Asset Allocation

Feature In a Global Investment Strategy service Special Report sent to all BCA clients yesterday,1 we recommended downgrading global equities to neutral (from overweight) over the coming year. For BCA's China Investment Strategy service, the most immediate implication of this change in recommendation is that an overweight stance towards Chinese stocks within a global portfolio is no longer justified. Consequently, we are closing two open positions in our trade book: 1) long MSCI China ex-technology / short MSCI All Country World ex-technology, and 2) long MSCI China value / short MSCI All Country World value. The rationale behind our downgrade of global equities is rooted in the view that there has been an unfavorable shift in the risk/reward balance for risky assets. A potential slowdown in global growth, fueled by protectionist action in the U.S. and dollar-driven weakness in emerging markets, could be met by intransigent policy, particularly in the U.S. In this scenario, financial markets would be set up for a collision course with global policymakers, which could precipitate a material selloff in risky asset prices before a sufficiently large policy response could be deployed. In the case of China, we have argued many times over the past several months that a slowdown in its industrial sector raised the risk of eventual underperformance of ex-tech "old economy" stocks versus their global peers. Chart 1 highlights that our leading indicator for the Li Keqiang index suggests that the index itself is set to decelerate further over the coming months, and we have highlighted that this poor domestic growth momentum means that fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. This week's sharp escalation of protectionist action between the U.S. and China clearly raises the risk of such a shock. In addition, we showed in a January Special Report that China has become a high-beta equity market versus the global benchmark (in common currency terms) over the past few years,2 and Chart 2 shows that this is true even for ex-tech stock prices. In our judgement, the combination of an ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices is a compelling reason to reduce pro-cyclical exposure to China. Chart 1China's Old Economy Will Continue To Slow Chart 2Chinese Stocks Are High Beta, Even Excluding Technology Bottom Line: We are closing two pro-cyclical positions in our trade book, and recommend that investors downgrade Chinese stocks to neutral within a global equity portfolio. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will ##br##Push Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far Chart 8China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

Highlights Monetary Policy: Position for rate hikes of 25 bps per quarter for the next 6-12 months and watch nominal GDP growth, cyclical spending and the price of gold for signals about the position of the fed funds rate relative to its equilibrium level. Yield Curve: Curve flattening will proceed as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations. Against this back-drop, and given currently attractive valuations, a position long the 7-year bullet and short the duration-matched 1/20 barbell makes the most sense. IG Credit: Moving down-in-quality has a greater positive impact on the risk-adjusted performance of a credit portfolio when excess return volatility and index duration-times-spread are low. At present, down-in-quality allocations within investment grade credit are only marginally attractive. Feature "You just let the machines get on with the adding up," warned Majikthise, "and we'll take care of the eternal verities, thank you very much. [...] "That's right," shouted Vroomfondel, "we demand rigidly defined areas of doubt and uncertainty!" - The Hitchhiker's Guide To The Galaxy, By Douglas Adams Jerome Powell put his stamp on Fed communications at last week's FOMC meeting. He trimmed 100 words from the policy statement and began his post-meeting press conference with a concise "plain-English" summary of how the economy is doing. In short: "the economy is doing very well". But while he expressed confidence in the Fed's assessment of the economy, he was also keen to point out areas where the outlook is cloudier. His central theme seemed to be that we must delineate between those questions that can be addressed by the Fed's reading of the economic data and those that are better left to the philosophers in Douglas Adams' novel. The Chairman stressed the uncertainty surrounding two concepts in particular: the non-accelerating inflation rate of unemployment (NAIRU) and the neutral (or equilibrium) interest rate, even advising that "we can't be too attached to these unobservable variables." But what can we say about these traditionally important policy guideposts? And more importantly, how should we think about them when formulating an investment strategy? The Importance Of NAIRU Chart 1The Fed's Projections One issue that came up repeatedly in the Chairman's press conference was the seeming disconnect between the Fed's labor market projections and its inflation projections. The Fed expects the unemployment rate to fall far below NAIRU during the next two years, and yet it anticipates only a mild overshoot of its inflation target (Chart 1).1 Ultimately this disconnect will be resolved in one of two ways. Either the Fed is underestimating the inflation pressures that will result from running the unemployment rate so far below NAIRU and will be forced to hike rates more quickly than anticipated, or it will eventually revise its estimate of NAIRU downward. From an investment perspective, this disconnect will only matter if inflation starts to rise more quickly than anticipated and the Fed is forced to ramp up the pace of rate hikes. We discussed this possibility in a recent report and concluded that, on a 6-12 month horizon, the odds of the Fed hiking more quickly than its current 25 bps per quarter pace are low.2 This is principally because the Fed will likely tolerate a fairly substantial overshoot of its inflation target before it feels the need to tighten more quickly. The Importance Of The Neutral Rate For bond investors the theoretical concept of the neutral (or equilibrium) interest rate is much more important. This interest rate represents the threshold between accommodative and restrictive monetary policy. When the fed funds rate is above neutral we should expect the pace of economic growth to slow and inflation pressures to dissipate. At present, the majority of FOMC participants estimate that the neutral fed funds rate is between 2.75% and 3%. At the Fed's current 25 bps per quarter pace, the funds rate will reach neutral by the middle of next year (Chart 2). Chart 2The Federal Funds Rate Will Hit Neutral Next Year The important question for investors is whether the Fed will start to slow its rate hike pace at that time, or whether it will revise its estimate of the neutral rate based on trends in the economy. Chairman Powell's emphasis on uncertainty makes us lean toward the latter. In a recent report we outlined three factors to monitor that will help us determine whether monetary policy is accommodative (fed funds rate below neutral) or restrictive (fed funds rate above neutral).3 The first factor is the year-over-year growth rate in nominal GDP relative to the fed funds rate (Chart 3). Historically, the year-over-year growth rate in nominal GDP falling below the fed funds rate is a reliable (though often lagging) signal that monetary policy has turned restrictive. A more leading signal of restrictive monetary policy is the proportion of nominal GDP that comes from the most cyclical (or interest rate sensitive) sectors of the economy. Those sectors being consumer spending on durable goods, residential investment and investment on equipment & software. When cyclical spending declines as a proportion of overall growth it is often a sign that the fed funds rate is above its neutral level (Chart 3, panel 2). Finally, we also recommend monitoring the price of gold for clues about the neutral rate of interest. Gold tends to appreciate when the stance of monetary policy becomes more accommodative and depreciate when it becomes more restrictive. The steep decline in the gold price between 2013 and 2016 even preceded downward revisions to the Fed's estimate of the neutral rate (Chart 4). Going forward, an upside breakout in the price of gold would be a signal that we should revise our estimate of the neutral fed funds rate higher. Conversely, a large decline would suggest that monetary policy is turning restrictive and we should think about calling the cyclical peak in bond yields. Chart 3Tracking The Neutral Rate I Chart 4Tracking The Neutral Rate II Bottom Line: Rather than rely on current estimates of unobservable variables like NAIRU and the neutral rate of interest, investors should monitor developments in the economy and consider how those estimates might evolve over time. For now, investors should expect a rate hike pace of 25 bps per quarter and watch nominal GDP growth, cyclical spending and the price of gold for signals about the position of the fed funds rate relative to its equilibrium level. Gradualism And The Slope Of The Curve The Fed's fairly explicit guidance that rates will rise by 25 bps per quarter is quite helpful when formulating expectations about the slope of the yield curve. For example, we know that the current 1-year par coupon Treasury yield of 2.35% is priced for exactly 100 bps of rate hikes during the next 12 months with no term premium. In other words, investors today should be indifferent between an investment in cash and an investment in a 1-year Treasury note if they are 100% certain that the Fed will stick to its 25 bps per quarter hike pace for the next 12 months. We can also forecast where the 1-year Treasury yield will be six months from now under a few different scenarios (Table 1). The forward curve is consistent with a 1-year Treasury yield of 2.69% six months from now, and we calculate that it will be 2.83% if the market moves to fully discount a rate hike pace of 25 bps per quarter until the end of 2019. If the market only prices in the Fed's median funds rate projection, which calls for three hikes in 2019, then the 1-year Treasury yield will be between 2.62% and 2.81% six months from now, depending on which meetings in 2019 those three rate hikes are delivered. Table 1Forecasting The 1-Year Treasury Yield The main takeaway from these observations is that even in the most hawkish scenario the 1-year Treasury yield will only rise to 2.83%. This is 48 bps above its current level and a mere 14 bps more than what is already priced into the forward curve. Now let's consider the long-end of the curve. The 10-year and 20-year TIPS breakeven inflation rates currently sit at 2.12% and 2.10%, respectively. If inflation expectations become re-anchored around the Fed's 2% target during the next six months, which we expect they will, then both of these rates will reach a range between 2.3% and 2.5% (Chart 5). This alone will apply between 20 bps and 40 bps of upward pressure to the 20-year Treasury yield. The nominal 20-year Treasury yield is currently 2.98% and the forward curve is priced for it to rise to 3.01% in six months. In the most hawkish scenario where the Fed lifts rates 25 bps per quarter and long-maturity yields remain constant, the 1/20 Treasury slope will flatten by 48 bps during the next six months. In the more likely scenario where Fed rate hikes coincide with the re-anchoring of long-dated inflation expectations, the 1/20 slope will flatten by 28 bps or less. Meanwhile, our model of the 1/7/20 butterfly spread shows that it is priced for 55 bps of 1/20 flattening during the next six months (Chart 6). Or put differently, there is so much extra yield pick-up in the 7-year bullet relative to the duration-matched 1/20 barbell that being long the bullet and short the barbell will be profitable unless the 1/20 slope flattens by more than 55 bps. Chart 5Inflation Expectations Are Still Too Low Chart 6Butterfly Spread Fair Value Model Bottom Line: Curve flattening will proceed as the Fed lifts rates, but some flattening pressure will be offset by the re-anchoring of long-dated inflation expectations. Against this back-drop, and given currently attractive valuations, a position long the 7-year bullet and short the duration-matched 1/20 barbell makes the most sense. Risk Update On May 22 we initiated a tactical long duration position premised on extended net short positioning in the bond market and the high likelihood of negative near-term data surprises.4 We have seen considerable movement in our indicators during the past two weeks - positioning is now much closer to neutral (Chart 7) and our model no longer expects data surprises to turn negative (Chart 8). Therefore, this week we remove our tactical long duration recommendation. The biggest current risk to our below-benchmark duration stance is the large divergence that has opened up between U.S. growth and the rest of the world (Chart 9). This divergence is putting upward pressure on the U.S. dollar and, much like in 2015, is starting to hurt growth in emerging markets, as we discussed last week. Chart 7Bond Market Positioning Chart 8Data Surprises Should Remain Positive Chart 9Foreign Growth Is The Greatest Risk But dollar strength and emerging market weakness is not an imminent threat to higher U.S. yields. Using the 2015 experience as a template, we see in Chart 9 that U.S. yields did not fall until after emerging market financial conditions and global growth had already troughed. In fact, it was not until dollar strength and weak global growth culminated in a dramatic tightening of U.S. financial conditions that the Fed finally signaled a slower pace of rate hikes and Treasury yields declined (Chart 9, bottom panel). Similarly, we don't think the Fed will react to a strong dollar and weak foreign growth until the impact is felt by U.S. risk assets. With U.S. growth still elevated and the dollar having appreciated only modestly so far, we think Treasury yields will avoid this risk during the next few months. Nonetheless, the divergence between U.S. and foreign growth is a risk that bears close monitoring. We will not hesitate to alter our duration stance if the dollar continues to appreciate and the divergence appears close to a breaking point. The Best Time To Move Down In Quality In last week's report we reviewed our assessment of where we stand in the credit cycle. That assessment determines whether we should be overweight or underweight investment grade corporate bonds relative to a duration-equivalent position in Treasuries. This week we zero-in on our allocation to investment grade corporate bonds and consider how we should allocate between the different credit tiers (Aaa, Aa, A and Baa). In next week's report we will look at positioning across the different maturity buckets and industries. We begin our analysis with the four Bond Maps presented in Charts 10-13. These Bond Maps show risk-adjusted return potential on the y-axis. Specifically, the number of months of average spread tightening necessary to achieve the excess return threshold listed in each map's title. The risk-adjusted potential for losses is shown on the x-axis. In this case, it shows the number of months of average spread widening required to underperform Treasuries by the amount listed in the title. Chart 10Investment Grade Corporate Excess Return Bond Map:##br## +/- 50 BPs Threshold Chart 11Investment Grade Corporate Excess Return Bond Map: ##br##+/- 100 BPs Threshold Chart 12Investment Grade Corporate Excess Return Bond Map: ##br##+/- 200 BPs Threshold Chart 13Investment Grade Corporate Excess Return Bond Map:##br## +/- 300 BPs Threshold Credit tiers plotting closer to the bottom-left of the Bond Maps have less potential for return and less risk. Credit tiers plotting closer to the upper-right have greater potential for return and more risk. What we find particularly interesting is that when we set a low return threshold, such as +/- 50 bps, the credit tiers plot almost right on top of each other. In other words, an allocation to Baa-rated corporate bonds gives you a much greater chance of earning 50 bps with about the same risk of losing 50 bps as the other credit tiers. But as we increase the excess return threshold the risk/reward trade-off between the different credit tiers becomes more linear. In Chart 13 we see that Baa-rated bonds have a greater chance of earning 300 bps than the other credit tiers, but also carry a significantly greater risk of losing 300 bps. Chart 14Down-In-Quality Works ##br##Best When Vol Is Low This leads to an interesting conclusion. A macro environment where we would expect low excess return volatility is also one where moving down in quality within investment grade corporate bonds is most beneficial from a risk/reward perspective. Conversely, moving down in quality will improve the risk-adjusted performance of your portfolio by less (and might even hurt the risk-adjusted performance of your portfolio) in a highly volatile return environment. To test this theory, we first recognize that the excess return volatility of the investment grade corporate bond index is tightly linked with its duration-times-spread (DTS). Low DTS environments have lower excess return volatility, and also less of a spread differential between the lower and higher credit tiers (Chart 14). With this in mind we split the historical time series of monthly corporate bond excess returns into four quartiles based on the index DTS (Table 2). We also exclude recessions from our sample, meaning this analysis is only valid during periods of economic recovery. Not surprisingly, the results show that the standard deviation of monthly excess returns increases alongside index DTS. But we also see that the average return advantage in the Baa-rated credit tier is lower when the index DTS is higher. Table 2Investment Grade Corporate Bond Excess Returns By Credit Tier (1989-Present)* When the index DTS is between 3 and 4.5, the reward/risk ratio in the Baa-rated credit tier exceeds the average of the other three credit tiers by 0.13. This advantage falls to 0.07 when the DTS is between 4.5 and 6.7; and falls further to 0.04 when the DTS is between 6.7 and 9.7. In the highest DTS quartile, the Baa-rated credit tier provides a lower reward/risk ratio than the average of the other three credit tiers. At present the index DTS is 8.4. This puts us in the second highest quartile relative to history, and is consistent with a 12-month standard deviation of monthly excess returns of roughly 77 bps for the corporate bond index. In this environment we should expect down-in-quality allocations to positively impact the risk-adjusted performance of a credit portfolio, but not by as much as in lower DTS environments. Bottom Line: Moving down-in-quality has a greater positive impact on the risk-adjusted performance of a credit portfolio when excess return volatility and index duration-times-spread are low. At present, down-in-quality allocations within investment grade credit are only marginally attractive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 In order to display a longer history, Chart 1 shows the Congressional Budget Office's estimate of NAIRU rather than the Fed's. At present both estimates are very close. The CBO estimates NAIRU to be 4.65% and the Fed's median projection calls for a NAIRU of 4.5%. 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy A rare buying opportunity has emerged in the S&P consumer staples index, especially for long-term oriented capital. The bearish story is already baked into current valuations, and industry green-shoots are flying under the radar. Similarly, the bearish packaged foods narrative is well ingrained in depressed relative valuations, whereas the budding recovery in industry final demand is severely underappreciated. This offers investors a compelling entry point to this unloved and under-owned consumer products subgroup. Recent Changes There are no changes to our portfolio this week Table 1 Feature The S&P 500 digested receding geopolitical risks last week, and continued to consolidate recent gains. Stocks are poking at the upper end of the 10% trading range in place since early-February, and internal equity dynamics suggest that a breakout in a bullish fashion is in store for later in the summer, as we first posited in late April.1 Chart 1 shows our Equity Market Internal Dynamics Indicator (EMIDI) that does an excellent job capturing the shifting internal forces that drive market returns. This coincident-to-leading market Indicator comprising economically sensitive sectors and portfolio biases is signaling that the path of least resistance is higher for the SPX. Similar to the EMIDI, the Value Line Arithmetic Index (an equal weighted broad-based stock market index) broke out to fresh all-time highs and the Value Line Geometric Index (a gauge of median stock prices) is following closely behind (third & fourth panels, Chart 2). Market darling AAPL is making a run at a $1tn valuation, spearheading the tech-laden NASDAQ Composite that remains on a pattern of hitting higher highs (top panel, Chart 2). Equity buying power is also evident in the breakout of Thomson/Reuters' "Most Shorted Stocks Index" (second panel, Chart 2). All of this suggests that before long the SPX will follow the uptrend and vault to all-time highs, a message corroborated by the record highs in the broad market's advance/decline (A/D) line (bottom panel, Chart 2). Chart 1Breakout... Chart 2...Looming An enticing macro backdrop continues to underpin equities. The latest ISM manufacturing report confirmed the IHS Markit U.S. manufacturing PMI release that we highlighted in our Report two weeks ago2: the U.S. is firing on all cylinders and has the potential to pull global growth out of its recent lull. In particular, the reacceleration in the ISM new orders-to-inventories ratio suggests that equities will gain steam in the coming months (second panel, Chart 3). Another source of upbeat news was the backlog subcomponent of the May ISM manufacturing survey. Unfilled orders hit a 14-year high, just shy of the all-time record. Historically, backlogs have been an excellent leading indicator of SPX revenue growth and the current message is that S&P 500 top line growth is on a solid footing (bottom panel, Chart 3). The Fed acknowledged this mini economic overheating last week, and the FOMC slightly bumped its median expectation to a total of four hikes in calendar 2018. Moreover, fiscal easing will continue to gain thrust as the year progresses and the cash repatriation will also provide an assist to the stock market. We are modeling between $650bn-to-$800bn in equity retirement for calendar 2018. Chart 4 depicts our estimates and if the historical correlation between share buybacks and equity prices holds, then there is more upside to stocks in the back half of the year. Nevertheless, retail investors are replenishing cash coffers according to the American Association of Individual Investors (AAII), rather than actively participating in the latest market run up. At the margin, this beefing up of retail investor dry powder represents a headwind to additional equity market gains. We heed the message from this traditionally leading Indicator and in order for our cyclical (9-12 month horizon) sanguine equity market view to pan out, individual investors will have to drawdown their cash balances (AAII cash shown inverted, Chart 5). Chart 3Macro Tailwinds Chart 4Corporate Underpinnings... Chart 5...But Retail Investor Has To Participate This week we are revisiting a broad defensive sector and one of its key subcomponents. What To Do With Staples Investors have deserted consumer staples stocks at a dizzying speed, and valuations have cratered to a multi-decade low, according to our composite Valuation Indicator (Chart 6). Technicals are also as washed out as can be, as staples equities have been sold off indiscriminately. Other sentiment and breadth measures confirm that this safe haven sector has lost its allure: the A/D line is probing multi-year lows, EPS breadth is waning and groups with a positive 52-week rate of change and trading above the 40-week moving average have all but disappeared (Chart 7). Chart 6Buy Into Weakness Chart 7Bombed Out Sentiment Our sense is that this consumer staples wholesale liquidation provides a great buying opportunity, especially for longer-term oriented capital with a time horizon of at least 2-3 years. Even on a shorter-term outlook, a bounce seems likely from extremely depressed levels, as relative share prices may find support close to the pre-Great Recession trough (top panel, Chart 7). From a cyclical perspective we continue to view this defensive sector as a hedge to our overall portfolio position that sustains a pro-cyclical bent. Importantly, the bearish consumer staples case is well discounted in bombed out valuations. The stock-to-bond ratio is weighing on this fixed income proxy sector that sports a dividend yield on a par with the 10-year Treasury (top & second panels, Chart 8). Moreover, subsiding volatility bodes ill for relative share prices; the opposite is also true (bottom panel, Chart 8). On the demand front, once again the uninspiring non-cyclical spending backdrop is well entrenched in sinking relative share prices. Relative staples retail sales - both compared to discretionary and to total sales - are deflating as is typical in the late stages of the business cycle (top & second panels, Chart 9). Chart 8Bearish Narrative Baked In Chart 9Lack Of Demand... Such waning demand has weighed on industry selling prices at a time when executives are making labor additions, blowing out our wage bill proxy. As a result, profits margins are suffering a squeeze (Chart 10). However, there are some pockets of strength hidden beneath the surface. While non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. True, this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (bottom panel, Chart 9). Other industry green-shoots are also surfacing. Consumer staples exports are on a slingshot recovery path, expanding by a low double digit growth rate, defying the year-to-date trade-weighted U.S. dollar appreciation (second panel, Chart 11). In fact, given the defensive stature of this index, any additional greenback gains will boost relative profits especially in the first half of 2019 (third panel, Chart 11). Chart 10...Weighing On Margins... Chart 11...But Green-Shoots Surfacing Finally, CEO confidence of non-durable industries is far outpacing the broad animal spirit recovery according to The Conference Board, and this relative Chief Executive euphoria has historically been positively correlated with share price momentum, underscoring that better times lie ahead for consumer staples stocks (bottom panel, Chart 11). Adding it up, a rare buying opportunity has emerged in the S&P consumer staples index, especially for long-term oriented capital. The bearish story is already baked into current valuations, and industry green-shoots are flying under the radar. Tack on impressive industry return on equity and this index appears extremely undervalued (bottom panel, Chart 6). Bottom Line: Were we not already overweight the S&P consumer staples index, we would not hesitate to lift exposure to above benchmark. Appetizing Packaged Foods Not only have investors shunned consumer staples stocks in general, but the S&P packaged foods sub-index has also suffered, even trailing the broad staples sector. As a reminder, within consumer products we are overweight packaged foods and household products but maintain a below-benchmark allocation to soft drinks. Packaged foods relative share prices have returned to the mid-2000s level offering a compelling entry point for fresh capital, especially longer-term oriented money (top panel, Chart 12). Part of the reason that these stocks are under-owned boils down to their defensive characteristics. These safe-haven equities pay handsome, steadily growing and secure dividends. Thus, when the bond market's selloff gains steam, investors flock to deep cyclical stocks and trim fixed income proxied equities, and vice versa. Moreover, the Warren Buffett induced M&A premia have now fully reversed from this group, with the base effect weighing on relative performance (bottom panel, Chart 12). Nevertheless, we are not willing to throw in the towel in this staples sub-index that offers hidden value. A number of leading industry demand indicators are firming and suggest that a top line growth period is in the cards. Food and beverage exports are rising at a healthy clip, despite the U.S. dollar's year-to-date appreciation, and so are domestic consumer outlays (second panel, Chart 12). The industry's shipments-to-inventories ratio is sending a similar message, jumping to a level last seen four years ago (third panel, Chart 12. Importantly, relative to overall spending, real (volume) food and beverage spending is expanding smartly. Add on tame raw food commodity costs, especially compared with broad commodity price inflation and relative EPS will overwhelm extremely depressed analysts' expectations (relative grain prices shown inverted, bottom panel, Chart 13). Chart 12Budding Demand Recovery... Chart 13...Should Aid Top Line Growth This encouraging demand backdrop is showing up in industry pricing power. Rising food manufacturing shipments are underpinning food producers' selling prices (second panel, Chart 14), and coupled with the contained crude food input costs suggest that packaged foods margins will continue to expand (middle panel, Chart 14). Even down the supply chain, food manufacturers' appear to be making significant headway, a harbinger at least of a profit margin relief phase. While channel captains food retailers have been dictating pricing terms to food suppliers for the better part of the past five years, industry producer prices are now on an even keel with CPI foods, a good proxy of what super markets are charging the consumer (fourth panel, Chart 14). Any additional pricing power gains will represent a boost to industry margins and, thus, profitability. Finally, firming demand is also showing up on industry operating metrics: factory activity is running red hot with resource utilization rates vaulting to multi-decade highs and industry hours worked picking up momentum (third panel, Chart 15). While CEOs have expanded the labor footprint and wage inflation is a cause for concern (bottom panel, Chart 15), a simple industry productivity proxy (industrial production divided by employment) shows that profits should enjoy a lift in the coming quarters. Chart 14Margins Can Expand Further Chart 15Brisk Factory Activity Netting it out, the bearish packaged foods narrative is well ingrained in depressed relative valuations (bottom panel, Chart 14), whereas the budding recovery in industry final demand is severely underappreciated, offering investors a compelling entry point to this unloved and under-owned consumer products subgroup. Bottom Line: Stay overweight the S&P packaged foods index. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, KHC, GIS, TSN, K, CAG, HSY, MKC, SJM, HRL, CPB. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs Chart I-9Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights After having written about the role of the U.S. yield curve in forecasting recessions, we are devoting this Special Report to addressing the widely asked question on the effectiveness of the yield curve in determining asset allocation. A naïve, rules-based approach is applied to the yield curve in each of seven countries/regions to produce a dynamic allocation signal between equities and bonds in each country/region. Despite its simplicity, we find that the dynamic portfolio systematically outperforms the 60/40 equity/bond benchmark portfolio in the U.S., Canada, euro area, Switzerland, U.K. and Australia from a long-term perspective (four years), with Japan being the outlier. Despite the dominance of the U.S. in the global economy and also in global asset markets, the equity/bond performance cycle outside the U.S. does not necessarily follow the U.S. Instead, the yield curve in each country provides a consistently better signal than just following U.S. decisions alone. Currently, signals from yield curves still favor equities over bonds. Feature U.S. yield curve inversion has been a good leading indicator for recessions in the U.S. Since the mid-1950s, every U.S. recession has been preceded with curve inversion, as shown in Chart 1. The lead time, however, varies from one month to 18 months. In addition, even though it is true that stocks underperform bonds in a recession, stocks can begin to underperform bonds long before a recession starts and can also continue to underperform long after a recession ends. For example, U.S. stocks/bonds performance ratio peaked in December 1999 and then troughed in September 2002 with a more than 50% drawdown, yet only about 6% occurred between March 2001 and November 2001 - the NBER official dates for the 2001 recession. So could information from the U.S. yield curve itself systematically add value to a stock-bond allocation decision in the U.S.? Even if it could in the U.S., could the same apply elsewhere, given that yield curves in different countries do not move in a synchronized fashion? (Chart 2) Chart 1U.S. Yield Curve Vs. Recession Chart 2Global Yield Curve Cycle In this Special Report, we use a simplified naïve, rules-based approach to attempt to demonstrate if information from yield curves in seven countries - the U.S., Japan, the U.K, Euro Area, Canada, Australia and Switzerland - can systematically add value in asset allocation decisions. Yield Curves Are An Effective Indicator For Long-Term Asset Allocation The test results are quite encouraging, despite the simplicity and need for further refinement. Except in Japan, yield curves in all six other countries provide value-add information for stock-bond allocation decisions. The solid lines in Chart 3 are the relative total return performance of the active stock/bond portfolio versus the benchmark for each country. The active portfolio is simply constructed based on a naïve rule such that a 10% underweight is given to equities and a 10% overweight is given to bonds when the yield curve reaches the lower band from above. Once the yield curve reaches the upper band from below, the allocation is reversed. The upper and lower bands are explained in our methodology section on page 5, we omit Japan from these charts because, as explained on page 9, its stock/bond ratio has not had a consistent relationship with the yield curve. The dash lines in Chart 3 are the monthly four-year rolling return differentials between the active portfolios and the benchmarks. It is encouraging to see that the four-year rolling performance in each country has suffered only very limited downside. Chart 4 is the same as Chart 3 except that the active bet is maxed out to 40% over- or underweight relative to the 60/40 equity/bond benchmark - i.e. when the signal is bullish for stocks, 100% is in stocks, and when it is bullish for bonds, the weights are 80% bonds and 20% stocks. This is a more extreme version of risk-taking, though the upside/downside trade-off is still quite impressive. This simple approach illustrates that in the long run, the yield curve is a useful indicator for equity/bond allocations. However, it does not do very well on a shorter-term time horizon. As shown in Chart 5, the one-year performance differentials are less appealing. Chart 3Backtest Base Case Chart 4Backtest Aggressive Case Chart 5Short-Term Risk Reward Less Appealing So how are the back tests conducted? The Methodology The Passive Benchmark: A 60/40 fixed-weight equity/bond benchmark is constructed for each country using the MSCI equity total return index and Bloomberg/Barclays Treasury Total Return Index, all in local currencies. The Active Allocation Rule: For each country, a range is set for its yield curve with an upper band and a lower band. The bands are set based on yield curve cycles and also their correlation with stock/bond performance cycles. When the curve reaches the upper band from below, an overweight is assigned to equities until the yield curve reaches the lower band from above, at which point the overweight then shifts to bonds. To determine how the size of the over- and underweight positions impacts the efficacy of the signal, we tested four different bet sizes - from 10% to 40% - in 10% increments, since no short selling is allowed. Objective: The active portfolio in each country is aimed to outperform its passive benchmark with a minimal four-year rolling drawdown. The same approach is applied to all seven countries. In terms of yield curve, the 3M/10 curve works better than the 2/10 curve for the U.S. because the former has better cyclicality. For all other countries, 2/10 yield curves are used. Despite the simplicity of our approach, some interesting observations are worth highlighting: U.S. And Canada: Reduce Risk When Yield Curve Inverts As shown in Chart 6, yield curve inversion in these two countries has historically been a good indication to reduce risk in equities. Bonds in general start to outperform equities after the curve is inverted and continue to do so as the yield curve steepens. However, when the curves steepens near to its cyclical high, then it's time to add risk in equities. Historically, the upper threshold for the U.S. 3M/10 is 3.4%, while for the Canadian 2/10 it is 1.8%. Currently, this indicator alone still favors equities in these two countries. Chart 6AU.S. & Canada: Curve Inversion ##br##Triggers Risk Reduction (I) Chart 6BU.S. & Canada: Curve Inversion ##br##Triggers Risk Reduction (II) Euro Area And Switzerland: Reduce Risk Before Yield Curve Approaches Inversion As shown in Chart 7, the yield curve of the euro area does not invert often, while the Swiss curve has never gone into inversion during the short period for which we have historical data. However, both curves have good cyclicality, which makes the 0.2%-1.8% range works very well for both. Chart 7AEuro Area & Swiss: Reduce Risk##br## Before Curve Inverts (I) Chart 7BEuro Area & Swiss: Reduce Risk ##br##Before Curve Inverts (II) U.K And Australia: Reduce Risk After Yield Curve Has Inverted 2/10 yield curves in both the U.K. and Australia invert more often than in other countries. However, unlike other countries, equities can continue to outperform bonds even after the curve is inverted. The turning point is about minus 50 basis points, as shown in Chart 8. The upper band for Australia is 1.25% and 0.9% for the U.K. Chart 8AU.K. & Australia: Reduce Risk ##br##After Yield Curve Has Inverted (I) Chart 8BU.K. & Australia: Reduce Risk ##br##After Yield Curve Has Inverted (II) Japan: Yield Curve Does Not Provide Consistent Information The Japanese stock/bond ratio does not have a consistent relationship with the 2/10 yield curve, as shown in Chart 9. This makes it very difficult to apply the simple approach employed here. Country Divergence U.S. economic cycles have been widely studied. But as shown in Chart 1, correctly identifying recessions in the U.S. does not systematically capture equity/bond relative performance cycles because even U.S. equities can underperform bonds before a recession starts and after a recession ends. Using the yield curve, on the other hand, does a much better job in capturing the equity/bond performance cycle in each country. Chart 10 shows that investors in different countries should pay more attention to local yield curve cycles other than just following a U.S.-centric analysis, even though the U.S. does play a dominant role in the global economy and in global equity and bond indices. Chart 9Japan Is The Outlier Chart 10Country Divergences Bottom Line: The yield curve is an effective indicator for equity/bond allocation in most developed countries from a long-run perspective. Currently, yield curve-based signals from the U.S., Canada, Euro Area, Switzerland, the U.K. and Australia all still favor equities over bonds. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com

Highlights Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. There have been a number of noteworthy divergences in the EM space of late. They are probably part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. The selloff in EM risk assets will broaden and intensify. A defensive positioning is warranted. India's relative equity performance has by and large been undermined by rising oil prices. A potential roll-over in crude prices will aid the Indian bourse's relative performance versus its EM peers. The South African rand remains on shaky foundation; stay short. Feature There have been a number of noteworthy divergences in financial markets of late, in particular between emerging markets (EM) and commodities, as well as between Chinese investable stocks trading outside the mainland and equity prices listed domestically. In our view, these divergences are part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. In dominos, tiles do not all fall simultaneously. They fall one by one, and there is a time lag between the first domino and the last-standing domino to drop. Also, unlike in natural sciences, time lags and speed in economics and finance vary with each experiment - because they are contingent on complex human psychology and behavior, not on well defined natural phenomena such as gravity or motions of objects. Hence, they are impossible to forecast with much precision. A Message From Our Risky Versus Safe-Haven Currency Ratio Although U.S. share prices have lately been firm, EM stocks have broken below their 200-day moving average (Chart I-1, top panel). So has our risky versus safe-haven currencies ratio 1 (Chart I-1, bottom panel). Indeed, while having held up at its 200-day moving average several times in the past two years, the ratio has recently decisively broken below this technical support line. This indicator correlates extremely well with EM share prices, and its message is presently unambiguous: The rally in EM is over, and a bear market has likely commenced. Crucially, this ratio measures commodities currencies versus the average of the Japanese yen and Swiss franc - two defensive currencies - not against the U.S. dollar. Hence, it is not impacted by the greenback's trend. Given that all six risky currencies used in the numerator of this ratio - AUD, CAD, NZD, BRL, ZAR and CLP - are commodity currencies, it is not surprising that the ratio also correlates with commodities prices. In this context, it currently suggests the outlook for both industrial metals and oil is troublesome (Chart I-2). Chart I-1Beware Of These Breakdowns Chart I-2A Red Flag For Commodities Prices The common denominator that links all these financial variables is global growth. The risky versus safe-haven currencies ratio typically leads world trade cycles by several months, and it currently points to a notable slowdown in global export volumes (Chart I-3). Chart I-3Global Export Growth Is Set To Slow Further, commodities prices have exhibited a rare decoupling from the U.S. dollar. It is very unlikely that this divergence can be sustained for much longer. Our bias is that global trade will slow as China/EM demand weakens despite robust U.S. growth. Growth dynamics shifting in favor of the U.S. entails that the greenback will continue to appreciate. Consistently, EM/China growth disappointments and U.S. dollar's persisting strength suggest that commodities will reverse their current trend sooner rather than later. A relapse in commodities prices will reinforce EM currency depreciation, triggering more outflows from EM equities and fixed-income markets. Decoupling Or A Time Lag? Chart I-4Domino Effect In 2007-08 Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. The EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then it spread to Korea, Malaysia and Indonesia and finally, to the rest of Asia. In August 1998, Russian financial markets collapsed triggering the LTCM debacle. The last leg of this crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Similarly, the U.S. financial/credit crisis commenced with the selloff in sub-prime securities in March 2007. Following that, corporate spreads began widening and bank share prices rolled over in June 2007. In the meantime, the S&P 500 and EM stocks peaked on October 9 and 29, 2007, respectively. Despite all of these developments, commodities prices and EM currencies continued rallying until summer of 2008 and then quickly collapsed in the second half of that year (Chart I-4). Finally the Lehman crash took place on September 29 of 2008. That marked the apogee of the crisis, causing a complete unravelling of financial markets and the global economy, and lasting until March of 2009. It seems some sort of domino effect is now taking hold of the EM universe. Initially, it started with Turkey and Argentina. Then, it spread to Indonesia, India and Brazil. The currency weakness across the wider EM universe has already led to EM credit spread widening. Yet, there are a few EM financial markets, particularly Chinese, Korean and Taiwanese, that are still holding up relatively well. Moreover, U.S. share prices and high-yield credit spreads have done quite well too. How should investors interpret these divergences? Our view has been, and remains, that EM risk assets will do poorly regardless of the direction of the S&P 500. In fact, an escalation in EM turmoil and a slowdown in developing economies are among the main risks to American share prices themselves. The primary link from EM financial markets to the S&P 500 is via the exchange rate - a strong dollar along with an EM/China growth slump will weigh on American multinationals' profits. The following three questions are presently vital for investors: 1. Can EM and U.S. risk assets de-couple from each other, and has a sustainable divergence happened in the past? Although short-term moves in U.S. and EM equity indexes often appear correlated, from a big-picture perspective there have been considerable divergences. The overall EM stock index is now at the same level it was in 2007 (Chart I-5). Meanwhile, the S&P 500 index is a hair below its all-time high. Chart I-5EM Share Prices And The S&P 500: A Long-Term Perspective The same is true for many EM currencies and the S&P 500. A substantial decoupling did occur in the not-so-distant past: EM currencies depreciated from 2011 to early 2016, while U.S. share prices rallied strongly from late 2011 until 2015 (Chart I-6). With respect to U.S. credit spreads, Chart I-7 illustrates that EM and U.S. credit spreads have had a much higher correlation than their respective equity indexes. During the 1997-'98 EM crises and the 2014 -'15 EM turmoil, U.S. high-yield corporate spreads widened. In brief, there has historically been little decoupling between U.S. and EM credit markets. Hence, the U.S. high-yield credit market's latest resilience in the face of widening in EM credit spreads is historically exceptional. Chart I-6EM Currencies And The S&P 500 Chart I-7EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective As EM currencies continue to depreciate versus the U.S. dollar, EM sovereign and corporate credit spreads will widen. Given their past high correlation with U.S. credit markets, odds point to widening corporate credit spreads in the U.S. On the whole, if EM risk assets continue to sell off, which is our baseline scenario, the S&P 500 and U.S. credit markets could defy gravity for a while, but not forever. At some point, risks stemming from EM turbulence will cause a selloff in American stocks and corporate bonds. It is impossible to know when and by how much U.S. stocks will suffer. Our bias is that a U.S. equity selloff will likely be on par with the 2015-'16 episode. 2. Can North Asian equity markets such as China, Korea and Taiwan remain relatively resilient if the turbulence in other EM countries continues? Based on history, they can, but only for a short period of time. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - at which point they began plummeting (Chart I-8, top panel). In 2007-'08, emerging Asian equities started tumbling along with the S&P 500 in late 2007, but Latin American bourses fared well until the middle of 2008 due to surging commodities prices (Chart I-8, middle panel). Finally, the bottom panel of Chart I-8 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Regarding Asia's business cycle conditions, the slowdown is already taking place and will likely intensify. Leading indicators of exports and manufacturing such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart I-9). Chart I-8Asian And Latin American Equities: ##br##Unsustainable Divergences Chart I-9Asia's Export Slowdown Is In Making 3. Is there any other notable financial market decoupling that investors should be aware of? Chart I-10China: A Decoupling In Various Equity Segments Since early this year, there has been substantial decoupling between Chinese investable stocks and the onshore A-share market. First, the overall A-share index has dropped since early this year, but the MSCI Investable Chinese stock index has so far been resilient (Chart I-10). Second, while it might be tempting to explain this decoupling by discrepancies in the sectors' weights in these indexes, this has not been the case this time around. The fact remains that there has been considerable divergence between share prices of the same sectors. For example, onshore and offshore equity prices have diverged for the following sectors: real estate stocks, materials, industrials, technology, utilities and consumer discretionary (Chart I-11A and Chart I-11B). Only defensive sectors such as consumer staples and health care have done well in both universes. Share prices of financials and telecoms have dropped in both the onshore and offshore markets. Chart I-11AChinese Equity Sectors: Puzzling Decoupling Chart I-11BChinese Equity Sectors: Puzzling Decoupling Finally, a similar performance gap has appeared between Chinese small cap stocks trading onshore and in Hong Kong (Chart I-12). Chart I-12China's Small-Cap Stocks: A Perplexing Gap How do we explain these divergences? Our bias is that local investors in China are much more concerned about the mainland growth outlook than foreign investors. This is the opposite of what occurred in 2015. Back then, international investors were somewhat cautious on China - commodities prices and other China-related global financial market plays were in a bear market. Meanwhile, local investors were caught up in a full-fledged equity mania that ended with a crash. Given our downbeat outlook on China's capital spending and related plays in financial markets, we reckon that domestic investors in China will be proven right in the months ahead, while the international investment community will be left flat-footed. Importantly, there has been an unexplainable mismatch between monetary/credit tightening in China and complacency among international investors about the outlook for the mainland economy. Specifically, the cost of borrowing has gone up, and credit standards have tightened. Chart I-13 illustrates that both onshore and offshore corporate bond yields have risen to new cycle highs, Chinese banks' lending rates are rising, while banks' loan approvals are dropping. Consistently, money and credit growth have plunged. Importantly, this is occurring in an economy with immense credit excesses. Nevertheless, commodities prices have so far defied such a pronounced deceleration in money and credit aggregates in China (Chart I-14). Chart I-13China: Ongoing Credit Tightening Chart I-14China's Money/Credit And Commodities Prices All in all, we interpret these divergences by varying lead and lags rather than as a fundamental breakdown in the relationship between money/credit and the real economy. We continue to expect tightening liquidity and credit to escalate the growth slowdown in China. As a result, there continues to be considerable downside risks for Chinese investable stocks and commodities prices. Bottom Line: The dominos have begun to fall. We continue to recommend a defensive strategy and an underweight position in EM equities, credit and currencies versus their U.S./DM peers. High-yield local currency bonds that are a de-facto bet on the underlying currencies are vulnerable too. For investors willing to go short, it is not too late to short EM stocks and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Average of cad, aud, nzd, brl, clp & zar total return (including carry) indices relative to average of jpy & chf total returns. India's Equity Underperformance: Blame It On Oil Indian stocks have been underperforming their EM counterparts. Rising oil prices have created a toxic macro mix for India, triggering the equity underperformance (Chart II-1): Rising crude prices have led to widening current account and trade deficits. Oil price swings are often instrumental to trends in India's current account balance (Chart II-2). The deterioration in the nation's external accounts has been behind the rupee's poor performance. Chart II-1Higher Crude Oil Prices Hurt Indian Stocks Chart II-2Crude Oil And Current Account Deficit Given that India is a major oil importer, falling commodities prices - especially crude oil - will benefit India's stock market. The recent surge in oil prices has also reinforced inflation dynamics in India (Chart II-3). Chart II-3Higher Crude Oil Boosts Inflation The basis for the high correlation between core consumer price inflation (excluding energy and food) and oil prices is due to the fact that core inflation includes components that are heavily influenced by fluctuations in oil prices. For instance, the transportation and communication component of inflation is very sensitive to changes in oil prices. This component accounts for 18% of core consumer price index. Further, the personal care and effects component also correlates with crude oil. Personal care goods use petroleum products as an important input in their production process. This component accounts for 8% of core consumer price index. Together these components account for a non-trivial 26% of core consumer price index, and will likely subside as oil prices fall. On the inflation front, we highlighted in our April 19 Weekly Report that risks to inflation are tilted to the upside due to strong consumer and government spending in an otherwise under-invested economy.1 Domestic demand has been accelerating, providing tailwinds for higher inflation (Chart II-4). Higher inflation and currency weakness has led to a considerable rise in both government and corporates local currency bond yields (Chart II-5). Chart II-4Domestic Economy Is Strong Chart II-5Rising Borrowing Rates Given the very high equity valuations, share prices in India are especially sensitive to rising local borrowing costs. All in all, India's relative equity performance has by and large been undermined by rising oil prices. BCA's Emerging Markets Strategy team believes the risk-reward for oil prices is skewed to the downside due to the expected deterioration in EM/China oil demand, investors' extremely high net long positions in crude and appreciating dollar.2 That is why we are still reluctant to downgrade Indian stocks within the EM equity universe. It is vital to emphasize, however, that our overweight call is relevant to dedicated EM equity portfolios. We have been, and remain, negative on Indian share prices in absolute U.S. dollar terms. Bottom Line: Odds are that commodities prices will drop meaningfully in the months ahead and that will support India's relative equity performance versus the EM benchmark. EM dedicated investors should keep an overweight stance on Indian equities for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Country Perspectives: India And Turkey," dated April 19, 2018, link available on page 21. 2 The Emerging Markets Strategy team's view on oil differs from BCA's house view which remains bullish. The South African Rand Remains On Shaky Foundations Although the rand has not been among the worse hit EM currencies, investors should remain cautious on it. The currency presently finds itself resting on very shaky foundations, raising odds of substantial depreciation for the remainder of the year: First, South Africa's external funding has solely been driven by portfolio inflows, leaving the exchange rate highly exposed to potential portfolio outflows. As illustrated in Chart III-1, net portfolio inflows reached all-time highs while net FDIs reached all-time lows at the end of 2017 (the latest available statistics). Meanwhile, foreign ownership of domestic bonds has reached new highs (Chart III-2). The total return in dollar terms on South Africa's local currency bond index1 has failed to break above its previous highs and has relapsed (Chart III-3). It seems this asset class has entered a new bear market. Further decline in the total return of bonds will spur more selling or hedging of currency risks by international bond investors. Chart III-1South Africa: Highly Exposed To Portfolio Flows Chart III-2Foreign Holdings Of South African Local Bonds Is Elevated Chart III-3South African Bonds Were Unable To Break Out Second, the country's trade balance is set to deteriorate. Despite continued episodes of currency weakness throughout last decade, there has been little to no import substitution in South Africa. Consequently, a reviving domestic demand will prompt higher imports. That, and a potential relapse in export (raw materials) prices, will lead to a widening trade balance. Chart III-4The Rand Is Not Cheap Finally, the rand is not cheap; its valuation is neutral (Chart III-4). When an exchange rate is close to its fair value, it can either appreciate or depreciate. In short, the rand's valuation is not extreme enough to be a major factor in driving the market right now. Bottom Line: Currency traders should stay short the ZAR versus both the USD and the MXN. Relative trade balance dynamics and valuations continue to play in favor of the Mexican peso relative to the South African rand. Predicated by our negative view on the rand, we recommend EM dedicated equity and fixed-income investors to maintain an underweight allocation to South Africa. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 JP Morgan GBI-EM Global Diversified Emerging Markets Government Bond Index for South Africa. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general 'failure to launch' as they reach adulthood. However, the former is a misnomer as this age cohort is already the largest and the latter is simply untrue. In the report below, authored by guest editor Richard Dias, we explore these themes and conclude with our recommendations for a Millennials basket of stocks to capture the strength of this cohort as consumers. The Echo Boom Heard Round The World According to the U.S. Census Bureau, Millennials are the U.S.'s largest living generation. Millennials, (or Echo Boomers) defined as people aged 18 to 36 (born 1982 to 2000), now number more than +80mn and represent more than one quarter of the U.S.'s population - Baby Boomers (born 1946 to 1964) number about 75mn.1 Stealthily becoming the largest age group in the U.S. over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 1). Chart 1Echo Boom This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What's more, with the largest one-year age cohort only 25 years old, Millennials will be the dominant generation for many years. How these "kids" will impact the market as they become the most important consumers, borrowers and, to a lesser degree, investors is unclear but make no mistake: this is a seismic shift in economic power and it is here to stay. Also of note is how much better the demographic picture is in the U.S. versus other developed markets (Chart 2) but this last point will not be the focus of this report. Rather, the focus will be on the Echo Boom's domestic implications touching on the labor market (wage growth), inflation, debt and housing, CAPEX and growth. Chart 2Labor Force Growth The Graduates Chart 3Educational Intensity Is Increasing Unabated Millennials have invested in "human capital" more than any previous generations. By 2014, more received a postsecondary degree (associates, bachelor's, or graduate degree) than any other generation (Chart 3). More higher education is a rational response to a labor market that pays college graduates much more than adults without a college degree.2 Millennials have also been much more likely to attend graduate school than previous generations - enrollment increased at an even faster rate than undergraduate enrollment, jumping from 2.8% in 1995 to 3.8% in 2010.3 Timing Is Everything Unfortunately Echo Boomers entered the workforce at the worst possible time (Chart 4). During recessions, enrollment increases along with duration of study. This reflects a lower opportunity cost of schooling, as well as a stronger incentive to improve one's skills in a tougher job market. This cyclical pattern was exacerbated by the severity of the Great Recession. A lot has also been made of the historically low youth labor participation rates (Chart 5) but this is partly explained by Millennials focusing on studies instead of combining school and work.4 A rise in educational intensity - more time devoted to schoolwork and other extracurricular activities5 - has also played a role. Difficultly finding employment and poor returns therein (low wages) has also coincided with the massive uptake in student loans - now much more readily available - and acting as a major income substitute (more on this below). Chart 4Recessions Mean More Higher Learning... Chart 5...And Lower Participation Rates Forever Young Another dubious narrative is that Millennials don't want to grow up. In reality, horrible early career economic conditions have meant large and lasting delays to adulthood. Entering the labor market during a recession can result in substantial earnings losses that persist, with negative effects lasting longer for college graduates.6 Poor job prospects and earnings are reflected in reduced labor mobility (not chasing jobs that are no longer available), lower marriage rates (living with parents longer) (Table 1) and home ownership7 rates that are much lower than for previous generations (partly a combination of the two). Table 1Marital Status Of The Adult Population Millennials continue to delay marriage (and leaving home) for several reasons8 but this does not mean they do not want to marry. Indeed over 80% of Millennials say that they "think that they will marry", more than Generation Xers and Baby Boomers did at similar ages. Similarly, they are more likely to believe that they will have kids. Once you control for some of the demographic trends9 that keep kids at home, 25 to 34 year olds continue to set up independent households at roughly the same rate as they always have and recently this household formation has accelerated. It is also worth remembering that major inflection points in homeownership rates have happened before; following a large increase pre-war, there was a sustained decline in the number of young people living at home in the 1940-50s. Another problem with this narrative is that campus housing is considered "living at home". So as enrollment increased, so did the number of young "living at home". Now, almost half of young people "living with their parents" are in college (campus housing) - even if they pay for the education with student loans or are on scholarship. Assessing the merit of these commonplace assertions is important as an unwind of the negative impulses caused by the recession, along with echo boomers coming of age, will influence the U.S. economy for many years. Back In The Saddle With the youngest of Millennials finally coming of age (the largest one-year age cohort is now 25) and the economic recovery complete, Millennials are finally joining the labor force (Chart 5). Participation rates that were justifiably depressed during Millennials' college-going years have since made a recovery, though, notably, educational intensity remains unchanged for the younger cohort of Millennials (17 to 24) (Chart 5). This significant increase in participation occurred as the size of this cohort expanded at its fastest rate in 20 years (Chart 6). The growing numbers finishing college in a less horrible economic environment are faced with a higher opportunity cost; over the last two years there has been a big jump in the real median income for these older Millennials (Chart 7). Chart 6Participation Is Recovering... Chart 7...So Are Earnings Millennials' economic force (population times wages or wage growth) is set to increase in size and as such its relative importance over the next decade. These demographics are positive for home buying, consumption and, ultimately, economic growth. House Prices & Consumption Set To Reaccelerate Americans are moving at the lowest rate on record10 but as we have argued above, this is set to change. Ownership rates for residential real estate have a distinct life cycle pattern; rates start low when households first reach adulthood and rise substantially by the time they reach their late 30s and early 40s. Chart 8Better Household Balance Sheets Supports House Price Gains With a huge number of Millennials entering this cycle relatively unburdened (see grey box below) and households in aggregate having de-levered (top panel, Chart 8) since the recession, we have a situation where both demand and supply (bottom panel, Chart 8) dynamics point to a highly supportive environment for housing over the short to medium term. But What About All That Student Debt Chart 9Student Loans Are Rising But##br## Other Categories Are Falling A lot has been made about the levels of student debt in the U.S. It is obviously large; the total amount of debt currently stands at 1.4Tn dollars and it has trebled in 10 years (top panel, Chart 9). And it is clear that delinquency rates are high, at about 11% (bottom panel, Chart 9). The reigning theory is that new or recent graduates, heavily burdened by debt, are unable or unwilling to take the next steps into adulthood. This misses the point. Lost in all of this is that while student loan burdens climbed, every other major debt category fell (credit cards, auto loans, mortgages and home equity loans). According to the NY Fed, Millennials now have less per capita debt overall than they did in 2003.11 Granted, the difference (between 2003 & 2015) is modest but when you consider the difference within the context of the wider point, it becomes important to keep in mind: the largest cohort in a generation is entering their (albeit delayed) prime borrowing (and spending) years on better financial footing that in 2003!12 The issue of payments has also been overlooked.13 Although loan balances have ballooned, the average payment has increased only 50%. And, not to belabor the point, a misunderstanding about the debt distribution compounds this false narrative. A small fraction of borrowers have huge payments while 50% of borrowers had payments of $200 or less, and another 25% had payments of $200 to $400. The top panel of Chart 10 highlights the jump in home ownership.14 This is of course due in part to the recovery but Millennials are also now a growing portion of this household formation. As they continue to create millions of new households (delayed by the recession but now accelerating), mortgage debt and house prices (with the help of underwhelming housing supply growth) will be biased higher (bottom panel, Chart 10). This household formation drives consumption (e.g white goods & services). And, as Millennials mature into their peak earning and spending years, this consumption is set to increase (Chart 11). Chart 10Homeownership Is Rising Again Chart 11Millennials Are Consumers Phillips Curve Gaining Traction It has been 15 years since we have had employment growth (of young people) of this magnitude (in percentage terms and absolute numbers). The Phillips curve tells us employment and inflation are linked. Hence Chart 12 should not surprise, as it simply suggests that a big jump in the key segment of the population - newly employed, forming households, and able to borrow and consume - help drive up the costs of consumer goods and services. We should expect protracted rises in inflation over the next few years as a function of Millennials flexing their economic might. Bringing It All Together; What Does This All Mean For Growth? The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally here, this wave of echo-boomers is educated, relatively unburdened by debt, and as they inevitably "grow up", will soon begin to form new households (and have kids). They will borrow, spend, earn, but not necessarily save and invest. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Millennials will support household consumption. Employment growth will underpin much higher inflation. Private residential gross fixed capital formation - which has lagged - will pick up. Add to that a CAPEX cycle (largely independent) that is firing on all cylinders (Chart 13), and improving productivity growth which will follow stronger wage growth and it seems that real GDP growth reaccelerating is the odds-on likely scenario (Chart 14). Chart 12Demand Is Increasing Along With Employment Chart 13Capex Is Surging Chart 14GDP Growth Is Pointing Higher Admittedly this note paints a rosy picture of future growth (real and nominal) and takes a narrow view by focusing on demographics. And of course this is not without risks; Baby Boomer burdens (debt & health), corporate debt and a tighter monetary policy to name a few. But nominal GDP growth solves many of these and more. Investment Implications The report above does an excellent job underlining why Millennials will boost consumption spending but does not offer many insights on how that consumption will change. For example, healthcare currently makes up 17% of personal consumption expenditure in the U.S., roughly in line with housing and utilities. We would anticipate the natural attrition of the aging Baby Boomer generation to push down health care's share of the consumer's wallet (we currently have an underweight recommendation for the S&P health care index). At the same time, and as discussed in detail above, the positive implications of the relatively unburdened Millennial cohort entering prime home acquisition age factors into our sanguine home-related equities view (we currently have an overweight recommendation for the S&P home improvement retail index and recently upgraded S&P homebuilders to neutral).15 Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary-focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN's heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music, respectively, over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are "doers" and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation's largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, FB and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL's inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB too is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry we expect the connectivity and mobile computing demands of Millennials will accelerate. Chart 15BCA Millennial Basket It is worth noting at this point that at least some of the stocks noted above will be shifting out of both consumer discretionary and tech in September of this year. Stay tuned for our report on the to-be announced communications services sector later this summer. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket. Our basket is shown in Chart 15. To create the basket, we have imagined a $1M portfolio, invested $100,000 in each of our basket stocks at the date of publishing. While the resulting basket has obviously been an outstanding performer in the past year, meaning that it is not as attractive an entry point as it was in recent history, we think a long term view should support continued outperformance. With respect to stocks to avoid, we are believers that Environmental, Social and Governance (ESG) criteria will gain in importance as Millennials invest their newfound wealth in the stock market. Accordingly, we would tend to avoid 'sin stocks', including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, and as noted above, we think demographics and a clean energy shift will mean energy and health care will be long term underperformers. Bottom Line: Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, FB, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb and Uber, to this basket should they become investable. Richard Dias, CFA Guest Editor Chris Bowes Associate Editor chrisb@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Millennials Outnumber Baby Boomers and Are Far More Diverse (June 2015) http://www.census.gov/newsroom/press-releases/2015/cb15-113.html 2 The Rising Cost of Not Going to College (Feb 2014) http://www.pewsocialtrends.org/2014/02/11/the-rising-cost-of-not-going-to-college/ 3 15 Economic Facts About Millennials (Oct 2014) https://obamawhitehouse.archives.gov/sites/default/files/docs/millennials_report.pdf 4 NEET (Youth not in employment, education or training) level for youth 19 to 29 increased by only 4% during the Great Recession and has since returned to pre-recession levels about 15%. 5 Labor force participation: what has happened since the peak? (Sep 2016) https://www.bls.gov/opub/mlr/2016/article/labor-force-participation-what-has-happened-since-the-peak.htm 6 The long-term labor market consequences of graduating from college in a bad economy (Apr 2010) http://www.sciencedirect.com/science/article/pii/S0927537109001018 7 Homeownership Rates Are Falling, And It's Not Just A Millennial Problem (May 2016) https://www.forbes.com/sites/shreyaagarwal/2016/05/06/homeownership-rates-are-falling-and-its-not-just-a-millennial-problem/#3df54894494a 8 Reasons Millennials (17 to 35) stay at home longer include; this generation is younger (more 17 to 24 that 25 to 35), more culturally diverse, societally more tolerant, more time in post-secondary education, and houses have gotten much bigger 9 Five-year age subgroup, marital status, presence of children, sex, race, ethnicity, nativity (i.e. native- or foreign-born), current school enrollment, and educational attainment (Nov 2015) - http://jedkolko.com/2015/11/23/why-millennials-still-live-with-their-parents/ 10 Americans Moving at Historically Low Rates, Census Bureau Reports https://www.census.gov/newsroom/press-releases/2016/cb16-189.html 11 This myth about millennials needs debunking (Mar 2016) https://www.weforum.org/agenda/2016/03/this-myth-about-millennials-need… 12 Also of note from this two charts (Chart 21 & 22) is that it is NOT young people that are increasing their borrowing but old people. A 2016 blog post from the NY Fed "The Greying of American Debt" - expands on this theme. http://libertystreeteconomics.newyorkfed.org/2016/02/the-graying-of-ame… 13 Is There a Student Loan Crisis? Not in Payments (May 2016) https://clevelandfed.org/newsroom-and-events/publications/forefront/ff-… 14 Demographics: Renting vs. Owning (Feb 2017) http://www.calculatedriskblog.com/2017/03/demographics-renting-vs-ownin… 15 Please see BCA U.S. Equity Strategy Weekly Report, "Seeing The Light," dated May 29, 2018, available at uses.bcaresearch.com.

Highlights One of Europe's major success stories is the structural and broad-based increase in female labour participation rates. The trend is set to continue for the next decade. Stay overweight the Personal Products sector as a long-term position. Italy's decade-long stagnation is not a deep-seated structural malaise. It is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Buy exposure to Italian real estate as a new long-term position either directly or through Italy's small real estate equity sector. Feature Some analysts persist on comparing economic performances on the basis of real GDP per head of total population. But the total population includes children and the elderly who cannot contribute to economic output. Therefore, a correct assessment of economic performance should look at real GDP per head of working-age population. Chart I-1AWomen Are Powering The European Economy... Chart I-1B ...Less So In The U.S. Admittedly, as the retirement age rises, the definition of 'working-age' will gradually change, but the general principle still holds: only count in the denominator those who can contribute to economic output. GDP per head of working-age population can grow in several ways. One way is to get more output or better output from each hour worked through improvements in efficiency and/or quality. As this improvement is theoretically limitless, it is the main source of productivity gains in the long run. A second way is for each worker to work more hours. But given the physical and legal constraints on productive working time, there is only limited scope to increase output in this way. How Women Are Powering The European Economy There is one other way to increase GDP per head of working-age population: increase the percentage of the working age population that is in the labour force.1 In other words, structurally increase the labour participation rate. If this participation rate is already high - as it is for men - then there is little scope to increase it much further. But if the participation rate is low - as it is for European women - then there is considerable scope to increase it. This brings us to one of Europe's major, and largely untold, success stories - the structural and broad-based increase in female participation rates (Chart I-1-Chart I-5). Over the past twenty years, the EU28 female participation rate has risen from 57% to 68%, with an especially large contribution from the socially conservative southern countries. In Spain, female participation has surged from 47% to 70%. In Italy, it has shot up from 42% to 56% and has clear scope to rise much further. Chart I-2Italy: Labour Force Participation Rate Chart I-3Spain: Labour Force Participation Rate Chart I-4Germany: Labour Force Participation Rate Chart I-5France: Labour Force Participation Rate What is driving this structural trend? Two things. First, the employment sectors that are growing structurally - healthcare, social care, and education - tend to employ more women than men. Second, European countries have legislated a raft of policies encouraging women to join and remain in the labour force: generous paid maternity leave and subsidised childcare. The trend is for further improvements, with the focus now on improving paternity leave. Sharing parental and family responsibilities between mothers and fathers allows more women to enter and stay in the labour force.2 For the ultimate end-point in the trend, look to the Scandinavian countries which started such policies in the early 1970s. In Sweden, labour force participation for women and men is almost identical: 81% versus 84%. If the EU eventually adopts the Scandinavian model, it would mean another 20 million European women in employment and contributing to economic output (Chart I-6). Chart I-6Another 20 Million European Women ##br##Could Join The Labour Force Dispelling Two Myths: The Euro Area And Italy Having established that economic performances should be compared on the basis of GDP per head of working age population, we can now dispel two common myths. The first myth is that the U.S. generates superior productivity growth than the euro area. It is true that the U.S. has been better at getting more output from each hour worked, so on this measure, the U.S. does win. Against this, the euro area has been much better at getting more of its working-age population - albeit mostly women - into employment. So on this measure, the euro area wins (Chart of the Week). The net result is that, over the past twenty years, the U.S and the euro area have generated exactly the same growth in real GDP per working-age population (Chart I-7). Of course, the euro area's structural improvement in female participation rates cannot continue forever, but it can certainly continue for another decade or so, and this is generally the longest time horizon that most investors care about. Chart I-7The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The second myth concerns the subject du jour: Italy. Many people claim that Italy's economic stagnation is due to deep-seated structural problems which differentiate it from other major economies. The problem with this narrative is that from the mid-1990s until 2008 the growth in Italy's real GDP per head of working age population was little different to that in Germany, France or the U.S. (Chart I-8). Chart I-8Italy Performed In Line With Other Major Economies Until 2008 Italy's economic stagnation only started after the 2008 global financial crisis. After a financial crisis which cripples the banking system, there are two golden rules: unleash fiscal stimulus; and repair the banking system as quickly as possible. The U.S. and U.K. followed the golden rules perfectly and immediately; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as the fiscal stimulus kicked in and the banks recuperated. Italy neither unleashed fiscal stimulus, nor repaired its banks - so its economy has stagnated for a decade. Moreover, if output stagnates for a decade, it follows arithmetically that productivity growth will also look poor. In a back-to-front argument, critics have pounced on this as evidence of excessive 'red tape' and 'structural problems'. But this is a misdiagnosis of the malaise. To reiterate, Italy's real GDP per working-age population was growing very respectably before 2008. Italy's misfortune is that its indebtedness has an unusual profile: more public debt than private debt. France and Spain (and other major euro area economies) have the usual profile: less public debt than private debt. So the EU's fiscal rules - which can see only public debt and are blind to private debt - have severely and unfairly constrained Italy's ability to respond to financial crises. While every other major economy followed the golden rules to recover from the 2008 crisis, Italy could neither unleash fiscal stimulus to kick start the economy nor recapitalise its dysfunctional banking system. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Two Structural Investment Conclusions This week's two investment conclusions are both long term, and require a buy and hold mentality. The first conclusion reiterates a structural position: overweight the Personal Products sector. This is based on our expectation that, in Europe, female participation rates will continue their structural uptrend; while in the U.S. we expect female participation rates to continue outperforming male participation rates. Therefore the sales and profits of the Personal Products sector, in which female spending dominates, will benefit from a multi-year tailwind, at least relative to other sectors. And the extent of this tailwind is not fully discounted in valuations. The second conclusion is a new long-term recommendation: buy exposure to Italian real estate. This is based on our assessment that Italy's decade-long stagnation is not a deep-seated structural malaise. Instead, it is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. Removing these shackles will allow a long-term recovery, just as it did for Spain in 2013. If we are right, the best multi-year buy and hold play is Italian real estate which has been in a decade-long bear market (Chart I-9). For those that cannot directly invest in property, Italy has a small real estate equity sector which faithfully tracks the long term profile of real estate prices (Chart I-10), and whose main component is Beni Stabili. The caveat is that the stock has a market cap of just €2 billion; the appeal is that it offers a juicy dividend yield of 4.5%. Chart I-9Italian Real Estate Has Suffered ##br##A Decade-Long Bear Market Chart I-10Italian Real Estate Equities##br## Track Real Estate Prices Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 And in employment. 2 Please see the European Investment Strategy Special Report "Female Participation: Another Mega-Trend" published on April 6, 2017 and available at eis.bcaresearch.com Fractal Trading Model* This week, we note that the 130-day fractal dimension for platinum versus nickel is close to its lower bound, a level which has consistently predicted a tradeable countertrend move over the following 130 days. Hence, this week's trade is long platinum/short nickel on a 130 horizon before expiry. The profit target is 14% with a symmetric stop-loss. Our two other open trades, long SEK/GBP and long PLN/USD, are both in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations