurred since early this year. The exchange rate is critical for Turkish financial markets. As such, revisiting currency valuation is also important. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of July 11 the lira was slightly more than one standard deviation below its historical mean (Chart II-5). For it to reach two standard deviations below its mean, it would roughly take another 15-17% depreciation, versus an equal-weighted basket of the dollar and euro. Given the current macroeconomic backdrop and the outlook for more unorthodox policies, including possible capital controls following President Erdogan's appointment of his son-in law as the key economic policymaker, the lira will likely undershoot. Meantime, foreign holdings of Turkish local bonds and stocks were not yet depressed as of June 29 (Chart II-6). Chart II-5Turkish Lira: An Undershoot Is Likely Chart II-6Foreign Ownership Is Still High Bottom Line: Provided Turkey's political outlook has deteriorated further after the recent elections, we assess that only after a 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with a 15-20% drop in stocks in local currency terms, will Turkish equities be a true bargain and warrant a positive stance. For now, dedicated EM equity and fixed income portfolios (both credit and local currency bonds) should continue to underweight Turkey. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the following article Global automakers hail more ships as trade battles heat up. 2 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available on ems.bcaresearch.com 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, link is available on page 17. 4 Average of cad, aud, nzd, brl, clp & zar total return indices relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Robert P. Ryan, Chief Commodity & Energy Strategist The London Metal Exchange Index (LMEX) will remain under significant downward pressure, unless and until fears of escalating Sino - U.S. trade disputes are allayed. Should this dispute devolve into full-blown trade war - something our geopolitical strategists expect - EM economies deeply embedded in global supply chains could be especially hard hit.1 This would have ramifications for commodity prices in general, base metals in particular. Alternatively, if this trade dispute evolves into a more open and free global trading system, EM income growth will drive commodity demand - particularly for metals - significantly higher. Highlights Energy: Overweight. China's $5 billion loan and $250mm direct investment in Venezuela's oil industry will alleviate the country's oil-production and -export collapse for a brief interval. However, unless China brings its own industry experts in to run Venezuela's state-owned oil company, which has suffered a near-total loss of highly trained personnel, and manages to reverse government mismanagement and corruption, it is difficult to see the collapse in that country's oil industry being reversed. Separately, China's investment in and commitment to Venezuela could be a harbinger of future deals between it and Iran, if China decides to flex its economic muscle and widen the playing field in its trade dispute with the U.S. beyond ags. Base Metals: Neutral. Fears of a global trade war overly punishing EM economies, many of which are deeply entwined in global supply chains, are weighing on base metals prices (see below). Right-tail - i.e., upside risks - are, for the most part, being ignored. Our assessment of balances and upside risk, particularly in copper, makes getting long attractive. We are, therefore, going long the Dec/18 $3.00 COMEX calls vs. short $3.20/lb calls at tonight's close. This is a tactical position. Precious Metals: Neutral. Gold recovered somewhat - trading above $1,260/oz earlier in the week - as global trade tensions increased. It since settled to the $1,250/oz level as trade anxieties re-emerged. Ags/Softs: Underweight. Prompt soybeans futures are probing five-year lows, after the U.S. announced an additional $34 billion in tariffs against China, which were immediately followed by Chinese reprisals, highlighted by 25% tariffs against soybeans. Feature Prices of the six base metals futures comprising the LMEX are highly sensitive to EM growth, which has benefited from the expansion of global supply chains. As a result, metals' prices are highly sensitive to EM incomes, EM trade volumes, and FX levels. Our modeling indicates these global macro variables will continue to play an outsized role in determining the trajectory of the metals' prices, particularly as relates to EM - China trade (Chart of the Week).2 Chart Of The WeekEM Macro Variables Drive LMEX EM incomes and trade volumes have, for the most part, held up well this year. Our base case outlook is for the resilience underpinning the global economy to continue for the remainder of the year, in line with the IMF and World Bank expectations.3 However, escalating trade disputes are threatening to weigh on the global flow of goods, which, if they persist and deepen, will dampen demand for raw materials in general, and metals in particular. An acceleration in trade restrictions would dent not only trade flows, but also would harm EM incomes in the process. Our base case longer term gets cloudier. In the left tail of returns distributions, rising interest rates on the back of the Fed's interest-rate normalization process will remain on track, particularly as inflation and inflation expectations pick up. This will support a stronger dollar, which, all else equal, will increase EM debt servicing costs. Our colleagues in BCA Research's Global Investment Strategy note, "Emerging markets are particularly sensitive to changes in U.S. financial conditions. About 80% of EM foreign-currency debt is denominated in dollars. A stronger dollar and higher U.S. interest rates make it more difficult for EM borrowers to service their debts. While EM foreign-currency debt has declined as a share of total debt outstanding, this is only because the past decade has seen a boom in local debt issuance. As a share of GDP, exports, and international reserves, U.S. dollar debt is at levels not seen in over 15 years."4 We expect the Sino - U.S. trade dispute will get nastier, but we are mindful of the right tail risks in this process, as well. If leaders in the U.S., China, and EU can agree to revamp and modernize the rules of the road for global trade - i.e., protect intellectual property, remove forced technology transfers, and make markets more open and transparent - the upside risks to base metals returns, and commodities in general, would be significant. In such an evolution, EM income growth would accelerate, super-charging global trade volumes, and commodity demand. Trade Volumes Resilient For Now, But Protectionism Looms Overhead At present, global trade in goods amounts to more than $17 trillion of merchandise exports, while commercial services exports are more than $5 trillion.5 Accounting for tariffs imposed by the U.S. under Sections 232, and 301, as well as retaliatory action by China, Mexico, the EU, and Canada, barriers have so far been implemented on ~$150 billion worth of traded goods. This represents less than 1% of merchandise trade. Thus, current restrictions -- while intensifying -- will not significantly curb global flows (Chart 2). And, so far, EM trade volumes have held up well, with resilience in the flow of goods: Our forward-looking models are pointing toward continued trade-related support for base metals in coming months (Chart 3). Chart 2U.S.-China Trade Hit By Tariffs Chart 3EM Trade Will Hold Up, Absent A Trade War This should - ceteris paribus - translate into greater demand for metals, and a strong LMEX. Our modelling finds that the LMEX and EM trade volumes are cointegrated, and that a 1% increase in EM import volumes maps to a 1.3% increase in the LMEX, in line with the overall income elasticity of trade reported by the World Bank last month.6 However, risks surrounding the flow of goods globally - especially between the U.S. and China and the U.S. and EU - are mounting. This is jeopardizing our base case for resilient EM trade and income in the near term. Most notable is the recent U.S. trade restriction imposed on $34 billion worth of Chinese imports effective July 6, and China's subsequent retaliation in kind, which hit U.S. ag exports - particularly soybeans - hard. Additional barriers similar to the tit-for-tat of late between the U.S. and China, raise the odds of a global trade war and further depress metal prices.7 If this U.S.-Sino trade spat devolves into a full-blown trade war, in which the U.S., China and the EU erect trade barriers, or raise tariffs or restrictions on foreign investment, global trade momentum could slow significantly, which would be devastating for EM income growth. The World Bank finds that if tariffs were to reach legal maximum rates under WTO commitments, global trade flows would decline by 9% - in line with the decline experienced during the global financial crisis (GFC) (Chart 4).8 In addition to mounting trade restrictions, the sustainability of Chinese demand is also relevant to our metals demand-side outlook. China's imports account for the bulk of EM import volumes, and a significant domestic slowdown that dents import demand would weigh on the metals complex. To date, China's import volume growth appears to be holding up, reflecting a controlled domestic demand environment (Chart 5). Chart 4Trade War Would Hurt EM Trade Chart 5China Trade Indicates Slowdown Is Controlled Trade Barriers Would Hit EM Incomes Hard As noted above, in line with our base case outlook of supportive trade volumes so far this year, the IMF and World Bank expect the global economy to remain strong this year and next, highlighting trade as one of the two main growth catalysts (Table 1). DM growth, while showing signs of moderating, remains perched above potential. We expect this to persist, especially given fiscal stimulus measures in the U.S. announced earlier this year. According to our modelling, a 1% increase in EM GDP translates to a 1.1% rise in the LMEX. Global PMIs remain above the 50 mark, indicating global manufacturing continues to expand, which will remain supportive of commodity demand generally (Chart 6). Table 1Global Growth Expected To Remain Supportive Chart 6U.S. Will Outperform, Supporting DM Growth China's ~ $14 trillion GDP accounts for some ~ 16% of global GDP and is the highest among the EM economies.9 China accounts for ~ 50% of global demand for metals represented in the LMEX (Chart 7). China's base-metals demand has been resilient, despite tighter credit and monetary conditions and little in the way of fiscal stimulus in China. We continue to expect Chinese domestic demand will experience a managed slowdown as the government tackles its reform agenda in 2H18. Chart 7China's Outsized Role In Metal Markets Since 2000, the impact of income growth in China has only a slightly larger effect on the LME's price index versus that of DM regions such as the Euro Area.10 Our analysis indicates that, unlike the rest of the world, China's metal consumption is trend-stationary - i.e., mean reverting - and behaves almost as it if were a policy variable, which is to say a time series that is more a function of government policy than the laws of supply and demand. Bottom Line: EM income and trade volumes are expected to remain strong, which will be supportive of metals prices. Even so, markets are now dealing with a trade spat that could metastasize into a full-blown trade war. We are not there yet. However, the tail risks are increasing and markets now have to account for a higher likelihood of a slowdown in EM trade volumes, which could be followed by a redistribution of base-metals demand and re-ordering of trade flows. On the flip side, a resolution of the trade frictions would resolve many of these tail risks, and likely would lend support to metal prices via higher EM income growth. In any case, the FX outlook is not supportive for metal prices. A stronger dollar - our base case expectation - will weigh on metal demand and the LMEX. Fundamentals Will Play A Secondary Role Individual market fundamentals, such as aluminum supply cuts, copper mine strikes, and zinc's physical deficit contributed to the LMEX's outperformance last year (Chart 8). Metal-specific supply, demand and inventory conditions will continue influencing the individual metals in the index. Aluminum and copper constitute three-quarters of the LMEX, and fundamental developments in these two markets are especially relevant (Chart 9). Chart 8Individual Fundamentals Supported LMEX Last Year Chart 9Copper, Aluminum Markets Are Key U.S. sanctions on leading Russian aluminum producer Rusal and its top shareholder, the oligarch Oleg Deripaska, led to a 9% surge in the LMEX in the first few weeks of April, followed by a 6% retracement by the end of the month (Chart 10). While risks from this politically motivated tailwind have mostly faded - the U.S. announced that a change in ownership will exempt Rusal from these sanctions - geopolitical tensions remain relevant. Chart 10Individual Markets Remain Relevant In the very near term, ongoing contract renegotiations at Chile's Escondida mine are an upside risk to the LMEX in the coming weeks. BHP's final offer to the labor union is due on July 24. Reuters reports that little progress has been made to settle the disputes between BHP and the union: agreement has been reached on only one-fifth of the points of contention.11 While June upside from these renegotiations have since faded and taken a back seat to downside pressures from the fear of a global trade war, a labor strike at the mine which dents supply, would support copper prices, and offset at least part of the index's downside macro risks. At 14.8% of the index, zinc accounts for a much smaller weight in the LMEX. After strong gains last year, the metal has been a headwind to the LMEX since March. Following two consecutive years of physical deficits, the market is moving toward a surplus, causing prices to slide. However, recent news of a possible production cut by Chinese smelters is preventing major declines. If this were to materialize - details remain vague at best - we would expect to see some support in the zinc market. Bottom Line: Demand-side macro variables - EM trade, incomes, and currencies - explain almost all of the movements in the LMEX. To date, these variables exhibit resilience pointing to support for metal prices. Left-side tail risks arising from possible trade wars have the market's attention and have been weighing on the complex of late. We expect these downside risks to be most relevant in the remainder of this year, and to take a front seat to individual market fundamentals. Nevertheless, individual metals' fundamentals will be important to follow. Right-side tail risks also bear watching, particularly if the current trade spats involving the U.S., China and the EU are resolved in favor of freer, more open global trade. This would super-charge EM growth, which would be bullish for commodities generally, base metals and oil in particular. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy titled "The U.S. And China: Sizing Up The Crisis," published July 11, 2018, available at gps.bcaresearch.com. 2 The adjusted R-squared for each of our two cointegrating regressions is greater than 0.95. These models cover the 2000 to present period. Our modelling also indicates that the LMEX is cointegrated with these three explanatory variables, i.e., they share a long-term trend, wherein the LMEX rises as these variables rise. 3 Please see the IMF's World Economic Outlook of April 2018 (https://www.imf.org/en/Publications/WEO/Issues/2018/03/20/world-economic-outlook-april-2018), and the World Bank's June 2018 Global Economic Prospects (http://www.worldbank.org/en/publication/global-economic-prospects). 4 Please see BCA Research Global Investment Strategy Weekly Report titled "Who Suffers When The Fed Hikes Rates?" dated June 1, 2018, available at gis.bcaresearch.com. 5 Please see "Strong trade growth in 2018 rests on policy choices," published by the World Trade Organization April 12, 2018. 6 The period for our estimate is 2000 to now. We discuss the World Bank's trade elasticities in "Trade Wars, China Credit Policy Will Roil Global Copper Markets" published by BCA Research's Commodity & Energy Strategy June 21, 2018. It is available at ces.bcaresearch.com. 7 The U.S. is threatening to impose tariffs on an additional $200 billion worth of Chinese imports. 8 This is based on a simulation where WTO members increase tariffs to bound rates under WTO commitments as well as a 3% increase in the cost of traded services. This would mean average global tariff rates would legally more than triple from the current 2.7% to 10.2%. This exercise does not take into account the impact of other non-tariff restrictions, such as those on investments. Please see World Bank Policy Research Working Paper 8277 titled "The Global Costs of Protectionism," dated December 2017. 9 Please see "The world's biggest economies in 2018," published by The World Economic Forum at https://www.weforum.org/agenda/2018/04/the-worlds-biggest-economies-in-2018/. 10 A 1 percentage-point (p.p.) increase in China's year-on-year (y/y) GDP rate translates to a 1.8% increase in the LMEX, while a 1 p.p. increase in y/y changes in the Euro Area's y/y GDP rate is associated with a 1.6% increase in the LMEX. These results are based on a dynamic OLS model which also includes the JPM EM currency index and EM export volumes as explanatory variables. The adjusted R2 for the model is 0.97. 11 "Conversations can continue until July 24, at which point BHP must present its final offer, according to a negotiation schedule provided by the company. Between July 27 and July 31, the union will vote to either accept the company's offer or go on strike. After the vote, either party has as many as four days to request a period of government mediation that can last 10 days." Please see "Labour talks at BHP's Escondida mine in Chile enter 'home stretch," dated July 6, 2018, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Ryan Swift, Vice President U.S. Bond Strategy Highlights Chart 1Inflations Expectations Hard To Shake Low inflation expectations are proving difficult to shake. Year-over-year core PCE inflation moved to within 5 bps of the Fed's 2% target in May, but long-maturity TIPS breakeven inflation rates barely budged (Chart 1). Instead, breakevens are taking cues from commodity prices which are being held down by flagging global growth (bottom panel). The minutes from the June FOMC meeting revealed that "one participant" advocated postponing rate hikes in an attempt to re-anchor inflation expectations, but we do not expect the Fed to pursue this course. Instead, the Fed will continue to lift rates at a pace of 25 bps per quarter until a risk-off episode in financial markets prompts a delay, hoping that the incoming inflation data are strong enough to send TIPS breakevens higher in the meantime. Ultimately we think that strategy will be successful, but Fed hawkishness in the face of weakening global growth threatens the near-term performance of corporate credit. We recommend only a neutral allocation to spread product versus Treasuries, while maintaining a below-benchmark duration bias. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 60 basis points in June, dragging year-to-date excess returns down to -181 bps. Value is no longer stretched in the investment grade corporate bond market, though it is not attractive enough to compensate for being in the late stages of the credit cycle or for the looming collision between a hawkish Fed and decelerating global growth. These factors led us to reduce exposure to corporate bonds two weeks ago.1 With inflation running close to the Fed's 2% target and the 2/10 Treasury slope between 0 bps and 50 bps, our research shows that small positive excess returns are the best case scenario for corporate bonds. The likelihood that leverage will rise in the second half of this year is also a concern (Chart 2). Profit growth is only just keeping pace with debt growth and will soon have to contend with rising wage costs and the drag from recent dollar strength. The Fed's staunch hawkishness in the face of decelerating global growth is reminiscent of 2015. Then, the end result was a period of spread widening that culminated in the Fed pausing its rate hike cycle. In recent weeks we also explored how to position within the investment grade corporate bond sector, considering both the maturity spectrum and the different credit tiers.2 We concluded that in the current environment investors should favor long maturities and maintain a balanced or slightly up-in-quality bias (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 40 basis points in June, bringing year-to-date excess returns up to +76 bps. The average index option-adjusted spread widened 1 bp on the month, and currently sits at 365 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses has widened to 262 bps, just above its long-run mean (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 262 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in last week's report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.03% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than they are today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks to that forecast are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which remain low relative to history but have perked up in recent months (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to -24 bps. The conventional 30-year zero-volatility MBS spread widened 1 bp on the month, driven entirely by a 1 bp widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The MBS option-adjusted spread has widened since the beginning of the year (Chart 4), though by much less than the investment grade corporate bond spread (panel 3). The year-to-date OAS widening has been offset by a contraction in the option cost component of spreads, and this has kept the overall nominal MBS spread flat at very tight levels (bottom panel). Going forward, rising interest rates will limit mortgage refinancing activity and this will ensure that MBS spreads remain low. In other words, while MBS valuation is not attractive, the downside is limited. Our Bond Maps show an unfavorable risk/reward trade-off in the MBS sector. This analysis, based on volatility-adjusted breakeven spreads, shows that only 7 days of average spread widening are required for the MBS sector to lose 100 bps versus duration-matched Treasuries. While this speaks to the low spread buffer built into current MBS valuations, the message from the Bond Map must be weighed against the macro outlook which suggests that the odds of significant spread widening are quite low. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to -35 bps. Sovereign debt outperformed the Treasury benchmark by 33 bps on the month, bringing year-to-date excess returns up to -210 bps. Foreign Agencies outperformed by 10 bps on the month, bringing year-to-date excess returns up to -46 bps. Local Authorities underperformed by 9 bps on the month, dragging year-to-date excess returns down to +28 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to zero. The escalating tit-for-tat trade war and increasing divergence between U.S. and non-U.S. growth is a clear negative for USD-denominated Sovereign debt. Relative valuation also shows that U.S. corporate bonds are more attractive than similarly rated Sovereigns (Chart 5). Maintain an underweight allocation to Sovereign debt. Within the universe of Emerging Market Sovereign debt, we showed in a recent report that only Russian debt offers an attractive spread relative to the U.S. corporate sector.4 In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps). Maintain overweight allocations to these two sectors. The Bond Maps also show that the Supranational and Domestic Agency sectors are very low risk, but offer feeble return potential compared to other sectors. The Supranational and Domestic Agency sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 10 basis points in June, bringing year-to-date excess returns up to +120 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio fell 1% in June to reach 85%, close to one standard deviation below its post-crisis mean. It is also only slightly higher than the average 81% level that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The technical picture remains favorable for Muni / Treasury yield ratios. Fund inflows increased in recent weeks, and visible supply has contracted substantially compared to this time last year (Chart 6). State & local government credit fundamentals are also fairly robust. Net borrowing is on the decline and this should ensure that municipal ratings upgrades continue to outpace downgrades (bottom panel). Despite relatively tight valuation compared to history, the Total Return Bond Map on page 16 shows that municipal bonds offer a fairly attractive risk/reward trade-off compared to other U.S. fixed income sectors, particularly for investors exposed to the top marginal tax rate. Given the favorable reading from our Bond Map and the steadily improving credit fundamentals, we recommend an overweight allocation to Municipal bonds. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2/10 Treasury slope flattened 10 bps and the 5/30 slope flattened 7 bps. At present, the 2/10 slope sits at 29 bps, its flattest level of the cycle. The yield curve has flattened relentlessly in recent months as the impact of Fed rate hikes at the short-end of the curve have not been offset by higher inflation expectations at the long end. As explained in a recent report, we think it is unlikely that curve flattening can maintain this rapid pace.5 At 2.34%, the 1-year Treasury yield is already priced for 100 bps of Fed rate hikes during the next 12 months, assuming no term premium. Meanwhile, long-maturity TIPS breakeven inflation rates remain below levels that are consistent with the Fed's 2% inflation target. While curve flattening will proceed as the Fed lifts rates, higher breakeven inflation rates at the long-end of the curve will offset some flattening pressure during the next few months. With that in mind, we continue to recommend a position long the 7-year bullet and short the duration-matched 1/20 barbell. According to our models, this butterfly spread currently discounts 41 bps of 1/20 curve flattening during the next six months (Chart 7). This is considerably more than what is likely to occur. Table 4 of this report shows the output from our valuation models for each butterfly combination across the entire yield curve, as explained in a recent Special Report.6 Table 4Butterfly Strategy Valuation (As Of July 6, 2018) TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 35 basis points in June, bringing year-to-date excess returns up to +129 bps. The 10-year TIPS breakeven inflation rate increased 4 bps on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 5 bps and currently sits at 2.16% (Chart 8). Both the 10-year and 5-year/5-year TIPS breakeven inflation rates remain below the range of 2.3% to 2.5% that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, the current outlook is promising. Core PCE inflation has printed above the 0.17% month-over-month level that is consistent with 2% annual inflation in four of the past five months (panel 4). Year-over-year trimmed mean PCE inflation is at 1.84% and should continue to rise based on the 2.03% reading from the 6-month trimmed mean PCE (bottom panel). Finally, our Pipeline Inflation Indicator continues to point toward mounting inflationary pressures in the economy (panel 3). Maintain an overweight allocation to TIPS relative to nominal Treasury securities. We will reduce exposure to TIPS once long-maturity TIPS breakeven inflation rates return to our 2.3% to 2.5% target range. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in June, bringing year-to-date excess returns up to -2 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and now stands at 43 bps, 16 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends are moving against the sector. The household debt service ratio on consumer credit ticked down slightly in the first quarter, but its multi-year uptrend remains intact (Chart 9). Consumer credit delinquency rates follow the household debt service ratio with a lag. Meanwhile, banks are noticing the decline in credit quality and have begun tightening lending standards (bottom panel). Tighter lending standards tend to coincide with upward pressure on delinquencies and spreads. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +61 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month and currently sits at 74 bps (Chart 10). The gap between decelerating commercial real estate prices and tight CMBS spreads continues to send a worrying signal for CMBS (panel 3). However, delinquencies continue to decline and banks recently started to ease lending standards on nonfarm nonresidential loans (bottom panel). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in June, dragging year-to-date excess returns down to +6 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 51 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of July 6, 2018) Chart 12Total Return Bond Map (As Of July 6, 2018) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, for further details on positioning across different credit tiers. Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, for further details on positioning across the maturity spectrum. Both reports available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Threats & Opportunities In Emerging Markets", dated June 12, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Robert Robis, Chief Fixed Income Strategist Highlights Q2 Performance Breakdown: The return for the Global Fixed Income Strategy (GFIS) recommended model bond portfolio was flat (hedged into U.S. dollars) in the second quarter of 2018, outperforming the custom benchmark index by +13bps. This pushed the 2018 year-to-date performance back into positive territory. Winners & Losers: Nearly the entire outperformance came from our overweight stance on U.S. high-yield corporates versus our underweight tilt on emerging market corporates. Successful government bond country allocation (overweight U.K. & Australia, underweight Italy) helped offset the drag on performance from our overweight stance on U.S. investment grade corporates. Scenario Analysis: Our recent decision to downgrade overall spread product exposure, even as we maintain a below-benchmark duration stance, should help boost the expected alpha of the model portfolio over the next year. Feature This week, we present the performance numbers for the BCA Global Fixed Income Strategy (GFIS) model bond portfolio in the second quarter of 2018. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is meant to complement the usual macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. In this report, we update our estimates of future portfolio performance, using the scenario analysis framework that we introduced three months ago.1 After our recent decision to downgrade global spread product exposure, our model portfolio is now expected to outperform the custom benchmark index over the next year in both our base case and plausible stress test scenarios. Q2/2018 Model Portfolio Performance Breakdown: Country & Credit Selection Pays Off The total return of the GFIS model bond portfolio was flat (hedged into U.S. dollars) in the second quarter of the year, which outperformed our custom benchmark index by +13bps.2 The first half of the quarter was driven by gains from our below-benchmark duration tilt, as the 10-year U.S. Treasury yield hit a peak of 3.13%. As yields drifted a bit lower in the latter half of Q2 in response to some cooling of global economic growth amid rising concerns on U.S. trade policy, the gains from duration reversed. At the same time, the outperformance from the spread product portion of our model portfolio started to kick in (Chart of the Week), even as credit spreads in all markets widened. Chart of the WeekSpecific Country & Credit Allocations##BR##Boosted Q2 Performance Table 1GFIS Model Bond Portfolio##BR##Q2-2018 Overall Return Attribution In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +5bps of outperformance versus our custom benchmark index while the latter outperformed by +8bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio##BR##Q2/2018 Government Bond Performance Attribution By Country Chart 3GFIS Model Bond Portfolio##BR##Q2/2018 Spread Product Performance Attribution By Sector The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. high-yield B-rated corporates (+5bps) Overweight U.S. high-yield Caa-rated corporates (+2bps) Overweight Japanese government bonds (JGBs) with maturities up to ten years (+3bps) Underweight emerging market U.S. dollar-denominated corporate debt (+5bps) Underweight Italian government bonds (+4bps) Overweight U.K. Gilts (+1bp) Overweight Australian government bonds (+1bp) Biggest underperformers Overweight U.S. investment grade Financials (-2bps) Overweight U.S. investment grade Industrials (-2bps) Underweight JGBs with maturities beyond ten years (-5bps) Underweight French government bonds with maturities beyond ten years (-2bps) Two unusual trends stand out in the Q2 performance numbers: First, our overweight stance on U.S. high-yield debt was able to deliver positive alpha but a similar tilt on U.S. investment grade did not, even as U.S. corporate credit spreads widened during the quarter. It is odd for an asset class (high-yield) that is typically more volatile to outperform during a period of credit spread widening. Although that outcome did justify our view that U.S. investment grade corporates have been offering far less cushion to a period of spread volatility than U.S. junk bonds. Second, the flattening pressures on global government bond yield curves resulted in underperformance from the very long ends of curves in core Europe and Japan, even though the latter regions were the best performing bond markets in our model bond portfolio universe. This can be seen in Chart 4, which presents the benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during the second quarter.3 Chart 4Ranking The Winners & Losers From The Model Portfolio In Q2/2018 As can be seen in the chart, the best performers were government bonds in Germany, France and Japan. The fact that our excess return from those countries was only a combined +2bps, even with an aggregate overweight exposure to all three, suggests that our duration allocation within the maturity buckets of those countries was a meaningful drag on performance. Yet in terms of the overall success rate of our individual country and sector calls, the news was positive in Q2. We've been overweight U.K. Gilts and Australian government bonds, which were some of the top performers in Q2. On the other side, we have been underweight emerging market corporate debt and Italian sovereign debt, which were the worst performers in the quarter. Bottom Line: The GFIS model bond portfolio outperforming the custom benchmark index by +13bps. This pushed the 2018 year-to-date performance back into positive territory. Nearly the entire outperformance came from our overweight stance on U.S. high-yield corporates versus our underweight tilt on emerging market corporates. Future Drivers Of Portfolio Returns After Our Recent Changes Looking ahead, the performance of the model bond portfolio will have different drivers in the third quarter and beyond after the recent changes to BCA's recommended strategic asset allocations.4 We downgraded global equity and spread product exposure to neutral, based on our concern that the backdrop for global growth, inflation and monetary policy was turning less supportive for risk assets, particularly given the potential new economic shock from the "U.S. versus the world" trade tensions. In terms of the specific weightings in the GFIS model bond portfolio, we still prefer owning U.S. corporate debt versus equivalents in Europe and emerging markets. Thus, while we downgraded our recommended allocation to U.S. and investment grade corporates to neutral from overweight, we also cut our weightings to euro area corporates, as well as to all emerging market hard currency debt (see the table on page 12, which shows the model bond portfolio changes that were made back on June 26th). The latter changes were necessary to maintain the relatively higher exposure to U.S. corporate debt versus non-U.S. corporates, although it does leave the model portfolio with a small overall underweight stance to global spread product (Chart 5). Importantly, we are maintaining a below-benchmark stance on overall portfolio duration, even as we grow more cautious on credit exposure. This is because we still see potential medium-term upward pressure on bond yields coming from tightening monetary policies (Fed rate hikes, ECB tapering of bond purchases) and increasing inflation expectations. The majority of global central bankers are dealing with tight labor markets and slowly rising inflation rates. While global growth has cooled a bit from the rapid pace seen in 2017, it has not been by enough to have policymakers shift to a more dovish bias. Throughout the first half of 2018, we have been deliberately targeting a modest tracking error for our model portfolio, given the historical richness (low yields, tight spreads) of so many parts of the global bond universe. Our estimate of the tracking error is now below the 40-60bp range that we have been targeting (Chart 6), but we are willing to live with this given the higher degree of uncertainty at the moment.5 Chart 5New Spread Product Allocation:##BR##Neutral U.S., Underweight Non-U.S. Chart 6Staying Defensive With##BR##The Risk Budget Importantly, the changes to our asset allocation recommendations should help boost the expected return of the model portfolio over the next year. In our Q1/2018 portfolio review published in April, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors. For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using recent historical yield betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis based on projected returns of each asset class in the model bond portfolio universe by making assumptions on those individual risk factors. Table 2AFactor Regressions Used To Estimate##BR##Spread Product Yield Changes Table 2BEstimated Government Bond Yield##BR##Betas To U.S. Treasuries With these tools, we can forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios, but with our current relative allocations. In Tables 3A & 3B. we show three differing scenarios, with all the following changes occurring over a one-year horizon. Table 3AScenario Analysis For The GFIS Model Portfolio Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis Our Base Case: the Fed delivers another 100bps of rate hikes, the U.S. dollar rises +5%, oil prices rise by +10%, the VIX index increases by five points from current levels, and U.S. Treasury yields rise by 20-40bps across the curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by +10%, oil prices rise by +10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve. A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by -5%, oil prices fall by -20%, the VIX index increases by fifteen points from current levels and there is a modest bull steepening of the U.S. Treasury curve (in this scenario, the Fed puts the rate hiking cycle on hold because of a sharp selloff in U.S. financial markets). The top half of Table 3A shows the expected returns for all three scenarios under our more bullish asset allocation prior to the changes made on June 26th, while the bottom half shows the expected performance of the model portfolio after our downgrade to global spread product. Importantly, the model bond portfolio is now expected to outperform the custom benchmark index in not only the base case scenario (+25bps of outperformance) but also in the two alternative scenarios of a very hawkish Fed (+46bps) and a very dovish Fed (+6bps). Those positive outcomes are not surprising, given that all three scenarios have some degree of risk aversion (higher VIX) that would play into our now-reduced exposure to credit risk in the portfolio. Our negative view on duration risk (Chart 7) also helps boost excess returns versus the benchmark in two of the three scenarios. Interestingly, these outcomes all occur despite the fact that the portfolio is now running with a negative carry (i.e. a lower total yield versus the benchmark index) after the reduction in spread product exposure (Chart 8). Although given our views that market volatility, bond yields and credit spreads are more likely to move higher in the next 6-12 months, we think that carry considerations now play a secondary role in portfolio construction. The time to try and earn carry is during stable markets, not volatile markets. Chart 7The Model Portfolio Is Not Chasing Yield Chart 8Staying Below-Benchmark On Overall Duration Bottom Line: Our recent decision to downgrade overall spread product exposure, even as we maintain a below-benchmark duration stance, should help boost the expected alpha of the model portfolio over the next year. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start", dated April 10th 2018, available at gfis.bcareseach.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 For Italy, Germany & France, the bars have two colors since the portfolio weights were changed in mid-May, when we cut the recommended stance on Italy to underweight and raised the allocations to Germany & France as an offset. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Spread Product Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. 5 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Systemic, data-driven, political analysis is a "must-have" (and "nice to have" too!); Investment-relevant political analysis has to be data driven; Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on "beating the spread," not predicting the match winner; Focus on policymaker constraints, not their preferences; The median voter is the price maker in the political marketplace. Feature Since the launch of our Geopolitical Strategy service in 2012, BCA Research has made a simple proposition to financial professionals: political analysis is a vital tool in the investor toolbox. It may not be the most important tool, or the one used most frequently. But a toolbox without it is incomplete. At this year's BCA Investment Conference - taking place in Toronto from September 23-25 - I will lead a seminar that will introduce the attendees to the method and philosophy the Geopolitical Strategy team employs to generate geopolitical alpha. As an introduction to the seminar, this note focuses on five frequent myths about geopolitical forecasting. Myth Number 1: Getting Geopolitics Right Is A "Nice To Have, Not A Must Have" Some investors remain skeptical about the value of geopolitical analysis. The holdouts most frequently respond with a variation of "this analysis is a nice to have, but it is not a must have." In other words, investment-focused political analysis is seen as ancillary to the investment decision-making process. A tool to be used when an exogenous event threatens one's strategic decisions. Another way to put it is to say "we will call you when something blows up." Table 1Geopolitical Crises And SPX Returns Please don't. No need. If something does "blow up," just close your eyes and buy risk assets. Table 1 lists the major geopolitical crises since the Second World War. While the average peak-to-trough decline during a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis.1 To illustrate this trend, we have grafted the average S&P 500 return following past geopolitical crises on to the current equity bull market (Chart 1). The picture is encouraging and shows the market often grinds higher even if something does "blow up." BCA's Geopolitical Strategy takes a different approach to political analysis. We seek to understand the market-relevant interplay between global policy decisions. Rather than reacting to things "blowing up," we look to proactively predict the path of fiscal, monetary, and government policy. Take our fundamental view in 2018 that the resynchronization in global growth - the dominant market narrative in 2017 - would be interrupted by de-synchronization between U.S. and Chinese policy. The U.S. economy often dictates global monetary conditions given the dollar's status as the global reserve currency. However, China often influences global fiscal policy given its oversized contribution to global growth (Chart 2). In 2017, we argued with high conviction that U.S. fiscal policy would turn stimulative, thus encouraging the Fed to hike rates at a faster pace than investors expected.2 We also argued that Chinese policymakers would continue to double-down on growth-constraining structural reforms.3 The interplay of these two views would weigh on global growth, supercharge the U.S. economy relative to the rest of the world, and pull the U.S. dollar higher (Chart 3). Chart 1Buy Risk If Something Blows Up Chart 2China Makes The World Go Round Chart 3Political Analysis Predicted This Would Happen We relied minimally on economic data in making this strategic market call. In fact, for much of 2017, economic data was not supporting our out-of-consensus view. There were few indications of a slowdown in China and the U.S. dollar kept facing headwinds. Instead, we relied on a high conviction view that politics would be stimulative to growth in the U.S. and restrictive to Chinese growth.4 This allowed us to: Recommend a high-conviction "Long U.S. Dollar Index (DXY)" view on January 31, 2018 - up 5.90% since initiation; Recommend a "Long Developed Markets Equities / Short Emerging Markets Equities" view on March 6, 2018 - up 12.09% since initiation; Recommend a "Long Indian Equities / Short Brazilian Equities" view on March 6, 2018 - up 36.40% since initiation; Recommend that clients overweight U.S. equities relative to Europe and Japan in January 2018; Highlight in April that U.S. equities would face headwinds this summer and investors should be tactically cautious. These views have now become the House View of BCA Research as a whole.5 Prescient political analysis is indeed a "nice to have." Myth Number 2: Political Data Is Useless The second-most frequent claim by geopolitical Luddites is that political data is of poor quality and thus systematic research is impossible. Our favorite two examples of this shortcoming are the Brexit referendum and the 2016 U.S. election, which polls supposedly "got wrong." But the polls did not get Brexit and President Trump's election wrong, the pundits did. If anything, the polls were showing the Brexit camp comfortably ahead throughout June 2016. It was only once MP Jo Cox was tragically murdered on June 16, a week ahead of the vote, that the polls favored the "Stay" vote. But on the day of the vote, the "Stay" camp was ahead by only 4%, well within the statistical "margin of error."6 That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit occurring, in other words, should have been a lot higher than the 30% imbued by the betting markets (Chart 4). We made a case for alarm early in 2016 based on a fundamental analysis of the British electorate.7 Chart 4AOnline Betting Got Brexit Wrong... Chart 4B... Not The Polls Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory despite her slim poll lead on the day of the election. What modelers missed is the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for President Obama, and the presence of third-party challengers. We addressed these, as well as Trump's successful "White Hype" strategy, early on in the electoral process.8 The truth is that there is an incredible wealth of political data, but investors are not familiar with it because we have become over-professionalized in our own discipline. Polling agencies, political science academics, non-governmental organizations, all provide investors with an incredible array of historical data. Some of it is of poor quality, some of it is solid. But dismissing it all outright in favor of punditry, op-eds, and the whispers of "wise old men," is folly. More recently we relied on a Pew Research survey that began in 1976 to correctly forecast that there are very few genuine fiscal conservatives in America (Chart 5). This was a critical part of our forecast, last year, that the members of the Freedom Caucus - ideologically allied with the precepts of the Tea Party revolution - would vote in favor of a massively profligate tax cut. In fact, it was Freedom Caucus members who first supported President Trump's plan to pass non-revenue neutral tax cut. Chart 5Data Told Us That America's Fiscal Conservatism Is Optional Another notable example is our long-held assertion that the world is multipolar and thus more likely to face paradigm shifts in terms of security and trade policy (Chart 6).9 To drive this point home, we have relied on our Geopolitical Power Index (GPI). To construct our GPI, we enhanced the classic National Capability Index (NCI), which was originally created by political scientists in 1963 for the Correlates of War project. Chart 6BCA's Geopolitical Power Index Illustrates A Multipolar World Political data is all around us. Just because it is not served on a platter - or accessible on a Bloomberg Terminal - does not make it useless. Myth Number 3: One Cannot Predict Politics In sports betting, gamblers are not trying to predict the outcome of a game. To be a successful gambler, one has to be agnostic to the ultimate winner. In other words, you cannot be a fan and a gambler at the same time. Instead, the goal is to "beat the spread" or choose an "over/under" on the "line" set by the casino. This is precisely what we do for a living. We do not forecast politics. We try to "beat the spread" on political outcomes set by the ultimate bookie, the market. Take our Brexit forecast. In March of 2016, we argued the probability of Brexit was closer to 50% than the 30% that was priced-in by the currency markets. Did we actually forecast that Brexit would happen? No. We argued a week ahead of the vote that Bremain would win a tight referendum. Swing and a miss, right? Wrong. Our clients do not pay us to make political forecasts. They expect us to make market forecasts. We correctly forecasted that the U.K. currency, gilts, and equity markets were not pricing in the higher-than-expected odds of a Brexit outcome. Occasionally both our political and market calls will be correct. For example, we had an extremely high conviction view that Marine Le Pen would not be able to win the French election in 2017.10 The combination of Brexit and the U.S. presidential election had bid up the probability of an anti-establishment outcome in France. Investors were imbuing an extremely erroneous conditional relationship between political outcomes in those two Anglo-Saxon countries and France. But our net assessment, made in early 2016, was that populist outcomes were far more likely in laissez-faire economies than in continental Europe, where expensive social welfare states acted as political social shock absorbers.11 Generating geopolitical alpha is the art of finding overstated and understated geopolitical risks in capital markets. Therefore, whether predicting politics is possible is an irrelevant question. The fact is capital markets are constantly pricing geopolitical risk. We believe it is our job to unearth when the market is mispricing these risks. Myth Number 4: ______ (INSERT POLITICIAN NAME) Is Unpredictable Several of our clients have pointed out that trying to forecast President Trump's policies is impossible. He is erratic, emotional, and bound to make gross errors in judgement. Another set of clients believes, with a high conviction, he is a deal-making businessman obsessed with the performance of the equity market. Yet a third group holds both views at the same time! What do we think? Nothing. We have no view on President Trump's preferences. We are indifferent and aloof of them. The fundamental precept of our method is that constraints are the superior predictor of human behavior, rather than preferences. Preferences are optional and subject to constraints. Constraints are neither optional nor subject to preferences. This is not just a neat mantra we repeat at the onset of every meeting with a prospective client. As Lee Ross and Richard Nisbett discuss in their classic of social psychology, The Person and the Situation, the context and the situation are often more important than the person themselves. In other words, what (if anything) you had for breakfast matters more for whether you were grumpy this morning than your personality traits, education, religion, and usual disposition.12 The policy path of least resistance will be bound by constraints. When faced with rigid and material constraints, predicting policymaker action is easy and our conviction is high. Take the behavior of the Greek leaders in 2015. We had a high conviction view that their political, economic, financial, and geopolitical constraints would force Athens to accept the EU's loan conditionality. In the "Game of Chicken" between Prime Minister Alexis Tsipras and Chancellor Angela Merkel, the former was riding a tricycle, while Frau Merkel was behind the wheel of a Mercedes Benz G-Wagen (Diagram 1). We therefore assigned an extremely low probability of "Grexit" even following the Greek electorate's rejection of bailout conditionality in the June 2015 referendum.13 Diagram 1ARegular Game Of Chicken Diagram 1BGreece Versus Euro Area 2015 On the other hand, policymaker optionality increases when constraints are low. Following President Trump's victory in November 2016, we penned a report that correctly forecast the next 18 months of his presidency by purely focusing on what aspects of executive power were poorly bound by constraints.14 We particularly pointed out the U.S. Congress has given up its constitutional power over tariffs through successive legislative acts (Table 2). Table 2Trump Lacks Legal Constraints On Trade Issues When constraints on policymakers are low - as is the case with Trump and protectionism - investors are tempted to fall back on preference-based forecasting. This is folly. Nobody knows what Trump really wants. No private sector institution has the necessary human intelligence (HUMINT) that would produce a statistically significant forecast of President Trump's behavior. As such, when constraints are unclear or low, investors should prepare for volatility at best, downside risks at worst. Myth Number 5: Politicians Are Price Makers The most important constraint to policymakers is the public - particularly in a democracy, but not exclusively. The public can revolt through the ballot box, tweets, or with pitchforks. As such, policymakers drain their political capital by pursuing policies that are not aligned with the "median voter." The "Median Voter Theory" is one of the few genuine theories of political science.15 It argues that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Empirical work since the 1950s has both confirmed and challenged the theory, but the fact that every U.S. presidential election concludes with a mad dash to the "center" proves it has merits. That said, the median voter is not always a centrist. First, there are multiple political issues on which there exists a median voter. The job of a successful politician is to identify the most salient issue of the day and then gauge where the median voter sits on that issue. President Trump successfully identified "the issue" of the 2016 election globalization and where the American median voter sits on the topic. The American median voter is far less supportive of globalization and free trade than was previously assumed (Chart 7). By focusing on trade, President Trump forced his opponent, Secretary Clinton, and subsequently members of his pro-business, pro-free trade, Republican Party, to swing against globalization. Chart 7America Belongs To The Anti-Globalization Bloc To this day, investors continue to believe that the median voter will come to the rescue of globalization and free trade. The conventional view is that U.S. voters will revolt once the price of T-shirts, toaster ovens, and toys go up 10-15% at the local Walmart store. We vociferously disagree. The median voter is far less supportive of globalization. And ultimately, it is the median voter who sets the price in the political marketplace, policymakers are merely price takers. As such, investors should focus on the preferences of the median voter as they form the constraint matrix that policymakers have to navigate. Putting It All Together Investment-relevant political analysis is not a science. Data is of varying quality, theory is rarely foolproof, and confidence intervals are wide. However, investing is not a science either. If it were, finance and economics PhDs would be, on average, significantly wealthier than their less educated counterparts in the financial industry (they are not).16 Investors should not throw up their hands and ignore politics altogether just because of the disciplinary limitations of geopolitical analysis. By tweaking some key precepts of political science to fit the necessities of the financial industry, we have developed a set of "best practices" - if not exactly a scientific method - through which we have made geopolitical analysis investment-relevant. Ultimately, the key to sober and investment-relevant geopolitical analysis begins with the right state of mind. The job of an investor is not to predict what should happen or who will emerge victorious. Our job is much simpler: find inefficiencies in the market's pricing of geopolitical events and trends, and generate geopolitical alpha. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17 2018, available at gps.bcaresearch.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 6 Given that the Brexit referendum was a "one off" and without precedent, the margin of error should have been wide to begin with. 7 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 12 Please see our book review of this seminal work in our February 2014 Monthly Report. Lee Ross and Richard Nisbett, The Person and the Situation - Essential Contributions of Social Psychology, (London: Pinter & Martin, 2011). 13 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 15 The Median Voter Theory was in fact first posited by economist Harold Hotelling in his 1929 article "Stability in Competition." His en passant comment in an article otherwise focused on business decision-making remains prescient today. Please see "Stability in Competition," Economic Journal 39 (1929), pp. 41-57. For subsequent treatments of the concept in political science, please see Duncan Black, "On The Rationale of Group Decision-Making," Journal of Political Economy 56 (1948), pp. 23-34; and Anthony Downs, An Economic Theory of Democracy (New York: Harper Collins, 1957). 16 Please see The Economist, "Why doing a PhD is often a waste of time," dated December 27, 2016, available at economist.com.

Special Report

Highlights Systemic, data-driven, political analysis is a "must-have" (and "nice to have" too!); Investment-relevant political analysis has to be data driven; Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on "beating the spread," not predicting the match winner; Focus on policymaker constraints, not their preferences; The median voter is the price maker in the political marketplace. Feature Since the launch of our Geopolitical Strategy service in 2012, BCA Research has made a simple proposition to financial professionals: political analysis is a vital tool in the investor toolbox. It may not be the most important tool, or the one used most frequently. But a toolbox without it is incomplete. At this year's BCA Investment Conference - taking place in Toronto from September 23-25 - I will lead a seminar that will introduce the attendees to the method and philosophy the Geopolitical Strategy team employs to generate geopolitical alpha. As an introduction to the seminar, this note focuses on five frequent myths about geopolitical forecasting. Myth Number 1: Getting Geopolitics Right Is A "Nice To Have, Not A Must Have" Some investors remain skeptical about the value of geopolitical analysis. The holdouts most frequently respond with a variation of "this analysis is a nice to have, but it is not a must have." In other words, investment-focused political analysis is seen as ancillary to the investment decision-making process. A tool to be used when an exogenous event threatens one's strategic decisions. Another way to put it is to say "we will call you when something blows up." Table 1Geopolitical Crises And SPX Returns Please don't. No need. If something does "blow up," just close your eyes and buy risk assets. Table 1 lists the major geopolitical crises since the Second World War. While the average peak-to-trough decline during a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis.1 To illustrate this trend, we have grafted the average S&P 500 return following past geopolitical crises on to the current equity bull market (Chart 1). The picture is encouraging and shows the market often grinds higher even if something does "blow up." BCA's Geopolitical Strategy takes a different approach to political analysis. We seek to understand the market-relevant interplay between global policy decisions. Rather than reacting to things "blowing up," we look to proactively predict the path of fiscal, monetary, and government policy. Take our fundamental view in 2018 that the resynchronization in global growth - the dominant market narrative in 2017 - would be interrupted by de-synchronization between U.S. and Chinese policy. The U.S. economy often dictates global monetary conditions given the dollar's status as the global reserve currency. However, China often influences global fiscal policy given its oversized contribution to global growth (Chart 2). In 2017, we argued with high conviction that U.S. fiscal policy would turn stimulative, thus encouraging the Fed to hike rates at a faster pace than investors expected.2 We also argued that Chinese policymakers would continue to double-down on growth-constraining structural reforms.3 The interplay of these two views would weigh on global growth, supercharge the U.S. economy relative to the rest of the world, and pull the U.S. dollar higher (Chart 3). Chart 1Buy Risk If Something Blows Up Chart 2China Makes The World Go Round Chart 3Political Analysis Predicted This Would Happen We relied minimally on economic data in making this strategic market call. In fact, for much of 2017, economic data was not supporting our out-of-consensus view. There were few indications of a slowdown in China and the U.S. dollar kept facing headwinds. Instead, we relied on a high conviction view that politics would be stimulative to growth in the U.S. and restrictive to Chinese growth.4 This allowed us to: Recommend a high-conviction "Long U.S. Dollar Index (DXY)" view on January 31, 2018 - up 5.90% since initiation; Recommend a "Long Developed Markets Equities / Short Emerging Markets Equities" view on March 6, 2018 - up 12.09% since initiation; Recommend a "Long Indian Equities / Short Brazilian Equities" view on March 6, 2018 - up 36.40% since initiation; Recommend that clients overweight U.S. equities relative to Europe and Japan in January 2018; Highlight in April that U.S. equities would face headwinds this summer and investors should be tactically cautious. These views have now become the House View of BCA Research as a whole.5 Prescient political analysis is indeed a "nice to have." Myth Number 2: Political Data Is Useless The second-most frequent claim by geopolitical Luddites is that political data is of poor quality and thus systematic research is impossible. Our favorite two examples of this shortcoming are the Brexit referendum and the 2016 U.S. election, which polls supposedly "got wrong." But the polls did not get Brexit and President Trump's election wrong, the pundits did. If anything, the polls were showing the Brexit camp comfortably ahead throughout June 2016. It was only once MP Jo Cox was tragically murdered on June 16, a week ahead of the vote, that the polls favored the "Stay" vote. But on the day of the vote, the "Stay" camp was ahead by only 4%, well within the statistical "margin of error."6 That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit occurring, in other words, should have been a lot higher than the 30% imbued by the betting markets (Chart 4). We made a case for alarm early in 2016 based on a fundamental analysis of the British electorate.7 Chart 4AOnline Betting Got Brexit Wrong... Chart 4B... Not The Polls Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory despite her slim poll lead on the day of the election. What modelers missed is the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for President Obama, and the presence of third-party challengers. We addressed these, as well as Trump's successful "White Hype" strategy, early on in the electoral process.8 The truth is that there is an incredible wealth of political data, but investors are not familiar with it because we have become over-professionalized in our own discipline. Polling agencies, political science academics, non-governmental organizations, all provide investors with an incredible array of historical data. Some of it is of poor quality, some of it is solid. But dismissing it all outright in favor of punditry, op-eds, and the whispers of "wise old men," is folly. More recently we relied on a Pew Research survey that began in 1976 to correctly forecast that there are very few genuine fiscal conservatives in America (Chart 5). This was a critical part of our forecast, last year, that the members of the Freedom Caucus - ideologically allied with the precepts of the Tea Party revolution - would vote in favor of a massively profligate tax cut. In fact, it was Freedom Caucus members who first supported President Trump's plan to pass non-revenue neutral tax cut. Chart 5Data Told Us That America's Fiscal Conservatism Is Optional Another notable example is our long-held assertion that the world is multipolar and thus more likely to face paradigm shifts in terms of security and trade policy (Chart 6).9 To drive this point home, we have relied on our Geopolitical Power Index (GPI). To construct our GPI, we enhanced the classic National Capability Index (NCI), which was originally created by political scientists in 1963 for the Correlates of War project. Chart 6BCA's Geopolitical Power Index Illustrates A Multipolar World Political data is all around us. Just because it is not served on a platter - or accessible on a Bloomberg Terminal - does not make it useless. Myth Number 3: One Cannot Predict Politics In sports betting, gamblers are not trying to predict the outcome of a game. To be a successful gambler, one has to be agnostic to the ultimate winner. In other words, you cannot be a fan and a gambler at the same time. Instead, the goal is to "beat the spread" or choose an "over/under" on the "line" set by the casino. This is precisely what we do for a living. We do not forecast politics. We try to "beat the spread" on political outcomes set by the ultimate bookie, the market. Take our Brexit forecast. In March of 2016, we argued the probability of Brexit was closer to 50% than the 30% that was priced-in by the currency markets. Did we actually forecast that Brexit would happen? No. We argued a week ahead of the vote that Bremain would win a tight referendum. Swing and a miss, right? Wrong. Our clients do not pay us to make political forecasts. They expect us to make market forecasts. We correctly forecasted that the U.K. currency, gilts, and equity markets were not pricing in the higher-than-expected odds of a Brexit outcome. Occasionally both our political and market calls will be correct. For example, we had an extremely high conviction view that Marine Le Pen would not be able to win the French election in 2017.10 The combination of Brexit and the U.S. presidential election had bid up the probability of an anti-establishment outcome in France. Investors were imbuing an extremely erroneous conditional relationship between political outcomes in those two Anglo-Saxon countries and France. But our net assessment, made in early 2016, was that populist outcomes were far more likely in laissez-faire economies than in continental Europe, where expensive social welfare states acted as political social shock absorbers.11 Generating geopolitical alpha is the art of finding overstated and understated geopolitical risks in capital markets. Therefore, whether predicting politics is possible is an irrelevant question. The fact is capital markets are constantly pricing geopolitical risk. We believe it is our job to unearth when the market is mispricing these risks. Myth Number 4: ______ (INSERT POLITICIAN NAME) Is Unpredictable Several of our clients have pointed out that trying to forecast President Trump's policies is impossible. He is erratic, emotional, and bound to make gross errors in judgement. Another set of clients believes, with a high conviction, he is a deal-making businessman obsessed with the performance of the equity market. Yet a third group holds both views at the same time! What do we think? Nothing. We have no view on President Trump's preferences. We are indifferent and aloof of them. The fundamental precept of our method is that constraints are the superior predictor of human behavior, rather than preferences. Preferences are optional and subject to constraints. Constraints are neither optional nor subject to preferences. This is not just a neat mantra we repeat at the onset of every meeting with a prospective client. As Lee Ross and Richard Nisbett discuss in their classic of social psychology, The Person and the Situation, the context and the situation are often more important than the person themselves. In other words, what (if anything) you had for breakfast matters more for whether you were grumpy this morning than your personality traits, education, religion, and usual disposition.12 The policy path of least resistance will be bound by constraints. When faced with rigid and material constraints, predicting policymaker action is easy and our conviction is high. Take the behavior of the Greek leaders in 2015. We had a high conviction view that their political, economic, financial, and geopolitical constraints would force Athens to accept the EU's loan conditionality. In the "Game of Chicken" between Prime Minister Alexis Tsipras and Chancellor Angela Merkel, the former was riding a tricycle, while Frau Merkel was behind the wheel of a Mercedes Benz G-Wagen (Diagram 1). We therefore assigned an extremely low probability of "Grexit" even following the Greek electorate's rejection of bailout conditionality in the June 2015 referendum.13 Diagram 1ARegular Game Of Chicken Diagram 1BGreece Versus Euro Area 2015 On the other hand, policymaker optionality increases when constraints are low. Following President Trump's victory in November 2016, we penned a report that correctly forecast the next 18 months of his presidency by purely focusing on what aspects of executive power were poorly bound by constraints.14 We particularly pointed out the U.S. Congress has given up its constitutional power over tariffs through successive legislative acts (Table 2). Table 2Trump Lacks Legal Constraints On Trade Issues When constraints on policymakers are low - as is the case with Trump and protectionism - investors are tempted to fall back on preference-based forecasting. This is folly. Nobody knows what Trump really wants. No private sector institution has the necessary human intelligence (HUMINT) that would produce a statistically significant forecast of President Trump's behavior. As such, when constraints are unclear or low, investors should prepare for volatility at best, downside risks at worst. Myth Number 5: Politicians Are Price Makers The most important constraint to policymakers is the public - particularly in a democracy, but not exclusively. The public can revolt through the ballot box, tweets, or with pitchforks. As such, policymakers drain their political capital by pursuing policies that are not aligned with the "median voter." The "Median Voter Theory" is one of the few genuine theories of political science.15 It argues that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Empirical work since the 1950s has both confirmed and challenged the theory, but the fact that every U.S. presidential election concludes with a mad dash to the "center" proves it has merits. That said, the median voter is not always a centrist. First, there are multiple political issues on which there exists a median voter. The job of a successful politician is to identify the most salient issue of the day and then gauge where the median voter sits on that issue. President Trump successfully identified "the issue" of the 2016 election globalization and where the American median voter sits on the topic. The American median voter is far less supportive of globalization and free trade than was previously assumed (Chart 7). By focusing on trade, President Trump forced his opponent, Secretary Clinton, and subsequently members of his pro-business, pro-free trade, Republican Party, to swing against globalization. Chart 7America Belongs To The Anti-Globalization Bloc To this day, investors continue to believe that the median voter will come to the rescue of globalization and free trade. The conventional view is that U.S. voters will revolt once the price of T-shirts, toaster ovens, and toys go up 10-15% at the local Walmart store. We vociferously disagree. The median voter is far less supportive of globalization. And ultimately, it is the median voter who sets the price in the political marketplace, policymakers are merely price takers. As such, investors should focus on the preferences of the median voter as they form the constraint matrix that policymakers have to navigate. Putting It All Together Investment-relevant political analysis is not a science. Data is of varying quality, theory is rarely foolproof, and confidence intervals are wide. However, investing is not a science either. If it were, finance and economics PhDs would be, on average, significantly wealthier than their less educated counterparts in the financial industry (they are not).16 Investors should not throw up their hands and ignore politics altogether just because of the disciplinary limitations of geopolitical analysis. By tweaking some key precepts of political science to fit the necessities of the financial industry, we have developed a set of "best practices" - if not exactly a scientific method - through which we have made geopolitical analysis investment-relevant. Ultimately, the key to sober and investment-relevant geopolitical analysis begins with the right state of mind. The job of an investor is not to predict what should happen or who will emerge victorious. Our job is much simpler: find inefficiencies in the market's pricing of geopolitical events and trends, and generate geopolitical alpha. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17 2018, available at gps.bcaresearch.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 6 Given that the Brexit referendum was a "one off" and without precedent, the margin of error should have been wide to begin with. 7 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 12 Please see our book review of this seminal work in our February 2014 Monthly Report. Lee Ross and Richard Nisbett, The Person and the Situation - Essential Contributions of Social Psychology, (London: Pinter & Martin, 2011). 13 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 15 The Median Voter Theory was in fact first posited by economist Harold Hotelling in his 1929 article "Stability in Competition." His en passant comment in an article otherwise focused on business decision-making remains prescient today. Please see "Stability in Competition," Economic Journal 39 (1929), pp. 41-57. For subsequent treatments of the concept in political science, please see Duncan Black, "On The Rationale of Group Decision-Making," Journal of Political Economy 56 (1948), pp. 23-34; and Anthony Downs, An Economic Theory of Democracy (New York: Harper Collins, 1957). 16 Please see The Economist, "Why doing a PhD is often a waste of time," dated December 27, 2016, available at economist.com.

Special Report

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Anastasios Avgeriou, Vice President U.S. Equity Strategy An exploitable market- and industry-neutral opportunity has surfaced to generate alpha by going long the S&P homebuilding index/short the S&P REITs index. This ratio has only recently reclaimed its upward sloping long-term time trend, leaving ample room for additional gains as the business cycle is long in the tooth (Chart 1). Chart 1Ratio Is Only Back To Trend Line Four key pillars form the thesis for this intra-real estate pair trade: Favorable macro tailwinds for residential vs. commercial real estate (prices, credit, interest rates), Firm relative demand dynamics, Supportive relative supply backdrop, Compelling relative valuations and technicals. Of Prices, Credit And Rates... Commercial real estate (CRE) is in a slightly different stage of the real estate cycle than its brethren, the residential real estate sector. Chart 2 shows that real CRE prices have overtaken the previous top, whereas house prices deflated by inflation remain significantly below the 2006 zenith. In nominal terms, CRE prices are one standard deviation above the previous high, while residential real estate prices just recently made all-time highs. This makes the CRE sector extremely vulnerable, as there is no cushion for any potential mishap. Importantly, our CRE occupancy rate composite has peaked for the cycle and is actually contracting, warning that CRE prices will likely suffer the same fate (bottom panel, Chart 3). The residential occupancy rate is the mirror image of the CRE one. Not only are new plus existing home inventories extremely tight by historical standards in the housing market, but the ultra-low vacancy rate is also a harbinger of additional house price gains in the coming months (top two panels, Chart 3). Chart 2Trade Opportunity In Diverging... Chart 3...Real Estate Markets As with every bubble, ultra-cheap credit has fueled the excesses in the CRE sector. Total CRE credit outstanding has ballooned to over $2.1tn, and comprises more than half of the commercial banks' overall real estate loan portfolios (Chart 4). While CRE loan growth is no longer galloping north of 10%/annum, it is still expanding. The stock of residential real estate loans on U.S. commercial bank's balance sheets also hit fresh all-time highs recently, but CRE dwarfs its residential cousin both in growth and level terms. Real estate investors know all too well that, ultimately, rising interest rates prick bubbles and the specter of tightening monetary policy concentrates minds. While both sectors will suffer from rising interest rates, given that the excesses this cycle are concentrated in CRE, in a relative sense, residential real estate is more insulated from a hawkish Fed (Chart 5). Keep in mind that housing was at the epicenter of the Great Recession, a once in a life time crisis, whose ramifications are still reverberating across the financial system one decade later. We doubt another big bust looms large in the residential real estate market. Chart 5 also shows that relative share prices are not only positively correlated with the fed funds rate, but also with the 10-year Treasury yield. True, rising 10-year interest rates filter right through to 30-year fixed mortgages denting housing affordability, but homebuilders are less sensitive to interest rates than REITs. Thus, a rising interest rate backdrop, which remains one of BCA's key themes for the year, is not detrimental to the relative share price ratio, but conducive to relative gains. In more detail, rising interest rates are likely to cause more pain in CRE than in the residential market, given the different starting points for delinquencies. Chart 6 shows a steep divergence between the two real estate sectors in their respective delinquency rates. In fact, since data is available, the CRE delinquency rate has never been lower than its current 0.75%. The Fed continues to raise interest rates, but some CRE borrowers are having trouble serviving this debt as rental income growth (for more details refer to the supply section below) is under pressure. Thus, delinquency rates, charge-offs and foreclosures will shoot higher. Chart 4CRE Excesses This Cycle Chart 5Higher Interest Rates Are A Boon For The Ratio Chart 6Unsustainably Low CRE Delinquencies What About Relative Demand... On the demand front, our comparative demand proxy also corroborates the positive correlation of relative share prices with interest rates. Rising interest rates deal a blow to refinancing mortgage applications, but do not prohibit first-time homebuyers from making one of the largest purchase decisions of their lives (Chart 7). Moreover, there is a preference switch that is gaining steam on the horizon. The own versus rent dilemma has likely hit a multi-decade nadir. Rising job certainty and wages at a time when the economy is at full employment argue for a switch out of rent and into home ownership. Already, the ratio of home owners to renters has gone from 1.7 to 1.8 in the past 18 months; yet, it is still hovering near a generationally low level. Put differently, only 64.2% of the housing stock are owners and 35.8% are renters. This differential remains depressed and if there is a modest renormalization toward the historical mean, the ratio would have to revert closer to 1.9, and thus further lift relative share prices (Chart 8). Chart 7Relative ##br##Demand... Chart 8...Gauges Favor Residential Vs.##br## Commercial Real Estate ...And Supply Backdrops? The relative supply backdrop also favors homebuilders versus REITs. Multi-family housing starts have been running near previous cyclical peak levels and 33% above the historical mean for the better part of the past five years adding roughly 2mn apartment units in aggregate. In contrast, single family home construction has been in recovery mode and continues to trail its historical average, with single family housing starts also adding a similar amount of units since 2013. To put this number in perspective, on average single family home construction should be triple multi-family starts (Chart 9). This construction backdrop does not bode well for CRE prices relative to residential real estate prices. Another related source of CRE pricing pressures are CRE rents. Rental income is in danger of stalling from this massive multi-family supply overhang and so is REITs cash flow growth. The opposite is happening in residential housing. Household formation is still running higher than housing starts, underscoring that recent house price inflation rests on a solid foundation. Chart 9Mind The Massive CRE Supply Overhang Chart 10Alluring Entry Point Compelling Entry Point One final reason why we are warming up to this pair trade is valuations and technicals. Relative value has been restored with our Valuation Indicator correcting to one standard deviation below the historical mean, offering investors a great reward/risk tradeoff. Similarly, technicals are no longer waving a red flag; our Technical Indicator has also unwound extremely overbought conditions and recently sunk below the neutral line (Chart 10). Risks To Monitor Chart 11Monitor This Risk Nevertheless, there are two key risks that can put our thesis, and thus the relative share price ratio, offside. While both sectors are 100% domestically geared and appear insulated from all the trade war / protectionism risks, homebuilders have to contend with rising input costs both in terms of building materials (lumber in particular, as well as concrete and steel), but also with rising construction-related wage inflation. REITs, in contrast, are free of both such risks. Most importantly, the Fed's Senior Loan Officer Survey is waving yellow flags. Both in terms of demand for respective loans and bankers' willingness to extend credit, CRE has the upper hand. While loan officers are tightening standards in CRE and mortgage loans, they are more prudent with credit origination in residential housing than in CRE. Similarly in a relative sense, bankers are reporting a steeper decline in demand for residential mortgages than for CRE loans (Chart 11). Adding it up, four key drivers - favorable macro tailwinds for residential versus commercial real estate on the price, credit and interest rate fronts, firming relative demand dynamics, supportive relative supply backdrop and appealing relative valuations and technicals - argue for opening a long S&P homebuilders/short S&P REITs pair trade. Bottom Line: Initiate a long S&P homebuilding/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. John Canally, Chief U.S. Investment Strategist Highlights Late in the business cycle, investors should remain overweight risk assets generally, as long as margins are still rising. A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector. The bar remains high for Q2 2018 EPS, but investors are already focused on 2019 and the impact of trade policy on corporate results. Economic surprise is rolling over as inflation surprise climbs. Feature U.S. equities prices rose last week as U.S.-China tariffs kicked in. The U.S. dollar and 10-year Treasury yields dipped, while oil and gold held steady to start the first quarter. Despite the relative calm, investors remain concerned about the impact of trade policy and rising labor and raw materials costs on corporate margins. BCA expects S&P 500 margins to peak later this year. In the next section of this report, we examine the performance of a broad range of asset classes after the economy reaches full employment. Higher labor and input costs, along with the impact of global trade disputes, will be key topics of discussion as the Q2 earnings seasons kicks off this week. We provide a preview later in this report. Market participants are also worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. We explore those concerns in the second section below. Although the June jobs report (see below) was mixed relative to consensus expectations, the Citigroup Economic Surprise Index (CESI) is poised to turn negative. In the final section of this week's report, we discuss how investors should positions as CESI troughs and how to prepare for the inevitable bounce higher. The rise in the U.S. unemployment rate to 4% in June is not the start of a new trend. The labor market continues to tighten and the FOMC is noticing (Chart 1, panels 1 and 2). Chart 1Don't Be Fooled By The Uptick##BR##In The U.S. Unemployment Rate The June Establishment Survey revealed a 213k rise in payrolls, along with upward revisions to the previous two months. The three-month average, at 211k, remains well above the underlying trend in labor force growth. In contrast, the Household Survey showed a more modest 102k increase in jobs in the month. Moreover, the number of people entering the workforce surged by 601k, which caused the unemployment rate to rise from 3.8% to 4%. We doubt this signals a trend change in the unemployment rate. The Household Survey is quite volatile relative to the Establishment Survey, suggesting that employment gains in the former are likely to catch up next month. The surge in the labor force in June could reflect the possibility that the tight labor market is finally drawing people into the workforce who were not previously looking for work. The participation rate rose by 0.2 percentage points to 62.9% (panel 4). However, this rate bounces around from month-to-month and is still in its post-2015 range. Moreover, the typical wave of college and high school students entering the workforce at this time of the year may have distorted the labor force figures due to seasonal adjustment problems. The real story is that the underlying labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. Average hourly earnings edged up by 0.2% m/m in June. The y/y rate held at 2.7% in the month, but the trend in wage growth remains up (panel 3). Moreover, the June non-manufacturing ISM report highlighted that economic momentum remains very strong, and the respondents' comments noted widespread building cost pressures related to labor shortages, rising commodity prices and a shortage of transportation capacity. China: It's Not 2015...Yet Investor concerns escalated last week over emerging markets and specifically China. Market participants are worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. BCA's Foreign Exchange Strategy's view1 is that Beijing is letting the CNY depreciate at a faster pace against the U.S. dollar for two reasons. First, it is a means to reflate the economy because the proposed U.S. tariffs on Chinese goods would inflict a non-negligible blow to China that would need to be softened if it materializes. Secondly, letting the yuan depreciate sends a message to the U.S.: China can weaponize its currency if necessary. Meanwhile, our China Investment Strategy service remains cautious on Chinese equities, but notes that the recent selloff in domestic stocks may be overdone (we remain neutral on the investable market).2 Chart 2China's Borrowing Costs Have Climbed... A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector, which would be very problematic for financial markets given our view that China has a higher pain threshold for stimulus than in the past. But tight monetary policy was a key driver of China's 2015 slowdown, and while monetary conditions have tightened since late-2016, they remain easier than what prevailed four years ago (Chart 2). There are key differences between 2015 and today from a U.S./global perspective as well. In late 2015, the dollar had moved up by 27% from its mid-2014 low, business capital spending was in freefall, credit spreads widened and oil dropped by over 50% year-over year. None of those conditions are currently in place. The key difference between 2015 and today is that three years ago there was no threat of a trade war with China, or the widespread imposition of protectionist measures more generally. Late Cycle Asset Return Performance Some of our economic and policy analysis over the past year has focused on previous late-cycle periods, especially those that occurred at the end of long expansions such as the 1980s, 1990s and the 2000s.3 Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment - NAIRU). This week we look at asset class returns during late-cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart 3). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM or a peak in the S&P 500 index itself. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table 1 (and Appendix) presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the next recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in margins to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart 3Profit Margins Peak Late##BR##In The Late Cycle Period Table 1Historical Returns; Average Of##BR##Late 1990s And Mid-2000s We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cycles the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a 6-12 month horizon. Similar to Treasuries, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasuries after margins peaked and into the recession. High-yield (HY) bonds followed a similar pattern, but suffered negative returns in absolute terms after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but after margins peaked relative performance was mixed. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value before and after margins peaked, but tended to outperform in the recessions. Dividend aristocrat returns performed well relative to the overall equity market after margins peaked and into the recession on average, but the performance is not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge funds are supposed to be able to perform well in any environment, but returns have been a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns are attractive across all periods and cycles, except for Timberland during recessions where the return performance was mixed. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The return analysis underscores that investing late in an economic cycle is risky because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears promising. Based on this approach, investors should remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investor should scale back in most of these areas as soon as margins peak, although they can hold onto Farmland, Timberland, structured products, real estate (including REITs) for a while after margins peak because it may not be as important to exit these areas before the next recession begins. For fixed income, investor should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. S&P 500 margins are still rising at the moment which, on its own, suggests that investors should be fully-exposed to all risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market (e.g. trade war, economic China slowdown, and EM economic and financial vulnerabilities). We are not yet ready to go underweight on risk assets, but the risk/reward balance at the moment suggests that risk tolerance should be no more than benchmark. Still Going Strong The consensus predicts a 21% year-over-year increase in the S&P 500's EPS in Q2 2018 versus Q2 2017, and 22% in calendar year 2018. Expectations are high; at the start of 2018, analysts projected 11% growth in Q2 and 12% in 2018. Energy, materials, technology and financials will lead the way in Q2 earnings growth, while real estate and utilities will struggle. Excluding the energy sector, the consensus expects a robust 18% increase in profits. The stout profit environment for Q2 2018 and the year ahead reflects sharply higher oil prices compared with Q2 2017, and the impact of last year's Tax Cut and Jobs Act on share buybacks and management confidence. However, global growth, which was a tailwind for S&P 500 results in 2017 and early 2018, has stalled. Moreover, rising costs for raw materials and labor will erode margins, but not until later this year. S&P 500 revenues are forecast to rise by 8% in Q2 2018 versus Q2 2017, matching the Q1 2018 year-over-year increase. The consensus expects a year-over-year gain in Q2 sales in all 11 sectors. Trade policy will continue to be at the forefront as managements discuss Q2 outcomes and provide guidance for 2H 2018 and beyond. In addition, capacity constraints, labor shortages and rising input costs will be key topics. Elevated corporate debt levels4 and climbing interest rates also will be debated as CEOs and CFOs provide guidance to Wall Street for Q3 2018 and beyond. Their counsel is more vital than the actual Q2 results. The markets probably have already priced in a robust 2018 earnings profile linked to the Tax Cut and Jobs Act, and are looking ahead to 2019 and 2020 (Chart 4). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 22% increase expected this year. Chart 4High Bar For 2018... But Focus Will Quickly Turn To 2019 At 9%, the consensus estimate for S&P 500 EPS growth in 2020 is too high (Chart 4). BCA's view5 is that the next recession in the U.S. will commence in 2020. Since 1980, S&P 500 profits have dwindled by 28%, on average, in the first year of a recession. Chart 5 (panel 1) shows that elevated readings on the ISM manufacturing index still provide a very favorable backdrop for S&P 500 profit growth in 2018. However, the top panel also illustrates that the index rarely stays above 60 (it was 60.2 in June), especially late in the business cycle. The ISM is a good proxy for S&P 500 forward earnings (panel 2) and sales (panel 3). The implication is that while the near-term environment for S&P 500 earnings and sales is solid, there is not much more upside. Chart 5Domestic Backdrop For S&P Profits In ''18 Still Looks Solid... Global growth is peaking despite the rosy domestic economic environment. At close to 3%, the consensus view of U.S. GDP growth in 2018 is still accelerating thanks to pro-cyclical fiscal, monetary and legislative policies in the U.S.6 However, in early April, analysts estimates for 2019 GDP growth in the U.S. reached a zenith at 2.5% and have since rolled over (Chart 6). The FOMC projects real GDP growth at 2.8% in 2018 and 2.4% in 2019.7 Meanwhile, global GDP growth estimates for 2018 began flattening near 3.5% in early April 2018, about a month after President Trump announced the first round of tariffs. Estimates for 2019 economic growth peaked in mid-May, near 3.25% (Chart 6). Chart 6Consensus GDP Estimates For U.S., World Are Rolling Over BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. The trade-weighted dollar is up by 2.5% year-to-date, and by 7% from its recent (February 2018) trough. Nonetheless, the dollar is down by 2% year-over-year and should not have a major impact on Q2 results. Furthermore, based on the minimal references to a robust dollar (only eight in the past eight Beige Books), the dollar probably will not be an issue for corporate profits in Q2 2018 (Chart 7). The handful of recent references is in sharp contrast with a surge in comments during 2015 and early 2016. The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The implication is that a robust dollar may get a few mentions during the earnings season, but those mentions will be drowned out by concerns over global trade. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically-focused corporations versus globally-oriented ones. Economic growth trends, discussed above, also play a role. Chart 8 shows that sales of domestically-oriented firms in the U.S. are still in a clear uptrend (panel 2). However, revenues of U.S. companies with a global focus stalled in recent quarters, even before the first round of tariffs were announced (panel 4). Margins at domestically-focused firms are still accelerating (panel 1), while margins at global businesses are topping out, albeit at a higher level than domestic ones. Moreover, since the start of 2017, the weaker dollar has allowed profit and sales gains of global corporations to rebound and outpace those companies with only domestic concerns. BCA expects that margins for S&P 500 companies will peak later this year. Investors are skeptical that S&P 500 margins can advance in Q2 2018 for the eighth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate and raw materials costs escalate. Bottom Line: BCA expects that the earnings backdrop will support equity prices in 2018 (Chart 9). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on the upcoming 2019 and 2020 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 9). In late June,8 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Chart 7The Dollar Should Not Be##BR##A Big Concern In Q2 Earnings Season Chart 8Global Sales,##BR##Margins Stalled... Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Look Out Below Citi's Economic Surprise Index (CESI) is poised to turn negative (Chart 10) after hitting a four-year high in late 2017. Since then, a harsh winter and early spring in the U.S., coupled with elevated expectations following the introduction of the tax bill, saw most economic data fall short of expectations. Moreover, a slowdown in global growth and uncertainty around U.S. and global trade policy negatively affected U.S. economic data in the spring and early summer months. Chart 10Citi Economic Surprise Poised To Turn Negative In our late March 2018 report,9 we noted that there have been six other episodes since 2011 when the CESI behaved similarly. These phases lasted an average of 96 days; the median number of days from peak to trough was 66 days. Moreover, in our March 2018 report we stated that a trough in CESI may be a month or two away, but there are no signs that has occurred. Table 2 illustrates the performance of key U.S. dollar-based investments, commodities and the dollar itself as the CESI moves from zero to its ultimate trough. We identified eight periods since 2010 when the CESI moved lower from zero. Table 2U.S. Stocks, Credit And Commodities As Economic Surprise Turns Negative On average, these episodes lasted 43 days, with the longest (81 days) in early 2015 and the shortest (13 days) in January-February 2013. During these phases, U.S. equities posted minimal gains and underperformed Treasuries (Chart 11). Moreover, investment-grade and high-yield credit tracked Treasuries, and there was little difference between the performance of small cap and large cap equities. Gold and oil struggled, while the dollar barely budged. Chart 11U.S. Financial Assets, Commodities And The Dollar As Economic Surprise Troughs While the CESI is rolling over, the Citigroup Inflation Surprise index is on the upswing (Chart 12). We identified seven stages when the CESI rolled over while the Citi Inflation Surprise Index: 2003-2004, 2007-2008, 2009, 2011, 2012-13, 2014 and this year. The late 2007 period is most similar to today; the other five episodes occurred either during early cycle (2003-2004, 2009 and 2011) or mid-cycle (2012-13 and 2014). In late 2007, the U.S. economy was in the late stages of an expansion, the unemployment rate was below full employment and the Fed was raising rates. The stock-to-bond ratio fell, credit underperformed Treasuries and gold and oil rose. Furthermore, small caps outperformed large caps, and the dollar fell (Chart 13). Chart 12Episodes Of Rising Inflation Surprise##BR##When Economic Surprise Is Falling Chart 13U.S. Financial Assets,##BR##Commodities And The Dollar As... Our work10 shows that these periods were associated with higher wage and compensation metrics, and higher realized core inflation. Moreover, these phases tended to occur when the economy was at full employment and the Fed funds rate was above neutral. The implication is that inflation indices are poised to move higher in the coming year, and prompt the Fed to continue to boost rates gradually at first, but then more aggressively starting in mid-2019. Bottom Line: The disappointing run of economic data is not over. Treasury bond yields will likely dip as the CESI troughs. However, the weakness in the economic data does not signal recession. We expect that the Inflation Surprise Index will continue to grind higher, while unemployment dips further into excess demand territory and oil prices rise. After the CESI forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb.11 Fed policymakers have signaled that they will not mind an overshoot of their 2% inflation target. However, because core PCE inflation is already at the Fed's target, the central bank will be slower to defend the stock market in the event of a swoon. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix 1 Please see BCA Research's Foreign Exchange Strategy Weekly Report "What Is Good For China Doesn't Always Help The World", published June 29, 2018. Available at fes.bcaresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report "Standing On One Leg", published July 5, 2018. Available at cis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Weekly Report "Till Debt Do Us Part", published May 8, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Third Quarter 2018: The Beginning Of The End", published June 29, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Line Up," published March 12, 2018. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180613.pdf 8 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways," published June 25, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Waiting", published March 26, 2018. Available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report "Wait A Minute", published May 28, 2018. Available at usis.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Solid Start," published January 8, 2018 and "The Revenge Of Animal Spirits," published October 30, 2017. Both available at usis.bcaresearch.com.

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Mathieu Savary, Foreign Exchange Strategist Highlights On a short-term basis, the dollar is massively overextended and is likely to experience a correction over the coming weeks. EM assets and currencies are the anti-dollar, and will benefit from these dynamics. As a result, oversold commodity currencies like the AUD, CAD, and NZD should be the main beneficiaries of a dollar correction within the G-10 FX space. However, this bout of dollar weakness is unlikely to mark the end of the greenback's 2018 rally. Global liquidity conditions remain very dollar bullish as the U.S. economy is absorbing liquidity from the rest of the world. This creates a scarcity of greenbacks in international markets. It is also dollar bullish because it weighs on the outlook for global growth, flattering the countercyclical nature of the USD. Gold should be the key gauge to judge whether these dynamics will be playing out as we foresee. Feature The last quarter was dominated by the dollar's strength and weakness in EM bonds; weakness that has now spread to EM equities. After such violent moves, it is now time to reflect and to try to understand what the second half of the year may have in store for the dollar. In our view, the dollar move has become overextended. As a result, we anticipate the dollar to experience a correction over the course of the coming months - a move that should benefit risk assets, and EM plays in particular. However, while this correction is likely to be playable for tactical traders, this does not spell the end of the dollar rally and EM selloff. The global liquidity backdrop supports a continuation of the trends seen over the past few months. Short-Term Momentum Extremes The vigor of the dollar rally this year along with the violence of EM bond, currency and equity selling has been eye-catching. However, we are seeing many signs that these moves may have become overdone on a short-term basis. Let's begin with EM assets. EM assets are very important due to their high sensitivity to global liquidity, global growth and the dollar. The market breadth of EM stocks is near its most oversold levels since the financial crisis. This suggests that commodity currencies are likely to experience a relief rally in the coming weeks (Chart I-1). In fact, both the MACD and 14-day RSI oscillators of EM stocks are corroborating this message, having hit some of their lowest levels since 2016 (Chart I-2). Such a rebound could be especially beneficial for the AUD, NZD, and CAD, as speculators have accumulated large short positions in these currencies (Chart I-3). Chart I-1EM Are ##br##Oversold Chart I-2EM Oscillators Point##br## To A Rebound Chart I-3More Reasons For The AUD ##br##And His Friends To Rebound The key for this rally to unfold will be U.S. dollar weakness - a correction that we feel is likely to materialize. From a technical perspective, our dollar capitulation index is currently flagging massively overbought conditions, a picture that our intermediate-term indicator also highlights (Chart I-4). Looking at the euro - the largest constituent of the DXY dollar index - provides a mirror image. The EUR/USD's intermediate-term momentum measure is flagging deeply oversold levels, and the paucity of up days in this pair over the recent month is also congruent with a temporary bottom (Chart I-5). In fact, shorter-term indicators like the MACD and 14-day RSI oscillators have not only reached deeply oversold readings, but have also recently begun to form positive divergences with the price of EUR/USD itself (Chart I-6). Chart I-4The Dollar Should Correct Chart I-5Euro Is The Anti-Dollar Chart I-6Positive Divergences In The Euro What could be a catalyst for a dollar correction that would also help EM assets and thus provide a welcome boost to the euro, and even more so commodity currencies? China obviously plays a key role. One of the crucial ingredients behind the recent generalized USD strength and selloff in EM-related plays has been the rapid fall in the yuan against the dollar. As we argued last week, this remains a key risk for the remainder of the year. However, we also prophesized that Beijing is concerned by the speed of the recent decline, and could try to manage the pace of CNY's fall for now.1 Early this week, the People's Bank of China began "open-mouth" operations in an effort to support the RMB, which seems to be putting a temporary floor under the renminbi. As long as the dam resists, the DXY's rally will pause. Additionally, the speed of the divergence between U.S. growth and the rest of the world has probably reached a short-term peak that will temporarily get reversed. As Chart I-7 illustrates, European, Japanese and Australian economic surprises are attempting to form a bottom, while U.S. ones have just moved below the zero line. Finally, the dollar is likely to lose one of its key supports from last quarter: the U.S. Treasury. As Chart I-8 illustrates, when the Treasury rebuilds its cash balances, the dollar does well. Essentially, through 2017, the Treasury was draining its cash balance ahead of the debt-ceiling standoff. By spending its stash of cash, the U.S. federal government was injecting reserves - in effect liquidity - into the banking system. After the debt-ceiling extension last September, the Treasury proceeded to rebuild its pile of funds, draining reserves and liquidity out of the banking system. This process is now over, and therefore this support for the dollar will continue to fade. Chart I-7Economic Surprises And The Dollar: ##br##From Friends To Foes Chart I-8The U.S. Treasury Is Done Rebalancing##br## Its Cash Balance Altogether, these dynamics are likely to cause the dollar to soften in the near term, especially since, as Dhaval Joshi highlighted in BCA's European Investment Strategy, currency market players are displaying a high degree of groupthink - as measured by the trade-weighted dollar's fractal dimension - and could easily be panicked by a defusing of the growth divergence theme (Chart I-9). Chart I-9Group Think In The Dollar = Hightended Risk Of Countertrend Bottom Line: The dominant trends of the second quarter - a strong dollar, weak commodity currencies and EM plays - are now crowded trades. With the Chinese monetary authorities trying to limit the speed of the CNY's decline, with economic surprises outside the U.S. finding a floor, and with the U.S. Treasury backing away from reducing liquidity in the banking system, a countertrend move across the dollar, EM assets, and commodity currencies is a growing possibility. Why A Countertrend Move And Not A New Trend? Our view remains that global growth has further room to decelerate, that investors have fully anticipated an increase in global inflation, and that the renminbi has greater downside. All these support our expectation that if a period of weakness in the dollar were to materialize this summer, it would be temporary.2 However, another factor plays a big role: The evolution of liquidity flows in the global economy. Essentially, at the core of this argument lies the fact that we worry that the continued growth outperformance of the U.S. along with the revival of animal spirits in this enormous economy will suck in dollar liquidity from the rest of the world. Not only will this create a scarcity of dollars, thus bidding up the price of the greenback in the process, but it will also hurt highly indebted EM economies - nations that have high dollar debts and thus need dollar liquidity to stay afloat (Chart I-10). To begin with, U.S. banks have been slowly increasing their lending to the U.S. private sector. The upsurge in business confidence, with the NFIB small business survey and the Duke CFO survey near record highs, along with the increase in U.S. capex, confirms the durability of this rebound. Additionally, U.S. households also have the wherewithal to increase their borrowings. Not only is household debt as a percentage of disposable income near a 15-year low but, most importantly, debt servicing costs as a percentage of disposable income remain at levels last seen in the early 1980s (Chart I-11). Moreover, banks are still easing their lending standards on mortgages - which represent nearly 70% of household credit - and mortgage quality as measured by FICO scores are still well above levels that prevailed prior to the financial crisis. Chart I-10EM Dollar Debt Is High EM##br## Have A Lot Of Dollar Debt Chart I-11U.S. Households Have The ##br##Wherewithal To Take On Debt This is important, because when banks increase their loan books, they run down their liquidity (Chart I-12). To be more specific, rising loan issuance results in banks selling securities on their balance sheets and running down their cash balances. As Chart I-13 illustrates, when the cash and security inventories of U.S. commercial banks decrease, the U.S. dollar rallies. This relationship was very strong from 1980 to 2008 but loosened for two years during the financial crisis. Since 2010, it has re-established itself. The probability is therefore high that it will remain in place, and be a dollar-bullish factor over the medium term. Chart I-12Rapid Loan Growth Means Less Liquid Chart I-13The Dollar Abhors Liquid Bank Balance Sheets Moreover, by looking at the holdings of securities on banks' balance sheets, we can see that since 2012, they have even provided a leading signal on the dollar. This relationship currently points toward additional dollar strength (Chart I-14). The tighter relationship between securities holdings and the dollar than between total liquidity on banks' balance sheets and the dollar is due to the fact that securities can be re-hypothecated, and therefore can create a much greater supply of dollars in offshore markets than cash alone. The dollar-bullish liquidity backdrop is not limited to banks' balance sheets alone. Long-term portfolio flows into the U.S. have increased substantially in recent months, but still remain well below previous peaks (Chart I-15, top panel). Moreover, as the U.S.'s growing energy independence has prevented the trade deficit from expanding, the American basic balance of payments is now back in positive territory (Chart I-15, bottom panel). This too suggests that the U.S. is absorbing more dollars than it is supplying to the global economy. Chart I-14Declining Security Holdings Of Banks##br## Point To A Surge In The Dollar Chart I-15Money Is Flowing##br## Out Of The U.S. This reality is mirrored by the link between the bond issuance of U.S. firms and the dollar. When U.S. businesses increase their issuance of bonds, this tends to result in a strong dollar and weak majors (Chart I-16). The vigor of the U.S. economy and the deregulatory tendencies of the Trump administration suggest that U.S. companies could continue to issue more bonds, which will drag more liquidity out of the rest of the world and support the dollar in the process. The profit repatriation initiated by President Trump's tax reform is also supportive of the dollar. As Chart I-17 illustrates, when U.S. entities repatriate funds from abroad, the dollar tends to strengthen. Today, they are doing so with more gusto than ever. It is important to remember that this is not a reflection of American firms necessarily buying dollars directly. After all, a lot of their foreign earnings are already held in USD. Instead, it reflects the fact that when U.S. firms bring back their dollars into the U.S., the supply of high-quality collateral available in offshore markets declines, which means that acquiring dollars becomes more expensive.3 Chart I-16Rising Bond Issuance Helps The Dollar Chart I-17Trump's Tax Repatriation Is Dollar Bullish Finally, this decline in dollar liquidity is starting to be felt abroad, a phenomenon magnified by the slowdown in global trade. Global reserves are not increasing as fast as they were in 2017. As a result, a key component of global dollar-based liquidity, the Federal Reserve's accumulation of custodial holdings of securities, is also declining fast - a decrease exacerbated by the fact that the Fed is curtailing the size of its own balance sheet (Chart I-18). Historically, a decline in dollar-based liquidity is not only associated with lower global growth and a stronger greenback, but also with falling EM asset prices, EM currencies, and commodity currencies. Gold prices will provide insight on whether global liquidity remains favorable to the dollar and negative for EM assets. As Chart I-19 illustrates, gold has already broken down an intermediate upward sloping trend line, but is rebounding against the primary trend in place since the early days of 2016. If this rebound peters off and gold breaks below this primary trend line, it will be a clear indication that the decline in liquidity outside the U.S. is having a nefarious impact on global growth. This headwind to global economic activity will support additional dollar strength and asset price weakness. Chart I-18Declinning Dollar Bond Liquidity Chart I-19Litmus Test For Liquidity Bottom Line: The dollar faces near-term downside risk, but this move is likely to prove to be countertrend in nature as the global liquidity backdrop remains dollar bullish. The U.S. economy is currently sucking in global liquidity from the rest of the world, which is creating a scarcity of dollars in offshore markets. Not only is this scarcity inherently dollar bullish, but it also weighs on global growth, further flattering the dollar - a currency that performs well when global growth softens. As a result, while short-term investors should hedge some of their long-dollar exposure over the coming weeks, longer-term investors should use this correction to accumulate more dollars in order to benefit from another leg of the dollar's rally this fall. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Reports, titled "What Is Good For China Doesn't Always Help The World", dated June 19, 2018, "Inflation Is In The Price", dated June 15, 2018, and "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: ISM manufacturing increased to 60.2 from 58.7; ISM prices paid declined to 76.8 from 79.5; Continuing and initial jobless claims both increased, disappointing expectations; Factory orders grew by 0.4% in monthly terms. After hitting deeply overbought levels, the dollar is losing momentum and risks correcting as economic surprises in the U.S. continue to decline while global ones are finding a floor, for now. Even if the dollar were to correct, budding inflationary pressures and higher growth in the U.S. are likely to prompt the Fed to hike at a faster rate than the rest of the developed world, providing the greenback with substantial upside. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 This Time Is NOT Different - May 25, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: Manufacturing PMI improved for Italy, declined for France and remained unchanged for Germany, while decreasing for the euro area as a whole; Euro area retail sales increased by 1.4%, less than the expected 1.5%; Speculations about the ECB's actions are causing substantial movements in markets. The French 5/30 yield curve flattened by about 30 bps at rumors of an "Operation Twist" by the ECB, following the end of the APP in December. However, the euro has remained stable for around a month now, suggesting that markets have already discounted a substantially easier monetary policy. Despite this, the current slowdown in global growth is likely to have a further detrimental effect on the euro. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth surprised to the upside, coming in at 1.3%. However, the Markit Services PMI came in at 51.4, underperforming expectations. Moreover, consumer confidence surprised to the downside, coming in at 43.7. USD/JPY has rallied by roughly 0.5% this past week. Overall we continue to be positive on the yen tactically, given that trade tensions as well as tightening in China should continue to create a risk-off environment where the yen thrives. However, on a longer term basis we maintain our bearish stance, as the BoJ will keep its ultra-dovish monetary policy in order to kick start Japan's moribund inflation. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: Mortgage approvals outperformed expectations, coming in at 64.526 thousand. Moreover, Construction PMI surprised to the upside, coming in at 53.1. Finally, Markit Services PMI also outperformed expectations, coming in at 55.1. GBP/USD has risen by roughly 1% since last week. Overall, we expect that cable will continue to depreciate, as any pullback in the dollar will likely be temporary. Nevertheless, the pound should outperform the euro, given that Europe will likely suffer more from emerging market weakness than the U.K. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was disappointing: The AiG Performance of Manufacturing Index declined slightly from 57.5 to 57.4; RBA Commodity Index in SDR terms grew by 6.6% only, less than the expected 7.5%; Building permits contracted by 3.2% on a monthly basis; The trade balance came out less than expected at AUD 827 million. In its latest monetary policy statement, the RBA highlighted that Australian monetary conditions have tightened, noting lower housing credit growth and tighter lending standards. As 85% of home loans are variable-rate mortgages, the highly indebted Australian households are extremely susceptible to a direct tightening in interest rates. Furthermore, wage growth at 2.1% and inflation at 1.9% implies a paltry 0.2% real wage growth, adding additional risk to household financial conditions. Alongside a clouded global growth outlook, the RBA is therefore unlikely to hike in this environment anytime soon. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has been relatively flat this week. Overall, even if a short-term bounce is likely over the coming weeks, we continue to be bearish on this cross, as commodity currencies like the NZD or the AUD should suffer in the current risk-off environment where liquidity is scarce. However, the New Zealand dollar will probably outperform the Australian dollar. After all, Australia is more exposed to the Chinese Industrial Cycle than New Zealand, being a large base metals exporter. Meanwhile, we remain bearish on the NZD on a longer term basis, as the new government will restrict immigration and implement a dual mandate for the RBNZ, both measures which will lower the neutral rate in New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Despite the rapid increase in oil prices, the Canadian dollar has not been able to keep up. NAFTA tensions are placing downward pressure on the loonie, despite the Canadian economy's rosy conditions. The most recent Business Outlook Survey by the BoC shows increasing economic activity with a robust sales outlook. In addition, capacity utilization is becoming ever tighter, with the amount of firms finding it difficult to meet unexpected demand at the highest level since the history of the data. Furthermore, the labor market continues to tighten, as hiring plans continue to trend upward. This is likely to keep the BoC somewhat hawkish, despite trade worries. The strength of the Canadian economy is therefore likely to lift the CAD above other G10 currencies this year, except against the greenback. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator outperformed expectations, coming in at 101.7. Moreover, the SVME PMI index also surprised to the upside, coming in at 61.6. However, retail sales yearly growth underperformed expectations, coming in at -0.1%. Finally, headline inflation came in line with expectations, coming in at 1.1%. EUR/CHF has risen by roughly 0.5% this week. Overall, we continue to be bullish on a tactical basis on the franc, given that trade tensions and the policy tightening in China should ultimately keep the current risk-off in place. That being said we are cyclically bearish on the CHF, as the SNB will continue to maintain an extraordinarily easy monetary policy stance in order to prevent an appreciating franc to prevent the Swiss central bank from reaching its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 1.8%. Moreover, registered unemployment continued to be very low at 2.2%, in line with expectations. USD/NOK has fallen by nearly 1% since last week, partly due to the rise in oil price, caused by a large draw in inventories. Overall we continue to be bullish on this cross, given that we maintain that the U.S. dollar will continue rising. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 A shift in stance at the Riksbank has been the major force behind the SEK's appreciation of around 2% against both USD and EUR in the past couple of days. The upward revision of CPIF inflation from 1.9% to 2.1% in both 2018 and 2019, and the downward revision of the unemployment rate were particularly important. In addition, three policymakers expressed hawkish views: Deputy Governors Flodén and Skingsley suggested a hike in October or December, while Ohlsson advocated for a higher repo rate of 25 bps now in response to stronger economic growth in both Sweden and abroad. Consistently, these members expressed similar opinions on the termination of foreign exchange interventions, as inflation is near its target. However, the underlying dovish intonations of Stegan Ingves still lurk within the Riksbank, presenting possible downside risk in the short-term. Nevertheless, these views support our longer-term bullish view of the SEK vis-à-vis the euro, based on diverging rate differentials. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Domino dynamics continue escalating within the EM universe confirming that a major bear market is underway. Several global cyclical market segments have recently experienced technical breakdowns. This confirms that global growth is slowing. It is not too late to short/sell EM risk assets. We reiterate the long Indian / short Chinese banks equity trade. Feature The selloff in global risk assets continues to exhibit a pattern of falling dominos. It began with the breakdown in the weakest spots of the EM world, Turkey and Argentina, and then spread to Brazil and Indonesia. Only weeks later it hit other vulnerable EM markets such as South Africa. During this period, north Asian stocks and currencies - Chinese, Korean and Taiwanese - displayed resilience. It was tempting to argue that the EM selloff was being driven by idiosyncratic risks and was limited to current account deficit countries vulnerable to U.S. Federal Reserve tightening. However, in recent weeks these north Asian markets have plunged - making the EM selloff largely broad-based and pervasive. In our June 14 report,1 we argued that major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. Since then, the domino effect has escalated confirming our bias that EMs are in a major bear market. Several important markets and cyclical market segments have recently broken down, and investors should heed messages from them: Copper prices fell below their 200-day moving average; they have also broken down the trading range that had persisted since last September (Chart I-1, top panel). The precious metals price index seems to be sliding through the floor of its trading range of the past 18 months (Chart I-1, bottom panel). Global cyclical equity sectors and sub-sectors such as mining, steel, chemicals and industrials have also broken their 200-day moving averages in absolute term (Chart I-2). They have also been underperforming the global equity index, which is consistent with the global trade slowdown that is beginning to escalate. Chart I-1Breakdown in Metals Prices Chart I-2Global Equities: Cyclicals Have Broken Down Although Chinese PMI data have not been particularly weak, anecdotal evidence from the ground suggests that the credit tightening of the past 18 months is taking its toll on China's financial system and economy. There are numerous reports about bankruptcies of Peer-to-peer lending platforms and struggles in other parts of the shadow banking system. The selloff in Chinese onshore A shares confirms this. Presently, this market has become less driven by retail investors as it was back in 2015. Hence, one can argue that portfolio managers on the mainland are selling their stocks because they believe economic conditions are worsening. Meanwhile, international investors have so far been more sanguine. Importantly, EM corporate and sovereign U.S. dollar bond yields are rising, heralding lower share prices (Chart I-3). Bond yields are shown inverted on this chart. The top panel is for EM overall and the bottom panel is for Asia only. Chart I-3EM Credit Markets Entail More Downside In EM Share Prices Chart I-4EM Versus U.S.: New Lows Lie Ahead Finally, the resilience of the U.S. equity index and corporate spreads has been due to robust domestic demand - the slowdown in global trade has not affected the U.S. However, odds are that the current global selloff continues to develop in a typical domino fashion. If so, the U.S. markets - equities and credit - will be the last dominos to fall but they will outperform their global peers. It is very unlikely that American stocks and credit markets will be able to sail through this EM storm unscathed. Notably, the resilience of the S&P 500 can be attributed to 10 large-cap stocks that are extremely overbought and likely expensive. This gives us more confidence to argue that this EM riot will meaningfully affect U.S. equity and credit markets. The link will be the U.S. dollar. The greenback will continue its unrelenting rally, which will trim U.S. multinationals' profits and weigh on the S&P 500. Bottom Line: EM risk assets are in a major bear market, and there is still a lot of downside. It is not too late to sell or underweight EM. This is despite EM's relative performance versus the S&P 500 is back to its early 2016 lows, as is the JP Morgan EM currency index (Chart I-4). News lows lie ahead. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018 available on page 17. Chart II-1More Upside In Long Indian/Short ##br##Chinese Bank Stocks Reiterating Long Indian / Short Chinese Banks Trade This week we revisit our long Indian / short Chinese banks trade that we initiated on January 17.1 The trade is up only 5.7% since inception (Chart II-1), and with more monetary policy easing occurring in China and the recent sharp rise in non-performing loans (NPL) in India, it is appropriate to reassess this recommendation. Having updated the stress tests on the largest public banks in both countries and performed a new stress test on five Indian private banks, we are reiterating our strategy of being long Indian / short Chinese banks. A Perspective On Credit Cycles In India And China Both India and China have gone through major credit binges over the past 10-15 years, albeit over different time periods (Chart II-2A and Chart II-2B). Chart II-2ACredit Boom Was Smaller In India...Than In China Chart II-2BCredit Boom Was Smaller In India...Than In China India's public banks have, in recent years, recognized bad loans and provisioned meaningfully for them. Non-performing loans (NPLs) for Indian public banks now stand at a whopping 15% of total outstanding loans, while provisioning levels have spiked to 7% of total loans (Chart II-3). Chart II-3NPLs And Their Provisions: India And China By comparison, Chinese public banks - the largest five banks, excluding policy banks, where the central government owns 70-80% of equity - are at the early stages of dealing with their troubled assets. Their NPLs and provisions stand at mere 1.8% and 3.3% of total outstanding loans, respectively (Chart II-3). Does such a wide disparity in NPL ratios between Chinese and Indian banks make sense? We do not think so. It is unlikely that Indian public banks are more poorly managed vis-a-vis Chinese public banks. All are run by government-appointed officials and are equally prone to politically driven and inefficient lending. Further, the magnitude of the Chinese credit boom since 2009 was considerably greater than India's during the 2003-2012 period. It is therefore highly unlikely that the resulting NPLs are substantially smaller in China than in India. In fact, several cases of Chinese banks hiding bad assets have recently been publicized.2 We strongly believe this phenomenon is widespread on the mainland, and that NPLs among Chinese public banks are being grossly underreported. It's All About Regulation The true vindication for this disparity lies in the drastically different stances that financial regulators in both countries have adopted to deal with the non-performing and stressed assets that their banks sit on. The Chinese authorities have been exhibiting greater forbearance with their commercial banks. For instance, in March, they lowered the provision coverage ratio for commercial banks. This is ameliorating Chinese commercial banks' short-term profitability and capitalization ratios. In brief, Chinese regulators have been very accommodative by allowing commercial banks to pursue "window dressing" of their financial statements and ratios. Indian regulators, by contrast, have been exerting relentless pressure on their banks to swiftly deal with their stressed assets at the cost of short-term profitability. For instance, the Reserve Bank of India (RBI) recently introduced an extremely stringent framework for the recognition and resolution of NPLs. Indian commercial banks now have to immediately recognize stressed assets and find a resolution within 180 days. Failure to resolve a stressed account forces banks to take the defaulter to court in order to initiate bankruptcy procedures. Bottom Line: India has taken painful measures to push its banks to clean up their balance sheets. By comparison, China has so far been kicking the can down the road with respect to its banking system. As a result, the banks' balance sheet cleansing cycle is much more advanced in India than in China. Public Banks Stress Tests Below we present our updated stress tests which we performed on India's top seven public banks and China's top five public commercial banks (excluding policy banks). We used the following assumptions in our analysis (Tables II-1 and II-2): Table II-1Stress Test Of Top 7 Indian Public Banks Table II-2Stress Test Of Top 5 Chinese Public Banks Indian non-performing risk-weighted assets (NPA) to rise to 16% (optimistic), 18% (baseline), and 19% (pessimistic), up from 15% currently. For China, we assume NPAs to rise to 10% (optimistic), 12% (baseline), and 13% (pessimistic), up from 1.6% currently. Provided the magnitude and duration of China's credit boom has considerably surpassed that of India, the assumption of this stress test that NPAs will rise to 12% in China but 18% in India implies that Chinese public banks allocated credit much better than their Indian peers. Hence, this exercise in no way favored Indian banks over Chinese ones. We used risk-weighted assets to calculate losses. Risk-weighting adjusts bank assets for their riskiness which in turn makes comparisons between the two banking systems more sensible. Finally, we assumed a 30% recovery ratio (RR) for both countries. The RR on Chinese banks' NPLs from 2001 to 2005 was 20%. This occurred amid much stronger nominal and real growth. Thus, a 30% RR rate today is not low. The outcome of the tests are as follows: Under the baseline scenario of 18% NPA in India and 12% NPA in China, losses post recovery and provisions amount to 1.8 trillion rupees in the former (1.3% of GDP) and RMB 3.3 trillion in the latter (3.9% of GDP) (Tables II-1 and II-2, column 6). These losses would impair 41% of equity capital in India and 44% in China (Tables II-1 and II-2, column 7). Adjusting the current price-to-book value (PBV) ratios for public banks in both countries to the equity impairment under the baseline scenario lifts their PBV ratios to 1.5 in India and 1.7 in China (Tables II-1 and II-2, column 8). Assuming a 1.3 fair PBV ratio3 for banks in both countries, Indian banks appear overvalued by 15% and Chinese banks by 29% (Tables II-1 and II-2, last column). In other words, after the recognition and provisioning of reasonable levels of NPA, Indian public banks appear less overvalued than their Chinese counterparts. These results make sense to us; Indian public banks have been provisioning aggressively for their troubled assets, and bad news is somewhat discounted in their share prices. Chart II-4Loan Write-Offs Have Been Much ##br##Greater In India Than In China Remarkably, Indian public banks have also been writing off more bad loans than their Chinese counterparts. Chart II-4 shows cumulated write-offs of these public banks in India and China since 2010. Bad asset write-offs have so far amounted to RMB 1.2 trillion in China and 3 trillion rupees in India. This is equivalent to 2% and 8% as a share of current risk-weighted assets, respectively. Another way to compare and analyze NPA cycles between two countries is to assess the progress that each country has made toward resolving the full amount of outstanding bad assets - i.e. a full NPA cycle. We define a full NPA cycle in the following way: Total NPA losses under our baseline scenario, plus cumulated past write-offs. In order to measure progress toward resolving the full NPA cycle, we take the ratio of the stock of provisions plus cumulated write-offs and divide that by the full NPA cycle losses (i.e. [provisions + write-offs] / full NPA cycle losses). In India, assuming that NPAs on its largest public banks reach 18% of risk weighted assets - then the full NPA cycle for India would amount to 9.4 trillion rupees, or 26% of current risk-weighted assets (i.e. 6.4 trillion rupees in NPA remaining plus 3 trillion in write-offs made). Meanwhile, India's public banks' progress amounts to 5.6 trillion rupees. This is equal to 60% of India's full NPA cycle. By contrast, Chinese public banks' full NPA cycle would amount to RMB 8 trillion (or 14% of risk-weighted assets) under our baseline scenario. Further, China's banks progress amounts to RMB 2.6 trillion. This is equivalent to only 33% of the full NPA cycle in China. Hence, Indian public banks are closer to their peak NPA cycle versus their Chinese counterparts. Note that this particular analysis assumes no recovery in bad loans in either country. Further, the above analysis does not attune for the fact that Chinese banks have more risky off-balance sheet assets than their Indian peers. Incorporating off-balance sheet assets and liabilities would make the stress tests much more favorable for Indian public banks relative to China. Stress Test For India's Private Banks Private banks are a part of our long Indian / short Chinese banks trade. Indian private banks are also not insulated from regulatory clean-up efforts. In recent years, these lenders significantly boosted their credit to the consumer and service sectors. Higher than normal defaults have not yet transpired but this is a scenario that cannot be ruled out given the frantic pace of lending (Chart II-5). We performed a stress test on five4 large Indian private banks as well (Table II-3): Chart II-5India: Consumer And Service ##br##Credit Is Booming Table II-3Stress Test Of 5 Large Indian Private Banks We assumed the following NPA scenarios: 6% (optimistic), 8% (baseline), and 9% (pessimistic), up from 5% currently. Similar to the above analysis, we used risk-weighted assets to calculate asset losses, though we used a recovery ratio of 50% for private banks instead of 30% for public banks. The basis is that private banks' lending has been concentrated on consumer loans and mortgages and the recovery ratio on these loans will likely be higher - especially taking into consideration the quality of collateral. Our results are as follows: Under the baseline scenario of an 8% NPA ratio, 7% of these private banks' equity would be impaired (Table II-3, column 7). The adjusted PBV would move to 3.9. This compares to a fair value of 3.3 for Indian private banks (Table II-3, column 8), which is the historical PBV mean of private banks in India. In other words, Indian private banks are overvalued by 18% - slightly more than their public peers (Table II-3, column 9). Bottom Line: Indian private banks are overvalued too but less so than Chinese public banks. Investment Conclusions We reiterate our long Indian / short Chinese banks equity trade, initiated on January 17. We track the performance of this recommendation using the BSE's Bankex index for India and the MSCI Investable bank index for China in common currency terms - currency unhedged. In addition, among Chinese-listed banks, we maintain our short small / long large banks (Chart II-6). Smaller banks are more leveraged as well as exposed to non-standard assets and regulatory tightening than large public banks. Finally, the Indian bourse's relative performance against the EM equity benchmark negatively correlates with oil prices - the oil price is shown inverted on this chart (Chart II-7). Chart II-6Stay Short Chinese Small / Long Large Banks Chart II-7India's Relative Equity Performance To EM And Oil Prices Given BCA's Emerging Markets Strategy service expects oil prices to drop meaningfully in the second half of this year,5 this should help Indian equities outperform their EM peers. Besides, Indian banks are more advanced than many of their EM peers in terms of bad assets recognition and provisioning and that should also help the Indian bourse outperform the EM overall equity index in common currency terms. We reiterate our overweight stance on Indian equities within a fully invested EM equity portfolio. In contrast, we are neutral on China's investable stock index's relative performance versus the EM stock index. The main reason why we have not underweighted the Chinese bourse - despite our negative view on China - is the exchange rate; the potential downside in the value of the RMB versus the U.S. dollar in the next six months is less than potential downside in many other EM exchange rates. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Long Indian / Short Chinese Banks" dated January 17, 2018 available at ems.bcaresearch.com. 2 Please see the following article: http://www.scmp.com/business/banking-finance/article/2139904/pressure-chinas-banks-report-bad-debt-good-news-foreign 3 It is the average PBV ratio for EM banks since 2011. 4 HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, and IDFC Bank. 5 Please see Emerging Markets Strategy Special Report "China's Crude Oil Inventories: A Slippery Slope" dated June 21, 2018 available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations