Commodities & Energy Sector

Highlights Chart of the WeekCrude Oil Prices Align With##BR##Supply-Demand Fundamentals Hedge funds are backing up the truck to get long oil in their portfolios, putting on record or near-record positions in everything from crude oil to gasoline, as global markets tighten and OPEC 2.0 leaders hint they are comfortable with prices that are higher for longer.1 When speculators significantly increase their positions in the market - on the long or the short side - market participants, policymakers and the general public typically begin to wonder whether prices are being artificially distorted by this activity. Our research into the effects of speculation in oil markets is not raising alarm bells at present. If anything, our fundamental models indicate prices are clearing the market in line with supply, demand and inventories (Chart of the Week). We remain overweight oil, and would use sell-offs to add to existing length, including energy-heavy commodity index exposure. Energy: Overweight. Oil markets remain on edge ahead of the May 12 deadline for U.S. President Trump to extend waivers on Iranian export sanctions. If waivers are extended, markets could sell off. Base Metals: Neutral. Aluminum prices fell ~ 10% earlier in the week on news the U.S. would extend the period during which American customers of Rusal had to comply with sanctions against Oleg Deripaska, the company's principal shareholder. U.S. officials also suggested they would lift the sanctions if Deripaska relinquished control over Rusal. Precious Metals: Neutral. Our tactical long position in spot silver established a week ago is down 3.1%, along with gold. A stronger USD weighed on both markets. Ags/Softs: Underweight. Chinese importers of U.S. sorghum petitioned their government to waive the 179% deposit required by Chinese customs for cargoes on the water, according to Reuters.2 The news service also reported soybean trade between the U.S. and China has ground to a halt. Feature Hedge funds are taking their oil exposure to record or near-record highs in crude oil and refined products markets. A tally of positioning by Reuters to the week ended April 20, 2018, shows specs took net oil and products positions to 1.41 billion barrels across CME Group's crude and products futures markets and those of the Intercontinental Exchange (ICE) (Chart 2).3 The reasons cited for the marked increase in speculative positioning in the oil markets have featured in our research since OPEC 2.0's formation in November 2016. These include: Restraint and erosion on the supply side. Production discipline by OPEC and non-OPEC producers has limited supply growth (Chart 3): We estimate crude oil production this year at 99.70mm b/d vs. our March estimate of 100.20mm b/d. Accelerated deterioration of Venezuelan supply has helped constrain global production growth; Chart 2Spec Open Interest Surges Chart 3OPEC 2.0 Discipline Restrains Supply Continued expansion of global demand (Chart 4). In our modeling, consumption growth for this year will be 1.70mm b/d, bringing demand to 100.30mm b/d in 2018. We expect growth for next year of 1.70mm b/d, which will take consumption to 102.00mm b/d; Together, these major fundamental drivers have combined to drain OECD commercial inventories by 395mm barrels from their peak of 3.1 billion barrels in July, 2016 (Chart 5). Chart 4Global Growth Supports Demand Chart 5OECD Inventories Will Continue Drawing As we noted last week, our price forecasts for Brent and WTI crude oil are unchanged at $74 and $70/bbl this year, and $67 and $64/bbl, respectively, next year. We expect OPEC 2.0 to provide forward guidance on its production for 2019, after member states agree on an organizational structure that institutionalizes it as a permanent production-management coalition. As we cautioned last week, this likely will cause us to revise our price forecast for 2019 upward.4 Measuring Speculative Influence In Oil Markets Oil speculators occupy a unique place in the academic literature, and the public's imagination. In the literature, academics largely see them either as bit players in the evolution of oil prices, or as traders who, by their activity, push price to levels far beyond anything justified by the fundamentals, particularly when commodity prices are rising.5 When that commodity is crude oil, and its chief refined product, gasoline - commodities with highly visible prices consumers can track continuously - everyone has an opinion. Not unsurprisingly, the media and politicians join this chorus of recrimination in rising markets, and vilify speculators as well.6 This is hardly surprising. Speculative influence over commodity prices - and the motives of speculators - has been debated for centuries.7 Chart 6Speculative Intensity (Working's T) Vs. Price In the modern era, Holbrook Working, the great Stanford ag economist, developed a speculative intensity index in 1960 to measure the effect of commodity market speculation.8 Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market.9 Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking."10 We plotted Working's T for Brent and WTI futures, and find speculative positioning has ranged between 1.10 and 1.60 (Chart 6). Speculative intensity was trending upward from 2000 - 2014, and then trended lower. Since January 2018, it has averaged 1.4. We would note this latter period encompasses the OPEC market-share war launched in November 2014, and the formation of OPEC 2.0 in November 2016. This was an especially difficult market for hedge funds and speculators generally, particularly last year, when many funds were forced to shutter their operations. Over the past three years, markets have had to adjust to a production free-for-all arising from OPEC's market-share war, which was followed by a supply shock induced by OPEC 2.0, when it agreed to remove 1.80mm b/d of oil production from the market.11 Given this backdrop, it is not surprising to see speculative intensity in oil markets falling, as our chart indicates. Specs And Prices Our research shows the evolution of oil prices is dominated by fundamentals - supply, demand, inventory and broad trade-weighted USD being the dominant fundamentals - and not by spec positioning.12 In forthcoming research, we will dig deeper into this, and also look at the evolution of price volatility in the oil markets. Our analysis using Working's T indicates speculators provide sufficient liquidity to hedgers in the Brent and WTI futures markets, suggesting they are fulfilling the role posited by the IEA in its 2012 medium-term analysis: "Speculators should not be viewed as adversarial agents. Rather, they are essential participants for the proper functioning of commodity derivatives markets by providing the necessary liquidity, thereby reducing market volatility."13 Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia, which pledged to remove 1.80mm b/d of production from the market. 2 Please see "China's sorghum importers ask government to drop tariff for cargoes en route," published by uk.reuters.com April 24, 2018, and "After sorghum spat, U.S. - China trade fears halt soybean imports," published April 25, 2018. 3 Please see "Commentary: Hedge fund oil bulls on the rampage as bears vanish," published by uk.reuters.com on April 23, 2018. 4 For our most recent assessment of supply-demand fundamentals, please see "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published by BCA Research's Commodity & Energy Strategy April 19, 2018. It is available at ces.bcaresearch.com. 5 Bookending this research are Hamilton, James D. (2009), "Causes and Consequences of the Oil Shock of 2007 - 08," published by the Brookings Institution re fundamentals dominating the evolution of oil prices, and, at the other end, Singleton, Kenneth (2011), "Investor Flows and the 2008 Boom/Bust in Oil Prices," available at SSRN. 6 Please see the International Energy Agency's "Oil: Medium-Term Market Report 2012," for a discussion on speculation beginning on p. 21. 7 See, for example, the discussion of how Thales of Miletus in modern-day Turkey monopolized the olive-press market, and how another unnamed individual in Sicily cornered the iron market, in the Politics of Aristotle, a Greek philosopher of the 4th century BCE (at 1259a in Politics). 8 Working was a pioneer in the analysis of prices and agricultural trading markets. Please see Working, Holbrook (1960), "Speculation on Hedging Markets," Stanford University Food Research Institute Studies 1: 185-220. 9 We use the specification of Working's T found in Adjemian, M. K., V. G. Bruno, M. A. Robe, and J. Wallen. "What Drives Volatility Expectations in Grain Markets?" Proceedings of the NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management (pp. 18, 19). Working's T is calculated as with SS = Speculative Short Open Interest, SL = Speculative Long Open Interest, HL = Hedge Long Open Interest, and HS = Hedge Short Open Interest. The U.S. Commodity Futures Trading Commission (CFTC) notes, "Working's T-index is silent on the direction of speculation (long versus short). Instead, the amount of speculation is gauged relative to what is needed to balance hedging positions. Because it is directionless Working's T-index is only tested as a causal variable for market volatility." Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 10 Please see Irwin and Sanders (2010), p. 5. 11 We discuss the extremely difficult trading environment confronted by hedge funds and others over the past two years in our Special Report titled "Key Themes For Energy Markets in 2018," which was published by BCA Research's Commodity & Energy Strategy December 7, 2017. It is available at ces.bcaresearch.com. 12 Granger-causality tests on Brent and WTI prices between 2010 and now - the post-GFC era - show the level of prices leads spec position levels in these markets. 13 Please see (p. 22) of the IEA's 2012 Medium-term Market Report cited above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Special Report

Highlights The scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. Sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. We project this will boost steel and coal output by 5.2% and 4.7% respectively, this year at a time when demand is set to slow. Steel, coal, iron ore and coke prices are all vulnerable to the downside. Share prices of the companies and currencies of countries that supply these commodities to China are most at risk. Feature Last November, our report titled, "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," painted a negative picture for steel and coal prices over 2018 and 2019.1 Since then, after having peaked in December and February respectively, both steel and thermal coal prices have so far declined by about 20% from their respective tops (Chart 1). In the meantime, iron ore and coking coal have also exhibited meaningful weakness (Chart 2). Chart 1More Downside In Steel And Coal Prices Chart 2Iron Ore And Coking Coal Prices Are Also At Risk In this report, we revisit the topic of de-capacity reforms and examine how Chinese supply side reforms in 2018 will affect steel and coal prices. The key message is as follows: Having implemented aggressive capacity reduction over the past two years, the authorities are shifting the focus of supply side reforms from "de-capacity" to "replacement" of already removed capacity with technologically advanced capacity. This means the scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. In addition, sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. From an investing standpoint, this means both steel and coal prices are still vulnerable to the downside. Both could drop by more than 15% from current levels over the course of 2018. Diminishing Scale Of "De-Capacity" Reforms Reducing capacity (also called "de-capacity") in the oversupplied steel and coal markets has been a key priority within China's structural supply side reforms over the past two years. Steel Table 1 shows that the capacity reduction target for steel in 2018 is 30 million tons, which is much lower than the 45 million tons in 2016 and 50 million tons in 2017. Table 1Capacity Reduction: Target And Actual Achievement In addition, between May and September 2017, the "Ditiaogang"2 removal policy eliminated about 120 million tons of steel capacity, and sharply reduced steel products production. Most of Ditiaogang capacity was completely dismantled last year. Therefore, there is not much downside to steel production from Ditiaogang output cutbacks going forward. Furthermore, between October and December 2017, environmental policies aimed at fighting against winter smog also cut steel products output substantially, which pushed steel prices to six-year highs in December (Chart 3). Chart 3Policy Actions And Market Dynamics: Steel Sector In particular, in the last quarter of 2017, to ensure fewer smog days around the Beijing area, Tianjin's steel products output was reduced by 50% from a year earlier. The second biggest contribution to total steel output decline occurred in Hebei - the largest steel-producing province in China - where steel output plummeted by 7%. Excluding Tianjin and Hebei, national steel products output fell only by 3.9% from a year ago. As a long-term solution to ameliorate ecology and air quality around Beijing, the government is aiming to reduce the heavy concentration of steel production in Tianjin and Hebei by shifting a considerable portion of steel capacity to other regions in 2018 and following years. These two provinces together accounted for about 30.6% of the nation's steel products output in 2016; their share dipped to 27.6% in 2017. As a result, next winter the required production reduction from these regions to achieve the air quality targets in Beijing will be smaller. In short, the scale of specific policy driven steel output reduction in 2018 will be meaningfully lower than last year. Coal For coal, despite the same target as last year (150 million tons), the actual capacity cut this year will be much less than last year's actual reduction of 250 million tons, which exceeded the 150 million-ton target. Amid still-high coal prices, the authorities will be more tolerant of producers not cutting too much capacity. Plus, with nearly two-thirds of the 2016-2020 target for capacity cuts having already been achieved in the past two years, there is much less outdated capacity in the industry (Table 1 above). In addition, the government's environment-related policies also led to a decline in total national coal output between October-December 2017 (Chart 4), with Hebei posting the biggest cut in coal output among all provinces. Chart 4Policy Actions And Market Dynamics: Coal Sector However, the authorities shortly thereafter relaxed restrictions on coal output, as the country was severely lacking gas supply for heating. In January and February of this year, the authorities reversed course, demanding that producers accelerate new advanced capacity replacement and increase coal production. Bottom Line: The scale of China's "de-capacity" reforms are diminishing, resulting in a lessening production cuts. Installing Technologically Advanced Capacity China's supply side reforms have included two major components - reducing inefficient capacity and low-quality supply that damaged the environment while boosting medium-to-high-quality production that is economically efficient and ecologically friendly. In brief, having removed significant obsolete capacity in the past two years, the policy focus is now shifting to capacity replacement. The latter enables China to upgrade its steel and coal industries to become more efficient and competitive worldwide, as well as ecologically safer. To guard against excessive production capacity of steel and coal, the authorities are reinforcing the following replacement principle: the ratio of newly installed-to-removed capacity should be less or equal to one. Two important points need to be noted: First and most important, the zero or negative growth of total capacity of steel and coal does not necessarily mean zero or negative growth in steel and coal output. For example, while total capacity for crude steel and steel products declined 4.8% and 1.8% year-on-year in 2016 respectively, output actually increased 0.5% and 1%. Despite falling total capacity, rising operational capacity could still contribute to an increase in final output. Total capacity (measured in tons) for steel and coal production includes both operational capacity and non-operational capacity, the latter representing obsolete/non-profitable capacity. As more technologically advanced capacity is installed to replace the already-removed one, both the size of operational capacity and the capacity utilization rate (CUR) will rise. Typically, advanced technologies have a higher CUR - consequently, production will grow. Second, an increase in the CUR of existing operational capacity will also result in rising output. In 2018, odds are that both the steel and coal industries in China will have non-trivial output increases as a result of new advanced capacity coming on stream. Steel Since late 2015, in environmentally sensitive areas of the Beijing-Tianjin-Hebei region and the Yangtze River Delta and the Pearl River Delta, steel plants have been required to add no more than 0.8 tons of new capacity for every 1 ton of outdated capacity removed. For other areas, the same ratio is 1 or less. Electric furnace (EF) steel-producing technology - which is cleaner, more advanced and used to produce high-quality specialized steel products - has become the major type of new capacity addition. This technology is favored by both the government and steel producers. Chinese EF-based steel production accounted for only 6.4% of the nation's total steel output in 2016, far lower than the world average of 25.7% (Chart 5). The EF technology uses scrap steel as raw materials, graphite electrodes and electricity to produce crude steel. Graphite electrodes, which have high levels of electrical conductivity and the capability of sustaining extremely high levels of heat, are consumed primarily in electric furnace steel production. Chart 6 demonstrates that prices of both graphite electrode and scrap steel have surged since mid-2017. This signifies that considerable new EF production capacity has been coming on stream. Chart 5Chinese Electric Furnace Crude Steel ##br##Production Will Go Up Chart 6Considerable New Addition Of##br## Chinese Electric Furnace Capacity Indeed, in 2017 alone, 44 units of EF were installed. In comparison, between 2014 and 2016, only 47 units of EF were installed. As the completion of a new EF installation in general takes eight to 10 months, all of EF capacity installed in 2017 - about 31 million tons of crude steel production capacity - will be operational in 2018. In addition, a report from China's Natural Resource Department indicates that as of mid-December there have been 54 replacement projects with total new steel production capacity of 91 million tons (including new EF capacity, new traditional capacity and recovered capacity). This compares to 120 million tons of capacity removed in 2016-'17. Assuming 60% of this 91 million tons capacity will be operating throughout 2018 at a utilization rate of 80% (the NBS 2017 CUR for the ferrous smelting and pressing industry was 75.8%), this alone will result in 43.6 million tons more output in 2018 from a year ago (5.2% growth from 2017 output) (Table 2). Table 2Strong Profit Margins Will Encourage Steel Production At the same time, strong profit margins will encourage steel makers to produce as much as possible to maximize profits (Chart 7). This will be especially true if the incumbent companies have to absorb liabilities of firms that were shutdown (please refer to page 14 for the discussion on this point). Facing more debt from shutdowns of other companies, steel incumbent producers would have an incentive to ramp up their production to generate more cash. Yet, we do not assume a rise in CUR for existing steel capacity. Hence, crude steel output growth in 2018 will likely be around 5.2%, higher than the 3% growth in 2017. This is in line with the top 10 Chinese steel producers' projected crude steel output growth in 2018 of 5.5%, based on their published production guidance data. The Ditiaogang and environmental policy caused a significant contraction in steel products growth in 2017, but will have limited impact in 2018 as discussed above. Eventually, increasing crude steel output will translate into strong growth in steel products output3 (Chart 8). Chart 7Strong Profit Margins ##br##Will Encourage Steel Production Chart 8Steel Products Production ##br##Will Rebound In 2018 Coal China's current coal capacity is about 5310 million tons, with 4780 million tons as operational capacity and the remaining 530 million tons as non-operational capacity, which has not produced coal for some time. As in general it takes roughly three to five years to build a coal mine, it will take a long time to replace the obsolete capacity. Yet there is hidden coal capacity in China. The China Coal Industry Association estimated last year that there was about 700 million tons of new technologically advanced capacity that has already been built and is ready to use, but has not yet received government approval. This is greater than the 530 million tons of coal production removed in the past two years by de-capacity reforms - equivalent to about 20% of China's total 2017 coal output. This hidden capacity originated from the fact that coal producers in China historically began building mines before applying for approval. However, since 2015, all applications for new coal mines have been halted. Consequently, in the past three years a lot of capacity has already been built but has not been put into operation. Some 70% of this hidden capacity includes large-scale coal mines, each with annual capacity of above 5 million tons. In comparison, China has about 126 million tons of small mines with annual capacity of 90,000 tons that will be forced to exit the market this year as they are non-competitive due to their small scale and inferior technology. Why do we expect this hidden capacity to become operational going forward? The authorities now allows trading in the replacement quota for coal across regions. Producers having these ready-to-use high-quality mines can buy the replacement quota from the producers who have eliminated the outdated capacity. The government wants to accelerate the process of allowing the advanced capacity to be in operation as fast as possible. The following policy initiative supports this: A new policy directive released this past February does not even require coal producers with advanced capacity to pay the quota first in order to apply for approval - they can apply for approval to start the replacement process first, and then have one year to pay for it. Economically, quotas trading makes sense. The mines with advanced technology that have lower costs and higher profit margins should be able to pay a reasonably high (attractive) price for quotas to companies with inferior technologies, so that the latter will be better off selling their quotas than continuing operations. The proceeds from the selling quotas will be used to settle termination benefits for employees of low-quality coal mines. Regarding our projections for coal output in 2018, assuming 30% of the 700 million tons of capacity among high-quality mines will be operational this year at a CUR of 78% (the NBS 2017 coal industry CUR was 68.2%), this alone will bring a 164 million-ton increase in coal output (4.7% of the 2017 coal output) (Table 3). Table 3Chinese Coal Output Will Rise By 4.7% In 2018 In addition, still-high profit margins could encourage existing coal producers to increase their CUR this year (Chart 9). Yet, we do not assume a rise in CUR for existing coal mining capacity. In total, Chinese coal output may increase 4.7% this year, higher than last year's 3.2% growth (Chart 10). Chart 9Strong Profit Margins Will Boost Coal Production Chart 10Coal Output Is Already Rising Bottom Line: Sizable technologically advanced new capacity is coming on stream for both steel and coal. This will boost both steel and coal output by about 5.2% and 4.7%, respectively, this year. Impact On Global Steel And Coal Prices In addition to diminishing capacity cuts and new technologically advanced capacity additions, the following factors will also weigh on steel prices: Relatively high steel product inventories (Chart 11, top panel) Weakening steel demand, mainly due to a potential slowdown in the property market4 Declining infrastructure investment growth (Chart 11, bottom panel). Chinese net steel product exports contracted 30% last year as steel producers opted to sell steel products domestically on higher domestic steel prices (Chart 12). Chart 11Elevated Steel Product Inventory##br## And Weakening Demand Chart 12China's Steel Product Exports ##br##Will Rebound Falling domestic steel prices may lead steel producers to ship their products overseas. In addition, the government has reduced steel products export tariffs starting January 1, 2018, which may also help increase Chinese steel product exports this year. This will pass falling Chinese domestic steel prices on to lower global steel prices. Between 2015 and 2017, about 1.6% of all Chinese steel exports were shipped to the U.S. Even if U.S. tariffs dampen its purchases of steel from China, mainland producers will try to sell their products to other countries. In a nutshell, U.S. tariffs will not prevent the transmission of lower steel prices in China to the global steel market. With respect to coal, in early April the Chinese government placed restrictions on Chinese coal imports at major ports in major imported-coal consuming provinces including Zhejiang, Fujian and Guangdong (Chart 13). The government demanded thermal power plants in those areas to limit their consumption of imported coal and use domestically produced coal. Clearly the government is trying to avoid cheaper imports flooding into the domestic coal market amid still elevated prices. This will help prevent a big drop in domestic coal prices but will be bearish for global coal prices. For example, 40% and 30% of Chinese coal imports are from Indonesia and Australia, respectively (Chart 14). These economies and their currencies are at risk from diminishing Chinese coal imports. Chart 13Chinese Coal Imports Will Decline Chart 14Indonesia and Australia May Face Falling ##br##Coal Demand From China For the demand side, continuing strong growth in non-thermal power supplies such as nuclear, wind and solar will curb thermal power growth in the long run and thus limit thermal coal consumption growth in China. This may also weigh on domestic coal prices and discourage coal imports. Bottom Line: The downtrend in domestic steel and coal prices will weigh on the global steel and coal markets. What About Iron Ore And Coking Coal? Iron ore and coking coal prices are also at risk: Chart 15Record High Chinese Iron Ore Inventory Given about 40% of newly installed steel capacity is advanced electric furnace (EF) based - which requires significant amounts of scrap steel rather than iron ore and coke - rising steel output will increase demand for iron ore and coke disproportionally less. As more Chinese steel producers shift to EF technology, mainland demand for iron ore and coke will diminish structurally in the years to come. Despite weakness in both domestic iron ore production and iron ore imports, Chinese iron ore inventories at major ports, expressed in number of months of consumption, have still reached record highs (Chart 15). This suggests rising EF capacity has indeed been constraining demand for iron ore. Increasing coal output will bring more coking coal and a corresponding rise in coke supply, thereby further depressing coke prices. Bottom Line: Global iron ore and coking coal prices are also vulnerable to the downside. Investment Implications From a macro perspective, investors can capitalize on these themes via a number of strategies: Shorting iron ore and coal prices, or these commodities producers' stocks. Chart 16Chinese Steel And Coal Shares:##br## Puzzling Drop Amid High Profit Going short the Indonesian rupiah (and possibly the Australian dollar) versus the U.S. dollar. Australia and Indonesia are large exporters of coal and industrial metals to China - they account for 30% and 40% of Chinese coal imports, respectively, so their currencies are vulnerable. Notably, although steel and coal prices are still well above their 2015 levels and producers' profit margins are very elevated, share prices of Chinese steel makers and coal producers have dropped almost to their 2015 levels (Chart 16). From a top-down standpoint, it is hard to explain such poor share price performance among Chinese steel and coal companies when their profits have been booming. Our hunch is that these companies have been forced by the government to shoulder the debt of the peer companies that were shut down. This is an example of how the government can force shareholders of profitable companies to bear losses from restructuring by merging zombie companies into profitable ones. On a more granular level, rapidly expanding EF steel-making capacity in China will lead to outperformance of stocks related to EF makers, graphite electrode producers and domestic scrap steel collecting companies. First, demand for graphite electrodes continues to rise, as EF steel production expands. Prices of graphite electrodes may stay high for quite some time (Chart 6 above, top panel). Second, scrap steel prices may go higher or stay high to encourage more domestic scrap steel collection. Companies who collect domestic scrap steel may soon have beneficial policy support, which will create huge potential for expansion (Chart 6 above, bottom panel). Third, EF makers will also benefit due to strong sales of electric furnaces. As a final note, equity investors should consider going long thermal power producers versus coal producers as thermal power producers will benefit from falling coal prices. Ellen JingYuan He, Associate Vice President Frontier Markets Strategy EllenJ@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed", dated November 22, 2017, available at ems.bcaresearch.com. 2 "Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality, and also lead to environmental degradation. 3 The big divergence between crude steel production expansion and steel products output contraction last year was due to both the removal of "Ditiaogang" and statistical issues. "Ditiaogang" is often converted into steel products like rebar and wire rods. As steel produced this way is illegal, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. 4 Please see Emerging Markets Strategy Special Report, "China Real Estate: A New-Bursting Bubble?", dated April 6, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Oil markets could get even tighter, depending on fundamental "known unknowns." Chart of the WeekEM Import Volumes Continue Expanding,##BR##Reflecting Rising Incomes And Oil Demand The largest of these unknowns are the evolution of Iranian and Venezuelan oil output. With the May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran fast approaching, and Venezuela's output in free fall, supply could contract dramatically. On the demand side, our short-term trade model is signaling EM imports continue to grow, which indicates continued income growth (Chart of the Week). EM growth drives oil demand growth. DM growth also will support commodity demand this year and next. The likelihood oil prices push toward - or exceed - $80/bbl this year is high. An extension of OPEC 2.0's production cuts into next year all but assures such excursions in 2019.1 Our forecast for 2018 remains at $74 and $70/bbl for Brent and WTI; we are leaving our 2019 forecasts at $67 and $64/bbl, respectively, but anticipate raising them as OPEC 2.0 forward guidance evolves. Energy: Overweight. Oil trade recommendations closed in 1Q18 were up an average 82%. The trades were initiated between Sep/17 and Jan/18. Base Metals: Neutral. LME aluminum's backwardation extends to end-2021, reflecting tighter physical markets. This supports our long S&P GSCI call, which is up 11.4% since Dec 7/17, when we recommended it. Precious Metals: Neutral. We are getting tactically long spot silver at tonight's close. Back-to-back physical deficits in 2016 and 2017, global income growth, and near-record speculative short positioning in COMEX silver - 79.8k futures contracts - are bullish. Ags/Softs: Underweight. Importers of U.S. sorghum into China now are required to post a 179% deposit with Chinese customs, according to Xinhuanet. The state-run news agency reported Ministry of Commerce findings of a surge in U.S. imports - from 317k MT in 2013 to 4.80mm MT in 2017 - which drove down local prices 31%, and "hurt local industries." Feature Our updated balances modeling indicates oil markets remain tight, and will continue to tighten this year, given our fundamental assumptions for supply and demand (Chart 2). We now estimate slightly lower crude oil production this year - 99.73mm b/d vs. our March estimate of 100.20mm b/d - with OPEC output at 32.12mm b/d, vs. 32.50mm b/d last month (Table 1). This is offset by non-OPEC supply growth, which continues to be led by rising U.S. shale-oil output (Chart 3). We expect production in the "Big 4" basins - Bakken, Permian, Eagle Ford and Niobrara - to average just over 6.44mm b/d this year, up 1.21mm b/d y/y, and 7.78mm b/d next year, up just over 1.34mm b/d. Chart 2Oil Markets Will Tighten Further Chart 3Lower OPEC Production Offset By U.S. Shales Table 1BCA Global Oil Supply - Demand Balances (mm b/d) We are leaving our consumption growth estimate for this year unchanged at 1.70mm b/d, bringing demand to 100.32mm b/d in 2018 on average, and raising our expectation for 2019 to 1.70mm b/d growth, which will take it to 102.00mm b/d on average (Chart 4). Global inventories will continue to drain on the back of these bullish fundamentals, falling somewhat more than we expected last month (Chart 5). We would note the trajectory of inventory growth likely will be altered once we have definitive 2019 production guidance from OPEC 2.0 - i.e., we expect some production cuts to be maintained next year, keeping inventories closer to end-2018 levels. These fundamentals leave our price forecasts unchanged at $74 and $70/bbl for Brent and WTI this year, and $67 and $64/bbl, respectively, next year (Chart 6). Again, we caution clients we fully expect to raise our 2019 forecast as OPEC 2.0 forward guidance evolves. Ministers of the coalition met this month in New Delhi and Riyadh, presumably to discuss institutionalizing their confederation.2 Chart 4Oil Demand##BR##Remains Stout Chart 5Bullish Fundamentals##BR##Drain Inventories Chart 6Price Forecast Unchanged,##BR##But Upside Risks Are Rising Once Again With "Known Unknowns"3 Supply-Side "Known Unknowns" A critical juncture in the evolution of the oil markets is fast approaching: The May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran, and a determination on whether the U.S. will impose sanctions directly against Venezuela's oil industry. We have no advance knowledge of what the administration will do, but the signaling from the Trump White House has us inclined to believe the Iran sanctions will not be waived this time around. Action against Venezuela also is difficult to predict, but, of late, markets are sourcing alternative crude streams against a growing likelihood such sanctions will be imposed.4 Approaching the deadline for waiving Iranian sanctions, we have Iranian crude production at ~ 3.85mm b/d in 2H18, and a little over 3.90mm b/d next year. Prior to sanctions being lifted in January 2016, Iran was producing 2.80mm b/d. It is difficult to determine what will happen if sanctions are not waived by the U.S. - critically, whether U.S. allies will support such a move - so it is difficult to determine how deeply Iranian production and exports will be affected, if at all. S&P Global's Platts service noted a former Obama administration official estimated as much as 500k b/d of Iranian exports could be lost to the market, should the sanctions be restored. Other estimates range as high as 1mm b/d.5 We are carrying Venezuelan crude production at 1.52mm b/d for March, and have it declining to just over 1.40mm b/d by December. Last year, production averaged just over 1.90mm b/d. The government of Nicolas Maduro has run the economy and the state oil company, PDVSA, into the ground. Inflation came in at 454% in 1Q18, leaving prices up 8,900% in the year ended in March, according to Reuters.6 Presently, oil workers are fleeing PDVSA in a "stampede," according to Reuters, leaving the company woefully short of experienced personnel.7 The company lacks the wherewithal to pay for basic additives (diluents) to make its crude oil marketable. It is possible some of the company's creditors in Russia or China will step in to take over operations, but so far nothing has been announced. Demand-Side "Known Unknowns" Our demand estimates are premised on continued global growth this year and next, consistent with the IMF's latest global economic assessment.8 The Fund expects global GDP growth of 3.9% this year and next, which we incorporate into our modeling. Aside from the usual litany of long-term economic ills plaguing DM and EM economies - high debt levels, aging populations, falling labor-force participation rates, low productivity growth, and the need for diversification among commodity-exporting EM economies - trade tensions have become a more prominent risk. The Fund notes increasing trade tensions - set off by the U.S. imposition of tariffs on aluminum and steel imports - have the potential to "undermine confidence and derail global growth prematurely." These tensions have been stoked by tit-for-tat tariff announcements by the U.S. and China over the past month or so. Our own research supports this concern, which we believe is particularly acute for EM economies, where income growth, trade and commodity demand are inextricably entwined. Continued EM trade growth is essential for commodity demand growth, particularly for oil: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000. These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes.9 EM growth accounts for slightly more than three-quarters of the overall oil-demand growth we expect this year and next - ~ 1.30mm b/d of the 1.70mm b/d of growth we are forecasting. While the odds of a full-blown trade war remain low, in our estimation, we could begin to see the erosion of confidence and the potential for growth to be derailed affecting investment, trade volumes and EM growth generally, which would be bearish for oil demand growth. That said, we share the view articulated by our colleagues in BCA's Global Investment Strategy last week: "Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now." "Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff ... . However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune."10 A Note On Permian Basis Differentials WTI - Midland differentials recently weakened considerably, as take away capacity out of the basin became strained (Chart 7). Weakness in the Light Houston Sweet differentials, which measure the spread between the producing and consuming markets for WTI produced in the Permian, traded as wide as -$9.00/bbl. This market has experienced similar such widening of the basis, which can be seen in the WTI-Midland vs. WTI - Cushing differentials, which widened considerably when Permian production increased (Chart 8).11 These basis blowouts typically incentivize additional pipeline capacity. Indeed, earlier this year, some 2.4mm b/d of new takeaway capacity had been proposed by pipeline operators.12 Once this capacity is online, we expect to see WTI exports from the Gulf increasing. Chart 7Growing Pains In The Permian:##BR##Takeaway Capacity Constraints Chart 8Permian Crude Oil Production##BR##Exceeded Takeaway In The Past Bottom Line: We are maintaining our $74 and $70/bbl prices forecasts for Brent and WTI in 2018, and expect to revise our 2019 forecasts of $67 and $64/bbl, respectively, once we get definitive forward guidance from OPEC 2.0. We continue to monitor supply-side risk - chiefly re Venezuela and Iran - and trade-war threats to the demand side, for any information that could cause us to substantially revise our forecasts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Member states pledged to remove 1.80mm b/d of production from the market, of which some 1.2mm b/d is believed to be actual production cuts, while the remainder is comprised of involuntary losses from Venezuela and other producers unable to offset decline curve losses. 2 Please see S&P Platts OPEC Guide of April 16, 2018, entitled "OPEC MAR CRUDE OIL PRODUCTION TUMBLES TO 32.14 MIL B/D, DOWN 250,000 B/D FROM FEB: PLATTS SURVEY," which reports on the OPEC 2.0 ministerial meetings this month in New Delhi and Riyadh. 3 "Known Unknowns" is a phrase popularized by Donald Rumsfeld, a former U.S. Secretary of Defence in the administration of George W. Bush, at a press conference. Please see the U.S. Department of Defence "News Transcript" of February 12, 2002, at http://archive.defense.gov/Transcripts/Transcript.aspx?TranscriptID=2636 4 Please see "A U.S. Ban On Crude Imports," published by vessel tracker KPLER April 13, 2018. 5 Please see "US foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts March 20, 2018. 6 Please see "Venezuela inflation 454 percent in first quarter: National Assembly," published by reuters.com on April 11, 2018. 7 Please see "Under military rule, Venezuela oil workers quit in a stampede," published by uk.reuters.com on April 17, 2018. 8 Please see "Global Economy: Good News for Now but Trade tensions a Threat," published on the Fund's blog April 17, 2018. 9 Please see "Trade Tensions Cloud Oil Outlook," in the March 8, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Is China Heading For A Minsky Moment?" in the April 13, 2018, issue of BCA Research's Global Investment Strategy. It is available at gis.bcaresearch.com. 11 LHS data is limited, as it only recently emerged as a benchmark for the Houston refining market. 12 Please see "Operators Race to Build Pipelines As Permian Nears Takeaway Capacity," in the March 2018 issue of Pipeline & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Special Report

Markets have been uneasy recently; last month saw the Fed raise rates, combined with language indicating a steeper path for interest rate moves in the coming two years. As of writing, markets are currently assigning a nearly 75% probability of at least two further rate hikes this year alone. However, amidst the Fed's tightening, the government has been embarking on fiscal largess. The recent tax cuts, budget announcements and potential infrastructure bill mean that we have entered a fairly rare period of loose fiscal policy and tight monetary policy; in our October 9th, 2017 Weekly Report, we highlighted seven such periods since the Second World War (shaded in Chart 1). Another two-year period of fiscal easing and tight money is upon us. Bull Markets Don't Die Of Old Age... To complete the adage above, "Bull markets don't die of old age, they are killed by higher interest rates". Thus the focus of roiled markets should be whether tight monetary policy can be offset by loose fiscal policy. In other words, can the government be stimulative enough to cushion the blow from higher interest rates and extend the business cycle? With all seven iterations of simultaneous fiscal easing and monetary tightening noted above resulting in positive stock market returns and the SPX rising by 16% on average, the answer appears to be a resounding yes (Table 1). Chart 1Loose Fiscal Policy Offsets##br## Tight Monetary Conditions Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Further, the infrastructure bill has not yet become part of the fiscal thrust in this current bull market, meaning that there is still dry powder in the stock market's battle against higher rates. Depending on the timing of the infrastructure bill (and the further away, the better for sustaining the equity market blow off phase), there are good odds that this bull market could be the longest in history (Table 2). Using months without an inverted yield curve as an alternative measure, we are already there as the current streak of 131 months beats the 104 month streak of much of the '90s (Chart 2). Table 2Bull Markets Since World War II Chart 2Longest Positive Yield Curve Streak In 50 Years Look To Earnings For Direction Our view remains that earnings will have to take up the mantle to drive the SPX higher.1 At this stage in the bull market's life, the SPX is no longer discounting many years of future growth and higher rates weigh on this growth rate. The implication is a forward P/E multiple that should drift sideways to lower leaving profits to do all the heavy lifting and largely explaining the S&P 500's return (bottom panel, Chart 3). Importantly, the combination of synchronized global growth and a soft U.S. dollar underpin EPS. Tack on the effect of tax reform (at least this year) and the 20% and 10% EPS growth rates penciled in by the sell side for 2018 and 2019, respectively, are achievable, barring a recession. Considering that stocks and EPS growth move together (top panel, Chart 3), the path of least resistance is higher still for the SPX. This positive equity backdrop warrants a positioning update. Accordingly, we have analyzed the GICS1 industry groups and their average annualized performance in each of the most recent five periods for which we have data of loose fiscal and tight monetary policy. The results presented in Table 3, however, are nuanced. Chart 3Stocks And EPS Are Joined At The Hip Table 3Sector Relative Performance In Tight Monetary/Loose Fiscal Conditions In the left column, our raw data suggests that technology is dominant in the periods we have examined. However, this is skewed by the 1998-99 iteration when this sector went parabolic as the dotcom bubble was inflating, making virtually all other sectors underperform, dramatically in most cases. We have adjusted for this exceptional period in the right column. The adjusted results are telling as cyclicals and positive interest rate sensitive sectors (the S&P financials and energy indexes) are the top performers. Conversely, defensives and negative interest rate sensitive sectors (the S&P utilities and real estate indexes) are the worst performers. Such a result is intuitive; loosening fiscal policy during expansions tends to extend/prolong the business cycle and may also arrive in late/later stages of the cycle where equity returns go parabolic and deep cyclicals roar. In addition, when the Fed raises rates, financials tend to benefit and competing fixed income proxies suffer. Further, there is a positive feedback loop in these actions as loose fiscal policy in good times is typically inflationary, especially when the economy is at full employment, which thus pushes the Fed to continue to or even accelerate its tightening mode. We note that we maintain a preference for cyclicals over defensives in our portfolio, based on our key investment themes for 2018: synchronous global capex growth and rising interest rates. Our analysis here serves to confirm our hypothesis. The purpose of this report is to identify winners and losers in times of easy fiscal and tight money phases, and provide a roadmap of how sector returns may pan out in the coming two year period of fiscal expansion and liquidity withdrawal, if history at least rhymes. Accordingly, what follows is an analysis of the two adjusted top and bottom performers noted above. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. Financials Are A Top Pick Financials benefit from both sides of a monetary tightening/fiscal loosening environment. Rising interest rates are a boon to sector EPS as the increasing price of credit translates directly into top line growth. The higher cost of borrowing should typically result in a slowdown in borrowing and consumption. With fiscal largesse serving to at least offset any natural demand declines, the result should be a banker's dream: simultaneous capital formation and better terms on the existing book of business. The benefits of monetary tightening and fiscal easing are not exclusive to businesses either; such an environment has typically been synonymous with soaring consumer confidence, keeping loan demand high (second panel, Chart 4). Further, low unemployment has historically meant peaking credit quality, implying a margin tailwind to the already-rising top lines of lenders (third panel, Chart 4. Chart 4RS2 Financials Are In A Goldilocks Scenario As operating cash flows are soaring, it is likely that financials will increasingly embark upon shareholder friendly activities. The GFC saw lenders in particular shore up weakened balance sheets with enormous equity issues; the reversal in fortunes (especially given the record number of banks passing Fed stress tests) will see accelerated equity retirement, yet another benefit to EPS growth. In sum, S&P financials should be a core holding during periods of monetary tightening and fiscal easing, (see appendix, Chart 1A); we reiterate our overweight recommendation on financials and our high-conviction overweight on the key S&P banks sub index. Energy Is Just Getting Warmed Up As noted above, one of BCA's key investment themes for 2018 is synchronized global capex, of which the S&P energy sector is a key beneficiary, at least in part fueled by lower taxes and the upcoming infrastructure bill. Recently, the capital expenditures part of the Dallas Fed manufacturing outlook survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 5). Chart 5Energy Should Benefit From High Capex Equally importantly, the recovery in the global economy has kept a solid floor underneath oil prices, which are pushing up against 3-year highs (top panel, Chart 5). Pricing power in energy is rising at its fastest pace this decade and (for now) the sector wage bill is continuing to contract (bottom panel, Chart 5), implying not only top line gains but also a much better margin profile. Still, monetary tightening represents a headwind for the sector. Higher interest rates tend to suppress investment demand and support the U.S. dollar which could put downward force on the price of oil. Our analysis suggests the stimulative effects from fiscal easing should more than offset any pressure from monetary tightening (see appendix, Chart 1B). Accordingly, we reiterate our high-conviction overweight recommendation on the S&P energy index. Be Cautious With Utilities We recently upgraded the beaten-down S&P utilities index to a benchmark allocation, based largely on a modest improvement in operating metrics, lifted by BCA's key 2018 capex growth investment theme; expansionary fiscal thrust should only enhance these metrics. Nat gas prices appear to have mostly stabilized and, as the marginal price setter for utilities, should support the nascent turnaround in industry pricing power (second panel, Chart 6). Further, the rebound in electricity production has peaked but remains comfortably in expansionary territory (third panel, Chart 6). Chart 6Higher Rates Offset Better Fundamentals Notwithstanding the operational positives, we think BCA's key theme of higher interest rates present a hefty offset. Utilities, a high dividend yielding sector, suffer when Treasury bond yields move higher, as competing risk free assets become more appealing (bottom panel, Chart 6). We suspect this fixed income-proxy characteristic is why the S&P utilities sector is historically the worst performer as the Fed is tightening monetary policy (see appendix, Chart 1C). Still, the sector has harshly sold down already and we think the positives and negatives are broadly in balance; we reiterate our neutral recommendation on the S&P utilities index. Real Estate Is Not Immune From Monetary Tightening Much like the S&P utilities index, the S&P real estate sector trades as a fixed income proxy. Accordingly, the anticipated advance in Treasury yields should weigh heavily on REIT prices (top panel, Chart 7), regardless of the underlying fundamentals; fortunately, there is some good news there. Chart 7CRE Prices Are Rising But ##br##How Much Further Can They Go? Lending standards had been tightening from 2013 until the middle of last year; since then, they have been loosening as fears of a second real estate recession gave way to general economic optimism. Given the tight correlation between lending standards and commercial property prices, a loosening of the former bodes well for the latter (second panel, Chart 7). Still, with commercial real estate prices approaching two standard deviations above the 30-year trend (bottom panel, Chart 7), the longevity of the good times should be questioned. Regardless of the modestly improving industry fundamentals, particularly in the context of the fiscal largesse that will certainly be stimulative, monetary tightening headwinds should at least provide an offset (see appendix, Chart 1D). On balance, we reiterate our neutral recommendation on the S&P real estate index. Appendix Chart 1A Chart 1B Chart 1C Chart 1D

Highlights Capacity cuts in China's steel and aluminum industries over the winter produced little in the way of output reductions, confounding our expectations. The resulting unintended inventory accumulation in Asian markets, reflecting high production relative to demand, and slowing Chinese steel exports are a downside risk to our neutral view. U.S. sanctions against Russian oligarchs close to President Putin could tighten the aluminum market, countering the unintended inventory accumulations. For now, we remain neutral base metals. Energy: Overweight. We are closing our long put spread position in Dec/18 Brent options at tonight's close. The fast-approaching May 12 deadline for President Trump to renew sanctions waivers against Iran shifts the balance of price risks to the upside. Base Metals: Neutral. COMEX copper rallied above $3.10/lb on the back of Chinese President Xi's remarks at the Boao Forum earlier this week, which re-hashed plans to open China's economy to imports. Precious Metals: Neutral. Gold likely becomes better bid as the May 12 deadline to waive Iran sanctions nears. Our long gold portfolio hedge is up 8.9%. Ags/Softs: Underweight. European buyers are scooping up U.S. soybeans, as Chinese purchases of Brazilian beans makes U.S.-sourced crops relatively cheaper, according to Reuters.1 China also announced plans to start selling corn stocks from state reserves this week, offering an alternative protein for animals to partially offset the price impact of tariffs on their imports of U.S. soybeans. Feature Chart of the WeekAluminum Rebounds On U.S. Sanctions Despite much-ballyhooed capacity reductions in China's steel and aluminum capacity, these markets - both in China and globally - remained relatively well supplied over the winter. Higher global supplies, and falling Chinese steel exports, will result in unintended inventory accumulation, which already is showing up in Shanghai Futures Exchange (SHFE) inventories. While we remain neutral base metals, continued unintended inventory accumulation could cause us to downgrade the sector. The MySteel Composite Index we use to track steel prices is down more than 10% since the beginning of the year (Chart of the Week). Similarly, the first-nearby primary aluminum contract on the LME was down ~ 12% year-to-date (ytd) early last week, before regaining most of these losses on news of U.S. sanctions against Russian oligarchs, which hit shares of Rusal very hard. Given that these sanctions will restrict access to up to 6% of global aluminum supply, ex-China supply dynamics will dominate the aluminum market this year making the outlook relatively favorable, putting a floor beneath the London Metal Exchange Index (LMEX).2 Ex-Post Winter Production Production cuts over the winter - when Chinese mills in 28 smog-prone northern cities were ordered to reduce capacity by up to 50% - did not live up to our expectations.3 China's steel and aluminum sectors have undergone major supply-side reforms, particularly re the removal of outdated capacity, most of which has been completed. In addition to the winter capacity cuts, past reforms that have already been implemented, and have shaped current market conditions, are as follows: In an effort to eliminate outdated and unlicensed facilities, China removed an estimated 3-4 mm MT of annual capacity in 2017 - amounting to approximately 10% of total aluminum smelting capacity. In the case of steel, Beijing announced plans to shut down 150 mm MT of annual steel capacity between 2016 and 2020. To date, 115 mm MT of capacity have already been eliminated. Another estimated 80-120 mm MT of induction furnace capacity was shuttered in 1H17. Going forward, China's steel and aluminum markets will be driven by: An estimated 3-4 mm MT of updated aluminum capacity is expected to come on line this year, offsetting constraints from last year's supply cuts. 30 mm MT of steel capacity shutdowns are planned this year, putting Beijing on track to meet its five-year target two years ahead of schedule. The Chinese National Development and Reform Commission (NDRC) has communicated its resolve to keep shuttered capacity offline. Major steelmaking cities in Hebei province - accounting for 22% of 2017 Chinese crude steel output - have announced plans to extend the capacity cuts to November 2018. The mid-November to mid-March capacity cuts implemented this past season are expected to be a recurring event. Winter Shutdowns Minimally Impact China's Steel Output ... According to steel production data released by the World Steel Association (WSA), winter capacity closures in China did not significantly affect overall output levels. Crude steel output from China was up 3.9% year-on-year (y/y) in the November to February period (Chart 2). At the same time, production from the rest of the world increased by 3.6% y/y in the November to February. Thus global crude steel supply remained in excess over the winter season, as global steel output increased 3.8% y/y. A caveat to these data: China does not account for the historical output of induction furnaces, which produced an estimated ~30-50 mm MT of steel in 2016. As mentioned in our previous research, the output of these furnaces was illegal and thus not carried in statistics we use to track supply.4 These data problems mean it is possible that actual output in the November 2016 to February 2017 period was higher than suggested by the data, and as a result, actual output during this year's winter season may actually be lower than last year. As induction-furnace data lie in the statistical shadows, we cannot ascertain this with certainty. Nevertheless, a buildup in China inventories - which we discuss below - indicates an oversupplied market. It is also likely producers - incentivized by high steel prices earlier this year - kept capacity utilization at maximum levels throughout the winter. ... And Aluminum Output According to International Aluminum Institute data, primary aluminum output in China fell 2.3% y/y in the November to February period, suggesting the winter cuts likely had an impact on aluminum supply (Chart 3). Data from the World Bureau of Metal Statistics (WBMS) show an even sharper decline in winter aluminum output: primary production in China fell 8.7% y/y in the November to January period. Chart 2Steel Output Grew##BR##Amid Winter Cuts Chart 3China Aluminum Market In Surplus##BR##Despite Production Decline Both sources reveal an especially pronounced contraction in November, at the onset of the winter cuts. Despite reduced supply, WBMS data indicate a positive Chinese aluminum market balance throughout the winter. A large contraction in demand offset the supply shortfall, and kept primary aluminum in a physical surplus throughout the winter, ultimately leading to a buildup in domestic inventories. A Look At The Trade Data Despite our disappointment regarding the impact of the winter cuts on steel and aluminum markets, trade data increasingly suggests China's steel exports have peaked. Aluminum exports from China, on the other hand, are likely to continue rising. Chinese Steel Exports Continue To Fall ... Chinese steel product net exports have been falling since mid-2016, and have continued falling in y/y terms throughout the winter. According to Chinese customs data, steel product net exports fell 35.1% y/y in the November to February period, driven by both falling exports as well as rising imports (Chart 4). Steel product exports plunged 30% y/y in the November to February period, more or less in line with the 2017 average. The decline mirrors the 2017 contraction in domestic supply, bringing exports to their lowest level since 2012. This indicates fears of a China slowdown leading to a flood of metal onto global markets have not materialized, at least not yet. In fact, Customs data show a 1.7% y/y increase in Chinese steel imports during the November to February period - a reversal from falling imports prior to the winter season. The conclusion we draw from this is that, while in the past, China was a source of supply for the world, ongoing capacity cuts and production controls could mean China will lack the ability to ramp up output in case of a global physical supply deficit. If this becomes the new normal, price volatility will likely increase. This trend is important, especially given our expectation of strong world ex-China demand this year. As such, global steel prices may find support amid this new normal. ... But Aluminum Exports Move Higher In the case of aluminum, Chinese net exports were up 28.7% y/y during the winter, continuing their upward trend. Customs data show a 14.8% y/y increase in aluminum exports in November to February, bringing exports in this period to their highest level since 2014/15 (Chart 5). At the same time, imports of aluminum have come down during this period - by 37.2% y/y. According to China customs data, 2017 imports over these winter months registered their lowest level since 1994. Chart 4Steel Exports Continue Falling ... Chart 5...While Aluminum Exports Are On the Uptrend The combination of growing exports amid falling imports puts China's net exports in expansionary territory. This will be especially true given the planned increase in capacity this year amid weak Chinese demand. All in all, ceteris paribus global supply of aluminum looks set to increase. However, we do not live in a ceteris paribus world and, as we explore below, sanctions against the top aluminum producer outside of China will have massive implications on the global aluminum supply chain. Are Inventories Due For A Turnaround? Chart 6Larger Than Expected##BR##Seasonal Inventory Buildup China Iron and Steel Association data indicate that since the beginning of the year, steel product inventories have been re-stocked to levels last seen in 1Q14. Inventories of the five main steel products we track have more than doubled since the beginning of the year (Chart 6). Although the Q1 build is seasonal, the re-stocking since the beginning of the year has been especially pronounced. This buildup occurred in an environment of stable supply - with minimal impact from the winter capacity cuts - amid weak exports, indicating domestic demand for the metal was subdued. However, steel inventories have turned around, and we expect further destocking as demand accelerates post the Chinese New Year. The question remains whether this destocking will bring inventories back down to their 5-year average. Aluminum inventories on the SHFE show similar dynamics. However in this case, it is part of the larger trend of rising stocks since the beginning of last year. Aluminum inventories at SHFE warehouses are up more than nine-fold - or 0.87 mm MT - since the end of 2016. In fact, the pace of buildup seems to have accelerated: the average weekly build of 16.6k MT of aluminum coming into warehouse inventories since the beginning of the year stands above the 2017 average weekly build of 12.6k MT. This brought SHFE aluminum inventories to almost 1 mm MT, more than double their previous record in 2010. Although the Chinese physical aluminum surplus weighed down on prices in 1Q18, we expect global aluminum prices to remain supported from here due to the impact of U.S. sanctions on world ex-China aluminum supply. U.S. Russian Sanctions Could Be A Game-Changer Chart 7Sanctions Will Restrict##BR##Marketable Aluminum Supply Last Friday, the U.S. announced sanctions on Russian oligarchs close to President Vladimir Putin. Among those sanctioned is Oleg Deripaska who controls EN+ Group, which owns a controlling interest in top aluminum producer United Company Rusal. Given that UC Rusal accounts for ~6% of global aluminum production, we view this move as significant to global aluminum markets. As the top producer of the metal outside China, Rusal aluminum likely makes up the majority of Russian supply, which account for 14% of U.S. imports (Chart 7). In fact, almost 15% of Rusal's revenues comes from its business with the U.S. While it is clear that these sanctions will, in effect, terminate aluminum trade between Russia and the U.S., more significant are the implications on the global supply chain. A clause in the U.S. Treasury Department's order extending the restrictions to non-U.S. citizens dealing with U.S. entities means the impact could be far-reaching, requiring a major re-shuffle in global aluminum trade. Earlier this week, the LME announced that it will no longer accept Rusal aluminum produced after April 6, effectively preventing the company's products from being delivered on the LME. These sanctions will likely turn global aluminum buyers off from Rusal products, as they can no longer deliver it to the LME. The net effect will be a contraction in global usable aluminum supply. Furthermore, these sanctions will likely disrupt supply chains as aluminum users scramble to avoid purchasing metal from the Russian producer. While the details of these restrictions are still unclear, the sanctions are a game changer in the global aluminum market - effectively restricting access to a major source of the metal. As such, primary aluminum on the LME is up more than 10% since the announcement last Friday. Bottom Line: While China's crude steel output increased y/y during government-mandated output cuts over the winter, seasonally weak demand meant that the metal piled up in inventories. Falling exports indicates that at least for now, the domestic surplus is not flooding global markets. The main risk to our neutral view here is that demand in China remains weak, and that this will lead to the offloading of Chinese metal to global markets, i.e. a pickup in exports. This has not yet materialized, so we are holding on to our neutral view for now. China's primary aluminum production declined y/y during the winter cuts. However the decline in domestic demand was greater - likely due to the decline in auto production and sales following the loss of tax credit incentives. Consequently, China's aluminum market remained in surplus throughout the winter. Some of the excess supply was exported, but SHFE inventories continued building. Our outlook on the aluminum market had been bearish, due to additional capacity coming online this year amid an uncertain China demand environment. However, the sanctions on Rusal could be a game changer, putting a floor beneath aluminum prices. This improves our near term outlook for the aluminum market. This makes our outlook on aluminum prices much more favorable. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "As U.S. and China trade tariff barbs, others scoop up U.S. soybeans," published by reuters.com on April 8, 2018. 2 The six non-ferrous metals represented in the LMEX and their respective weights are as follows: aluminum: 42.8%, copper: 31.2%, zinc: 14.8%, lead: 8.2%, nickel: 2.0%, and tin: 1.0%. 3 China's winter smog "battle plan" targeted polluting industries in the northern China region by mandating cuts on steel, cement and aluminum production during the smog-prone mid-November to mid-March months. Steel and aluminum production cuts targeted a range between 30-50% during this period. This event is expected to be an annually recurring event until 2020. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Solid fundamentals will keep the backwardation in the forward curves of the benchmark crude-oil streams - WTI and Brent - intact. If our long-held thesis is correct and OPEC 2.0 becomes a durable producer coalition, we believe it will maintain some level of production cuts in 2019.1 This will, in part, keep OECD commercial oil inventories close to their 2010 - 2014 levels, thus keeping oil forward curves backwardated beyond this year. Backwardation serves OPEC 2.0's interests by limiting the rate at which shale-oil production grows.2 It also drives returns from long-only commodity-index exposure, particularly the energy-heavy index exposure we favor, by maintaining an attractive roll yield for investors.3 We expect the S&P GSCI to return 10 - 20% this year. Energy: Overweight. Our recently concluded research shows commodity index exposure hedges portfolios against inflation risk. We remain long index exposure. Base Metals: Neutral. COMEX copper traded back through $3.00/lb on the back of strong official Chinese PMI data, indicating manufacturing activity continues to expand. It has since fallen back to ~ $3.00/lb, as U.S. - Sino trade-war fears grew. Precious Metals: Neutral. Gold remains range-bound, between $1,310 and $1,360/oz. Ags/Softs: Underweight. In a tit-for-tat fashion, Beijing announced on Wednesday that it would retaliate to the U.S. tariffs on $50 billion worth of Chinese imports. U.S. soybeans and beef are among the list of 106 items China plans to impose a 25% tariff on. Feature An unlikely commonality of interests unites the fates of OPEC 2.0 and long-only commodity index investors: The desire to see the crude-oil forward curves backwardated. Turns out, both interests benefit from the same configuration of the forward curves, in which prompt prices trade premium to deferred prices. Backwardation achieves a critical goal of OPEC 2.0 by making the prices most member states in the coalition receive on their crude oil sales - i.e., the spot price indexed in their term contracts - the highest point along the forward curve. A backwardated curve means the average price U.S. shale-oil producers realize over their hedging horizon - typically two years forward - is, perforce, lower than the spot price. We have shown rig counts are highly sensitive to the level and the shape of the WTI forward curve. A backwardated curve reduces the revenue that can be locked in by hedging. This reduces the number of rigs shale producers send to the field, which restrains - but does not quash - the rate at which they can grow their production (Chart of the Week). For commodity index investors - particularly those with exposure to the energy-heavy S&P GSCI index, where ~ 60% of the index is crude oil, refined products or natural gas - backwardation drives roll-yields, which are a critical component of the index's total returns. The steeper the backwardation, the higher the roll yield.4 Our balances modeling indicates oil markets will remain tight this year, given strong global growth in demand in excess of production growth, which will keep the market in a physical deficit (Chart 2). This will cause inventories to continue to draw this year (Chart 3), which will keep the crude-oil backwardation in place. This backwardation is one of the principal drivers of returns in the S&P GSCI. Chart of the WeekBackwardation Constrains##BR##Shale's Rate Of Growth Chart 2Balances Model Indicates##BR##Physical Deficit Persists This Year Chart 3Tighter Inventories Keep##BR##Backwardation In Place As for the other components of the S&P GSCI, we are neutral base and precious metals, expecting them to remain relatively well-balanced this year, and underweight ag markets, even though they appear to have bottomed, as the USDA indicated recently. As a result, we expect an energy-heavy commodity index exposure like the S&P GSCI will continue to perform for investors, driven largely by the stronger oil prices we expect this year, and the roll yields from backwardated energy futures. Any price upside from the other commodities will be a marginal contribution to returns, as energy price appreciation plus roll yields will be the primary driver of the long-index exposure. Can Crude Oil Backwardation Persist? Beyond 2018, reasonable doubts exist as to whether OPEC 2.0 can remain a durable coalition. These doubts arise from apparent differences in the long-term goals of OPEC 2.0's putative leaders, KSA and Russia. We believe that, over the short term (two years or so) KSA favors higher prices, and that the Kingdom's preferred range for Brent is $60 to $70/bbl, at least until the Saudi Aramco IPO is fully absorbed and trading in the market. Russia's apparent preference is for lower prices ($50 to $60/bbl), which will disincentivize U.S. shale producers from adding even more volume to the market and threaten its market share. How these goals are resolved within OPEC 2.0 as it negotiates its post-2018 structure will determine whether oil forward curves remain backwardated - the likely outcome if production cuts are extended into 2019 - or if OECD inventories start to rebuild and the backwardation returns to contango (i.e., deferred prices exceed prompt prices). This would happen if Russia and its allies decide they are uncomfortable with prices staying close to or above $70/bbl for too long, and therefore lift production and exports to bring them down. OPEC 2.0 Has Reconciled KSA's And Russia's Goals We believe OPEC 2.0 has reconciled KSA's desire for higher prices over the short term to allow a smooth IPO of Aramco. Both KSA and Russia share a longer-term goal of not overly incentivizing U.S. shale production, and production by others - e.g., Norway's Statoil - which also have significantly reduced their costs in order to remain competitive.5 If OPEC 2.0 is successful in achieving higher prices over the short term, it will have to offset them with lower prices further out the forward curve to reconcile KSA's and Russia's goals. This is the principal reason we believe backwardating the forward curve, and keeping it backwardated, achieves OPEC 2.0's short- and longer-term goals. After Aramco is IPO'd - something that, from time to time, seems doubtful - and the market's trading the stock, we believe KSA and Russia will want average prices to drift lower. KSA will, by that time, have lowered its fiscal break-even cost/barrel to $60 (they're at or below $70 now) and will be executing on its diversification strategy. But even with spot prices lower - we're assuming the target level would be ~ $60/bbl - the forward curve will have to remain backwardated to keep U.S. shale's growth somewhat contained. This can be done by keeping deferred contracts (2+ years out) close to $50/bbl using OPEC 2.0 production flexibility, global inventory holdings and forward guidance re production, export and inventory policies. By keeping the average price realization over the shale producers' hedging horizon in the low- to mid-$50s, OPEC 2.0 restrains rig deployment in the U.S. shales. Keeping the front of the forward curve closer to (or above) $60/bbl, means OPEC 2.0 member states get the high price on the forward curve, since their term contracts are indexed to spot prices. Once a persistent backwardation becomes a reliable feature of the forward curve, the short-term inelasticities of the global supply and demand curves - but mostly the supply curve - mean small changes by a production manager like OPEC 2.0 can readily change the price landscape and alter expectations along the forward curve covering the shale-oil producers' hedge horizon. OPEC 2.0 states already have lived through the alternative of not managing production to the best of their abilities during the 2014 - 2016 price collapse: A production free-for-all similar to what the market experienced then would again lead to massive unintended inventory accumulations globally. This would put the Brent and WTI forward curves into super-contangos, which occurred at the end of 2015 into early 2016. At that point, the market would, once again, begin pricing sub-$20/bbl oil as a global full-storage event becomes more probable. At that point, it's "game over" for OPEC 2.0 member states. The stakes remain sufficiently high for OPEC 2.0 member states to keep the coalition intact and to maintain production cuts to keep OECD inventories tight, and thus keep markets backwardated beyond 2018. Backwardation Works For Commodity Index Investors, Too We expect the S&P GSCI to continue to perform well this year - posting gains of 10 to 20% - given our expectation OPEC 2.0 will remain committed to maintaining production discipline. We've recently shown there is a close relationship between oil forward curves and oil inventories, expressed as the deviation of Days-Forward-Cover (DFC) from its 2- or 3-year average, and y/y percentage change (Chart 4).6 This analysis supports our view that - based on our expectation of a continuation of OECD commercial inventory decline - backwardation will continue throughout 2018 and early-2019. This tight relationship, allows us to include OECD commercial inventories as a proxy among our explanatory variables for the shape of the oil forward curves, when modeling and forecasting the GSCI total return. For 2018, we are modeling a continuation of the production cuts put in place at the beginning of 2017 to year end. At some point later this year, we expect the market to get forward guidance on what to expect in the way of OPEC 2.0 production levels for next year. In lieu of actual guidance, we've modelled three different scenarios for OPEC 2.0's production levels next year, leaving everything else affecting prices unchanged. This is a sensitivity analysis on OPEC 2.0's production only (Chart 5).7 Chart 4Oil Inventories, Spreads,##BR##DFC, Closely Related Chart 5BCA's 2019 Scenario Analysis##BR##For OPEC 2.0 Production Scenario 1: Our actual balances, most recently updated in our March 22, 2018, publication, with no production cuts in 2019; Scenario 2: An extension of the OPEC 2.0 production cuts to end-2019 at 100% of 2018 levels; Scenario 3: An extension of the OPEC 2.0 production cuts to end-2019 at 50% of 2018 levels. Under scenario 1, the GSCI's y/y returns slow in 2H18 and become negative in 3Q19. Returns peak in Feb/19 at 28%, and average 21% in 2018, and 9% in 2019. In scenario 2, y/y growth remains positive this year and next, peaking in Feb/19 at 30%, then falling to 13% in 2019. Average returns in 2018 are 21%, and in 2019 19%. In scenario 3, y/y growth remains positive in both years, and bottoms close to 0% but never turns negative. GSCI returns peak in Feb/19 at 29%, then fall to 3% in 2019. Average returns in 2018 are 21%, and in 2019 14%. Given the guidance already conveyed by KSA's oil minister Al-Falih, we would put a low weight on scenario 1, and attach a 50% probability to each of the 2019 simulations in scenarios 2 and 3. GSCI As An Inflation Hedge Our analysis shows the GSCI Total Return (TR) also is highly sensitive to the USD broad trade-weighted dollar (TWIB) and U.S. headline CPI inflation (Chart 6).8 This has powerful implications for the evolution of commodity-indices going forward. A decrease (increase) in the USD TWIB increases (decreases) USD-denominated commodity demand from buyers ex-U.S., thus raising prices, all else equal. An increase (decrease) in the U.S. CPI can lead to higher commodity costs, which are reflected in the GSCI, or to a positive (negative) net-inflow of cash into commodity-indices as a hedge against inflation risks. Importantly, we found the GSCI TR and U.S. CPI relationship to be bi-directional, enhancing the magnitude of the impact of a change in any of those variables. In other words, a rise in the GSCI TR causes inflation to rise which leads to a rise in the GSCI TR, and vice-versa until a new equilibrium is reached.9 Our colleagues at BCA's Global Fixed Income Strategy desk expect inflation pressures will continue to build this year. In particular, they note, "the global cyclical backdrop is boosting inflation."10 With 75% of OECD countries operating beyond full employment, capacity-utilization rates in the developed economies are approaching 80% - the highest level since mid-2008 (Chart 7, top panel). This closing of the global output gap likely will stoke inflation. Chart 6GSCI Highly Sensitive To USD, U.S. CPI Chart 7Inflation Risks Picking Up Consistent with our overweight view, we expect oil prices to move higher from current levels, as refiners come off 1Q18 maintenance turn-arounds and summer-driving-season demand picks up in the Northern Hemisphere (Chart 7, middle panel).11 Lastly, global export price inflation is showing no signs of slowing, suggesting that global headline inflation will continue moving higher (Chart 7, bottom panel). From the model shown in Chart 6, which captures ~ 82% of the variance in the y/y GSCI TR, we have high conviction that three of the four explanatory variables for the GSCI - crude spreads, DFC and U.S. CPI - will support the GSCI this year, leaving only a significant appreciation in USD TWIB as a potential risk to our view. Away from our modelling, other risks to our bullish oil case as a driver of GSCI returns remains a greater-than-expected economic deceleration in China arising from a policy error in Beijing as policymakers execute a managed slowdown, or a trade war with the U.S.12 These would affect our inflation and commodity-demand - hence commodity price - outlooks. Bottom Line: We expect persistent backwardation in the benchmark crude-oil forward curves- WTI and Brent - as OPEC 2.0 extends production cuts beyond 2018. This will achieve the goals of OPEC 2.0's leadership and underpin returns in the S&P GSCI, which we expect will post gains of 10 - 20% this year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Last month, the Kingdom of Saudi Arabia's (KSA) oil minister, Khalid Al-Falih, indicated OPEC 2.0 production cuts could be extended into 2019. Al-Falih suggested the level of the cuts could be at a reduced level. Please see "Saudi expects oil producers to extend output curbs into 2019," published by uk.reuters.com March 22, 2018. 2 OPEC 2.0 is the producer coalition led by KSA and Russia, which, at the end of 2016, agreed to remove 1.8mm b/d of production from the market. 3 Commodity-index total returns are the sum of price appreciation registered by being long the index; "roll yield," which comes buying deferred futures in backwardated markets, letting them roll up the forward curve as they approach delivery, selling them, then replacing them with cheaper deferred contracts in the same commodity; and collateral yield, which accrues to margin deposits on the futures comprising the index. For a primer on commodity index investing, please see "Convenience Yields, Term Structures & Volatility Across Commodity Markets," by Michael Lewis in An Investor Guide To Commodities (pp. 18 - 23), published by Deutsche Bank April 2005. 4 By way of a simplistic example, assume the oil exposure in an index is established in a backwardated market - say, spot is trading at $62/bbl and the 3rd nearby WTI future trades at $60/bbl. Assuming nothing changes, an investor can hold the 3rd nearby contract until it becomes spot, then roll it (i.e., sell it in the spot month and replace it with another 3rd nearby contract at $60/bbl) for a $2/bbl gain. This process can be repeated as long as the forward curve remains backwardated. 5 Please see "How we cut the break-even prices from USD 100 to USD 27 per barrel" on Statoil's website at https://www.statoil.com/en/magazine/achieving-lower-breakeven.html and "OPEC 2.0 Getting Comfortable With Higher Prices," published by BCA Research's Commodity & Energy Strategy February 22, 2018, where we discuss how KSA's and Russia's goals have been reconciled. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 7 This sensitivity analysis allows only for the path of OECD commercial inventories to vary while everything else is held constant. To obtain the forecasted values, we've combined the estimates of a set of different modelling techniques (i.e., a Markov switching model, threshold and break-OLS estimators). This increased the information and granularity obtained from the model and allowed us to capture time-varying characteristics in the global inventory/GSCI TR relationship. 8 We found there is two-way Granger-causality between the S&P GSCI and U.S. CPI y/y changes. This feedback loop indicates the GSCI will move with, and cause movement in, the CPI, as discussed herein. 9 This is supported statistically using Granger Causality tests in a VAR model of the GSCI TR and U.S. CPI inflation. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report titled "Nervous Complacency," published March 27, 2018. Available at gfis.bcaresearch.com. 11 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," for our latest oil price forecast. It was published March 22, 2018, and is available at ces.bcaresearch.com. 12 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Managed Slowdown Will Dampen Base Metals Demand," for a discussion of this risk. It was published March 29, 2018, and is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Key Portfolio Highlights Our portfolio positioning remains firmly behind cyclicals over defensives, driven principally by our key 2018 investment themes: synchronized global capex growth (Chart 1A) and higher interest rates on the back of a pickup in inflation (Chart 1B). The positioning has been lifted by synchronized global growth and a soft U.S. dollar (Chart 1C), while the key risk to our portfolio of a hard landing in China looks to be mitigated (Chart 1D). A return of volatility, spurred on by Fed tightening (Chart 1E), caused an SPX pullback in February, and while the market pushed through that rough patch, it has since been replaced with fears of a trade war, exacerbated by musical chairs in the Trump administration (Chart 1F). Our buy-the-dip strategy remains appropriate on a cyclical time horizon (Chart 1G), given a dearth of evidence of a recession in the next year. SPX forward EPS estimates still show near-20% increases this calendar year (corroborated by our EPS growth model, Chart 1H) which should underpin outsized equity returns in the absence of a major valuation rerating. Still, the return of volatility warrants a review of our macro, valuation and technical indicators. The best combination in our review is S&P financials (Overweight) with an elevated and accelerating cyclical macro indicator (CMI), fed by both of our key capex growth and rising interest rate themes, combined with a modest undervaluation. The worst combination is S&P telecom services (Underweight, high-conviction), whose CMI recently touched a 30-year low as sector deflation hit acute levels. Valuations make the sector look cheap, but every indication is that telecoms are a value trap. Chart 1AGlobal Trade Is Rising... Chart 1B...But So Too Is Inflation Chart 1CA Weaker Dollar Is A Boon To Growth Chart 1DSoft Landing In China Seems Likely Chart 1EThe Return Of Vol May Spoil The Party... Chart 1F...And Policy Uncertainty Doesnt Help Chart 1GBuy The Dip Has Worked Out Nicely Chart 1HHeed The Message From A Booming EPS Model Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI, Chart 2) has climbed to new cyclical highs with significant upward momentum, driven by broad improvement in virtually all of its underlying components. More than any other variable, rising yields and the accompanying higher price of credit are a boon to financials. Higher interest rates is one of BCA's key themes for 2018 and an ongoing selloff in the bond market bodes well for profits in the heavyweight banks sub-index and should deliver the next up leg in bank stocks performance (top panel, Chart 3). Another of BCA's key themes for 2018 is a global capex upcycle; higher demand for capital goods should drive outsized capital formation in the year to come. Our U.S. commercial banks loans and leases model echoes this positive outlook, pointing to the best loan growth of the past 30 years (middle panel, Chart 3). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 3). Despite the much-improved cyclical outlook and a revival of overall animal spirits, our valuation indicator (VI) suggests that financials are modestly undervalued. At this point in the cycle, we would expect a modest overvaluation; the implication is that financials should be a core portfolio overweight. Our technical indicator (TI) has approached overbought levels several times over the course of this bull market, though history suggests it can stay at elevated levels for a considerable time. Chart 2S&P Financials (Overweight) Chart 3RS1 Rising Yields Are A Boon To Financials Earnings S&P Industrials (Overweight) Our industrials CMI (Chart 4) has gone vertical and is very near its all-time high. A combination of a supportive currency, a recovery in commodity prices and synchronized global growth are responsible for the rise. A falling U.S. dollar and capital goods producers' top line growth acceleration have historically moved hand-in-hand as this group is one of the most international of the S&P 500. The trade-weighted U.S. dollar has fallen by more than 10% from its most recent peak at the end of 2016 which suggests U.S. industrials should have a leg up in sales for the year to come (top panel, Chart 5). The slide in the U.S. dollar is coming at an opportune time; global growth is remarkably synchronized (and remains a key BCA theme for 2018) and has proven an excellent harbinger of industrials margins (bottom panel, Chart 5). Overall, an expanding top line and widening margins imply solid relative EPS gains. Our valuation gauge is near the neutral zone, where it has been for much of the past 3 years as the market has failed to capture the sector's outlook strength. Our TI echoes the neutral message, having unwound a significant overbought position at the beginning of last year. Chart 4S&P Industrials (Overweight) Chart 5Global Euphoria Should Lift Industrials S&P Energy (Overweight) Our energy CMI (Chart 6) has maintained its upward trajectory after bouncing off all-time lows last year. Importantly, the relative share performance does not yet reflect the drastically improved cyclical conditions, underpinning our overweight recommendation. Falling oil inventories and rising prices (top and second panel, Chart 7) combined with solid gains in domestic production underlie the CMI recovery. Our key themes for 2018 of a global capex expansion and synchronized global growth should be the most important drivers for energy stocks this year. With respect to the former, the capex intentions from the Dallas Fed survey hit their highest level in a decade, which usually presages domestic oil patch expansion and energy stock outperformance (third panel, Chart 7) With respect to global growth, emerging markets/Chinese demand is the swing determinant of overall oil demand, and non-OECD demand has been moving higher for most of the past year (bottom panel, Chart 7). Our VI has retreated far into undervalued territory, a result of the aforementioned failure of stocks to react to the enticing macro outlook. The TI too is in deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are so appealing. Chart 6S&P Energy (Overweight) Chart 7Energy Share Prices Have Trailed Oils Recovery S&P Consumer Staples (Overweight) Our consumer staples CMI (Chart 8) has turned up recently, following a two year decline. Strong employment gains and positive retail sales are the key pillars underlying the modest recovery. The euphoric consumer continues to push our consumer staples EPS model higher, now pointing to the best earnings growth of the past 5 years (middle panel, Chart 9). Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (bottom panel, Chart 9). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put our positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. Further, our VI is waving a green flag as consumer staples are now nearly two standard deviations below their 30-year mean valuation. Technical conditions too are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 8S&P Consumer Staples (Overweight) Chart 9Robust Consumer Confidence Bodes Well S&P Utilities (Neutral) Our utilities CMI (Chart 10) has spent the last decade in a long-term downtrend, albeit one with periodic countertrend moves. The key underlying factors are natural gas prices and relative spending on utilities, both of which have been retreating since 2008 (middle panel, Chart 11). Encouragingly, the sector's wage bill has slowed from punitively high levels, though pricing power has followed it down, implying muted margin changes (bottom panel, Chart 11). Like other defensive sectors, utilities have underperformed cyclical sectors in the last year; utilities equities trade as fixed income proxies, and a rising interest rate environment is punitive. As a result of the underperformance and relatively constant earnings, valuations have collapsed to the neutral zone. We reacted by booking solid gains and upgrading to a benchmark allocation earlier this year; synchronized global growth and higher interest rates are headwinds for this niche defensive sector and prevent us from lifting positions further. Our TI has fallen steeply over the past year and is now closing in on two standard deviations below the 30-year average. Chart 10S&P Utilities (Neutral) Chart 11Pricing Is Falling But Margins Look Neutral S&P Real Estate (Neutral) Our real estate CMI (Chart 12) has been in decline since its most recent peak at the end of 2016. This is confirmed by a darkened outlook for REITs; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (top panel, Chart 13). Further, bankers appear less willing to extend commercial real estate credit, despite recent stability in underlying prices; declines in credit availability will directly impact REIT valuations (bottom panel, Chart 13). Our VI is consistent with BCA's Treasury bond indicator (not shown), indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 12S&P Real Estate (Neutral) Chart 13Peaking Rents and Tight Credit Are Headwinds S&P Materials (Neutral) Our materials CMI (Chart 14) has maintained its downward trajectory, largely due to the ongoing Fed tightening cycle. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as rates are moving higher (top panel, Chart 15). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018, representing a substantial headwind to sector performance. Still, the news is not all negative. Exceptionally strong global demand growth has revitalized chemicals prices (bottom panel, Chart 15). Combined with the industry's relatively newfound restraint, capacity has not overextended and the resulting productivity gains bode well for earnings growth. Despite the improving outlook, valuations have been retreating for much of the past year and our VI has fallen back to the neutral zone. Our TI has been hovering near the neutral line for the past year, though a recent hook downward indicates a loss of momentum and downside relative performance risks. Chart 14S&P Materials (Neutral) Chart 15Rising Rates Are Offset By Improving Demand S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI (Chart 16) has fallen back after reaching highs earlier in 2017, though remains elevated relative to the long term trend. Rising interest rates (top panel, Chart 17) are more than offsetting higher home prices and real wage growth, both have which have recently stalled. This rising short-term interest rate backdrop is not conducive to owning the extremely interest rate-sensitive equities that fall into the S&P consumer discretionary index. Both the household financial obligation ratio and household debt service payments have bottomed and are actually increasing. A higher interest rate backdrop will sustain the upward pressure on both and likely weigh on consumer discretionary relative share prices (third and bottom panels, Chart 17). This underpins our recent downgrade to a below benchmark allocation. Elevated valuations support our negative thesis as our valuation indicator has been rising recently out of the neutral zone. Our TI has fully recovered from oversold levels, and is now well into overbought territory, though historically this indicator has been excessively volatile. Chart 16S&P Consumer Discretionary (Underweight) Chart 17Higher Borrowing Costs Bode Ill For Consumer Discretionary S&P Health Care (Underweight) Our health care CMI (Chart 18) rolled over last year and has been treading water at these lower levels, driven by weak fundamentals in the key pharmaceuticals sector. Poor pricing power, a soft spending backdrop and a depreciating U.S. dollar have been pressuring the sector and keeping a tight lid on the CMI (top and second panels, Chart 19). Other non-pharma indicators are mixed as lower healthcare consumer spending is offset by a tick up in overall pricing power. Relative valuations have fallen deep into undervalued territory and are approaching one standard deviation below the 25 year average. Our TI too has reversed course and is well into oversold territory. However, the message from our health care earnings model is that sector earnings will continue to decelerate; this environment in not conducive for a sector re-rating (bottom panel, Chart 19). Chart 18S&P Health Care (Underweight) Chart 19Pharma Pricing Power Continues To Collapse S&P Telecommunication Services (Underweight) Our telecom services CMI (Chart 20), after moving sideways for much of the past decade, has recently fallen to a new 30-year low. Extreme deflation continues to reign in the beleaguered sector as relative consumer outlays on telecom services have nosedived (top panel, Chart 21) which is broadly matched by melting selling prices (middle panel, Chart 21) as demand contracts. This is reflected in our S&P telecom services revenue growth model, which remains deep in contractionary territory (bottom panel, Chart 21). The sector remains chronically cheap, exacerbated by the recent sell-off, and is currently as cheap as it has ever been. Still, given the brutal operating environment, we think such valuations have created a value trap. Our Technical Indicator has sunk but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. We recently downgraded the sector to underweight and added it to our high-conviction underweight list based on the factors noted above.1 Chart 20S&P Telecommunication Services (Underweight) Chart 21Telecom Services Remain A Value Trap S&P Technology (Underweight, Upgrade Alert) The technology CMI (Chart 22) has been falling for the past three years, driven by ongoing relative pricing power declines and new order weakness. However, the sector has proven resilient, at least until recently, as a handful of stocks (the FANGs, excluding the consumer discretionary components) and the red-hot semiconductor group have provided support. Still, market euphoria aside, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods; inflation is gradually rising after a prolonged disinflationary period (bottom panel, Chart 23). Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is extremely overbought, though it has been at this high level for several years. Chart 22S&P Technology (Underweight, Upgrade ALert) Chart 23Inflation Is No Friend To Tech Size Indicator (Neutral Small Vs. Large Caps) Our size CMI (Chart 24) has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher (top panel, Chart 25). A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. Earlier this year, we downgraded our recommendation on small caps vs. large caps to a neutral allocation, based on a deterioration in small cap margins and too-high leverage.2 Recent NFIB surveys would suggest this move was prescient; firms reporting planned labor compensation increases have steadied near a two decade high, while price increases are trailing far behind (middle panel, Chart 25). With "quality of labor" having overtaken "taxes" as the single most important problem facing businesses, labor compensation growth seems likely to continue moving up at an elevated pace and small cap margins should likely continue to trail large cap peers (bottom panel, Chart 25). Valuations have improved and small caps are relatively undervalued, though our TI echoes a neutral message. Chart 24Size Indicator (Neutral Small Vs. Large Caps) Chart 25Small Businesses Remain Exceptionally Confident Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.

Highlights Recommended Allocation Due to the boost from U.S. fiscal stimulus, we do not expect recession until 2020. Despite some signs that growth is peaking, global economic fundamentals remain robust. Markets have wobbled because of the risk of trade war and rising inflation. We think neither likely to derail growth. Not one of our recession indicators is yet sending a warning signal. We are late cycle and volatility is likely to remain high (particularly if the trade war intensifies). But, given strong earnings growth and three further Fed rate hikes this year, we expect global equities to beat bonds over the next 12 months. Except for particularly risk-averse investors, who care mostly about capital preservation, we continue to recommend overweights in risk assets. We are overweight equities (especially euro area and Japan), cyclical equity sectors such as financials and industrials, credit (especially cross-overs and high-yield), and return-enhancing alternative assets such as private equity. Feature Overview Stimulus Trumps Tariffs Risk assets have been choppy so far this year, with global equities flat in the first quarter and the stock-to-bond ratio turning down (Chart 1). Markets were battered by worries about a trade war, signs of growth peaking, a rise in inflation, and bad news from the tech sector. This late in the cycle, with stock market valuations stretched and investors skittish about what might go wrong, we expect volatility to stay high. But the global economy remains robust - and will be boosted by U.S. fiscal stimulus - earnings are growing strongly, and the usual signs of recession and equity bear markets are absent. Though the going will be bumpy over coming quarters, we continue to expect risk assets to outperform at least through the end of this year. U.S. tariffs on steel and aluminum and the threat of $50 billion of tariffs on Chinese imports so far represent a trade skirmish, not a trade war. The amounts pale by comparison with the positive impact coming though from U.S. tax cuts, increased fiscal spending, and repatriation (Chart 2). In history, fights over trade have rarely had a serious impact on growth. They flared up frequently in the 1980s, which was a period of strong economic growth. Even the infamous Smoot-Hawley tariff increase of 1930 is now viewed by most economic historians as having played only a minor role in the collapse of trade during the Great Depression.1 Of course, trade war could escalate. China, as the biggest part of the U.S. trade deficit, is the White House's clear target (Chart 3). Japan in the 1980s, an ally of the U.S., agreed to voluntary exports restraints and to relocate production to the U.S. But China is a global rival.2 Chart 1A Tricky Quarter Chart 2Stimulus Tops Tariffs Chart 3China Is The Target For now, we expect the impact to be limited since some degree of compromise is the most likely outcome. President Trump sees the stock market as his Key Performance Indicator and would be likely to back off if stocks fell sharply. China knows that it has the most to lose in a prolonged fight. It might suit Xi Jinping's reformist agenda to boost consumption, cut excess capacity, and allow the RMB to appreciate modestly. While the U.S. has some justification for arguing that China's investment rules are unfair, China can also argue that it has made significant progress in recent years in reducing its dependence on exports, its current account surplus, and the undervaluation of its currency (Chart 4). But jitters will continue for a while. May could be a particularly tricky month, with the Iran sanctions waiver expiring on May 12, and the 60-day consultation period for China tariffs ending on May 21. Investors should expect that volatility, which in early January was remarkably low in all asset classes, should stay significantly higher until the end of this cycle (Chart 5). Chart 4...But Has Reduced Dependence On Exports Chart 5Volatility Likely To Stay High? Meanwhile, economic fundamentals generally remain strong. The Global Manufacturing PMI has dipped slightly from its cycle-high level in December, with recent currency strength causing some softness in the euro area and Japan (Chart 6). But the diffusion index shows that only three out of the 48 countries currently have PMIs below 50 (Egypt, Indonesia and South Africa). Consensus forecasts expect 2018 global GDP growth to come in at around 3.3%, similar to last year, and as yet show no signs of faltering (Chart 7). On the back of this, BCA's models suggest that global earnings growth will continue to grow at a double-digit pace for at least the rest of this year (Chart 8). Despite the strong growth, we see U.S. inflation picking up only steadily towards the Fed's 2% target.3 Jerome Powell in his first congressional testimony and press conference as Fed Chair showed no rush to accelerate the pace of rate hikes. We think the Fed is likely to hike four times, not three, but the market should not find this unduly hard to digest, as long as it is against a background of robust growth. Chart 6Dip In Growth Momentum? Chart 7Economists' Forecasts Not Faltering Chart 8Earnings Still Growing Strongly For the past year, we have highlighted a number of simple indicators we are watching carefully that have previously been reliable indicators of recessions and equity bear markets. Several have started to move in the wrong direction, but none is yet flashing a warning signal (Table 1, Chart 9). Table 1What To Watch For Chart 9No Warnings Flashing Here In February, BCA pushed out its forecast of the next recession to 2020, on the back of the U.S. fiscal stimulus. That would suggest turning more cautious on risk assets towards the end of this year - at which time some of these indicators may be flashing. But, until then we continue to recommend - except for the most risk-averse investors who care mainly about capital preservation and not about maximizing quarterly performance - an overweight allocation to risk assets. Garry Evans, Senior Vice President garry@bcaresearch.com Chart 10Not A Full Blown Trade War... For Now! What Our Clients Are Asking What Are The Implications Of U.S. Tariffs? Following recent announcements of tariffs on steel and aluminum and possible broad-based tariffs on Chinese imports, investors have started to worry about the future of global trade. But these moves should be no surprise since President Trump is merely delivering on electoral promises. From a macro-perspective, here are the key implications of rising trade barriers: An all-out trade war would certainly hurt U.S. growth, but a minor skirmish would have little impact. The U.S. is the advanced economy least exposed to global trade, which makes it harder for nations to retaliate. Running a large trade deficit, with imports from China representing 2.7% of GDP whereas exports to China are just 1.0% of U.S. GDP, gives the U.S. considerable leverage in negotiations. Additionally, the majority of Chinese imports from the U.S. are agricultural products, making it harder for China to retaliate with tariffs since these would raise prices for Chinese consumers (Chart 10). On the other hand, U.S. trade partners also have a case. With trade growth trailing output growth, other nations will be less willing to give in to U.S. threats. Additionally, unlike the Cold War era, when the U.S. had a greater influence on Europe and Japan, the world is moving toward a more multipolar structure. However, we do not believe nations will retaliate by dumping U.S. Treasuries, as that would deliver the U.S.'s desired end result of a weaker dollar. Chart 11Rising Wages Are The Missing Factor Finally, if tariffs lead to a smaller trade deficit and firms start to move production back to the U.S., aggregate demand will increase. And, given a positive output gap in the U.S., the Fed would be forced to turn more hawkish, ultimately forcing the dollar up. Equity markets do not like tariffs, and bonds will follow the path that real growth and inflation take. How the situation will develop depends on whether Trump embraces America's traditional transatlantic alliance with Europe and harnesses it for the trade war against China. If he does so, the combined forces of the U.S. and Europe will likely force China to concede. But if Trump goes it alone, a prolonged U.S.-China trade war could turn into a significant risk to global growth. How Quickly Will U.S. Inflation Rise? The equity sell-off in early February was triggered by a slightly higher-than-expected average hourly earnings number. In recent meetings, we find that clients, who last year argued that the structural pressures would keep inflation depressed ("the Philips Curve is dead"), now worry that it will quickly exceed 2%. And it is true that the three-month rate of change of core CPI has jumped recently (Chart 11, panel 1). Investors are clearly skittish about the risk of higher inflation, which would push the Fed to accelerate the pace of rate hikes. We continue to argue that core PCE inflation (the Fed's main measure) will rise slowly to 2% over the next 12 months, but we do not see it accelerating dramatically. Inflation tends to lag GDP growth by around 18 months and the pickup in growth from Q2 last year should start to feed through. This will be magnified by the 8% weakness in the US dollar over the past 12 months, which has already pushed up import prices by 2% YoY. What is missing, however, is wage pressure. Average hourly earnings are growing only at 2.6% YoY. We find that wage growth tends to lag profits by around 24 months (panel 2) and, since profits moved sideways for close to two years until Q2 last year, it may be a few quarters yet before companies feel confident enough to raise wages. Note, too, that wages have been weak compared to profits in this cycle. This is likely partly because of automation, but also because the participation rate for the core working population continues to recover towards its 2007 level, indicating there is more slack in the labor market than the headline unemployment data suggest (panel 3). Should Investors Still Own Junk Bonds? Chart 12Credit Cycle Still On The current late stage of the economic cycle has investors worried about the credit cycle and the outlook for corporate credit, in particular high-yield bonds. The number-one concern is stretched valuations. Spreads are close to all-time lows, which means investors should not expect significant capital gain. However, spreads can stay low for extended periods, especially in the late stages of the credit cycle. Junk bonds are a carry trade at this point, and investors can continue to pick up carry before a sustained period of spread widening sets in (Chart 12). A flattening yield curve is bad for junk returns, as it signals monetary policy is too restrictive. But, as inflation continues to trend higher, the curve is likely to steepen while allowing the Fed to deliver rate hikes close to its median projection. The key risk is a scenario in which inflation falters, but the Fed continues to hike. In this case a risk-off episode in credit markets would be likely, but this would be a buying opportunity and not the end of the cycle. Corporate balance-sheets have weakened, and logically investors should demand greater compensation to hold high-yield bonds. But spreads have diverged from this measure since early 2016. However, we expect improvements in corporate health since the outlook for profit growth is strong. However, a great deal of bond issuance has been used for share buybacks. If capital structures have less of an equity cushion, then recovery rates are likely to be lower when defaults do start to rise. Cross-asset volatility has returned. But credit spreads have remained calm thanks to accommodative monetary policy and easing bank lending standards. Also, stricter post-crisis bank capital regulations have mitigated the risk. Finally, the growing presence of open-ended junk bond funds and ETFs increases the risk that, once spreads start to widen, they will widen much more quickly than they would have otherwise. Who Should Invest In Hedged Foreign Government Bonds? In a recently published Special Report,4 we found that hedged foreign government bonds are a good source of diversification for bond portfolios. Hedging not only reduces the volatility of the foreign bonds, it reduces it so much that the risk-adjusted return ratio has significantly improved for investors with home currency in USD, GBP, AUD, NZD, CAD and EUR (Table 2). This is true across different time periods for most fixed income investors other than those in Japan, as shown in Chart 13. Table 2Domestic And Foreign Government Risk Return Profile (December 1999 - January 2018) Chart 13Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time So the answer depends on investors' objectives and constraints: If investors are comfortable with the volatility in their local aggregate bond indexes, which are already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K. and Canada are better off investing a large portion overseas. Global Economy Overview: Global growth remains robust, though momentum has slowed slightly in recent weeks. No recession is likely before 2020 at the earliest due to strong U.S. fiscal stimulus. Inflation will slowly rise towards central bank targets but there is little reason to expect it to accelerate dramatically, and so we see no need for aggressive monetary tightening. U.S.: Short-term, growth looks to have softened, with the Citigroup Economic Surprise Index turning down (Chart 14, top panel), and the regional Fed NowCasts for Q1 GDP growth pointing to 2.4%-2.7%. However, growth over the next two years should be boosted by the recent tax cuts and government spending increases, which we estimate will push up GDP growth by 0.8% in 2018 and 1.3% in 2019. Wages should start to rise from their current sluggish levels (average hourly earnings only up 2.6% YoY) given the tight labor market, which should boost consumption. Capex (panel 5) is likely to continue to recover due to tax cuts and a high level of businesses confidence. Euro Area: Growth has been steady in recent quarters, with Q4 GDP rising 2.5% QoQ annualized. However, lead indicators such as the PMI (Chart 15, top panel) have rolled over, probably because of the strong euro (up 6.2% in trade-weighted terms over the past 12 months). The effect has yet to be seen in exports, which continue to grow strongly, 6.2% YoY in February, but earnings results for Q4 surprised much less on the upside in the euro area than in the U.S. Chart 14Growth Robust, But Momentum Slowing Chart 15Strong Currencies Denting EU And Japanese Growth Japan: As an export-oriented, cyclical economy, Japan has also benefitted from better global conditions, with GDP rising by 1.6% QoQ annualized in Q4. However, like Europe, the stronger currency has begun to dent the external sector, with industrial production and the leading index slowing (Chart 15, panel 2). However, more encouraging signs are appearing domestically: retail sales rose by 2.5% YoY in January and part-time wages are up 2.0% YoY. As a result, inflation is finally emerging, with CPI (excluding food and energy) up 0.3% YoY. Emerging Markets: China's growth remains steady, with the Caixin PMI at 51 (panel 3). However, credit and money supply growth continue to point to a slowdown in coming months. This may be evident when March data (unaffected by the shifting timing of Chinese New Year) becomes available. Elsewhere in EM, growth has picked up moderately: Q4 GDP growth came in at an annualized rate of 7.2% in India, 3.0% in Korea, and even 2.1% in Brazil and 1.8% in Russia. Interest rates: A modest rise in inflation expectations (panel 4) has led to a rise in long-term rates, with the U.S. 10-year yield rising from 2.5% to almost 3% during Q1 before slipping back a little. We expect the Fed to hike four times this year, and think this will push up the 10-year Treasury yield to 3.3-3.5% by year-end. The ECB continues to emphasize that it will move only slowly to raise rates after halting asset purchases later this year, and we think the market has correctly priced the timing of the first hike for Q4 2019. We see no reason why the BoJ will end its Yield Curve Control policy, with inflation still well below the 2% target. Chart 16Cautiously Optimistic Global Equities Tip-Toeing Through The Late Cycle. Global equities experienced widespread corrections in the first quarter after a very strong start in January gave way to fear of rising inflation in the U.S., fear of slowing growth in China, and fear of rising geopolitical tensions globally. The return of macro volatility was so violent that it pushed the VIX to high readings not seen since 2015. Granted, a background of stretched valuations, complacency, and the "fear of missing out" also contributed to the market correction. The healthy correction of global equities from the high in late January has seen valuations contracting as earnings continued to grow at strong pace (Chart 16). BCA's house view is that global growth may be peaking, but should remain strong and above trend, underpinning decent earnings growth for the next 9-12 months. As such, we retain our pro-cyclical tilts in global equity allocations, overweight cyclical sectors and underweight defensive sectors; overweight high-beta DM markets (Japan and euro area); neutral on the U.S. and Canada; and underweight EM and Australia, the markets that would suffer most from a deceleration in Chinese growth. However, we are late in the cycle and valuations remain stretched by historical standards despite the recent correction. With macro volatility returning, investors should be very conscious of potential risks that could derail the uptrend in equities. For investors with higher aversion to risk, we suggest raising cash by selling into strength or dialing down the overweight of cyclicals vs defensives. Anatomy Of EM/DM Outperformance Since their low in early 2016, EM equities have outperformed DM in total return terms by more than 20%, of which 262 bps came in the first quarter of 2018, despite the rising volatility in all asset classes recently. As show in Chart 17, the outperformance of EM over DM has been dominated by three sectors: Technology, Financials and Energy. In the two-year period ending December 2017, over half of the EM outperformance came from the Tech sector, followed by Financials and Energy, accounting for 32% and 14% respectively. In Q1 2018, however, Tech's contribution dropped sharply to 0.3%, while Financials and Energy shot up to 51% and 33% respectively. Even though Energy is a relatively small sector, accounting for 6-7% of benchmark weights in both EM and DM, the diverging performance between EM and DM Energy sectors has played an important role in the EM outperformance. In the two years ending December 2017, EM Energy outperformed its DM counterpart by 32%, the same magnitude as the Tech sector (Table 3). In Q1 2018, EM Energy gained 7.6% while DM Energy suffered a 5.2% decline, resulting in a staggering 13% outperformance (Table 4). Chart 17Sector Contributions To EM/DM Outperformance Table 3Two-Year Performance Attribution* (December 2015 - December 2017) Table 4Q1/2018 Attribution* (December 2015 - December 2017) Country-wise, Brazil and China led the outperformance, helped by the Brazilian real's 30% appreciation against the U.S. dollar. BCA's EM Strategy believes that Brazilian equities and the real will both weaken given the country's weak governance and poor fiscal profile. Chart 18Style Performance We are neutral on Tech globally, and the general reliance of EM equities on Chinese growth, and the high leverage in EM do not bode well for EM equities. Remain underweight EM vs. DM. A Sector Approach To Style Year to date, the equal-weighted multi-factor portfolio has outperformed the global benchmark slightly, largely driven by the strong outperformance of Momentum and Quality, while Value and Minimum Volatility (MinVol) have underperformed (Chart 18, top three panels). This is in line with our previous regime analysis that indicated rising growth and inflation is a good environment for Momentum and Quality, but a bad one for Min Vol.5 As we have argued before, we prefer sector positioning to style positioning because 1) the major style tilts such as Value/Growth, Min Vol and Small Cap/Large Cap have seen significant sector shifts over time, and 2) sector selection offers more flexibility. As shown in Chart 18 (bottom three panels), the relative performance of Min Vol is a mirror image of Cyclicals vs Defensives, while Value/Growth is highly correlated with Cyclicals/Defensives. In a Special Report,6 we elaborated in-depth that sector selection is a better alternative to size selection, especially in the U.S. We maintain our neutral view on styles, and continue to favor Cyclicals versus Defensives. Given that we are at the late stage of the business cycle, investors with lower risk tolerance may consider gradually dialing down exposure to cyclical tilts. For stock pickers, this would mean favoring stocks with low volatility, high quality and strong momentum. Government Bonds Maintain Slight Underweight On Duration. Despite rising volatility due to changes in inflation expectations and uncertain developments in geopolitics, the investment backdrop has been evolving in line with our 2018 Strategy Outlook. Global growth continues at a strong pace (Chart 19) and our U.S. Bond Strategy has increased its yield forecast to the range of 3.3-3.6%, from 2.80-3.25% previously, reflecting both a higher real yield and higher inflation expectations. The U.S. 10-year Treasury yield increased by 34 bps in Q1 to 2.74%, still lower than our fair value estimate, implying that there is still upside risk for global bond yields. As such, investors should continue to underweight duration in global government bonds. Favor Linkers Vs. Nominal Bonds. The base case forecast from our U.S. Bond Strategy is that the U.S. TIPS breakeven will rise to 2.3-2.5% around the time that U.S. core PCE reaches the Fed's 2% target rate, likely sometime in 2H 2018. Compared to the current level of 2.05, this means the 10-year TIPS has upside of 25-45 bps, an important source of relative return in the low-return fixed income space (Chart 20). Maintain overweight TIPS vs. nominal bonds. In terms of relative value, however, TIPS are no longer cheap. For those who have not moved to overweight TIPS, we suggest "buying TIPS on dips". In addition, inflation-linked bonds (ILBs) in Australia and Japan are still very attractive vs. their respective nominal bonds (Chart 20, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Chart 19Further Upside In Bond Yields Chart 20Favor Inflation linkers Corporate Bonds We continue to favor both investment grade and high-yield corporate bonds within the fixed-income category. High-yield spreads barely reacted to the sell-offs in equities in February and March (Chart 21). We see credit spreads as a useful indicator of recessions and equity bear markets and so the fact that they did not rise suggests no broad-based risk aversion. Moreover, this resilience comes despite significant outflows from high-yield ETFs, $4.4 billion year-to-date, almost completely reversing the inflows over the previous three quarters. We still find spreads in this space attractive. BCA estimates the default-adjusted spread is still around 250 basis points (assuming default losses of 1.3% over the coming 12 months) which, while not cheap, is less overvalued than other fixed-income categories (Chart 22). Investment grade spreads, however, have widened in recent weeks (Chart 21), with the rise concentrated in the highest-quality credits. This is most likely because investors see little value in these securities. We keep our overweight but we focus on cross-over credits and sectors where valuations are still reasonable, for example energy, airlines and insurance companies. Excessive leverage remains a concern for corporate bond losses in the next recession. BCA's Corporate Health Monitor (Chart 23) has improved in recent quarters, mostly due to stronger profitability. But the deterioration in interest coverage ratios in recent years makes companies vulnerable to higher rates. We estimate that a 100 basis point increase in interest rates across the corporate curve would lead to a drop in the ratio of EBITDA to interest expenses from 4.0 to 2.5.7 Sectors such as Materials, Technology, Consumer Discretionary and Energy appear especially at risk.8 Chart 21IG Spreads Have Widened, But Not HY Chart 22Junk Bonds Still Offer Some Value Chart 23Leverage Is A Worry For The Next Recession Commodities Chart 24OPEC Agreements Hold The Key Energy (Overweight): Demand/supply fundamentals have been driving prices in crude oil markets (Chart 24). Fundamentals remain favorable as strong global demand is keeping the market in physical deficit. However, the outlook for demand has turned cloudy as the market may start to price in the possibility of a trade war which would dent growth. Also, threats of renewed sanctions against Iran and deeper ones against Venezuela could potentially disrupt supply sufficiently to push up the crude price. Given rising uncertainties with the demand and supply outlook, we expect increased volatility in the crude price. We maintain our forecasts for the average 2018 prices for Brent and WTI at $74 and $70 respectively. Industrial Metals (Neutral): As President Trump moves ahead with protectionist policies, markets are being spooked by the possibility of a trade war. Looking past the noise, since China remains the largest source of demand, price action will follow domestic Chinese market fundamentals which are a function of how authorities handle a possible growth slowdown. The possibility of global trade disruptions, coupled with a recovery in the U.S. dollar, suggests increased price volatility. We are particularly negative on zinc. Spanish zinc has been flooding into China, depressing physical premiums and causing inventory accumulation (Chart 24, panel 3). Precious Metals (Neutral): Rising trade protectionism, geopolitical tensions, and diverging monetary policy will be sources of increased market volatility for the rest of the year. When equity markets went through a minor correction earlier this year, gold outperformed global equities by 6%. However, rising interest rates and a potentially stronger U.S. dollar are two headwinds for the gold price. We continue to recommend gold as a safe haven asset against unexpected market volatility and inflation surprises (Chart 24, panel 4). Currencies Chart 25Dollar Will Stage A Recovery Rally U.S. Dollar: Following its 7% depreciation last year, the greenback is flat year to date. A positive output gap and strong inflation readings are giving the Fed enough reasons not to fall behind the curve. Secondly, the proposed fiscal stimulus is likely to increase the U.S.'s twin deficits which has historically been bullish for the currency, as long as it is accompanied by rising real rates. Finally, speculative positions in the dollar are net short, which means any positive surprises will be bullish for the currency. We expect the U.S. dollar to stage a recovery rally in the coming months (Chart 25, panel 1). Carry Trades: Cross-asset class volatility is making a strong comeback. Carry trades fare poorly in volatile FX markets. High-yielding EM currencies like the BRL, TRY, and ZAR will underperform, whereas low yielding safe-haven funding currencies like the Swiss franc and Japanese yen, in countries with outsized net international investment positions, will be the winners. Finally, the return of volatility could hurt global economic sentiment and possibly weigh on growth-sensitive currencies like the KRW, AUD and NZD (Chart 25, panel 2). Euro: Analyzing the euro's strength, we see a 9% divergence in performance between the EUR/USD pair and the trade-weighted euro. Global synchronized growth was driven predominantly by a recovery in manufacturing which benefited the euro area more than the U.S. Also looking at history, the euro tends to appreciate relative to USD in the last two years of economic upswings driven by strong growth. Finally, the recent divergence in relative interest rates is a clear sign that other fundamental factors, such as the current account balance, have been exerting pressure. Sentiment and positioning remain extremely euro bullish, hence any disappointment with economic data will force a correction (Chart 25, panel 3). GBP: Since 2017, the pound has strengthened by over 16% vs. USD. An appreciating currency has dented inflation readings, thereby limiting the pass-through effects via the Bank of England hiking rates. A hurdle to further appreciation is negative growth in real disposable income and declining household confidence. Finally, weak FDI inflows will hurt the U.K.'s basic balance. Since the BoE will find it difficult to tighten policy much, we expect a correction in the next few months (Chart 25, panel 4). Alternatives Investors have been increasing their allocation to alternatives, pushing AUM to a record $7.7 trillion. We continue to recommend allocations through three different buckets: 1) among return enhancers, we favor private equity vs hedge funds; 2) favor direct real estate vs. commodity futures in inflation hedges; 3) favor farmland & timberland vs. structured products as volatility dampeners. But alternatives have a few challenges that require special consideration. Private Equity: Key drivers of returns have changed. In the past, managers were able to succeed by "buying low/selling high". But today, investors need to pick general partners (GPs) who can identify attractive targets and effect strategic and operational improvements. $1.7 trillion of dry powder. Global buyout value grew by 19% in 2017, but deal count grew by only 2%. High valuations multiples, stiff competition, and an uncertain macro outlook will force funds to be selective. Competition from corporate buyers. GPs are fighting with large corporations looking for growth through acquisition. Private equity's share of overall M&A activity globally declined in 2017 for the fourth year running. Competition for targets is boosting entry multiples in the middle-market segment. Hedge Funds: Net exposure for long/short managers has remained static over market cycles, which means investors pay too much for market exposure. But if we see market rotation or increased dispersion of single stock returns, this hedge fund group will benefit. Discretionary macro will benefit from differing growth outlooks, idiosyncratic events, and local rate cycles. Also, potential for more dispersion in the large-cap space and at the index level will benefit systematic macro. Event-driven funds have been hurt by deal-spread volatility as shareholder opposition, anti-trust concerns and political issues led to deal delays. But we continue to favor short-term special situations in less-followed markets such as Asia. Real Estate: After strong growth in capital values, driven by low rates and cap rate compression, investors need to focus on income-driven total returns. Additionally, income returns do not vary across markets nearly as much as capital value growth. Increase focus on core strategies. Look for properties in prime locations with long and stable lease contracts. Investors can also consider loans made to high-quality borrowers which are secured against properties with stable cash flows. Private Debt: With ultra-low yields, private debt offers attractive risk-adjusted return, diversification, and a potential cash flow profile ideal for institutional investors. However, it is critical to source a differentiated pipeline of opportunities. Infrastructure debt, with a long expected useful life, can provide effective duration for liability matching. Risk-adjusted returns can be enhanced by directly sourcing and structuring. Risks To Our View We see the risks to our main scenario (strong growth continuing through 2019, moderate inflation, late cycle volatility, and rising geopolitical risks) as balanced. There are a number of obvious downside risks, including an escalating trade war, a sharp upside surprise to inflation, and the Fed turning more hawkish (perhaps in an attempt to demonstrate its independence if President Trump pressures it not to raise rates). Among the risks less appreciated by investors is a slowdown in China. Leading indicators of the Chinese economy, particularly money supply and credit growth, continue to slow (Chart 26). Xi Jinping's recent senior appointments suggests he is serious about structural reform, which would mean accepting slower growth in the short-term to put China on a sounder long-term growth path. Linked to this, we also think investors are insufficiently concerned about the impact of rising rates on emerging market borrowers. If, as we expect, U.S. long rates rise to close to 3.5% over the next year and the dollar strengthens, the $3.5 trillion of foreign-currency borrowing by EM borrowers could become a burden (Chart 27). Chart 26What If China Slows? Chart 27Highed Indebted EM Borrowers Are A Risk Chart 28Presidents Like Markets To Rise Upside risk centers on a continuation of strong growth and dovish central banks. We may be underestimating the impact of U.S. fiscal policy. Our assumption that it will peter out in 2020 may be wrong, if President Trump goes for further stimulus ahead of the presidential election - the third and fourth years of presidential cycles are usually the best for stocks (Chart 28). Wages may stay low because of automation. In the face of this the Fed may stay dovish: it already shows some signs of allowing an overshoot of its 2% inflation target, to balance the six years that it missed it to the downside. All this could produce a stock market meltup, similar to 1999. 1 See, for example, Clashing Over Commerce: A History of U.S. Trade Policy, Douglas J, Irwin, Chicago 2017, chapter 8. 2 For an analysis of the geopolitical implications, please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 27, 2018. 3 Please see the What Our Clients Are Asking: How Quickly Will U.S. Inflation Rise? on page 8 of this Quarterly Portfolio Outlook for the reasons why this is our view. 4 Please see Global Asset Allocation Special Report, "Why Invest In Foreign Government Bonds?" dated March 12, 2018 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?" dated July 8, 2016, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation Special Report, "Small Cap Outperformance: Fact Or Myth?" dated April 7, 2017, available at gaa.bcaresearch.com 7 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 8 Please see also What Our Clients Are Asking: Should Investors Still Own Junk Bonds, on page 9 of this Quarterly Update, for more analysis of this asset class. GAA Asset Allocation

Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow Chart I-4A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations