Developed Countries

Neutral In yesterday's Weekly Report, we pulled the trigger on our upgrade watch for the niche S&P homebuilding index,1 monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather, 2. Housing fundamentals remain robust and 3. Compelling valuations reflect most, if not all, of the bad news. With respect to the first of these, BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased. This should support continued gains in the MBA's mortgage purchase index, which has climbed to a fresh cycle high (top panel). Housing fundamentals have proven resilient; new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (second panel). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel). Bottom Line: We are acting on our upgrade alert in the S&P homebuilding index and lifting exposure to neutral. Please see this week's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.

Special Report

Highlights Investors are underestimating the risks of U.S.-Iran tensions; The Obama administration's 2015 deal resulted in Iran curbing aggressive regional behavior that threatened global oil supply; The U.S. negotiating position vis-à-vis Iran has not improved; Unlike North Korea, Iran can retaliate against the Trump administration's "Maximum Pressure" doctrine - particularly in Iraq; U.S.-Iran conflicts will negatively affect global oil supply, critical geographies, and sectarian tensions - hence a geopolitical risk premium is warranted. Average Brent and WTI oil prices should rise to $80/bbl and $72/bbl in 2019 even without adding the full range of events that will drive up the geopolitical risk premium. Risks lie to the upside. Feature Tensions between the U.S. and Iran snuck up on the markets (Chart 1), even though President Trump's policy agenda was well telegraphed via rhetoric, action, and White House personnel moves.1 Still, investors doubt the market relevance of the U.S. withdrawal from the Joint Comprehensive Plan of Action (JCPOA), the international agreement between Iran and the P5+1.2 Chart 1Iran: Nobody Was Paying Attention! Several reasons to fade the risks - and hence to fade any implications for global oil supply - have become conventional wisdom. These include the alleged ability of OPEC and Russia to boost production and Washington's supposed ineffectiveness without an internationally binding sanction regime. Our view is that investors and markets are underestimating the geopolitical, economic, and financial relevance of the U.S.-Iran tensions. First, the ideological rhetoric surrounding the original U.S.-Iran détente tends to be devoid of strategic analysis. Second, Iran's hard power capabilities are underestimated. Third, OPEC 2.0's ability to tap into its spare capacity is overestimated.3 To put some numbers on the difference between our view and the market's view, we rely on the implied option volatilities for crude oil futures.4 As Chart 2 illustrates, the oil markets are currently pricing in just under 30% probability that oil prices will exceed $80/bbl by year-end, and merely 14% that they will touch $90/bbl in the same timeframe. We believe these odds are too low and will take the other side of that bet. Chart 2The Market Continues To Underestimate High Oil Prices Why Did The U.S.-Iran Détente Emerge In 2015? Both detractors and defenders of the 2015 nuclear deal often misunderstand the logic of the deal. First, the defenders are wrong when they claim that the deal creates a robust mechanism that ensures that Iran will never produce a nuclear device. Given that the most critical components of the deal expire in 10 or 15 years, it is simply false to assert that the deal is a permanent solution. More importantly, Iran already reached "breakout capacity" in mid-2013, which means that it had already achieved the necessary know-how to become a nuclear power.5 We know because we wrote about it at the time, using the data of Iran's cumulative production of enriched uranium provided to the International Atomic Energy Agency (IAEA).6 In August 2013, Iran's stockpile of 20% enriched uranium, produced at the impregnable Fordow facility, reached 200kg (Chart 3). Chart 3Iran's Negotiating Leverage At that point, Israeli threats of attacking Iran became vacuous, as the Israeli air force lacked the necessary bunker-busting technology to penetrate Fordow.7 As we wrote in 2013, this critical moment gave Tehran the confidence to give up "some material/physical components of its nuclear program as it has developed the human capital necessary to achieve nuclear status."8 The JCPOA forced Iran to stop enriching uranium at the Fordow facility altogether and to give up its stockpile of uranium enriched at 20%. However, Iran only agreed to the deal because it had reached a level of technological know-how that has not been eliminated by mothballing centrifuges and "converting" facilities to civilian nuclear research. Iran is a nuclear power in all but name. Second, the detractors of the JCPOA are incorrect when they claim that Iran did not give up any regional hegemony when it signed the deal. This criticism focuses on Iran's expanded role in the Syrian Civil War since 2011, as well as its traditional patronage networks with the Lebanese Shia militants Hezbollah and with Yemen's Houthis. However, critics ignore several other, far more critical, fronts of Iranian influence: Strait of Hormuz: In 2012, Iran's nearly daily threats to close the Strait of Hormuz were very much a clear and present danger for global investors (Map 1). Although we argued in 2012 that Iran's capability was limited to a 10-day closure, followed by another month during which they could threaten the safe passage of vessels through the Strait, even such a short crisis would add a considerable risk premium to oil markets given that it would remove about 17-18 million bbl/day from global oil supply (Chart 4).9 Since 2012, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities have largely stayed the same.10 Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Chart 4Geopolitical Crises And Global Peak Supply Losses Iraq: The key geographic buffer between Saudi Arabia and Iran is Iraq (Map 2). Iran filled the power vacuum created by the U.S. invasion almost immediately after Saddam Hussein's overthrow. It deployed members of the infamous Quds Force of the Iranian Revolutionary Guard Corps (IRGC) into Iraq to support the initial anti-American insurgency. Iran's support for Prime Minister Nouri al-Maliki was critical following the American withdrawal in 2011, particularly as his government became increasingly focused on anti-Sunni insurgency. Map 2Iraq: A Buffer Between Saudi Arabia And Iran Bahrain: Home of the U.S. Fifth Fleet, Bahrain experienced social unrest in 2011. The majority of Bahrain's population are Shia, while the country is ruled by the Saudi-aligned, Sunni, Al Khalifa monarchy. The majority of Shia protests were at least rhetorically, and some reports suggest materially, supported by Iran. To quell the protests, and preempt any potential Iranian interference, Saudi Arabia intervened militarily with a Gulf Cooperation Council (GCC) Peninsula Shield Force. Eastern Province: Similar to the unrest in Bahrain, Shia protests engulfed Saudi Arabia's Eastern Province in 2011. The province is highly strategic, as it is where nearly all of Saudi oil production, processing, and transportation facilities are located (Map 1). Like Bahrain, it has a large Shia population. Saudi security forces cracked down on the uprising and have continued to do so, with paramilitary operations lasting into 2017. While Iranian involvement in the protests is unproven, it has been suspected. Anti-Israel Rhetoric: Under President Mahmoud Ahmadinejad, Iran threatened Israel with destruction on a regular basis. While these were mostly rhetorical attacks, the implication of the threat was that any attack against Iran and its nuclear facilities would result in retaliation against U.S. interests in the Persian Gulf and Iraq and direct military action against Israel. Both defenders and detractors of the JCPOA are therefore mistaken. The JCPOA does not impact Iran's ability to achieve "breakout capacity" given that it already reached it in mid-2013. And Iran's regional influence has not expanded since the deal was signed in 2015. In fact, since the détente in 2015, and in some cases since negotiations between the Obama administration and Tehran began in 2013, Iran has been a factor of stability in the Middle East. Specifically, Iran has willingly: Stopped threatening the Strait of Hormuz (the last overt threats to close the Strait of Hormuz were made in 2012); Acquiesced to Nouri al-Maliki's ousting as Prime Minister of Iraq in 2014 and his replacement by the far more moderate and less sectarian Haider al-Abadi; Stopped meddling in Bahraini and Saudi internal affairs; Stopped threatening Israel's existence (although its material support for Hezbollah clearly continues and presents a threat to Israel's security); Participated in joint military operations with the U.S. military against the Islamic State, cooperation without which Baghdad would have most likely fallen to the Sunni radicals in late 2014. The final point is worth expanding on. After the fall of Mosul - Iraq's second largest city - to the Islamic State in May 2014, Iranian troops and military advisors on the ground in Iraq cooperated with the U.S. air force to arrest and ultimately reverse the gains by the radical Sunni terrorist group. Without direct Iranian military cooperation - and without Tehran's material and logistical support for the Iraqi Shia militias - the Islamic State could not have been eradicated from Iraq (Map 3). How did such a dramatic change in Tehran's foreign policy emerge between 2012 and 2015? Iranian leadership realized in 2012 that the U.S. military and economic threats against it were real. Internationally coordinated sanctions had a damaging effect on the economy, threatening to destabilize a regime that had experienced social upheaval in the 2009 Green Revolution (Chart 5). It therefore began negotiations almost immediately after the imposition of stringent economic sanctions in early and mid-2012.11 Map 3The Collapse Of A Would-Be Caliphate Chart 5Iran's Sanctions Had A Hard Bite To facilitate the negotiations, the Guardian Council of Iran disqualified President Ahmadinejad's preferred candidate for the 2013 Iranian presidential elections, while allowing Hassan Rouhani's candidacy.12 Rouhani, a moderate, won the June 2013 election in a landslide win, giving him a strong political mandate to continue the negotiations and, relatedly, to pursue economic development. Many commentators forget, however, that Supreme Leader Ayatollah Sayyid Ali Hosseini Khamenei allowed Rouhani to run in the first place, knowing full well that he would likely win. In other words, Rouhani's victory revealed the preferences of the Iranian regime to negotiate and adjust its foreign policy. Bottom Line: The 2015 U.S.-Iran détente traded American acquiescence in Iranian nuclear development - frozen at the point of "breakout capacity" - in exchange for Iran's cooperation on a number of strategically vital regional issues. As such, focusing on just the JCPOA, without considering the totality of Iranian behavior before and since the deal, is a mistake. Iran curbed its influence in several regional hot spots - almost all of which are critical to global oil supply. The Obama administration essentially agreed to Iran becoming a de facto nuclear power in exchange for Iran backing away from aggressive regional behavior. This included Iran's jeopardizing the safe passage of oil through the Strait of Hormuz either by directly threatening to close the channel or through covert actions in Bahrain and the Eastern Province. The U.S. also drove Iran to accept a far less sectarian Iraq, by forcing out the ardently pro-Tehran al-Maliki and replacing him with a prime minister far more acceptable to Saudi Arabia and Iraqi Sunnis. Why Did The U.S. Chose Diplomacy In 2011? The alternative to the above deal was some sort of military action against Iranian nuclear facilities. The U.S. contemplated such action in late 2011. Two options existed, either striking Iran's facilities with its own military or allowing Israel to do it themselves. One reason to choose diplomacy and economic sanctions over war was the limited capability of Israel to attack Iran alone.13 Israel does not possess strategic bombing capability. As such, it would have required a massive air flotilla of bomber-fighters to get to the Iranian nuclear facilities. While the Israeli air force has the capability to reach Iranian facilities and bomb them, their effectiveness is dubious and the ability to counter Iranian retaliatory capacity with follow-up strikes is non-existent. The second was the fact that a U.S. strike against Iran would be exceedingly complex. Compared to previous Israeli strikes against nuclear facilities in Iraq (Operation Opera 1981) and Syria (Operation Outside The Box 2007), Iran presented a much more challenging target. Its superior surface-to-air missile capability would necessitate a prolonged, and dangerous, suppression of enemy air defense (SEAD) mission.14 In parallel, the U.S. would have to preemptively strike Iran's ballistic missile launching pads as well as its entire navy, so as to obviate Iran's ability to retaliate against international shipping or the U.S. and its allies in the region. The U.S. also had a strategic reason to avoid entangling itself in yet another military campaign in the Middle East. The public was war-weary and the Obama administration gauged that in a world where global adversaries like China and Russia were growing in geopolitical power, avoiding another major military confrontation in a region of decreasing value to U.S. interests (thanks partly to growing U.S. shale oil production) was of paramount importance (Chart 6). Notable in 2011 was growing Chinese assertiveness throughout East Asia (please see the Appendix). Particularly alarming was the willingness of Beijing to assert dubious claims to atolls and isles in the South China Sea, a globally vital piece of real estate (Diagram 1). There was a belief - which has at best only partially materialized - that if the United States divested itself of the Middle East, then it could focus more intently on countering China's challenge to traditional U.S. dominance in East Asia and the Pacific. Chart 6Great Power Competition Diagram 1South China Sea As Traffic Roundabout Bottom Line: The Obama administration therefore chose a policy of military posturing toward Iran to establish a credible threat. The military option was signaled in order to get the international community - both allies and adversaries - on board with tough economic sanctions. The ultimate deal, the JCPOA, did not give the U.S. and its allies everything they wanted precisely because they did not enter the negotiations from a position of preponderance of power. Critics of the JCPOA ignore this reality and assume that going back to the status quo ante bellum will somehow improve the U.S. negotiating position. It won't. What Happens If The U.S.-Iran Détente Ends? The Trump administration is serious about applying its Maximum Pressure tactics on Iran. Buoyed by the successful application of this strategy in North Korea, the White House believes that it can get a better deal with Tehran. We do not necessarily disagree. It is indeed true that the U.S. is a far more powerful country than Iran, with a far more powerful military. On a long enough timeline, with enough pressure, it ought to be able to force Tehran to concede, assuming that credible threats are used.15 Unlike the Obama administration, the Trump administration will presumably rely on Israel far less, and on its own military capability a lot more, to deliver those threats, which should be more effective. The problem is that the timeline on which such a strategy would work is likely to be a lot longer with Iran than with North Korea. This is because Iran's retaliatory capabilities are far greater than the one-trick-pony Pyongyang, which could effectively only launch ballistic missiles and threaten all-out war with U.S. and its regional allies.16 While those threats are indeed worrisome, they are also vacuous as they would lead to a total war in which the North Korean regime would meet its demise. Iran has a far more effective array of potential retaliation that can serve a strategic purpose without leading to total war. As we listed above, it could rhetorically threaten the Strait of Hormuz or attempt to incite further unrest in Bahrain and Saudi Arabia's Eastern Province. The key retaliation could be to take the war to Iraq. The just-concluded election in Iraq appears to have favored Shia political forces not allied to Iran, including the Alliance Towards Reform (Saairun) led by the infamous cleric, Muqtada al-Sadr (Chart 7). Surrounding this election, various Iranian policymakers and military leaders have said that they would not allow Iraq to drift outside of Iran's sphere of influence, a warning to the nationalist Sadr who has fought against both the American and Iranian military presence in his country. Iraq is not only a strategic buffer between Saudi Arabia and Iran, the two regional rivals, but also a critical source of global oil supply, having brought online about half as much new supply as U.S. shale since 2011 (Chart 8). If Iranian-allied Shia factions engage in an armed confrontation with nationalist Shias allied with Muqtada al-Sadr, such a conflict will not play out in irrelevant desert governorates, as the fight against the Islamic State did. Chart 7Iraqi Elections Favored Shiites But Not Iran Chart 8Iraq Critical To Global Oil Supply Instead, a Shia-on-Shia conflict would play out precisely in regions with oil production and transportation facilities. In 2008, for example, Iranian-allied Prime Minister Nouri al-Maliki fought a brief civil war against Sadr's Mahdi Army in what came to be known as the "Battle of Basra." While Iran had originally supported Sadr in his insurgency against the U.S., it came to Maliki's support in that brief but deadly six-day conflict. Basra is Iraq's chief port through which much of the country's oil exports flow. Iraq may therefore become a critical battleground as Iran retaliates against U.S. Maximum Pressure. From Iran's perspective, holding onto influence in Iraq is critical. It is the transit route through which Iran has established an over-land connection with its allies in Syria and Lebanon (Map 4). Threatening Iraqi oil exports, or even causing some of the supply to come off-line, would also be a convenient way to reduce the financial costs of the sanctions. A 500,000 b/d loss of exports - at an average price of $70 per barrel (as Brent has averaged in 2018) - could roughly be compensated by an increase in oil prices by $10 per barrel, given Iran's total exports. As such, Iran, faced with lost supply due to sanctions, will have an incentive to make sure that prices go up (i.e., that rivals do not simply replace Iranian supply, keeping prices more or less level). The easiest way to accomplish this, to add a geopolitical risk premium to oil prices, is through the meddling in Iraqi affairs. Map 4Iran Needs Iraq To Project Power Through The Levant It is too early to forecast with a high degree of confidence precisely how the U.S.-Iran confrontation will develop. However, Diagram 2 offers our take on the path towards retaliation. Diagram 2Iran-U.S. Tensions Decision Tree The critical U.S. sanctions against Iran will become effective on November 4 (Box 1). We believe that the Trump administration is serious and that it will force European allies, as well as South Korea and Japan, to cease imports of oil from Iran. China will be much harder to cajole. BOX 1 Iranian Sanction Timeline President Trump issued a National Security Presidential Memorandum to re-impose all U.S. sanctions lifted or waived in connection with the JCPOA. The Office of Foreign Assets Control expects all sanctions lifted under the JCPOA to be re-imposed and in full effect after November 4, 2018. However, there are two schedules by which sanctions will be re-imposed, a 90-day and 180-day wind-down periods.1 Sanctions Re-Imposed After August 6, 2018 The first batch of sanctions that will be re-imposed will come into effect 90 days after the announced withdrawal from the JCPOA. These include: Sanctions on direct or indirect sale, supply, or transfer to or from Iran of several commodities (including gold), semi-finished metals, and industrial process software; Sanctions on the purchase or acquisition of U.S. dollar banknotes by the government of Iran; Sanctions on trade in Iranian currency and facilitation of the issuance of Iranian sovereign debt; Sanctions on Iran's automotive sector; Sanctions on export or re-export to Iran of commercial passenger aircraft and related parts. Sanctions Re-Imposed After November 4, 2018 The second batch of sanctions will come into effect 180 days after the announced Trump administration JCPOA withdrawal decision. These include: Sanctions on Iranian port operators, shipping, and shipbuilding activities; Sanctions against petroleum-related transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC); Sanctions against the purchase of petroleum, petroleum products, or petrochemical products from Iran; Sanctions on transactions and provision of financial messaging services by foreign financial institutions with the Central Bank of Iran; Sanctions on Iran's energy sector; Sanctions on the provision of insurance, reinsurance, and underwriting services. 1 Please see the U.S. Treasury Department, "Frequently Asked Questions Regarding the Re-Imposition of Sanctions Pursuant to the May 8, 2018, National Security Presidential Memorandum Relating to the Joint Comprehensive Plan of Action (JCPOA)," dated May 8, 2018, available at www.treasury.gov. By Q1 2019, the impact on Iranian oil exports will be clear. We suspect that Iran will, at that point, have the choice of either relenting to Trump's Maximum Pressure, or escalating tensions through retaliation. We give the latter a much higher degree of confidence and suspect that a cycle of retaliation and Maximum Pressure would lead to a conditional probability of war between Iran and the U.S. of around 20%. This is a significant number, and it is critical if President Trump wants to apply credible threats of war to Iran. Bottom Line: Unlike North Korea, Iran has several levers it can use to retaliate against U.S. Maximum Pressure. Iran agreed to set these levers aside as negotiations with the Obama administration progressed, and it has kept them aside since the conclusion of the JCPOA. It is therefore easy for Tehran to resurrect them against the Trump administration. Critical among these levers is meddling in Iraq's internal affairs. Not only is Iraq critical to Iran's regional influence; it is also key to global oil supply. We suspect that a cycle of Iranian retaliation and American Maximum Pressure raises the probability of U.S.-Iran military confrontation to 20%. We will be looking at several key factors in assessing whether the U.S. and Iran are heading towards a confrontation. To that end, we have compiled a U.S.-Iran confrontation checklist (Table 1). Table 1Will The U.S. Attack Iran? Investment Implications Over the past several years, there have been many geopolitical crises in the Middle East. We have tended to fade most of them, from a perspective of a geopolitical risk premium applied to oil prices. This is because we always seek the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying, market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. In 2015, we identified three factors that we believe are critical for a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications.17 These are: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Renewed sanctions against Iran do so directly. So would Iranian retaliation in Iraq or the Persian Gulf. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Re-imposed sanctions obviously directly impact Iran as they could increase domestic political crisis. A potential Iranian proxy-war in Iraq would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni vs. Shia - which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. A renewed U.S.-Iran tensions check all of our factors. The risk is therefore real and should be priced by the market through a geopolitical risk premium. In addition, Iranian sanctions could tighten up the outlook for oil markets in 2019 by 400,000-600,000 b/d, reversing most of the production gains that Iran has made since 2016 (Chart 9). This is a problem given that the enormous oversupply of crude oil and oil products held in inventories has already been significantly cut. BCA's Commodity & Energy Strategy and Energy Sector Strategy teams believe that global petroleum inventories will be further reduced in 2019 (Chart 10). Chart 9Current And Future Iran##br## Production Is At Risk Chart 10Tighter Markets And Lower Inventories,##br## Keep Forward Curves Backwardated What about the hints from the OPEC 2.0 alliance that they would surge production in light of supply loss from Iran? Oil prices fell on the belief OPEC 2.0 could easily restore 1.8 MMb/d of production that they agreed to hold off the market since early 2017. Our commodity strategists have always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually achieved (Chart 11). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 12). Chart 11Primary OPEC 2.0 Members Are Producing##br## 1.0 MMb/d Below Pre-Cut Levels Chart 12Secondary OPEC 2.0 "Contributors" ##br##Can't Even Reach Their Quotas Furthermore, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.2 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 13). BCA's Commodity & Energy Strategy therefore projects that the combination of stable global demand, steady declines in Venezuela's crude oil output, and the loss of Iranian exports to U.S. sanctions in 2019 will lift the average Brent and WTI prices to $80 and $72/bbl respectively (Chart 14).18 This forecast, however, represents our baseline based on fundamentals of global oil supply and demand (Chart 15) and does not include our potential scenarios outlined in Diagram 2, which would obviously add additional geopolitical risk premium. Chart 13Venezuela Is A Bigger Risk Chart 14Brent Will Average $80/bbl In 2019 Chart 15Balances Tighter As Supply Falls For investors looking for equity-market exposure in this scenario, BCA's Energy Sector Strategy recommends overweighing U.S. shale producers and shale-focused service companies for investors looking for equity-market exposure to oil prices. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has broken down this recommendation into specific equity calls, which we encourage our clients to peruse.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 The JCPOA was concluded in Vienna on July 14, 2015 between Iran and the five permanent members of the United Nations Security Council (China, France, Russia, the United Kingdom, and the United States), plus Germany (the "+1" of the P5+1). 3 BCA's Senior Commodity & Energy Strategist Robert P. Ryan has given the name "OPEC 2.0" to the Saudi-Russian alliance that is focused on regaining a modicum of control over the rate at which U.S. shale-oil resources are developed. Please see BCA Commodity & Energy Strategy Weekly Report, "KSA's, Russia's End Game: Contain U.S. Shale Oil," dated March 30, 2017; and "The Game's Afoot In Oil, But Which One?" dated April 6, 2017, available at ces.bcaresearch.com. 4 We use Brent implied volatility - of at-the-money options of the selected futures contract - as an input to construct the cumulative normal density of future prices. Thus, the probability obtained is one where the terminal futures price, at the selected months, exceeds the strike price quoted. In order to derive this probability, we need the current market price of the selected future contract, the number of days to expiration, the strike price, and a measure of the volatility of this contract. 5 "Breakout" nuclear capacity is defined here as having enough uranium enriched at lower levels, such as at 20%, to produce sufficient quantities of highly-enriched uranium (HEU) required for a nuclear device. The often-reported amount of 20% enriched uranium required for breakout capacity is 200kg. However, the actual amount of uranium required depends on the number of centrifuges being employed and their efficiency. In our 2013 report, we gauged that Iran could produce enough HEU within 4-5 weeks at the Fordow facility to develop a weapon, which means that it had effectively reached "breakout capacity." 6 Please see International Atomic Energy Agency, "Implementation Of The NPT Safeguards Agreement And Relevant Provisions Of Security Council Resolutions In The Islamic Republic Of Iran," IAEA Board Report, dated August 28, 2013, available at www.iaea.org. 7 Although, in a move designed to increase pressure on Iran and its main trade partners, the Obama administration sold Israel the GBU-28 bunker-busting ordinance. That specific ordinance is very powerful, but still not capable enough to penetrate Fordow. 8 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, available at gps.bcaresearch.com. 9 Please see BCA Special Report, "Crisis In The Persian Gulf: Investment Implications," dated March 1, 2012, available at gps.bcaresearch.com. 10 There are four U.S. Navy Avenger-class minesweepers based in Bahrain as part of the joint U.S.-U.K. TF-52. This number has been the same since 2012, when they were deployed to the region. 11 Particularly crippling for Iran's economy was the EU oil embargo imposed in January 2012, effective from July of that year, and the banning of Iranian financial institutions from participating in the SWIFT system in March 2012. 12 The Guardian Council of the Constitution is a 12-member, unelected body wielding considerable power in Iran. It has consistently disqualified reformist candidates from running in elections, which makes its approval of Rouhani's candidacy all the more significant. 13 Please see BCA Geopolitical Strategy Special Report, "Reality Check: Israel Will Not Bomb Iran (Ever)," dated August 14, 2013, available at gps.bcaresearch.com. 14 The NATO war with Yugoslavia in 1999 reveals how challenging SEAD missions can be if the adversary refuses to engage its air defense systems. The U.S. and its NATO allies bombed Serbia and its forces for nearly three months with limited effectiveness against the country's surface-to-air capabilities. The Serbian military simply refused to turn on its radar installations, making U.S. AGM-88 HARM air-to-surface anti-radiation missiles, designed to home in on electronic transmissions coming from radar systems, ineffective. 15 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threats,'" dated April 7, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 18 Please see BCA Commodity & Energy Strategy Weekly Report, "Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019," dated May 24, 2018, available at ces.bcaresearch.com. 19 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. Appendix Notable Clashes In The South China Sea (2010-18) Notable Clashes In The South China Sea (2010-18) (Continued) Notable Clashes In The South China Sea (2010-18) (Continued)

Highlights In this Weekly Report, we review all of the individual trades in our Tactical Overlay portfolio. These are positions that are intended to complement our strategic Model Bond Portfolio, typically with shorter holding periods, and sometimes in smaller or less liquid markets that are outside our usual core bond coverage (like Swedish government bonds or euro area CPI swaps). This report includes a summary of the rationale for each position, as well as a decision on whether to retain the position, close it or switch it into a new trade that has more profit potential for the same theme underlying the original trade (Table 1). Table 1Global Fixed Income Strategy Tactical Overlay Trades Feature U.S. Long 5-year U.S. Treasury bullet vs. 2-year/10-year duration-matched barbell (CLOSE AND SWITCH TO NEW TRADE) Long U.S. TIPS vs. nominal U.S. Treasuries (HOLD) Short 10-year U.S. Treasuries vs. 10-year German Bunds (HOLD) Chart 1UST Curve Trading More Off The Funds##BR##Rate Than Inflation Expectations We have three U.S.-focused tactical trades that are all expressions of our core views on U.S. inflation expectations and future Fed monetary policy moves. We first recommended a U.S. butterfly trade, going long the 5-year U.S. Treasury bullet and short a duration-matched 2-year/10-year Treasury barbell (Chart 1), back on December 20th, 2016. We have kept the recommendation during periodic reviews of our tactical trades since then. This is a position that was expected to benefit from a bearish steepening of the U.S. Treasury curve as the market priced in higher longer-term inflation expectations. The trade has not performed according to our expectations, however, generating a loss of -0.40% since inception.1 There was a positive correlation between the slope of the Treasury curve, the butterfly spread and TIPS breakevens shortly after trade inception. However, the Treasury curve flattened through 2017 as the Fed continued to hike rates, even as realized inflation fell (2nd panel), pushing the real fed funds towards neutral levels as measured by estimates like r* (3rd panel). This has left the 2/5/10 Treasury butterfly cheap on our valuation model (bottom panel), Looking ahead, the case for a renewed bear-steepening of the U.S. Treasury curve, and widening of the 2/5/10 butterfly spread, rests on the Fed accommodating the current rise in U.S. inflation by being cautious with future rate hikes. Recent comments from Fed officials suggest that policymakers are in no hurry to rapidly raise rates in order to cool off an "overheating" U.S. economy. Yet at the same time, U.S. inflation continues to rise and the economy is in good shape, so the Fed can't take a pause on rate hikes. This will likely leave the Treasury curve range bound, with the potential for some periods of bear-steepening as inflation expectations rise. Our conviction on this Treasury butterfly spread trade has fallen of late. Yet with our model suggesting that the belly of the curve is somewhat cheap to the wings, and given our view that U.S. inflation expectations have not reached a cyclical peak, we are reluctant to completely exit this position. Instead, we are opting to switch out of the 2/5/10 U.S. Treasury butterfly into another butterfly that our colleagues at BCA U.S. Bond Strategy have identified as cheap within their newly-expanded curve modeling framework - the 1/7/20 butterfly (long the 7-year bullet vs. short a duration-matched 1/20 barbell).2 That butterfly offers better carry than the 2/5/10 butterfly (Chart 2), and is nearly one standard deviation cheap to estimated fair value. Another of our U.S.-focused tactical trades has been to directly play for rising U.S. inflation expectations by going long TIPS versus nominal U.S. Treasuries. This is a long-held trade (initiated on August 23rd, 2016) which has performed very well, delivering a return of 4.13%.3 We continue to see the potential for TIPS breakevens to widen back to levels consistent with the market believing that inflation can sustainably return to the Fed's 2% target on the PCE deflator, which is equivalent to 2.4-2.5% on CPI-based 10-year TIPS inflation expectations. Given the persistent strong correlation between oil prices and breakevens, and with the BCA Commodity & Energy Strategy team continuing to forecast Brent oil prices jumping above $80/bbl over the next year (Chart 3), there is still solid underlying support for wider breakevens. This is especially true given the uptrend in overall global inflation (middle panel), and the likelihood that core U.S. inflation can also continue to rise alongside an expanding U.S. economy (bottom panel). We are sticking with our long TIPS position vs. nominal Treasuries. Chart 2Switch The UST Butterfly##BR##Trade From 2/5/10 to 1/7/20 Chart 3Stay Long U.S. TIPS##BR##Vs. Nominal Treasuries Our final U.S.-focused tactical trade is actually a cross-market trade where we are short 10-year U.S. Treasuries versus 10-year German Bunds. We initiated that trade on August 8th, 2017 when the Treasury-Bund spread was at 179bps. With the spread now at 252bps, the trade has delivered a solid total return of 4.23%. This was driven primarily by the rapid move higher in Treasury yields in response to faster U.S. growth (Chart 4), more rapid U.S. inflation and Fed rate hikes versus a stand-pat European Central Bank (ECB).4 From a medium-term perspective, those three fundamental drivers of the Treasury-Bund spread continue to point to U.S. bond underperformance (Chart 5). From this perspective, the peak in the spread will not be reached until U.S. economic growth and inflation peak and the Fed signals an end to its current tightening cycle. None of those outcomes is on the horizon, and we continue to target an eventual cyclical top in the 10-year Treasury yield in the 3.25-3.5% range as inflation expectations move higher. Yet the Treasury-Bund spread has reached an overvalued extreme according to our "fair value" model (Chart 6). In other words, the markets have moved to more than fully discount the cyclical differences between the U.S. and euro area - a trend that surely reflects the huge short positioning in the U.S. Treasury market. Yet it is also important to note that the fair value spread continues to steadily climb higher. In our model, the spread is primarily a function of differences in central bank policy rates between the Fed and ECB, relative unemployment rates and relative headline inflation rates. All three of those factors continue to move in a direction favorable to a wider Treasury-Bund spread, and the gap is only growing wider with both growth and inflation in the euro zone losing momentum. Chart 4Stay Long 10yr UST##BR##Vs. 10yr German Bund Chart 5UST-Bund Spread Widening##BR##Due To Relative Fundamentals... Chart 6...But The Spread##BR##Has Overshot A Bit The spread is currently being pushed to even wider extremes by the current turmoil in Italy, which is pushing money out of Italian BTPs into safer assets like Bunds. The situation remains fluid and new elections are likely in Italy later this year, thus it is unlikely that any more to restore investor confidence in Italy is on the immediate horizon. This will keep Bund yields depressed versus Treasuries, even as the ECB continues to signal that it will fully taper its asset purchases by year-end (rate hikes remain a long way off in Europe, however). We continue to recommend staying short Treasuries versus Bunds, and would view any tightening of the spread back towards our model estimate of fair value as an opportunity to enter the position or add to an existing position. Euro Area Long 10-year euro area CPI swaps (HOLD, BUT ADD A STOP AT 1.5%) Short 5-year Italy government bonds vs. 5-year Spain government bonds (HOLD) Chart 7Stay Long 10-Year Euro Area CPI Swaps We have two tactical trades that are purely within the euro area: positioning for higher inflation expectations through a long position in 10-year euro CPI swaps, and playing relative credit quality within the Peripheral countries by shorting 5-year Italian bonds versus a long position in 5-year Spanish debt. The long 10-year CPI swaps trade, which was initiated on December 20th, 2016, has generated a total return of +0.45% over the life of the trade so far (Chart 7).5 The rationale for the recommendation, and our conviction behind it, has evolved over that time. We first recommended the trade when the ECB was aggressively easing monetary policy and there was clear positive momentum in euro area economic growth that was driving down unemployment. At a time when oil prices were steadily climbing and the euro was very weak, the case for seeing some improvement in inflation expectations in the euro area was a strong one. Inflation expectations stayed resilient in 2017, however, despite the unexpected strength of the euro. Continued gains in oil prices and above-trend economic growth that rapidly absorbed spare capacity in the euro area more than offset any downward pressure on inflation from a stronger currency. Looking ahead, the combination of renewed weakness in the euro and firm oil prices should allow headline inflation in the euro area to drift higher from current levels in the next 3-6 months (2nd panel). However, the euro area economy has lost the positive momentum seen last year with steady declines in cyclical data like manufacturing PMIs, industrial production and exports (3rd panel). Admittedly, that deceleration has come from a high level and leading indicators are not yet pointing to a prolonged period of below-potential growth that could raise unemployment and reduce domestic inflation pressures. Yet with core inflation still struggling to climb beyond the 1% level (bottom panel), any worsening of euro area economic momentum could lead to inflation expectations stalling out well before getting close to the ECB's 2% target level. Thus, we continue to recommend this long 10-year CPI swaps position, but we are adding a new stop-out level at 1.5% to protect against downside risks if the euro area growth outlook darkens. On our other euro area tactical trade, we have been recommending shorting Italian government bonds versus Spanish equivalents. We initiated that trade on December 16th, 2016 and it has produced a total return of +0.57% over the life of the trade. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign debt fundamentals and political stability were all much worse than that of Spain (Chart 8), yet Italian bond yields were still trading at too low a spread to Spanish debt. The cyclical improvement in the Italian economy in 2017 helped pushed Italian yields even closer to Spanish yields, yet we stuck with the trade given the looming political risk from the Italian parliamentary elections. The recent political turmoil in Italy has justified our persistence with this trade, with the 5-year Italy-Spain spread widening out by 46 bps over just the past two weeks. With the situation remaining highly fluid as the Italian coalition partners (the 5-Star Movement and the League) struggle to form a new government, Italian assets will continue to trade with a substantial risk premium to Spain and other European bond markets. Yet with the Italian economy now also showing signs of losing cyclical momentum, the case for continued Italian bond underperformance is a strong one, and we moved to a strategic underweight stance on Italian debt last week.6 Looking ahead, we see the potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth, the deficit outlook is worsening for Italy with the new coalition government proposing a stimulus that could widen the budget deficit by as much as 6% of GDP, and Spanish support for the euro currency is far higher than it is in Italy. All those factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 9). Chart 8Spain Trumps Italy On All Fronts Chart 9Stay Short 5-Year Italy Versus 5-Year Spain Our view on Italian debt, both from a tactical and strategic viewpoint, is bearish. We are maintaining our tactical trade, and we also advise selling into any rallies in Italy rather than buying the dips. U.K. Long 5-year Gilt bullet vs. duration-matched 2-year/10-year Gilt barbell (HOLD) We entered into a U.K. Gilt butterfly trade, long the 5-year bullet versus the duration-matched 2-year/10-year barbell, back on March 27th, 2018.7 The logic of the trade was a simple one. We simply did not believe that the Bank of England (BoE) would follow through on its hawkish commentary by hiking rates as much as was discounted in the Gilt curve. Our view came to fruition as the BoE held rates steady at the May monetary policy meeting, which resulted in a bullish steepening at the front end of the Gilt curve. Our butterfly trade has returned +0.25% since inception, and we see more to come in the coming months.8 The U.K. economy has lost considerable momentum, with no growth shown in Q1 (real GDP only expanded +0.1%). The OECD leading economic indicator for the U.K. is at the weakest level in five years, and now consumer confidence is rolling over as rising oil costs are offsetting the pickup in wages (Chart 10). Overall headline inflation has peaked, however, after the big currency-fueled surge in 2016 and 2017 (bottom panel). With both growth and inflation slowing, and with the lingering uncertainty of the Brexit negotiations weighing on business confidence and investment, the BoE will have a tough time hiking rates even one more time this year. There are still 34bps of rate hikes priced into the U.K. Overnight Index Swap (OIS) curve, which leaves room for 2-year Gilts to decline as the BoE stays on hold for longer (Chart 11). This will cause the front-end of the Gilt curve to steepen. Meanwhile, longer-term Gilt yields will have a difficult time falling given the deceleration of global central bank asset purchase programs that is slowly raising depressed term premia on government bonds (3rd panel). Another factor that will help keep the Gilt curve steeper, all else equal, is the path of the inflation expectations curve. Shorter-dated expectations are likely to fall faster as growth slows and headline inflation continues to drift lower (bottom panel). Chart 10Fading Momentum For##BR##U.K. Growth & Inflation Chart 11Stay Long The 5yr U.K. Gilt Bullet##BR##Vs. The 2/10 Gilt Barbell Although some narrowing of the butterfly spread is already priced in the forwards (top panel), we see that outperformance of the 5-year happening faster, and by a greater amount, than the forwards. Stay long the belly of the Gilt curve versus the wings. Canada Long 10-year Canada inflation-linked government bonds vs. nominal Canada government bonds (HOLD) We recommended entering a long Canada 10-year breakeven inflation trade on January 9th, 2018.9 Since then, the 10-year breakeven inflation rate rose by 6bps along with the rise in oil prices denominated in Canadian dollars (Chart 12). This has helped our tactical trade deliver a return of +0.64% since inception.10 More fundamentally, the breakeven has risen as strong Canadian growth has helped close the output gap and push realized Canadian inflation back to the middle of the Bank of Canada (BoC)'s 1-3% target band. The rapid rate of real GDP growth has decelerated a bit after approaching 4% last year, and the OECD leading economic indicator for Canada may be peaking at a high level (Chart 13). Growth in consumer spending is also look a bit toppy, with bigger downside risks evident in the sharp declines in the growth of retail sales and house prices (3rd panel). Both were affected by a harsher-than-usual Canadian winter, but the cooling of the overheated Canadian housing market (especially in Toronto) is a welcome development for financial stability. Chart 12Stay Long Canadian##BR##Inflation Breakevens Chart 13Canadian Inflation At BoC Target,##BR##But Has Growth Peaked? On balance, however, the current state of Canadian economic data shows an economy that is slowing a bit from a very overheated pace, but is still likely to grow above potential with no spare capacity available. Both headline and core inflation will remain under upward pressure against this backdrop, at a time when the BoC's policy rate is still well below neutral. We continue to recommend staying long Canadian inflation-linked government bonds over nominal equivalents with a near-term target of 2% on the 10-year breakeven inflation rate. We will re-evaluate the position with regards to Canadian growth and inflation trends once that target is reached. Australia Long December 2018 Australian Bank Bill futures (SELL AND SWITCH TO NEW TRADE). We entered into a long December 2018 Australian Bank Bill futures trade on October 17, 2017 as a focused way to express the view that the Reserve Bank of Australia (RBA) would stay on hold for longer than markets expect. The trade has worked out nicely, generating a profit of +0.25%. The potential for further upside is fairly low at these levels so we are now closing the trade. However, our view remains that the RBA will not be able to hike as early as markets are pricing. As such, we are opening a new position - long October 2019 Australia Bank Bill futures. Markets expect the first rate hike will occur in nine months' time. The October 2019 Australia Bank Bill futures are currently pricing in a massive 180bps of rate hikes over the next sixteen months. That will not happen. The RBA will not be able to hike this much given the lack of inflation pressures and a wide output gap. Our Australia Central Bank Monitor, which measures cyclical growth and inflation pressures, has pulled back to the zero line, confirming that there is no current need to tighten policy (Chart 14). Real GDP growth slowed to 2.4% in Q4 2017, from 2.9% the previous quarter. Weakness in the OECD leading economic indicator and Citigroup economic surprise index for Australia suggest that the Q1 reading will also disappoint. Consumer spending will be dampened by weak wage growth, softening consumer sentiment and the recent decline in house prices in multiple major cities. As a result of easing house prices, the growth rate of household net wealth was considerably lower in 2017 relative to the previous four years. Additionally, credit growth has been slowing, even before the recent news of the bank scandals that will force banks to be more stringent with lending practices. Most importantly, however, inflation remains below the RBA's target and there is a lack of inflationary pressures. The inflation component of our Central Bank Monitor has collapsed and is now well below the zero line. Both headline and core inflation readings are stable but remain persistently below 2%. Tradeable goods prices have declined for nine consecutive months despite the currency weakness seen in the Australian dollar over the past twelve months. The IMF is not projecting Australia to have a closed output gap until 2020, and that is with the optimistic expectation that Australia achieves 3% growth. Labor markets have plenty of slack as evidenced by rising unemployment rate, nonexistent wage growth and elevated level of underemployment. The RBA estimates that the current unemployment rate is still approximately 0.5% above full employment. Against this backdrop, it is unlikely that inflation will sustainably rise enough to force the RBA's hand, leaving scope for interest rate expectations to decline (Chart 15). Chart 14The RBA Will##BR##Stay Dovish Chart 15Switch Long Australia Bank Bill Futures##BR##Trade From Dec/18 Contract To Oct/19 Contract New Zealand Long 5-year New Zealand government bonds vs. 5-year U.S. Treasuries, currency-hedged into U.S. dollars (HOLD) Long 5-year New Zealand government bonds vs. 5-year German government bonds, with no currency hedge (HOLD) One of our more successful tactical trades has been in New Zealand (NZ) government bonds. We entered long positions in 5-year NZ debt versus 5-year U.S. Treasuries and 5-year German Bunds on May 30th, 2017, but we reviewed, and decided to maintain, those positions in a recent Weekly Report.11 The NZ-US spread trade has returned 4.67% since inception, hedged into U.S. dollars (Chart 16).12 The NZ-Germany trade, however, was a very rare instance where we recommended a cross-country spread trade on a currency UN-hedged basis, based on the negative view on the euro that we had last year. With the euro rising sharply against the New Zealand dollar, the unhedged return on that trade has been -2.87% (a return that, if hedged back into the euro denomination of the German bonds, would have generated a return of +3.56%). Looking ahead, we see continued scope for NZ bond outperformance, although the return potential is far less than it was when we first put on the trade. NZ economic growth is in the process of peaking, with export growth already rolling over (Chart 17, top panel). Net immigration inflows, which have been a major support for the NZ housing market and overall consumer spending over the past five years, have already begun to slow with the Reserve Bank of New Zealand (RBNZ) projecting bigger declines in the next couple of years (2nd panel). Both headline and core CPI inflation took a surprising downward turn in Q1 of this year, and both are well below the midpoint of the RBNZ target band (3rd panel). Chart 16Stay Long NZ 5yr Bonds##BR##Vs. The U.S. & Germany... Chart 17...With NZ Growth &##BR##Inflation Losing Momentum With both growth and inflation slowing, the RBNZ can remain dovish on monetary policy. An additional factor is the NZ government has recently changed the mandate of the RBNZ to include both inflation targeting and "maximizing employment" in a similar fashion to the Federal Reserve. With inflation posing no threat, the RBNZ can focus on its employment mandate by maintaining highly accommodative policy settings. With the NZ OIS curve still discounting one full 25bp RBNZ hike over the next year (bottom panel), there is scope for NZ bonds to outperform as that hike will not happen. This will allow NZ bond spreads to tighten, or at least outperform versus the forwards where some modest widening is currently priced. We are sticking with both spread trades, but we are choosing to leave the NZ-Germany trade currency unhedged given the renewed weakness in the euro (the unhedged return has already improved by over two full percentage points since the euro peaked earlier this year). We will monitor levels of the NZD/EUR currency cross rate to determine when to potentially hedge the currency exposure of our trade back into euros. Sweden Long Sweden 10-year government bond vs. 2-year government bond Short 2-year Sweden government bond vs. 2-year German government bond We recently entered two Sweden tactical bond trades on May 8, 2018, going long the Swedish 10-year vs. the 2-year and shorting the Swedish 2-year vs. the German 2-year (Chart 18).13 We expect that strong growth momentum, rising inflation and a tight labor market will force the Riksbank to raise rates earlier, and by more, than markets expect. Since inception for these "young" trades, each has returned -1bp.14 Sweden's economy made a solid recovery in 2017, with year-over-year real GDP growth reaching 3.3% in Q4. Going forward, export growth will remain supported by strong global activity, low unit labor costs, and a weak krona. Our own Swedish export growth model is already signaling a pickup over the rest of 2018. Consumption has been resilient and should continue to be supported by steadily recovering wages. Capital spending has been robust and industrial confidence remains in an uptrend. Additionally, leading indicators are still signaling positive growth momentum. The Riksbank's preferred measure of inflation, CPIF, slowed to 1.9% in April after briefly touching the central bank's target last month (Chart 19). In our view, this is a minor pullback rather than the start of a sustained reversal. Our core inflation model projects a gradual increase in the coming months, driven by above-trend growth that has soaked up all spare capacity. Labor markets have tightened considerably, and the unemployment rate is now more than one percentage point below the OECD's estimate of the full-employment NAIRU. During the last period when unemployment was this far below NAIRU, wage growth surged to over 4%. Chart 18Stay In A Sweden 2/10 Curve Flattener##BR##& Short 2yr Swedish Bonds Vs Germany Chart 19The Riksbank Will Not Ignore##BR##The Coming Inflation Overshoot For the curve flattener trade, our expectation is that the Riksbank will shift to a more hawkish tone in the coming months, leading markets to reprice the shape of the Swedish yield curve, as too few rate hikes are discounted in the short-end. With their mandates met, the Riksbank will be forced to act more aggressively. Importantly, there is no flattening currently priced into the Swedish bond forward curve, thus there is no negative carry associated with putting on a flattener now. In the relative value trade, we shorted the Swedish 2-year relative to the German 2-year. Growth in Sweden is likely to outpace that of the euro area once again in 2018. Swedish inflation is almost at the Riksbank target while euro area inflation continues to undershoot the ECB benchmark. The ECB is signaling that it is in no hurry to begin raising interest rates, therefore policy rate differentials will drive the 2-year Sweden-Germany spread wider over the next 12-18 months, with no spread move currently priced into the forwards. South Korea Short Korea 10-Year Government Bonds Vs. Long 2-Year Korea Government Bonds (CLOSE) We first introduced this trade on May 30th, 2017, after the election of Moon Jae-In as the South Korean president.15 The new government made major campaign promises to greatly expand fiscal spending on social welfare, public sector job creation, and increased aid to North Korea. With the central government's budget balance set to worsen significantly, we expected longer-term Korean bond yields to begin to price in faster growth and rising future debt levels, resulting in a bearish steepening of the yield curve (Chart 20). Since the new president was elected, however, the Korean economy worsened - even as much of the global economy was enjoying a cyclical upturn - with the trend likely to continue (Chart 21). The OECD leading economic indicator for Korea is weakening, while the annual growth in industrial production now sits at -4.2% - the worst level since the 2009 recession. Capital spending and exports are also slowing rapidly. Chart 20Close The 2yr/10y Korean##BR##Government Bond Curve Steepener Chart 21Korean Curve Stable,##BR##Despite Slower Growth & Fiscal Stimulus Due to the slowdown in the economy, Korean firms' capacity utilization is now at the worst level since the middle of 2009. Although businesses were already suffering from downward pressure on revenues, the Moon administration dramatically increased the minimum wage last year, directly leading to a rise in bankruptcies for small and medium size firms (the bankruptcy rate rose from 1.9% in the first half of 2017 to 2.5% in the latter half). Looking ahead, the Moon government will continue to increase spending on welfare and financial aid for North Korea, especially if the domestic economy continues to struggle. We still believe that the rise in deficits and debt will eventually lead the market to price in some increase in the fiscal risk premium and a steeper Korean yield curve. Yet with the Bank of Korea (BoK) having already surprised the markets last November with a rate hike, and with Korean inflation now ticking higher alongside a stable won, we fear that any renewed steepening of the Korean curve awaits a shift to a more dovish BoK that is not yet on the horizon. For now, given the competing forces on the Korean yield curve, we are choosing to close our 2/10 Korea curve steepener at a loss of -0.63%.16 We will continue to monitor the Korean situation to look for opportunities to re-enter the trade at a later date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Returns are calculated using Bloomberg pricing of the total return of a 2/5/10 butterfly. 2 Please see BCA U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15th 2018, available at usbs.bcaresearch.com. 3 Return is taken directly from Bloomberg Barclays index data on the duration-adjusted excess return of the entire TIPS index versus the entire Treasury index. 4 This return is calculated using Bloomberg data on actual U.S. and German bonds, and is shown on a currency-hedged basis into U.S. dollars - the currency denomination of the bond we are short in this spread trade. 5 Returns are calculated using Bloomberg Barclays inflation swap index data for a euro area CPI swap with a rolling 10-year maturity. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. 7 Please see BCA Global Fixed Income Strategy Weekly Report, "Nervous Complacency", dated March 27th, 2018, available at gfis.bcaresearch.com. 8 Returns are calculated using Bloomberg data on actual Gilts, rather than bond index data. 9 Please see BCA Global Fixed Income Strategy Weekly Report, "Let The Good Times Roll", dated January 9th 2018, available at gfis.bcaresearch.com. 10 This return is measured as the total return of the Canadian inflation-linked bond index less that of the nominal Canadian government bond index from the Bloomberg Barclays family of bond indices. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Serenity Now", dated May 15th 2018, available at gfis.bcaresearch.com. 12 Returns are calculated using Bloomberg data on actual New Zealand government bonds, with our own adjustments for the impact on returns from currency hedging. 13 Please see BCA Global Fixed Income Strategy Special Report, "Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore", dated May 8th 2018, available at gfis.bcaresearch.com. 14 Returns are calculated using Bloomberg data for actual individual Swedish government bonds, rather than bond index data. Both legs of the trade are duration-matched. 15 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30th 2017, available at gfis.bcaresearch.com. 16 Returns are calculated using Bloomberg data for actual individual Korean government bonds, rather than bond index data. Both legs of the trade are duration-matched and funding costs are included. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy A near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to lift the S&P homebuilding index to neutral. Troughing health care outlays versus overall PCE, minor cracks in small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest that managed health care relative share prices are as good as they get. Recent Changes Book profits of 24% and augment the S&P Homebuilding Index to a benchmark allocation. Downgrade the S&P Managed Health Care Index to neutral, locking in profits of 28%. Take the S&P Telecom Services Index off the high-conviction underweight list for a gain of 10% (please see the Insight Report on May 24, 2018). Table 1 Feature Stocks held on to their early-May gains and are on track to end the month with handsome returns. While the SPX is not out of the woods yet, still shaking off the early-February tremor, our cyclically upbeat view remains intact. Recent data suggest that earnings will remain healthy, and we expect this will propel the S&P 500 to a fresh all-time high in the back half of the year. It's true that elevated corporate debt levels are a cause for concern, as we detailed in a recent Special Report titled 'Til Debt Do Us Part', and this week we highlight that the Bank for International Settlements (BIS) private non-financial business sector debt-to-GDP ratio confirms the Fed data we presented in that report (Chart 1). Similarly, BIS's debt service ratio1 for non-financial corporates also confirms the Datastream Worldscope stock market data of a deteriorating interest coverage ratio (EBIT/interest expense) for non-financial equities (Chart 1). While we are closely monitoring unfolding debt dynamics, high debt levels are probably a longer-term problem (beyond the next 9-12 months) for the U.S. equity market. Higher interest rates are required in order for a debt crisis to unravel. With that in mind we were pleasantly surprised to notice that net bond ratings migration is moving in the right direction i.e. upgrades are outpacing downgrades. This is impressive as the V-shaped recovery following the late-2015/early-2016 manufacturing recession is already reflected in the data and the most recent uptick likely represents a fresh/different mini credit cycle (downgrades minus upgrades as a percent of total shown inverted, bottom panel, Chart 2). Chart 1Saddled With Debt... Chart 2...But Ratings Migration Moving In The Right Direction Either bond rating agencies are lowering their standards or euphoric rating agencies just reflect the recent fiscal policy easing, extremely low starting point of interest rates and an overall recovery in animal spirits. We side with the latter, and the implication is that SPX momentum will reaccelerate in the coming months, if history at least rhymes (bottom panel, Chart 2). Other indicators we monitor corroborate the positive equity backdrop suggested by the ratings migration data. For example, tracking tax revenue provides an excellent near real-time gauge on corporate sector cash flows. Federal income tax receipts have spiked into double-digit territory. Even state and local government tax coffers are surging, although this dataset is quarterly and trails the monthly released Federal series by four months. Government tax receipt growth has either led or coincided with previous major and sustainable overall profit recoveries (Chart 3). This suggests that S&P 500 second quarter earnings growth will surprise to the upside, despite an already high bar, in-line with our still expanding EPS growth model; the ISM, interest rates, the U.S. dollar and house prices comprise our four factor model (Chart 4). Nevertheless, the latest bout of EM currency weakness spreading beyond the 'fragile five' is a risk to our sanguine EPS growth view, especially in the back half of the year and into 2019. In other words, if this episode mostly resembles the 2013 'taper tantrum' induced devaluations then most of the damage is already done (Chart 5). However, if all of a sudden China falls off a cliff and is forced to devalue à la 2015 then all bets are off and a 'risk off' phase will ensue leading to a spike in the U.S. dollar. Chart 3Money Flowing Into Government Coffers Takes##br## A Real Time Pulse Of Corporate Profits Chart 4Q2 Profits Will Likely ##br##Surprise To The Upside... Chart 5...But A U.S. Dollar##br## Spike Is A Risk As a reminder, the greenback is a key input to our EPS growth regression model and any sustained gains will eventually weigh on SPX profits. This is clearly a risk, but our sense is that there are more parallels with 2013 than with 2015 and one big difference is the bond market's response. The third panel of Chart 5 shows that spreads have not blown out to an alarming level, at least not yet, and signal that a generalized emerging market currency crisis will be averted. Finally, another big difference with the 2015 episode is that the commodity complex is not reeling (bottom panel, Chart 5). This week we are acting on two alerts, one downgrade and one upgrade, and crystalizing outsized gains in a defensive subsector and also taking profits in a niche early cyclical sub-index. Enough Is Enough, Upgrade Homebuilders To Neutral We put the niche S&P homebuilding index on upgrade watch in late-March,2 and today we recommend pulling the trigger and monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather 2. Housing fundamentals remain robust 3. Compelling valuations reflect most, if not all, of the bad news In March we posited that "any rise above 3.05% on the 10-year Treasury yield in a short timeframe would likely prove restrictive for the U.S. economy".3 Fast forward to today and BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased on the back of largely discounted Fed rate hikes, extended net short positioning and the recent moderation in economic data. This backdrop should, at the margin, give some breathing room to this interest rate-sensitive index. True, refinancing mortgage application activity has nearly ground to a halt, but the MBA's mortgage purchase index continues to climb to fresh cycle highs defying rising 30-year fixed mortgage rates (top panel, Chart 6). The MBA weekly survey is nearly exhaustive as it "covers over 75 percent of all U.S. retail residential mortgage applications".4 Importantly, examining the relative volume of purchase activity is instructive. Currently, purchase applications comprise over 2/3 of total applications. There is a positive correlation between interest rates and the purchase share of overall mortgage activity as the middle panel of Chart 6 clearly depicts. This is because refinancing takes the back seat as mortgage rates rise, whereas first time home buyers are less sensitive to the level of interest rates. Wage growth and job security are most important when undertaking the first mortgage. Put differently, a pick up in economic growth that is synonymous with higher interest rates entices rather than dissuades would-be first time home buyers. The U.S. economy is currently at full employment, underscoring that the unemployment rate should move inversely with the purchase share of mortgage activity. Indeed, empirical evidence confirms this negative correlation (bottom panel, Chart 6). Similarly, the firming economic backdrop should also lead to a renormalization of the residential housing market. Household formation is still running at a higher clip than housing starts, signaling that there is little slack in the residential housing market (middle panel, Chart 7). Homebuilder confidence is as good as it gets and home prices are expanding at a healthy pace (bottom panel, Chart 7). Chart 6Housing Fundamentals... Chart 7...Remain On A Solid Footing Importantly, new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (third panel, Chart 8). The tightness in the new home market is also evident in the relative sales backdrop: new home sales are outshining existing home sales which is conducive to a further increase in relative top line growth and thus relative share prices (top and second panels, Chart 8). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel, Chart 8). We deem that most of the bad news is likely reflected in cheap valuations and the message is that it no longer pays to be bearish the niche S&P homebuilding index. Nevertheless, we refrain from swinging all the way to an above benchmark allocation as spiking building material costs are starting to bite, according to the latest NAHB sentiment survey (middle panel, Chart 9). Moreover, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel, Chart 9). Were lumber prices to give way either courtesy of a rising U.S. dollar and/or a positive resolution in the NAFTA negotiations we would not hesitate to boost this index to an overweight stance. Chart 8Firming Top And Bottom Line Growth Prospects Chart 9Surging Building Supply Costs Are A Big Risk Netting it all out, a near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to move to a neutral stance in the S&P homebuilding index. Bottom Line: We are acting on our upgrade alert and booking gains of 24% in the S&P homebuilding index and lifting exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Managed Health Care: Don't Overstay Your Welcome Relative share price gains for the S&P managed health care index are nearly exhausted. We are acting on our late-March downgrade alert and taking profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. Long-term trends in HMOs move in distinct cycles tied with overall health care spending. When overall health care outlays begin to accelerate relative to total consumption the pressure increases on payers of medical services (i.e. health insurance) relative to the providers of those services. The opposite is also true (relative health care outlays shown inverted, Chart 10). Chart 10Rising Relative Health Care##br## Outlays Weigh On HMOs If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place. Industry top-line growth is also fraying around the edges. The second panel of Chart 11 shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. Despite an overall stable and growing employment backdrop, this letdown is disconcerting as roughly 65% of all net new job gains occur in the SME space.5 The implication is that enrollment may also be nearing a peak. Meanwhile, on the input cost front, a softer than expected blow to drug pricing practices revealed in the President's recent speech was music to the ears of Big Pharma executives, but cacophony to HMO CEOs. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net negative for managed health care profits. Historically, our medical care cost proxy has been inversely correlated with industry operating margins and the current message is that the mini margin expansion phase may be short-circuited (middle panel, Chart 12). Tack on a tick up in HMO labor costs and profits will likely underwhelm analysts' optimistic forecasts: the sell-side expects S&P managed health care index profits to outperform the SPX by 330bps in the coming twelve months (bottom panel, Chart 12). We deem it a tall order. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of this health care sub-group (top panel, Chart 13). Importantly, all this euphoria is likely reflected in relative valuations with the relative forward P/E trading one standard deviation above the historical mean (middle panel, Chart 13). Chart 11Early Signs Of... Chart 12...Margin Pressures Chart 13M&A Frenzy Fully Priced Into Expensive Valuations In sum, we do not want to overstay our welcome in the HMO space that has added considerable alpha to our portfolio since our overweight inception in April 2016. Troughing health care outlays versus overall PCE, minor cracks in the small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest relative share prices are as good as they get. Bottom Line: Downgrade the S&P managed health care index to neutral for a gain of 28% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 "The DSR reflects the share of income used to service debt, given interest rates, principal repayments and loan maturities," https://www.bis.org/statistics/dsr.htm. 2 Please see BCA U.S. Equity Strategy Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 https://www.mba.org/2018-press-releases/may/mortgage-rates-increase-applications-decrease-in-latest-mba-weekly-survey 5 https://www.stlouisfed.org/publications/regional-economist/april-2011/are-small-businesses-the-biggest-producers-of-jobs Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights The Fed Vs. The Market: The market believes the Fed will deliver on its "gradual" rate hike pace in a status quo economic scenario. But investors also view the odds of the Fed slowing the pace of hikes as greater than the odds of it hiking more quickly. Dovish Catalysts: The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. Hawkish Catalysts: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Feature In last week's report we recommended that nimble investors should position for a near-term (0-3 month) decline in Treasury yields.1 Since then, the 10-year Treasury yield has fallen from 3.06% to 2.93% but we are not yet ready to remove our recommendation. The two criteria we named in last week's report - extended net short bond positioning and a high likelihood of negative data surprises - remain in place. As such, we expect bond yields to fall further in the near-term, though we remain bond bears on a cyclical (6-12 month) investment horizon. This week we turn to Fed policy, and specifically the following three questions: What does the Fed mean when it says it will make "further gradual adjustments" to the stance of monetary policy? How do "gradual adjustments" relate to what is currently priced in the market? What factors would cause the Fed to deviate from its "gradual" path, leading to either a faster or slower pace of tightening? The Market Trusts The Fed...To A Point We have noted in previous reports that the Fed's "gradual" pace of rate hikes is quite clearly defined as one 25 basis point rate hike per quarter. The Fed has tightened policy at this pace since December 2016, with the exception of last September when it announced the winding down of its balance sheet in place of a hike. It seems to us that the Fed's policy intentions have rarely been more transparent. The Fed will continue to lift rates by 25 bps per quarter until either (i) something breaks in the economy causing the Fed to slow down, or (ii) inflation pressures mount causing the Fed to speed up. But what about market pricing? To be consistent with the Fed's "gradual" pace of one hike per quarter the market would need to be priced for 50 bps of tightening during the next six months, 100 bps of tightening during the next 12 months, etc... Chart 1 shows that the market believes the Fed will deliver on its "gradual" pace for the next six months, but that it will fall somewhat short during the next year. Looking beyond the next 12 months, the market is not priced for the Fed to deliver on its "gradual" hike pace during the next 18 or 24 months either (Chart 2). Chart 1The Fed Versus The Market Part I Chart 2The Fed Versus The Market Part II A more realistic interpretation of Charts 1 and 2 is that while the market believes the Fed will deliver on its "gradual" hike pace in a status quo economic scenario, investors also view the odds of something breaking in the economy as greater than the odds that inflation will force the Fed to move faster. We also agree that the odds of something breaking are greater than the odds that inflation will force the Fed's hand. However, we would still favor a cyclical (6-12 month) below-benchmark duration stance because the market is not priced for the most likely status quo / "gradual" rate hike environment. Identifying Breaking Points How will we be able to tell if something is breaking in the economy that will cause the Fed to slow its pace of hikes? Candidate 1: Domestic Economic Growth One way is to simply monitor leading indicators of U.S. economic growth, particularly the contribution of cyclical spending to overall GDP (Chart 3). The cyclical sectors of the economy (consumer spending on durable goods, residential investment and investment on equipment & software) are most sensitive to interest rates and often provide an early warning sign for the overall economy. At the moment we see no evidence that cyclical spending is poised to slow meaningfully. Recent data showed solid gains in April retail sales, while consumer sentiment remains near its all-time high (Chart 4, panel 1). On the investment side, core durable goods orders were stronger than expected in April and the regional manufacturing PMIs that have been released so far in May (Philadelphia, New York, Richmond and Kansas City) have all increased (Chart 4, panel 2). Recent housing data have been more disappointing relative to expectations, but even here we continue to see steady growth in building permits and a continued contraction in outstanding supply. Supply increases typically precede a decline in construction activity (Chart 4, bottom panel). Chart 3Domestic Economy Looks Strong Chart 4Focus On Cyclical Sectors Candidate 2: The Financial Markets Even if U.S. economic growth is robust, it is conceivable that a sharp tightening of financial conditions - a falling stock market, widening credit spreads and/or an appreciating dollar - could cause the Fed to slow its pace of hikes. After all, the Fed would interpret a large enough tightening of financial conditions as a signal that economic growth will slow in the future. To assess this risk we turn to our Fed Monitor (Chart 5). Our Fed Monitor is a composite of many different variables that fall into one of three categories (i) economic growth, (ii) inflation and (iii) financial conditions. It is constructed in such a way that a reading above zero means the Fed should be tightening policy and a reading below zero means the Fed should be easing. Chart 5Fed Monitor Recommends Tighter Policy The bottom panel of Chart 5 shows that we have in fact seen a relatively large tightening of financial conditions since the equity market sold off in February. However, our overall Fed Monitor has barely ticked down, and remains solidly above zero. There is an important message here. The Fed can tolerate more tightening in financial conditions when economic growth and inflation are higher. When a similar tightening of financial conditions occurred in 2015, it did in fact drive our overall Fed Monitor below zero. This is because the economic growth and inflation components of the Monitor provided less of an offset (Chart 5, panels 3 & 4). Now, with stronger readings from those components, the Fed will need to see a much larger tightening of financial conditions before reacting. We will pay close attention to our Fed Monitor going forward for any signs that a sell-off in financial markets might be severe enough to spook the Fed. Another financial market signal that bears monitoring is the slope of the yield curve (Chart 6). It is no secret that an inverted yield curve always precedes a recession, and the Fed could interpret a very flat curve as a signal that monetary policy is becoming restrictive. In fact, Atlanta Fed President Raphael Bostic said two weeks ago that: Chart 6Not Flat Enough To Worry The Fed I have had extended conversations with my colleagues about a flattening yield curve. It is my job to make sure that [yield curve inversion] doesn't happen. In contrast, the minutes from the May FOMC meeting reveal a more balanced tone from the committee as a whole. "Several" participants thought "it would be important to monitor" the slope of the curve, while "a few" thought that the slope of the curve could be less important this cycle because of several special factors. These factors include: depressed term premiums because of large central bank balance sheets and reductions in investors' estimates of the longer-run neutral real interest rate. Our sense is that the yield curve is a good economic indicator simply because it reflects market expectations about the path of the fed funds rate. When the curve is inverted, and long-maturity yields are below short-maturity yields, it means that investors expect rate cuts to occur in the future. In contrast, a very steep yield curve indicates that the market expects a large number of rate hikes. When the stance of monetary policy is perceived to be close to neutral, investors will expect very little future movement in the fed funds rate and the yield curve will be very flat.2 In an ideal world, the Fed will move the funds rate close to its neutral level by the time that inflation stabilizes around its 2% target. In other words, the Fed will not be overly concerned with a very flat yield curve as long as inflation is close to its target. A very flat curve will only worry policymakers if it coincides with below-target inflation, because that would suggest that the market does not believe that the Fed will hit its inflation goal. With inflation already close to the Fed's target, we don't think a flat yield curve will cause the Fed to turn dovish any time soon. Candidate 3: Foreign Economic Growth One final factor that could eventually cause the Fed to slow its pace of rate hikes is weak foreign economic growth. Here we already see mounting signs of stress. Chart 7 shows that while the U.S. Leading Economic Indicator is the strongest it has been in several years, our Global Leading Economic Indicator excluding the U.S. has begun to contract. This divergence in growth between the U.S. and the rest of the world is reminiscent of the 2014/15 period when the dollar came under strong upward pressure. Not surprisingly, the dollar is once again starting to appreciate (Chart 7, panel 2). Much like in 2014/15, a strengthening dollar is already putting pressure on Emerging Markets where CDS spreads are widening and currencies are weakening (Chart 7, bottom panel). As an aside, while USD-denominated Sovereign bond spreads have widened, they remain expensive compared to similarly-rated U.S. corporate bonds (Chart 8). We continue to recommend an underweight allocation to USD-denominated Sovereign debt. Turning back to U.S. monetary policy, the key reason the Fed might concern itself with weak foreign economic growth is that the resultant strengthening of the dollar will eventually cause financial conditions to tighten and domestic economic growth to slow. This is exactly what occurred in 2014/15, though unfortunately the Fed waited until the strong dollar culminated in a sell-off in equity and credit markets before it adopted a more dovish policy stance (Chart 9). We would once again expect the Fed to wait for divergent growth between the U.S. and the rest of the world (and the resultant stronger dollar) to be reflected in financial conditions indexes and domestic equity and credit markets before it responded by slowing the pace of hikes. Chart 7Global Growth Divergences##br## Are Back Chart 8Sovereigns Still##br## Expensive Chart 9Growth Divergences Led To ##br##Market Turmoil In 2014/15 Bottom Line: The Fed would slow its pace of rate hikes if the cyclical sectors of the U.S. economy started to slow, financial conditions tightened significantly, or if the slope of the yield curve moved close to zero while inflation was below the Fed's target. The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. What Would Make The Fed Hike More Quickly? The most obvious factor that would make the Fed increase its pace of rate hikes to greater than 25 bps per quarter would be if inflation rose above its 2% target and continued to accelerate. It is unclear how much of an inflation overshoot the Fed is willing to tolerate before it increases the pace of hikes, but our sense is that it's fairly substantial. The Fed has gone out of its way in recent months to stress the "symmetric" nature of its 2% inflation target and, as long as inflation expectations remained well contained, we think the Fed would stick with its "gradual" rate hike pace as long as core PCE inflation is below 2.5%. Inflation pressures in the economy would have to change dramatically for core PCE inflation to break above 2.5%. Chart 10 shows two hypothetical scenarios for year-over-year core PCE inflation. One scenario where core PCE inflation rises 0.2% every month going forward, and another where it rises 0.15% every month. In the 0.2% per month scenario, year-over-year core PCE inflation eventually levels off at around 2.4%. In the 0.15% per month scenario it levels off at 1.8%. Monthly core PCE inflation has only printed above 0.2% seven times since 2015 (Chart 11), meaning that we would need to see a huge shift in the inflation data for it to start worrying policymakers. Chart 10How Much Overshoot Will Fed Tolerate? Chart 11Prints Above 0.2% Have Been Rare Another important factor that we have flagged in recent research is the price of gold.3 We noted that the gold price tends to rise when Fed policy eases and fall when it becomes more restrictive. We also observed that Fed policy can ease/tighten in two ways: The Fed can alter market expectations about the pace of rate hikes The market can revise its assessment of the equilibrium (or neutral) fed funds rate Chart 12Gold Has Led The Fed Notice that the decline in the gold price between 2013 and 2016 foreshadowed downward revisions to the Fed's estimate of the long-run equilibrium fed funds rate, and that those estimates have leveled-off alongside the price of gold since then (Chart 12). It follows that an upside break-out in the price of gold would be a signal that monetary policy is becoming easier, and that current estimates of the equilibrium fed funds rate need to be revised up. This is another signal we are monitoring that could lead to a quicker pace of rate hikes from the Fed. Bottom Line: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 In practice, the term premium in long-dated Treasury yields will lead to a slightly positive yield curve slope when monetary policy is perceived to be neutral. 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The prospects for U.S. economic and earnings growth remain solid but overseas growth is rolling over. The U.S. economic surprise index is poised to turn negative but inflation surprise is headed the in the opposite direction. The Fed remains vigilant on financial stability issues. The minutes of the May FOMC meeting provided an update on the Fed's views of inflation, fiscal and trade policy. In addition, financial stability and the Fed's forward guidance were discussed. Feature Economic data released in recent weeks reinforce BCA's view that the U.S. economy is accelerating while the global economy is decelerating. Chart 1 (panel 1) shows that the index of leading economic indicators (LEI) is gaining strength in the U.S., but slowing in the rest of the developed economies (panels 2 through 6). However, the U.S. Purchasing Managers Index (PMI, solid line) is rolling over, along with the PMIs in the E.U., Japan, Canada and Australia, albeit from a high level. Still, the Treasury and currency markets are focused on the LEIs and not the PMIs, driving up both Treasury bond yields and the dollar (Chart 2). Chart 1U.S. Growth##BR##Stands Out Chart 2Treasury Yields And The Dollar##BR##Responding To Growth Differentials The fallout from political turmoil last week in both North Korea and Italy spilled over into U.S. financial markets, driving U.S. risk assets and Treasury yields lower. Of the two, the situation in Italy is the more significant threat to our view that the U.S. stock-to-bond ratio will continue to move higher this year. BCA's Global Fixed Income Strategy service notes that while investors are right to be worried about a new populist government in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns.1 Our Geopolitical Strategy service's baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals.2 However, this will first require the pain of higher bond yields. BCA's view is that the dollar will continue to climb as the Fed boosts rates more than the market expects and as U.S. domestic growth outpaces its global counterpart.3 BCA's U.S. Bond Strategy service maintains that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. In addition, spread product returns should continue to beat Treasuries, but the window for outperformance is closing.4 Investors' positioning in Treasuries and our view that the Citigroup Economic Surprise Index (CESI) may soon drop below zero,5 suggest that there is a near-term risk of a countertrend rally in Treasury prices. Assessing The Cycle BCA's view is that the next recession will be sparked by the Fed overtightening in 2019 and 2020 as it finds itself behind the curve on inflation. Chart 3 shows that the odds of a recession in the next 12 months are low. Moreover, the traditional recession signals we track are not flashing red (Chart 4). At 45 bps, the 10/2 Treasury curve remains positive (panel 2). BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5%. We anticipate that upward pressure on the short end from Fed rate hikes will be offset by the upward thrust of the breakevens on the long end.6 Panel 3 shows that the LEI crosses below zero when a recession is imminent. The April LEI rose by 6.42% year-over-year. Initial claims for unemployment insurance in the week ending May 18 were 17K below their mid-November 2017 reading. Panel 4 shows that a 6-month increase in unemployment claims of between 75,000 and 100,000 is associated with a recession. Chart 3Odds Of A Recession Remain Low Chart 4No Recession Signals Here Credit spreads also indicate that the economic expansion remains in place. Charts 5 and 6 show that the corporate bond market often warns of an approaching major top in the stock market and/or a recession. Spreads barely budged during February's spike in financial market volatility. Chart 5Credit Spreads On Both Investment Grade... Chart 6... And High Yield Debt Signal That The Expansion Has Legs Financial conditions remain supportive of above-potential growth in the final three quarters of 2018. The January peak in equity markets and troughs in investment- grade and high-yield spreads marked the recent zenith in BCA's Financial Conditions Index (FCI). Nonetheless, the FCI in the U.S. remains more expansionary than it was a year ago and our research7 shows that financial conditions lead the U.S. economy by six to nine months (Chart 7). As a result, U.S. economic growth is poised to accelerate even more in 2018. This will further push down the unemployment rate below NAIRU and ultimately force up wage and price inflation. Chart 7Lagged Effect Of Easier Monetary##BR##Conditions Will Boost Growth Bottom Line: The prospects for U.S. economic and earnings growth remain solid, aided by the lagged effect of easy financial conditions, the ongoing benefits of the 2017 Tax Cut and Jobs Act and other doses of fiscal stimulus enacted in the past six months. Moreover, several of the geopolitical risks that we flagged earlier this year have ebbed. However, as noted above, the political situation in Italy warrants investors' attention. Nonetheless, the period of synchronous global growth that lifted risk assets in 2017 and in early 2018 has ended. Chinese growth is slowing, and other emerging market economies and financial markets are under duress as U.S. rates escalate. Moreover, the U.S. economy is in the late part of the cycle. Lofty valuations implied that equity returns will be well below-average in the next five to seven years. Stay overweight stocks versus bonds for now. However, investors with longer horizons should begin to prepare for lower real returns in the 2020s after a recession early in that decade. Surprise Surprise Citi's Economic Surprise Index (CESI) is poised to turn negative (Chart 8) after hitting a four-year high, 110 days ago, in late 2017. Since then, a colder and wetter winter and early spring across the U.S., coupled with elevated expectations after the tax bill, saw most economic data fall short of expectations. Chart 8Economic Surprise Poised To Move Lower Our late March 2018 report8 noted that since 2011, there were six other episodes when the CESI behaved similarly. These phases lasted an average of 96 days; the median number of days from peak to trough was 66 days. Moreover, we stated in our March 2018 report that a trough in the Citigroup Economic Surprise reading may be a month or two away. Based on BCA's research,9 tactical investors should add to their risk positions as the Citigroup Economic Surprise Index bottoms and begins to climb. On the other hand, the inflation surprise index is about to turn positive for the first time since 2011. Chart 9 shows that the last time reports on the CPI, PPI and average hourly earnings consistently exceeded consensus forecasts was in late 2009 and early 2010. Moreover, from the last few years of the 2001-2007 economic expansion through to early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Typically these periods when inflation surprise is positive are associated with higher wage and compensation metrics and higher realized core inflation. Moreover, Chart 9 shows that sustained episodes where the inflation surprise index is above zero occurred when the economy was at full employment (panel 2) and when the Fed funds rate was above neutral (panel 3). The implication is that inflation indices are poised to move higher in the coming year, and prompt the Fed to continue to raise rates gradually at first, but then more aggressively starting in mid-2019. Nonetheless, inflation due to cyclical factors remains muted for now. Chart 10 shows that pro-cyclical inflation decelerated through March 2018, while acyclical inflation accelerated. Late last year we discussed this measure of inflation and its origins at the San Francisco Fed.10 Chart 9Inflation Surprise Vs.##BR##Realized Inflation And Slack Chart 10Noncyclical Sources Still##BR##Driving Inflation Lower Bottom Line: The disappointing run of economic data is not over. Treasury bond yields will likely dip as the CESI turns negative. However, the weakness in the economic data does not signal recession. We expect that the inflation surprise index will continue to grind higher, while unemployment dips further into excess demand territory and oil prices rise. After the CESI forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb. Stay overweight stocks versus bonds, long credit and underweight duration. On The MOVE Both equity and bond market volatility (measured by the VIX and the MOVE indexes respectively) climbed in late January and early February, but have since eased (Chart 11). However, in the past 9 weeks, bond volatility surged relative to equity vol. Looking ahead, the subdued readings from the Chicago Board Options Exchange VVIX index, which measures the implied volatility of VIX options, indicate that the VIX can continue to head lower in the coming weeks. The implication is that bond-to-stock volatility ratio will move higher. Periods when bond volatility is rising faster than equity volatility are associated with turning points in the stock-to-bond ratio, and both real and nominal Treasury yields (Chart 12). That said, we are not making the case that the current upward thrust of the stock-to-bond ratio is about to change direction. Since 1990, both the stock-to-bond ratio and real bond yields rose in six of the eight periods when the MOVE/VIX rose; nominal yields climbed in all but one of these episodes. Moreover, small cap equities tend to outperform large when the MOVE index is increasing faster than the VIX. Chart 11Equity Vol Vs. Bond Market Vol Chart 12Is The MOVE/VIX Ratio On The Rise Again? Bottom Line: The increase in both equity and bond market volatility will impact the way the Fed conducts monetary policy in the coming years. Financial stability, or the lack thereof, is now top of mind among policymakers, and even more so as policy turns restrictive. The Fed's Third Mandate Revisited Chart 13FOMC Is Closely Monitoring##BR##Financial Stability BCA views financial stability as a third mandate11 for the central bank, along with low and stable inflation, and full employment. Financial stability was discussed at the May meeting by both Fed staff and voting FOMC members, but it was not on the agenda at March's meeting. Nonetheless, we expect Fed Chair Jay Powell to follow the former chair's lead on this issue. At the May meeting, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance. This overall assessment incorporated the staff's judgment that asset valuations remain elevated. Fed staff appraised vulnerabilities as low from financial sector leverage and maturity and liquidity transformation, low-to-moderate from household leverage, and elevated from leverage in the non-financial business sector (Chart 13). In May the Fed also provided an assessment of foreign financial stability for the first time since November 2017. The central bank's economists and analysts characterized overall vulnerabilities to foreign financial stability as moderate while highlighting specific issues in some foreign economies, including elevated asset valuation pressures, high private or sovereign debt burdens and political uncertainties. Fed staff made the same assessment in November 2017. In a report last month we highlighted research from the Federal Reserve Bank of San Francisco which found that a more restrictive monetary policy could pose risks to financial stability.12 Bottom Line: The Fed will remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses if policy stays too loose for too long. Counting The Minutes Inflation appeared to be a key topic at the May 1-2 Federal Open Market Committee (FOMC) meeting.13 Moreover, at least a few members indicated that the Fed is willing to tolerate inflation above the central bank's 2% target. Trade and fiscal policy, the labor market, financial stability, the yield curve and the Fed's communication plan were also discussed. Fed economists recently updated their quantitative assessments of the FOMC's minutes.14 The note provides a guide (Table 1 in the Fed paper and Table 1) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the FOMC's latest views. Table 1FOMC Minutes Rubric Tables 2 and 3 evaluate the Fed's latest thinking on inflation and its outlook. Most FOMC participants viewed the recent firming in inflation as reassurance that inflation is on track to hit the central bank's 2% target, while some thought inflation may overshoot. Several opined that the underlying inflation trend had changed little (Table 2). There was wide disagreement on the inflation outlook. Table 3 shows that many participants agreed that the Fed's goal was to return inflation to the 2% target. Many participants cited the tight labor and product markets, and stable inflation expectations, to support their views that inflation would remain near 2% this year. This approach is in line with BCA's inflation stance. A few participants worried about the impact of higher oil prices on inflation, but a similar number expressed concern that inflation would not stay at the Fed's 2% goal. Table 2FOMC Assessment Of Current Inflation Table 3FOMC Assessment Of Inflation Outlook There were extensive comments from both Fed staff and FOMC participants about the impact of fiscal policy and trade on the economy and inflation. Chart 14 presents the IMF's estimate of the impact of fiscal policy on the U.S. economy in the next few years. Fed staff continued to assume that the tax cuts would boost real GDP growth moderately in the medium term, but noted that fiscal policy may not provide a boost to growth if the economy is operating above full employment. Several FOMC participants noted the challenges in assessing the influence of fiscal policy on both the demand and supply side of the economy. We discussed the impact of fiscal policy on the supply side in last week's report.15 Chart 14U.S. Fiscal Stimulus Will##BR##Support Growth In '18 And '19 On trade, some FOMC participants noted that there was a wide range of outcomes for economic activity and inflation depending on what actions were taken by the U.S. and how U.S. trading partners responded. A few noted that the uncertainty around trade could dampen business sentiment and spending. In a recent report,16 we stated that the Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition. The FOMC also discussed factors contributing to the flat yield curve, citing the expected gradual rise of the federal funds rate, the downward pressure on term premiums from the Fed's still-large balance sheet as well as asset purchase programs by other central banks, and a reduction in investors' estimates of the longer-run neutral real interest rate. Notably, only a handful of participants said that the curve was not a reliable signal of future economic activity, while several endorsed the idea that an inverted curve indicated an increased risk of recession. On financial stability, a couple of participants noted that after the bout of financial market volatility in early February, the use of investment strategies predicated on a low-volatility environment may have become less prevalent, and that some investors are more cautious. However, they also noted that asset valuations across a range of markets and leverage in the nonfinancial corporate sector remained elevated relative to historical norms, leaving some borrowers vulnerable to unexpected negative shocks. Several noted that regulatory reform since the crisis had contributed to stronger capital positions, while only a few emphasized the need to build additional buffers in the financial system. The key takeaway from the FOMC's discussion on its communication policy is that the Fed may soon alter the forward guidance in its post-meeting statement to acknowledge that policy will not remain accommodative indefinitely. Bottom Line: The minutes of the May FOMC meeting indicate that the Fed is gearing up to raise rates again next month, but it is not signaling a more hawkish path than what is discounted. At the same time, the Fed is not trying to drive market expectations for the future path of short-term interest rates sharply higher. Fed officials noted that a temporary overshoot of the 2% inflation target would not be a disaster. In other words, the Fed is not willing to deviate from its path of "gradual" rate hikes. This is defined as one 25bps rate hike per quarter, which is mostly in line with current market pricing. We maintain our base case scenario: the FOMC will continue to monitor financial stability under Powell and raise rates four times in 2018. However, the FOMC will have to become more aggressive when realized inflation climbs and inflation expectations approach 2.3 to 2.5%. At that point another vol shock is likely, given that the Fed would target slower growth to curb inflation. This would be a negative signal for risk assets. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny or Mostly Cloudy?", published May 22, 2018. Available at gfis.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Italy: Growth Cures All Ills...For Now", February 21, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "Swan Song", published May 18, 2018. Available at gis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", published May 22, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", published October 31, 2017. Available at usbs.bcaresearch.com. 6 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Back To Basics", published April 17, 2018. Available at usbs.bcaresearch.com. 7 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear", published October 4, 2017. Available at gfis.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Waiting...", published March 26, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Reports, "Solid Start", published January 8, 2018 and "The Revenge Of Animal Spirits", published October 30, 2017. Both available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "2018: Synchronized Global Growth: Drives U.S. Economy And Markets", published December 4, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", published July 24, 2017. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short-Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com. 13 https://www.federalreserve.gov/monetarypolicy/fomcminutes20180502.htm 14 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 15 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Too Soon For Stagflation?", published May 21, 2018. Available at usis.bcaresearch.com. 16 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Stressing The Housing And Consumer Sectors", published May 7, 2018. Available at usis.bcaresearch.com.

Neutral - Downgrade Alert The National Restaurant Association's Restaurant Performance Index (RPI), a measure of the industry's outlook, has spent most of the past decade above 100, indicating industry expansion (second panel). However, this has not translated into restaurant stock outperformance (top panel). On a rate of change basis (right side, second panel), the direction of the RPI offers better insight in the relative share price ratio movements. This metric has recently rolled over, sending a negative message. Restaurants have been continuously losing share of the consumer's wallet for the past two years, while food input costs have held mostly constant (third panel), suggesting industry margins are tightening. At the same time, construction spending has been steadily heading upward (bottom panel) at a time when employment costs (the largest industry input cost) have also been rising. This implication of lower returns on a higher capital base does not bode well for still reasonably expensive valuations. Bottom Line: We are adding a downgrade alert to our neutral recommendation on the S&P restaurants index. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG.

Highlights Last year's broad-based global growth recovery has given way to slower growth and increasing differentiation in growth rates across economies. The U.S. has gone from laggard to leader in the global growth horse race, helping to drive the dollar to a five-month high. The biggest risk to our cautious view on emerging markets is that China stimulates the economy proactively as an insurance policy against a possible trade war. So far, there is little evidence that this is happening, but we are watching the data closely. The turmoil in Italy's bond markets is a timely reminder that if the European periphery wants more stimulus, this has to happen through a weaker euro rather than through larger budget deficits. Stay short EUR/USD. We expect to take profits at around the 1.15 level. Feature From Convergence To Divergence 2017 was the year of synchronized global growth. For the first time since 2007, all 46 countries tracked by the OECD experienced positive GDP growth. The euro area economy surprised on the upside, recording real GDP growth of 2.3%. This was slightly above U.S. levels, despite the fact that trend growth is about half a percentage point lower in the euro area. Growth in Japan nearly doubled to 1.7% from the prior year. Emerging markets, which succumbed to a broad-based slowdown starting in 2015, came roaring back. The U.S. dollar tends to perform poorly when global growth is accelerating and the composition of that growth is shifting away from the United States. This was precisely the setting that the global economy found itself in last year, which is why the greenback came under pressure. Things are looking sharply different this year. Global growth has cooled, as evidenced by both the PMIs and economic surprise indices (Chart 1). Euro area growth was sliced in half in the first quarter; U.K. growth decelerated further; and Japanese growth fell into negative territory for the first time since 2015. In contrast, the U.S. has held up relatively well. While growth did dip to 2.3% in Q1, the latest tracking estimates suggest a rebound in the second quarter. Retail sales accelerated in April. The Philly Fed PMI also surprised on the upside, with the new orders component reaching the highest level since 1973. The New York's Fed model is pointing to growth of 3.2% in Q2, while the Atlanta Fed's Nowcast is signaling growth of 4.1%. The divergence in growth rates between the U.S. and most major economies has been mirrored in recent inflation prints. U.S. core inflation has moved higher, but has stumbled elsewhere (Chart 2). Chart 1Global Growth Has Cooled With The U.S.##br## Faring Best Chart 2Inflation Is Accelerating In The U.S., ##br##Decelerating Elsewhere The relatively strong pace of U.S. growth has led to a widening in interest-rate differentials between the United States and its peers. The 10-year U.S. Treasury yield has risen by 95 basis points since its September lows, compared to 20 points for German bunds, 47 points for U.K. gilts, and 4 points for JGBs. With the exception of the U.K., the increase in spreads has been dominated by the real rate component (Chart 3). Chart 3Widening Interest Rate Differentials Between The U.S. And Its Peers ##br##Have Been Driven By The Real Component King Dollar Reigns Supreme Conceptually, it is real, rather than nominal, interest rate differentials that ought to move currencies. We noted earlier this year that the dollar's failure to strengthen on the back of rising Treasury yields was an anomaly that was unlikely to persist. Sure enough, the dollar has now begun to recouple with real interest rate differentials (Chart 4). Our sense is that this year's trends can last a while longer. Leading Economic Indicators have continued to move in favor of the U.S., suggesting that U.S. outperformance is not likely to end anytime soon (Chart 5). Fiscal policy should also help prop up U.S. aggregate demand. The U.S. structural budget deficit is set to widen much more than elsewhere over the next few years (Chart 6). Chart 4Dollar Is Recoupling With Rate Differentials Chart 5U.S. Is Outshining Its Peers Chart 6U.S. Fiscal Policy Is More Stimulative The U.S. economy is now back to full employment. For the first time in the 17-year history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), the number of job openings exceeds the number of unemployed workers (Chart 7). Our composite labor survey indicator has continued to move higher (Chart 8). Core PCE inflation has already accelerated to 2.3% on an annualized 6-month basis and 2.6% on a 3-month basis. The New York Fed's Inflation Gauge, which leads inflation by about 18 months, is pointing to higher inflation over the coming quarters (Chart 9). This means that the bar for further gradual rate hikes is quite low. Chart 7There Are Now More Vacancies Than Jobseekers Chart 8U.S. Wage Growth Is Set To Grind Higher Chart 9U.S. Inflation: Upside Risks Recent revelations by Kevin Warsh - who was once the favorite to lead the Federal Reserve - that Trump was dismissive of the Fed's historic independence during their interview, is only likely to strengthen Jay Powell's resolve to avoid being seen as a Trump flunky.1 China: Shifting Into The Slow Lane? Of course, the outlook for the dollar and bond spreads will also hinge on what happens in the rest of the world. We are watching two economies especially closely: China and Italy. The latest data suggest that China has lost some growth momentum. Retail sales and fixed asset investment decelerated in April. Property sales also declined from an elevated level. Sales tend to lead prices. Home prices were flat in most tier 1 cities over the prior year, reflecting elevated inventory levels, tighter lending standards, and stricter administrative controls (Chart 10). Further price weakness is likely, which could dampen construction activity in the months ahead. Industrial production beat expectations in April, but the overall trend in industrial activity remains to the downside. Electricity production, freight traffic, and excavator sales have all been decelerating (Chart 11). Import growth has also come down, which is one reason why GDP growth in the rest of the world has moderated (Chart 12). Chart 10China: Housing Has Cooled Chart 11China: Industrial Activity Is Slowing Chart 12China: Import Growth Has Decelerated Trade War Fears: Will China Overcompensate? In addition to the regular cyclical growth risks, concerns about a trade war loom in the background. The Trump Administration's decision last weekend to defer imposing tariffs on China caused investors to breathe a sigh of relief, but much remains unresolved, including ongoing allegations that China is stealing intellectual property from the U.S. and other countries. Trump's decision to pull out of June's summit with North Korea will only strain America's relationship with China. Considering the damage to China that a full-out trade war would cause, it would be sensible for the government to take out some insurance against a possible downturn. Thus far, any evidence that the authorities are trying to stimulate the economy through either fiscal or monetary means is sketchy (Chart 13). Reserve requirements were cut by 100 basis points in April, but corporate borrowing costs remain elevated. Fiscal outlays are growing at broadly the same pace as last year. The trade-weighted RMB has continued to strengthen. Still, it is hard to believe that the government has not put together a contingency plan that it could roll out if circumstances warrant it. The biggest risk to our fairly cautious view on emerging markets is that China launches a stimulus package in response to a trade war that quickly ends in détente. Similar to what occurred in 2008/09, this would leave China with more stimulus than it actually needed. Italy: From Fiscal Austerity To Bunga Bunga Unlike in China, Italy's incoming coalition government - forged through an uneasy alliance between the populist Five Star Movement (M5S) and the right-leaning League - has made no secret about its desire to ease fiscal policy. The M5S wants more social spending while the League has lobbied for a flat tax. These measures, along with a host of others, would add €100 billion, or 6% of GDP, to the budget deficit. Given that the Italian unemployment rate stands at 11% - 5.3 percentage points above its 2007 low - one could make a compelling case that Italy would benefit from temporary fiscal stimulus. However, the proposed policies are being marketed as permanent in nature. Moreover, several policies, such as the proposal to roll back the planned increase in the retirement age, would actually reduce potential GDP by shrinking the size of the labor force. It is no wonder that bond markets are worried (Chart 14). Chart 13China: No Clear Evidence Of Stimulus ... Yet Chart 14Mamma Mia! Propping Up Demand In Italy Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from a shrinking working-age population and anemic productivity growth, both of which reduce the incentive for firms to expand capacity. Like many other European countries, Italy also suffers from a debt overhang. This is obviously true for government debt but it is also true, to some extent, for private debt. While the ratio of private debt-to-GDP is below the euro area average, it stills stands at 113%, up from 65% in the mid-1990s (Chart 15). The desire to save more in order to pay back debt, coupled with a reluctance to invest in new capacity, has left Italy with what economists call a private-sector financial surplus (Chart 16). Chart 15Italian Private Sector Has Been Taking ##br## On Less Debt Since The Crisis Chart 16Italy: The Private Sector Wants To Save If the private sector earns more than it spends, the excess savings have to be absorbed either by the government through its own dissaving or by the rest of the world through a current account surplus. Both options are problematic for Italy. Running large budget deficits for a prolonged period of time would take the level of government debt-to-GDP to stratospheric levels. Japan has been able to get away with this strategy because it issues debt in its own currency. This is a luxury that is not at Italy's disposal. Despite Mario Draghi's pledge to do "whatever it takes" to preserve the euro area, it is far from clear that the ECB would keep buying Italian debt if the country began to openly skirt the EU's deficit rules. Absent an effective lender of last resort, the Italian bond market could fall victim to a speculative attack - a process in which higher yields lead to even higher yields, and eventually a default (Chart 17). Chart 17When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible This just leaves the option of trying to bolster aggregate demand by exporting excess production abroad via a current account surplus. To its credit, Italy has been able to shift its current account balance from a deficit of 1.4% of GDP in 2007 to a projected surplus of 2.6% of GDP this year. However, some of that surplus simply reflects the fact that a weak economy has suppressed imports. Progress in reducing unit labor costs relative to its euro area peers has been painfully slow (Chart 18). Chart 18Italy: More Work To Be Done To Improve Competitiveness If Italy had a flexible exchange rate, it could simply devalue its currency to gain competitiveness. Since it does not have one, it has to improve competitiveness by restraining wage growth and implementing productivity-enhancing structural reforms. The former requires the presence of labor market slack, while the latter, even in a best-case scenario, will take substantial time to achieve. And neither option is politically popular. Given the difficulty of raising Italy's competitiveness relative to the rest of the euro area, the only realistic short-term solution is to boost it relative to the rest of the world. That requires a weak euro which, in turn, requires a dovish ECB. Investment Conclusions In our Second Quarter Strategy Outlook, published on March 30th, we predicted that the dollar was poised to experience a violent rally as short sellers rushed to cover their positions. This view has played out in spades. As we go to press, the nominal broad-trade weighted dollar has gained 4% since early April. It is up 30% since bottoming in July 2011 and is only 6% below its December 2016 peak (Chart 19). The dollar rally has brought our views closer in line with the market. Notably, EUR/USD is now less than two percent above our target of $1.15. The dollar is an ultra-high momentum currency. Chart 20 shows that a simple strategy of buying the DXY when it was above its moving average and selling it when it was below its moving average would have delivered a sizable profit over the past two decades (the exact moving average does not matter much, but the 50-day seems to work best). As such, while we intend to turn neutral on the dollar if it gains another few percent or so, an overshoot is quite probable. Chart 19The Dollar Has Bounced Back Chart 20The Dollar Trades On Momentum About 80% of EM foreign-currency debt is denominated in dollars. In many cases, dollar borrowers have non-dollar revenue streams. Thus, a stronger dollar automatically hurts their businesses. In the past, this has often ignited a feedback loop where a stronger dollar triggers capital outflows from emerging markets, leading to an even stronger dollar. Our EM strategists strongly feel that such a vicious cycle is fast approaching, especially if China's economy continues to slow. In the late 1990s, brewing EM tensions triggered several brutal equity selloffs. For example, the S&P lost 22% between July 20 and October 8, 1998. However, EM stress also restrained the Fed from tightening too quickly. The resulting dose of liquidity set the stage for a massive blow-off rally between the fall of 1998 and the spring of 2000. A similar dynamic could unfold this time around. We remain overweight global equities for now, but are hedging the risk by being short AUD/JPY, a trade that has gained 5% since we initiated it on February 1st. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Ben White, "How Trump could break from the Fed's independence," Politico, May 9, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The dollar rally is set to continue. The dollar tends to perform best when real rates are rising and above r-star. We are entering this environment and raising our DXY target to 98. Moreover, the rest of the world is likely to be more vulnerable to higher U.S. rates than the U.S. itself. Not only does the Federal Reserve set the cost of capital for the world, debt excesses are more prevalent outside the U.S. than in it. Additionally, the U.S. is less impacted by slowing global industrial activity than the rest of the world. Relative growth dynamics will therefore flatter the greenback. Italy is weighing on the euro, and any deterioration in the pricing of Italian risk will further hurt the common currency. However, EUR/USD does not even need Italian drama to depreciate. Relative growth and inflation are enough to push the euro toward 1.12. Feature The beginning of the year was a tough time for the dollar, with the DXY plunging nearly 4% from January 1 to February 15th. However, soon after Valentine's day, the market became enamored with the greenback, prompting the USD to rally a hefty 6%. Now that the dollar has hit our target of 94, it is time to pause and ask a simple question: can the U.S. currency rally further, or is it time to bail on the rally? While we do think the secular trend for the greenback is down, we also believe the current rebound has further to run. We are revising our DXY price target to 98. Essentially, we are entering a window where both U.S. monetary policy and the global growth backdrop will give the dollar an additional boost. The Over And Under On R-Star Table I-1Fed And The Dollar: Where We Stand ##br##Matters As Much As The Direction A common market lore is that the dollar tends to appreciate in anticipation of rising rates, but once the Fed actually begins to increase rates, the dollar weakens. There is some truth to this assertion. The 1994 and 2004 experiences do bear these facts. Moreover, the DXY fell 8.5% after the ill-fated December 2015 hike, and fell more than 11% as the Fed hiked rates through 2017. However, these kinds of simple heuristics can be deceiving. Where we stand in the hiking process matters just as much. In other words, it is not only whether interest rates are rising that counts, but whether or not they are rising above the neutral rate, or r-star. This distinction makes all the difference. As Table I-1 illustrates, the heuristic holds true when the Fed begins lifting rates but the real fed funds rate is below r-star. In this environment, the average annual return of the DXY since 1973 has been -5%, and the dollar has generated negative returns 75% of the time. However, the picture changes drastically if the real fed funds rate rests above the r-star. In this environment, the DXY rises alongside the fed funds rate, generating average annual gains of 4.7% 70% of the time. These results have been robust, independent of what was expected in interest rates futures. When the fed funds rate is falling, it is difficult to generate any strong views, as neither the expected returns nor the batting averages are statistically different from the expected outcomes of coin tosses. Chart I-1We Are Entering The Dollar-Bullish##br## Part Of The Fed Cycle Interwoven behind this picture is global growth. We have long argued that global growth is a key determinant for the dollar: When it is strong, the dollar weakens; when it is weak, the dollar strengthens.1 Essentially, when the fed funds rate rises but is still below r-star, global growth is improving, often even more so than U.S. growth, leading to a soggy greenback. When the fed funds rate moves above r-star, we tend to see hiccups around the world, essentially because the global cost of capital starts to rise, hurting the most vulnerable places. This helps the dollar. Sometimes, the most vulnerable country to higher U.S. interest rates happens to be the U.S., in which case the dollar does not respond positively to rising rates, even if they are above r-star. This is exactly what happened between 2005 and 2006. Today, we are entering an environment where the dollar is likely to receive a fillip from the Fed. As Chart I-1 illustrates, the real fed funds rate is about to punch above the Laubach-Williams estimate for r-star. It is true that the LW measure for r-star is only an estimate of this crucial but unobservable concept, and that it is subject to revisions, but the Fed is set to increase rates at least four times over the next 12 months, which in our view will definitely push the fed funds rate above realistic estimates of r-star. As a result, we should anticipate the dollar to rally further. Bottom Line: When we think about the Fed and the dollar, rising interest rates are not enough to boost the greenback. Actually, if U.S. real rates rise but are still below the neutral rate of interest, this generally results in very poor dollar performance, like what transpired in 2017 and the first month of 2018. If, however, the fed funds rate is both rising and above the neutral rate, the dollar rallies. We are entering this environment. Why Is This Time NOT Different? If one were to make the argument that the dollar will not rally as the fed funds rate moves above the neutral rate - which has happened in 30% of past occurrences - one needs to make the case that the U.S. is more vulnerable to higher U.S. rates than the rest of the world. We do not want to make this bet. First, there does not seem to be any obvious imbalances in the U.S. economy right now. Historically, periods of vulnerability in the U.S. have been preceded by an elevated share of cyclical sectors as a percentage of GDP. This was particularly obvious last cycle, when cyclical sectors represented 28% of GDP in 2006, and residential investment was particularly out of norm, at almost 7% of GDP (Chart I-2). Today, cyclical sectors represent 24.3% of GDP, in line with the average of 25.4% since 1960. Moreover, while there are rampant fears that the U.S. current account deficit will blow up, at the moment - thanks to decreasing oil imports - it only stands at -2.5% of GDP, much narrower than the levels that prevailed in 2006 (Chart I-3). Second, the key ingredient that would generate vulnerability in the U.S. is not present, but it is visible around the world: too fast a pace of debt accumulation. Not only do debt buildups make financial systems and economies illiquid, if the accretion is built swiftly it raises the probability of a misallocation of capital. After all, investing is a time-consuming activity, and if done too quickly chances are that due diligence was not very diligent. Today, it is true that there has been a deterioration in the quality of the corporate sector debt in the U.S., but nonetheless, the U.S. private sector has curtailed its debt load, and has been rather reluctant to re-lever. In the rest of the G-10, debt loads are as elevated as ever, and in fact are hitting record highs in Canada, Australia, and the Scandinavian economies. In EM and China, not only are debt levels elevated, they have also been rising briskly (Chart I-4). The vulnerabilities are therefore outside the U.S. and not in the U.S Chart I-2No Cyclical Imbalances In The U.S. Chart I-3Better External Balance As Well Chart I-4Debt: U.S. Robust, RoW Not So Much Third, global growth is facing an important headwind emanating from China. The Chinese economy has been in the process of slowing, and continues to do so: Leading the charge have been efforts by Chinese policymakers to diminish the pace of debt accumulation. As Chart I-5 illustrates, not only has the Chinese credit impulse rolled over, but the decline in working capital of small financial intuitions suggests that more pain is in the pipeline. Real estate activity is slowing down. The prices of newly built units in the main cities are contracting on an annual basis, and in second-tier cities price appreciation is slowing. As a result, construction activity is also downshifting. The growth of industrial profits has slowed considerably, hitting a 14-month low. Railway traffic, electricity production and excavator sales are all decelerating sharply. The Li-Keqiang index is also slowing and, according to our leading index based on credit activity, is set to continue to do so (Chart I-6). Unsurprisingly, Chinese import growth is also slowing significantly, implying that China is not providing as much of a shot in the arm for the rest of the world as it did 12 months ago (Chart I-6, bottom panel). Chart I-5Chinese Policy Tightening In Action Chart I-6The China Syndrome EM economies are particularly exposed to these dynamics. As we like to put it when we talk to our clients, if EM economies were a security, Chinese activity would drive cash flow growth, while U.S. monetary policy dictates the cost of capital. This is especially true today, as a record amount of EM-ex-China exports go to China, while USD-debt as a percentage of EM GDP, reserves and exports is at multi-decade highs (Chart I-7). This analogy suggests that EM economies are therefore the most vulnerable corner of the world to higher U.S. rates: Not only is their indebtedness high, but they are also facing a potent headwind from China. Hence, we expect EM financial conditions to deteriorate further, with negative implications for EM growth. However, EM have been the most dynamic contributor to global growth and global trade. This implies that if EM growth conditions deteriorate, so will global trade and global industrial activity (Chart I-8). As we have highlighted before, the U.S. is normally insulated from these dynamics as commodity production, manufacturing and exports represent a relatively low share of gross value added in what is fundamentally a domestically driven economy. Through this aperture, the relative resilience of the U.S. to the recent decline in global growth is unsurprising. To the contrary, we can expect this current bout of growth divergence to stay in place for much of 2018 (Chart I-9). Chart I-7EM Have A Lot Of Dollar Debt Chart I-8Weak EM Equals Weak Global IP Chart I-9Global Growth Divergences As a result, global growth dynamics are likely to buttress the bullish implications for the dollar of a Fed lifting rates above r-star. As Chart I-10 shows, slowing global growth is good for the dollar. This is likely to be especially true this time around as investors have yet to purge their overhang of short-dollar bets (Chart I-11). Moreover, as we highlighted five months ago, from a stylistic perspective, the dollar is the epitome of momentum currencies within the G-10.2 The indicator that has empirically best captured the momentum-continuation behavior of the dollar is the gap between the 1-month moving average and the 6-month moving average. Currently, this indicator is flashing an unabashedly bullish signal for the USD (Chart I-12). Chart I-10The Dollar Is A Countercyclical Currency Chart I-11Still Short The Dollar Chart I-12Momentum Currrently Favors The Dollar Bottom Line: This time will not be different, and the dollar should rise as the Fed pushes interest rates above r-star. The U.S. private sector has not experienced any material debt buildup in recent years, and is less vulnerable to higher rates than emerging markets. Since the U.S. is less sensitive to EM growth than other advanced economies, the U.S. is relatively insulated from any EM slowdown, explaining why the U.S. economy is not slowing like the rest of the world is right now. This is a positive backdrop for the dollar. Euro Weakness: More Than Just Italy The euro's weakness through the recent dollar rally has been particularly striking. Recent developments in Italy have supercharged this weakness, as investors are once again questioning the commitment of Italy to staying in the euro area - an assessment that is weighing on Italian assets (Chart I-13). However, Marko Papic argues in BCA's Geopolitical Strategy service that Italy is not on the verge of leaving the euro area.3 However, the Five-Star movement / Lega Nord coalition wants to challenge the EU's Stability and Growth Pact 3% limit on budget deficits. As Dhaval Joshi argues in BCA's European Investment Strategy service, Italy has a fiscal multiplier greater than one, and thus more spending is likely to help the Italian economy over the coming year - whether or not the now-infamous issuance of mini-BOTs are involved.4 And to be honest, the Italian economy needs all the help it can get (Chart I-14). Chart I-13Markets Are Worried About Italy Chart I-14Italian Economy Has Yet To Heal However, it remains to be seen how much Italy will be able to open the fiscal spigot. Much depends on the willingness of the bond market to finance this intended profligacy. So far, the move in Italian BTPs has been small, but any repeat of 2010-2012 will prevent the coalition government from implementing its desired spending plans. Such a confrontation between the bond market and Italian politicians could cause a sharp decline in the euro. To be clear, it is highly unlikely that the coalition will be able to increase the deficit by the EUR100bn planned in its manifesto. To note, Rob Robis has downgraded Italian bonds to underweight in BCA's Global Fixed Income Strategy service.5 While Italian risks have exacerbated the weakness in the euro, ultimately the weakness in the common currency simply reflects the greater shock to European growth resulting from a slowing China. As Chart I-15 illustrates, European growth tends to underperform U.S. growth when Chinese monetary conditions are tightened, or when China's marginal propensity to consume - as approximated by the growth rate of M1 relative to M2 - declines. We are currently facing this environment. Chart I-15AChina's Deceleration Is Filtering Into Europe (I) Chart I-15BChina's Deceleration Is Filtering Into Europe (II) In addition, not only is European growth falling behind the U.S., but the European economy is also feeling the pinch from the tightening in financial conditions vis-à-vis the U.S. that ensued following the furious euro rally of 2017. In response to these combined shocks, European core inflation is now weakening relative to the U.S., which normally portends to a weakening euro over the course of the subsequent six months (Chart I-16). Since investors have yet to clear their massive long bets on the euro, we think the euro will need to flirt again with fair value before being able to stage a durable rally (Chart I-17). While the euro's fair value is currently 1.12, we will re-evaluate the situation once EUR/USD moves below 1.15. Despite the upbeat picture we have painted for the dollar, the greenback still faces potent structural headwinds, which means that we cannot be too careful and need to approach any dollar rebound with a great deal of care, always keeping an eye open for potential risks to the dollar. Chart I-16Relative Inflation And The Euro Chart I-17More Downside In EUR For Now Bottom Line: Italian political developments are currently hurting the euro. The euro will suffer further if the bond market ends up rioting, unwilling to finance the coalition's deficit-busting proposals. While such dynamics would precipitate a sharp and violent fall in the euro, EUR/USD does not need Italian misadventures to weaken further. The euro continues to trade at a premium to its fair value, and the euro area is feeling the pain of a slowing China deeper than the U.S. is. Therefore, European growth and inflation are likely to weigh further on the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "More Than Just Trade Wars", dated April 6 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, titled "Some Goods News (Trade), Some Bad News (Italy)", dated May 23, 2018, available at gps.bcaresearch.com 4 Please see European Investment Strategy Special Report, titled "Italy Vs Brussels: Who's Right?", dated May 24, 2018, available at eis.bcaresearch.com 5 Please see Global Fixed Income Strategy Weekly Report, titled "Is It Partly Sunny Or Mostly Cloudy?", dated May 22, 2018, available at gfis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy continues to perform well with the Manufacturing and Services PMI coming in at 56.6 and 55.7, respectively, beating expectations. However, the dovish Fed minutes were the highlight of this week. While inflation seems to finally be making a comeback, members of the FOMC opined that it was "premature to conclude that inflation would remain at level around 2 percent". This implies a higher possibility of the Fed's pursuit towards a more "symmetric" inflation target, indicating that the Fed doesn't want to raise rates more aggressively than what is implied it the current dot forecasts. The 2-year yield fell by 7.1 bps, while the 10-year fell by 6.9 bps on the news. Furthermore, the Fed has become increasingly cautious in its communications in the face of a flattening yield curve. Despite these potential negatives, the dollar continues to appreciate as global growth softens. This rally could run further as European and EM data continues to disappoint. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Is King Dollar Facing Regicide? - April 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 This week was negative across the board for the euro area. French, German and overall euro area Manufacturing, Services and Composite PMIs all underperformed expectations. In addition to lackluster economic data, the eurosceptic M5S-Lega coalition is now putting the Brussels to the test. As expected, the BTP-Bund spread spiked to just below 2%, near levels that last prevailed in early 2017, and the euro has been suffering as a result of this. While the ECB's QE program is scheduled to end in September, the current situation is a threat and may necessitate a lower euro to ease monetary conditions. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: The Nikkei Manufacturing PMI came in below expectations, coming in at 52.5. This measure also decreased from last month's reading. Annualized gross domestic product growth for Qtk surprised to the downside, coming at -0.6%. Moreover, machinery orders yearly growth also surprised negatively, coming in at -2.4%. After rising by more than 2% the last couple weeks, USD/JPY has come back below 110 recently. We believe that the yen will most likely be amongst the best performing G-10 currencies, given that an environment of declining global growth and rising risk normally supports the yen. However, on a longer term basis, the yen is likely to see downside, given that the BoJ will not allow an appreciating yen from derailing the economy. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen's Mighty Rise Continues... For Now - February 16, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative: Headline and core inflation both surprised to the downside, coming in at 2.4% and 2.1% respectively. They also both decreased from last month's number. Industrial Production yearly growth also underperformed expectations, coming in at 2.9%. Finally, Halifax house price yearly growth also surprised negatively, coming in at 2.2%. GBP/USD has gone down by nearly 1.5% these past few weeks, dragged down by the euro's weakness. Overall, we remain bearish on cable, given that inflation should continue to surprise to the downside in the U.K, as a result of the appreciation of the pound last year. On the other hand inflation in the U.S. should outperform, as a result of the decreased excess capacity and tight labor market. This will force the Fed to raise rates more than the BoE, putting downward pressure on the pound. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data has been mixed recently: Westpac Consumer Confidence was negative in May, at -0.6%; The Wage Price Index annual growth remain unchanged at 2.1%, also in line with expectations; The unemployment rate picked up to 5.6% from 5.5%, however, the participation rate also increased by 0.1% to 65.6%; Employment grew by 22,600, with full-time employment at 32,700 and part-time contracting by 10,000; Governor Lowe spoke in Sydney this week at the Australia-China Relations Institute, citing Australia increased dependence on the second largest economy in the world, and the "bumpy" journey along the path of financial reform that China is likely to experience. This is likely to bring increased volatility to an Australian economy already replete with excess capacity. The RBA is unlikely to raise interest rates any time soon. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Both exports and imports surprised to the upside, coming in at 5.05 billion and 4.79 billion respectively. Additionally, the trade balance also outperformed expectations, coming in at -3.78 billion dollars. Finally, the Producer Input Price Index quarterly growth also surprised positively, coming in at 0.6%. The kiwi has declined by more than 1.5% this past weeks. Overall we continue to be bearish on NZD/USD, given that we expect the current environment of heightened volatility to persist. That being said, we are bullish on the NZD against the AUD, as Australia is much more exposed to a slowdown in the Chinese industrial cycle and as the Australian economy exhibits more signs of slack than New Zealand's. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian dollar has managed to remain flat despite the recent broad-based selloff of commodity currencies against the greenback. Canada's inflation has been in line with the BoC's target. Furthermore, a resilient labor market and robust wage growth point to favorable domestic demand conditions and greater inflationary pressures in the coming quarters. External factors such as a favorable oil market, relative to metals, have helped the CAD against other commodity currencies, despite this week's weakness. Going forward, these variables are likely to continue to support the loonie against the likes of the Aussie or the Kiwi. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: The Producer Price index underperformed expectations, coming in at 2.7%. Moreover, headline CPI inflation also underperformed expectations, coming in at 0.8%. EUR/CHF has declined by almost 2% these past weeks. We continue to be bearish on this cross, given that an environment of continued risk aversion should hurt the euro, while giving a boost to safe heavens like the franc. Italy's political tumult only adds credence to this argument. However, on a long term basis we are positive on EUR/CHF, given that the SNB will maintain an extremely easy monetary policy, much more so than the ECB, in order to prevent an appreciating franc which would derail its objective of ever reviving inflation in Switzerland. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Headline CPI inflation outperformed expectation, coming in at 2.4%. Meanwhile, core CPI inflation came in line with expectations, at 1.3%. USD/NOK has been relatively flat in the month of May. Overall rising U.S. real rates relative to Norway should lift USD/NOK, even amid rising oil prices. That being said, the krone is likely to outperform other commodity currencies like the AUD or the NZD. This is because oil is less sensitive to China than other commodities, and the black gold is supported by a friendlier supply backdrop, especially as tensions in the Middle East are once again rising and Venezuela is circling down the drain. NOK should continue to appreciate against the EUR as well. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 While Swedish producer prices annual growth picked up to 4.9% from 4% in April - suggesting a resurgence in inflationary pressures, labor market conditions softened as the unemployment rate climbed to 6.8% from 6.5%. The Riksbank also released a commentary on household debt, citing a "poorly functioning housing market" and a "tax system not being well designed from a financial stability perspective" as reasons for the current predicament. There was also emphasis placed on the uncertainty of house prices going forward. While these factors are present, resurgent inflation will ultimately prompt the Riksbank to hike, albeit cautiously, in order to avoid having to raise rates too violently down the road, which could cause serious harm to a Swedish economy afflicted by considerable internal imbalances. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Feature The prospect of a 5S-Lega government in Italy is unnerving some analysts and commentators. Italy's sovereign debt-to-GDP ratio is already one of the highest in the world. A seemingly endless economic stagnation is constraining GDP, and now the populists are proposing policies that would increase the deficit, lifting sovereign debt even higher. Feature ChartFiscal Thrust Has Driven Italy's ##br##Growth In Recent Years The suggested cures to Italy's high sovereign debt-to-GDP ratio divide into two opposing camps. One camp - Italy's populists - wants to boost GDP, the ratio's denominator. The other camp - Brussels - wants to rein in sovereign debt, the ratio's numerator. Who's right? It is not a simple choice. Growth and debt are not independent variables. It is impossible to boost growth quickly without a positive credit impulse from some part of the economy. Equally, reducing government borrowing can have a devastating impact on growth (Chart I-2). Therefore, to resolve the conflict between Italy's populists and Brussels, we need to understand the specific relationship in Italy between government debt, GDP, and their interaction: the fiscal multiplier. Chart I-2The Fiscal Multiplier Is High ##br##When The Private Sector Or Banks Are Financially Unhealthy Italy Is Right, Brussels Is Wrong Imagine that government debt starts at 130 and GDP starts at 100. Imagine also that each unit of government borrowing to spend lifts GDP by one unit, meaning the fiscal multiplier equals one. Under these assumptions, three units of fiscal thrust would lift debt to 133 and lift GDP to 103, reducing the debt-to-GDP ratio to 129%. Conversely, three units of fiscal drag would reduce debt to 127 and reduce GDP to 97, paradoxically increasing the debt-to-GDP ratio to 131% and making the austerity strategy entirely counterproductive. Critics will snap back that these two assumptions appear inconsistent. When sovereign indebtedness is already high, at say 130% of GDP, it seems implausible that the fiscal multiplier could also be high: the government has already done its useful borrowing to spend and, at the margin, additional borrowing is likely to be 'fiscally irresponsible'. This criticism would be valid if the government was the only part of the economy that could borrow. But it isn't. Whether the fiscal multiplier is high or low also depends on what is happening in the private sector (Chart I-3). Chart I-3The Fiscal Multiplier Is Low ##br##When The Private Sector And Banks Are Financially Healthy Fiscal multipliers become very high when there is a breakdown in the ability of households and firms to borrow and/or a breakdown in the ability of banks to lend. After such a breakdown, credit flows to the private sector remain depressed however low (or negative) interest rates go. Specifically, this happens after a severe economic trauma when large numbers of households and firms are simultaneously repairing their badly damaged balance sheets and/or when banks are insolvent. If the one and only engine of demand - government spending - then cuts out, the economy can enter a prolonged stagnation. Under such conditions, thrift reinforces thrift: one unit of fiscal drag can trigger an additional private sector spending cut, magnifying the impact of the original cut. In other words, the fiscal multiplier can exceed one and reach a level as high as two according to several academic and empirical studies.1 During and immediately after the global financial crisis, fiscal multipliers surged. Through 2009-12, fiscal thrust had a very strong explanatory power for GDP growth; across 14 major economies, the regression slope of 1.5 confirms a high average fiscal multiplier. In other words, each unit of fiscal thrust boosted GDP by 1.5 units; and each unit of fiscal drag depressed GDP by 1.5 units.2 Another way to see this is to observe that in the global financial crisis the economies that had the largest fiscal thrusts tended to experience the least severe recessions. The annual fiscal thrust in the U.S., U.K. and France equalled 2% of GDP; in Spain it equalled 3%.3 By contrast, Germany and Italy had negligible fiscal thrusts, and they suffered the worst recessions. But by 2012, households and firms around the world were willing to borrow again, and banks were sufficiently recapitalised to lend. Hence, fiscal multipliers slumped: fiscal thrust no longer had any explanatory power for GDP growth (Charts I-4 - I-7). Chart I-4Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The U.S. Chart I-5Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The U.K. Chart I-6Post 2012: No Connection Between ##br##Fiscal Thrust And Growth In The Germany Chart I-7Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The France There was one glaring exception to this trend: alas, poor Italy. Trapped in the EU's inflexible and misguided fiscal compact, and without an outright crisis, the Italian government could not recapitalise the dysfunctional banks. Although the solvency of the banks has improved in the past year, the evidence strongly suggests that fiscal thrust remains the main driver of the Italian economy (Feature Chart). On this evidence, the best economic policy for Italy right now is not to adhere slavishly to the misguided one-size-fits-all EU fiscal compact. The best policy is to use fiscal thrust intelligently to boost growth. We conclude that, on this specific point, Italy's populists are right and Brussels is wrong. Italy Needs Growth Italian BTPs offer a yield premium over German bunds as a compensation for two possible risks. One risk is a haircut or, more euphemistically, a 'restructuring'. But the likelihood of such a restructuring is very low. Putting aside the damage it would do to Italy's international standing, the simpler explanation is that it would kill the Italian banking system. As a rule of thumb, a bank's investors start to get nervous about its solvency when equity capital no longer covers its net non-performing loans (NPLs). In this regard, the largest Italian banks now have €165 billion of equity capital against €130 billion of NPLs, implying excess capital of €35 billion. The banks also hold around €350 billion of Italian government bonds (Chart I-8). Chart I-8Italian Banks Own 350 Billion Euro Of Italian Government Bonds So a mere 10% haircut on these BTPs could cripple the banking system and send the economy into a new tailspin. Meaning, it is in nobody's interest to restructure Italian bonds. The more likely risk to BTP holders - albeit still small - is redenomination out of the euro and into a reinstated lira. In which case the yield premium on BTPs ought to equal: (The likely loss on being paid in liras rather than deutschmarks) multiplied by (the annual probability of Italy leaving the euro) The first of these terms captures Italy's competitiveness shortfall versus Germany, which will change quite gradually. The second term captures a political risk, as leaving the euro would require a mandate from the Italian people. This means that the second term is very sensitive (inversely) to the popularity of the euro in Italy. It follows that a policy that kick starts growth and improves living standards - thereby boosting the popularity of the euro amongst the Italian people - is also a good policy for Italian bonds, banks, sustainable growth in Italy, and therefore for the euro itself. Bear in mind that Italy's structural deficit, at just 1%, is nowhere near the double-digit percentage levels that reliably signal the onset of a sovereign debt trap (Table I-1). Table I-1Italy's Structural Deficit Has Almost Disappeared Given Italy's high fiscal multiplier, we conclude once again that Italy's populists are right and Brussels is wrong. Some Investment Considerations Italian assets rallied strongly at the start of the year and certainly did not discount an election outcome in which the unlikely bedfellows 5S and La Lega formed a government. Therefore, from a technical perspective, the rally was extended and ripe for a pullback. A further consideration for Italy's MIB is that it is over-weighted to banks, so a sustained outperformance from the stock market requires a sustained outperformance from global banks, which we do not expect to start imminently. So in the near term, we prefer France's CAC to Italy's MIB. We have also opened a tactical pair-trade: long Poland's Warsaw General Index, short Italy's MIB. However, later this year, we expect both our credit impulse (cyclical) indicator and fractal dimension (technical) indicator to signal a better entry point into banks, into the Italian equity market and for BTP yield spread compression. Italy's structural deficit, at 1%, is amongst the lowest in the world, so Italy has plenty of 'fiscal space'. Moreover, fiscal stimulus can deliver bang for its buck because Italy appears to have a high fiscal multiplier. This differentiates Italy from other major economies, and makes the EU's one-size-fits-all fiscal compact entirely counterproductive for the euro area's third largest economy. This means that policies that push back against Brussels on this specific point might finally permit Italy to escape its decade-long growth trap. And therefore, somewhat paradoxically, they will enable the yield premium on 10-year Italian BTPs versus 10-year French OATs ultimately to compress. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, please see: When Is The Government Spending Multiplier Large? Christiano, Eichenbaum and Rebelo, Northwestern University. 2 Even removing the outlier data point that is Greece, the best-fit line has a slope of 1.1. And the r-squared explanatory power remains significant at 0.5. 3 Through 2008-9.