Developed Countries

Special Report

As with all bull markets, the question on investors' minds has never been if it would end but when it will end as the former is a certainty and the latter is the source of alpha. We have previously noted that by almost all measures, this is the longest bull market in history1 and, with its age starting to show, it is time to focus on late-cycle dynamics. Our preferred leading indicator for declines in U.S. equity markets has been the ISM manufacturing composite index. The ISM has, despite a few false positives, led both recessions and S&P 500 troughs with remarkable accuracy (Chart 1). Chart 1Our Preferred Leading Indicator When gains in the S&P 500 are broken into their respective components, it becomes apparent that the ISM is a strong predictor of both sentiment, as measured by changes in the valuation multiple (Chart 2), as well as profit prospects, as measured by earnings growth (Chart 3). Chart 2ISM Leads Valuation... Chart 3...And Earnings Still, valuations and earnings eventually, and invariably, converge, usually explosively so in a recession. Accordingly, measuring the ISM's lead time should provide some insight into the duration of the economic expansion as well as appropriate sector allocation. In our last Weekly Report,2 we examined how in the late/later stages of economic expansion, banks, representing a prototypical early-cyclical sector, underperformed the broad market. In this report, we are broadening the analysis to all of the GICS1 sectors of the S&P 500. Timing Is Everything We begin our analysis by examining the duration of leads between the cyclical peak of the ISM and the end of economic expansion (i.e. the start of recession as defined by the NBER) going back to the 1960s with our results summarized in Table 1. These results are somewhat unhelpful as the durations range from as short as 8 months at the beginning of the 1980s to more than 3 years, as in the period preceding the Great Recession. With the hypothesis in mind that the market would have sniffed out a recession before economic activity actually began to contract, we split the duration into two periods: the time between the peak of the ISM and the peak of the S&P 500 and the time between the peak of the S&P 500 and the beginning of the recession (Table 2). While the duration inconsistency between iterations argues against using this data to forecast the longevity of an equity bull market, a closer examination of the periods yields a key insight: The duration of the blow off phase of the bull market is on average more than three times longer than the fall before the recession. Table 1ISM Peak To Recession Table 2Late Cycle Can Be Split in Two Phases Still, the purpose of this report is not to estimate the length of time between the most recent ISM peak (March, 2018) and recession; as shown above, such an exercise would be meaningless as history has never rhymed in this regard. Rather, this Special Report should offer a portfolio allocation roadmap if, as we believe, the ISM has peaked but the S&P 500 has yet to see its cyclical highs.3 Riding The Wave Chart 4S&P 500 Cycle-On-Cycle Returns Chart 4 shows a cycle-on-cycle analysis of S&P 500 returns in the periods between the peak of the ISM and the beginning of the recession, across the seven iterations since the 1960's. This chart requires some explanation; because the time frames between ISM peak and recession vary so substantially per iteration, we have segmented each period into eight parts. Each part can represent a time frame as short as one or as long as eight months; what matters is the direction of the market, not the time frame. We have overlaid this cycle-on-cycle chart with the S&P 500, indexed to 0 at the most recent ISM peak in March of this year. It is worth qualifying that the S&P 500 peaked before the ISM in two of the seven iterations we have examined and, by overlaying the year-to-date S&P 500 over this curve, we are explicitly stating that we expect the S&P 500 peak in the current cycle to follow the peak in the ISM, as happened in five iterations, including the most recent three (please refer to our recent publication where we lifted our SPX peak target to 32004). Despite the machinations in creating Chart 4, the pattern is remarkably consistent; the S&P 500 falls modestly after the ISM peaks but then delivers one last hurrah, before the end of the cycle. Once again, however, the trick to securing the excess returns earned in the fat times is timing, as the fall after the S&P 500 peak is precipitous. Further, given the much shorter time frame on the back end of the curve, haste is of the essence. Sector Winners & Losers As shown in Table 3, the average return of the S&P 500 from the peak of the ISM to the beginning of the recession is a fairly modest 6.7% (non-compounded). That return appears even more modest in the context of an average 25 month duration. When the returns are split into the periods before and after the peak of the S&P 500, the 25% gain before the peak and the 12% decline after (Tables 4 and 5) are more significant and underscore the role of timing for capital preservation in the late cycle. Table 3Health Care Outperforms In The Late Cycle Table 4High Beta Stocks Outperform Early... Table 5...Defensive Stocks Beat Late The top performers in the first phase of the late cycle equity market surge are some of the highest beta sectors, including energy and technology. Also, unsurprisingly, these sectors have performed poorly in the latter phase we examined when the market slides toward recession. Still, we would highlight the S&P energy index as a portfolio overweight in the late cycle. Energy has historically been the top performer from the peak of the ISM to the peak of the S&P 500 and, while it is a sub-par performer in the latter stages, it continues to outperform the falling broad market. Further, energy registered relative performance gains in every iteration we examined and was the only sector to consistently repeat its performance, positive or negative. The current iteration of the late cycle should probably see stellar returns in this sector as crude oil prices have only recently broken out, a pattern that has repeated following other ISM peaks (Chart 5); BCA's Commodity & Energy Strategy expects this trend to continue in 2018. As such, the nascent turnaround in sector performance (Chart 6) should have long legs; we reiterate our high-conviction overweight in this deep cyclical sector. Chart 5Oil And ISM Move In Sync... Chart 6...And So Do Energy Equities Another interesting insight from this research is the strong performance of the S&P health care sector in both phases we examined (Chart 7). This is largely due to the high-beta biotech sub-sector outperforming early (Chart 8) with the more defensive managed health care and pharma sub-indexes sustaining the outperformance following the SPX peak (Chart 9). Chart 7Health Care Is A Resilient Late Cycle Performer Chart 8Biotech Leads Early In light of this research and given recent pricing power developments, we are adding an upgrade alert to the pharma and biotech groups and thus to the broad S&P health care index. The ticker symbols for the stocks in these indexes are: BLBG: S5BIOT - ABBV, AMGN, GILD,CELG, BIIB, VRTX, ALXN, REGN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, LLY, AGN, ZTS, MYL, NKTR, PRGO. Chart 9...While Pharma Outperforms Late Stay Cyclical (For Now) The current backdrop of a Fed that seems likely to be permissive of an inflation overshoot (or at least not too hawkish), combined with a strong domestic fiscal thrust in the form of tax cuts and a potential infrastructure bill, supports our thesis that, despite being past the peak of the ISM, the S&P 500 has not yet seen its best days. Accordingly, the upshot of our analysis is that it pays to maintain a cyclical portfolio bent to capture the most lucrative phase of the bull market. This is reflected in our overall portfolio allocation; we note that the top and bottom performers in this analysis (S&P energy and S&P telecom services, Table 3) are overweight and underweight, respectively, on our high conviction list. Still, our upgrade alerts in the health care sector should stand as a caution to readers that we are prepared to reduce beta in our portfolio allocation should our other leading indicators flash yellow. For now, however, we continue to believe the odds of recession are close to nil on a 9-12 month horizon and, accordingly, remain positive on the broad market's prospects with a cyclical portfolio allocation over defensive. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening," dated April 16, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Resilient," dated May 14, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 4 Ibid.

Highlights 0 To 3 Months: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. 6 to 12 Months: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. Total Return Forecasts: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Feature Chart 1Two Milestones The U.S. bond market reached one noteworthy milestone last week and is quickly closing in on another. The first milestone is that the 10-year Treasury yield decisively broke through the 3% level that had defined its most recent peak (Chart 1). The second milestone is that the market is now close to fully pricing-in the likely near-term path for Fed rate hikes. We noted in a recent report that the Fed's "gradual" rate hike path is quite clearly defined as one 25 basis point rate hike per quarter.1 This equates to 100 bps on our 12-month Fed Funds Discounter, which currently sits at 91 bps, just below this key level (Chart 1, bottom panel). We continue to see upside in Treasury yields on a cyclical horizon. Though tactically, the likelihood of a near-term pullback in yields has increased greatly during the past few days. In this week's report we outline the case for a near-term (0-3 month) pullback in Treasury yields, but also look ahead by introducing a simple framework investors can use to make total return forecasts for all different U.S. bond sectors. The Case For A Near-Term Pullback In addition to the fact that the market is closer to fully discounting the likely near-term path of rate hikes than it has been for some time, there are two other reasons to expect a near-term, temporary pullback in yields. The first is that the below-benchmark duration trade has become the consensus position in the market (Chart 2). Net speculative short positions in 10-year Treasury futures have rarely been greater, and since the financial crisis large net short positions have correlated quite strongly with a decline in the 10-year yield during the subsequent three months. Similarly, positions reported in the JP Morgan Duration Survey are firmly in "net short" territory for both the "all clients" and "active clients" surveys. The Marketvane survey of bond sentiment has also turned bearish for only the fourth time since 2010. Each of the other three times has coincided with a near-term drop in yields. Chart 2Bond Market Looks Oversold But positioning alone would not be enough to convince us that yields might decline in the near-term. Investors also need a catalyst. An excuse to take profits on large net short positions that have been working well. That catalyst is typically a period of worse-than-expected economic data. To judge the trend in economic data relative to expectations we turn to the Economic Surprise Index. Chart 3Economic Surprise Index In a report from last year we demonstrated that if the Economic Surprise Index ends a month below (above) the zero line, it is very likely that Treasury yields fell (rose) during that month.2 Also, we know that the surprise index is mean reverting by its very nature. A long period of positive (negative) data surprises will certainly be followed an upward (downward) revision to investors' economic expectations. Eventually expectations become so elevated (depressed) that they become impossible to surpass (disappoint). The index will then start to mean revert. In that same report from last year we also introduced a simple auto-regressive model of the surprise index, designed to capture its average speed of mean reversion. Based on that model, which is purely a function of the index's own lags, we would expect the surprise index to dip slightly into negative territory in one month's time (Chart 3). Though given the large amount of uncertainty in the model, a fairer assessment would be that it is no longer a given that the surprise index will remain above the zero line in the near-term. Bottom Line: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. Less nimble investors are better off riding out any potential near-term volatility and maintaining below-benchmark portfolio duration on a 6-12 month horizon. The Cyclical Picture Is Unchanged On a 6-12 month investment horizon, we are sticking with the playbook of our Two-Stage Bond Bear Market.3 The first stage is characterized by the re-anchoring of inflation expectations, and here, long-maturity TIPS breakeven inflation rates are still slightly below our target range of 2.3% to 2.5% (Chart 4). We also think bond investors should maintain an overweight allocation to spread product, though the time to trim exposure is approaching. Because the Fed's support for credit markets will weaken as inflation pressures mount, we will start reducing exposure to spread product once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are within our target 2.3% to 2.5% band. The intuition that the credit cycle is long in the tooth is further supported by the fact that the 2/10 Treasury curve is close to 50 bps (Chart 4, bottom panel). In a recent report we showed that while corporate bond excess returns relative to Treasuries usually remain positive until the yield curve inverts, they decline dramatically once the slope dips below 50 bps.4 Valuation also remains tight in the corporate bond market. While investment grade corporate bond spreads have widened in recent months, the junk spread is still close to its post-crisis low, as is the differential between the junk and investment grade spread (Chart 5). Chart 4Inflation Compensation Chart 5Flirting With The Lows The recent widening of investment grade corporate spreads appears to simply reflect a reversion to more reasonable valuation levels, after they had been extremely expensive at the start of the year. Chart 6 shows the 12-month breakeven spread for each investment grade credit tier. We look at the breakeven spread - defined as the spread widening required to lose money versus Treasuries on a 12-month horizon - in order to adjust for the changing duration of the index over time. Chart 6 also shows the breakeven spread as a percentile rank relative to history. In other words, it shows the percentage of time that the breakeven spread has been lower in the past. Notice that earlier in the year investment grade corporate spreads had been approaching all-time expensive levels. They are now closer to the 25th percentile, much more in line with similar spreads for the High-Yield credit tiers (Chart 7). Chart 6Investment Grade Breakeven Spreads Chart 7High-Yield Breakeven Spreads There is no longer a risk-adjusted opportunity in high-yield corporate bonds relative to investment grade. Bottom Line: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. A Simple Framework For Forecasting Total Returns In a recent report we observed that, using a 12-month investment horizon, the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.5 With that in mind, this week we extend that analysis to develop a simple framework for forecasting bond total returns. The framework relies on the fact that the "12-month rate hike surprise" described above is correlated with the 12-month change in Treasury yields. The Appendix to this report shows the historical correlation between the 12-month rate hike surprise and the 12-month change in several different par-coupon Treasury yields. Unsurprisingly, the correlation is very strong for short maturity yields, and gradually weakens as we move further out the curve. This is important because it means that the total return forecasts we generate from this exercise will be more accurate for bond sectors with low duration than for those with high duration. Table 1 shows the total return forecasts we generated for the Bloomberg Barclays Treasury Master Index and for several of its maturity buckets. The results are presented in such a way that readers can impose their own forecasts for the number of Fed rate hikes that will occur during the next 12 months, and then map that forecast to a reasonable expectation for Treasury total returns. Table 1Treasury Index Total Return Forecasts For example, in a scenario where the Fed lifts rates four times (100 bps) during the next year, given current market pricing the rate hike surprise will be modestly negative.6 Using the historical correlations shown in the Appendix, we map that rate hike surprise to changes in the par-coupon Treasury curve and then use the duration and convexity attributes of each individual index to determine how that shift in the Treasury curve will impact index returns. In the scenario described above we would expect the Treasury Master Index to return +2.13% during the next year. While this is a slightly positive number, it is close enough to zero that it does not provide much insulation from changes in long-dated yields that are unrelated to the near-term path for rate hikes. Further, in the four rate hike scenario, investors moving from the Treasury Master Index to the 1-3 year index need only sacrifice 12 bps of expected return to reduce their duration risk by a factor of three. Such a risk/reward trade-off clearly favors a below-benchmark duration stance on a 12-month investment horizon. Table 2 repeats the same exercise but for the major spread sectors of the U.S. bond market. To estimate spread sector total returns we need to forecast both the shift in the Treasury curve and whether spreads will widen, tighten or remain constant. Specifically, we assume that spreads either widen or tighten by the standard deviation of annual spread changes for each index, calculated using a post-crisis interval. Table 2Spread Product Total Return Forecasts The results show that, in a four rate hike scenario, we should expect 12-month investment grade corporate bond total returns of approximately 3.4%, assuming also that spreads stay flat. In a scenario where the average index spread widens by 42 bps, we should expect total returns of only 1%. Bottom Line: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Spread product returns should continue to beat Treasuries for the time being, but the window for outperformance is starting to close. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix Chart 8Change In 1-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 9Change In 2-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 10Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 11Change In 5-Year Yield Vs.12-Month ##br##Fed Funds Rate Surprise Chart 12Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 13Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 14Change In 30-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", dated May 8, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 6 The 12-month rate hike surprise is defined as the 12-month Fed Funds Discounter less the actual change in the fed funds rate during the following 12 months. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. The 2017 tax bill, rising energy prices, and banks' willingness to lend all suggest strong capital spending this year. Our view is that stagflation is not a near-term threat. Nonetheless, investors are concerned about a return of a period of decelerating growth and rising inflation. We examine the performance of U.S. financials in and out of stagflation. We reexamine the link between inflation, deficits, credit and money supply growth. Feature Chart 11H GDP Tracking Well Above Potential The VIX moved lower last week even as U.S. bond yields rose. Tensions with North Korea re-escalated, but Trump's trade spat with China eased. On balance, the spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. Economic growth prospects in the U.S. remained upbeat. A series of reports for April and May on housing, consumer spending, manufacturing and capital spending all indicated that real GDP growth in Q2 2018 was tracking to over 4% after a 2.3% gain in Q1, well above the economy's potential growth rate of 1.8% (Chart 1). Capital spending remains poised to lift off in 2018 aided by the supply-side impact of the 2017 tax cut bill and higher oil prices. Despite upbeat economic news in the U.S., there were additional signs last week that growth outside the U.S. was slowing.1 This deceleration, coupled with recent readings on wage and price inflation, suggest that investors may be concerned that stagflation is imminent. BCA's view is that the next bout of stagflation is still several years away. In this week's report, we look at the longer-term relationship between inflation, money supply, credit growth and deficits. Early 2018 Volatility Spike: An Update Surges in volatility do not signal either the end of a business cycle or an equity bear market. Moreover, while there are many examples of shifts in correlation around elevated equity volatility, there is no consistent relationship between the two.2 Nonetheless, 60% of volatility upheavals outside of recessions occurred during the late stages of a business cycle. Thus, the recent jump in volatility is another signal that the economy is in the final stages of expansion. Our November 13, 2017 report discussed financial market volatility and its relationship with the business cycle, monetary policy and economic volatility.3 In that report, we noted that any meaningful pickup in inflation would upset the 'low vol' applecart. Prices of U.S. dollar financial assets have recovered since early February's market turbulence, but are not back to pre-spike levels. Chart 2 shows that at 13.7, the VIX is 63% lower than its early February peak. Neither the stock-to-bond ratio (panel 2) nor the S&P 500 (panel 3) has returned to its late January high, but both have bounced up. Small caps (panel 4) have hit a new record, but emerging market equity prices (in U.S. dollars) have languished. The price of West Texas Intermediate oil reached a fresh cycle high in late March and is now above $70 (Chart 3, panel 2). BCA's Commodity & Energy Strategy service expects West Texas to average $70/bbl this year. Moreover, increasing geopolitical risks to supplies (Venezuela and Iran) raise the chances of WTI prices reaching $80/bbl by the end of the year, with Brent prices threatening $90/bbl.4 Our stance on oil prices this year supports more energy-related capex (see next section). Panel 3 shows that despite higher realized inflation and inflation expectations, gold prices have rolled over since the volatility spike. High-yield spreads briefly returned to their late January lows in mid-April, but are now back to the middle of the range that they have been in since early February (panel 4). The dollar has surged in recent months (panel 5). BCA's view is that the dollar will continue to strengthen as the Fed raises rates more than the market expects and as U.S. economic growth outpaces growth outside the U.S.5 Chart 2The VIX And U.S. Financial Assets... Chart 3...Before And After The February Vol Spike Chart 4 shows three-year rolling correlations between several major U.S. asset classes. The early 2018 volatility spike coincided with a shift in the link between the 10-year Treasury yield and the broad dollar (panel 2). The relationship between Treasury yields and oil troughed prior to the spike and continues to climb (panel 4). Otherwise, the longer-term, cross-asset class correlations in place prior to early February are still in play. Chart 4Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations However, shorter-term correlations within the S&P 500 have shifted (Chart 5). The early February volatility run up marked a bottom in the correlation between sectors, industries and individual S&P 500 stocks. This is consistent with what happened in the wake of volatility spikes in 2010 and 2011, but not following the 2015 episode. Bottom Line: The recent vol spike did not signal the end of the expansion or the bull market. Stay long stocks over bonds. Chart 5Intra-S&P 500 Correlations Shifted After The Vol Spike Soundings From The Supply Side BCA expects the U.S. economy to grow above its long-term potential this year and into next year, further reducing slack in both the product and labor markets, and ultimately pushing up inflation. We discussed the housing and consumer sectors in early May6 and this week, we assess business capital spending. Our recent reports7 discussed the near-term benefits to the U.S. economy from higher government spending, but there are supply side benefits as well. The Congressional Budget Office (CBO) boosted its estimate of the economy's long-run potential growth rate due to the supply-side benefits of lower taxes on the labor market and the immediate expensing of capital outlays. Faster growth in the long run would reduce the projected cumulative budget deficit from 2018-2027 by $1 trillion. The CBO also expects that labor force growth will pick up as lower personal income tax rates encourage workers to work longer hours.8 BCA's view is that capital spending was on the upswing before the tax bill passed last year (Chart 6). Moreover, our model for business capital spending suggests gains even without higher oil prices (Chart 7). Chart 8 shows that banks are easing their lending standards for C&I loans (panel 1) and that higher rates have not yet increased the cost of funding to restrictive levels (panel 2). However, demand has been tepid, although it is still trending higher (panel 3). The tax repatriation portion of the 2017 tax cut may have temporarily reduced businesses' demand for loans. Chart 6S&P 500 Sensitive To Oil ##br##Prices And Oil Driven Capex Chart 7Business Spending Poised To Lift Off Chart 8Supply And Demand For C&I Loans Bottom Line: A surge in U.S. capital spending is likely in the second half of 2018 and into 2019. The rising cost of human capital and sagging productivity are additional incentives for firms to spend on labor-saving equipment. Moreover, increased oil prices will drive additional spending in the energy sector. Our U.S. Equity Strategy team recommends an overweight to the Industrials sector.9 While surging capex this year and next will help to boost productivity in the short run, a comprehensive, economy-wide infrastructure package would be helpful in steering the economy away from stagflation in the long run. Stagflation Scenario BCA's 2018 Outlook10 notes that stagflation may be not be present in the U.S. for several more years, likely not until the early 2020s after the next recession. However, BCA's Global Fixed Income Strategy service states that the global economy may be entering a period of mild stagflation characterized by slowing economic growth and rising inflation.11 Nonetheless, some investors are concerned that a prolonged period of stagflation may ensue. We define stagflation as episodes of decelerating real economic growth and accelerating core inflation (Chart 9). Accordingly, stagflation occurred in the 1960s, 1970s and early 1980s. Since then, there have been an additional six episodes, all of them milder than earlier occurrences. The last bout was between July 2015 and October 2016. Chart 9Risk Assets And Stagflation We show the performance of U.S. financial assets, commodities, the dollar and S&P 500 earnings when stagflation was present (Table 1) and when it was not (Table 2). Note that recessions occurred during four of the stagflationary periods (late '60s/early '70s, early-to-mid '70s, late '70s, and late '90s-to-early 2000s). There were two recessions (early 1980s and 2007-2009) when stagflation did not appear. Table 1Risk Assets, Commodities, Gold Oil And The Dollar During Stagflation Table 2Risk Assets, Commodities, Gold Oil And The Dollar When No Stagflation Is Present U.S. stocks, the stock-to-bond ratio, investment-grade credit and high-yield bonds outperform when there is no stagflation. Small cap performance relative to large caps is also better when stagflation is present. Gold (average gain of 85%) and oil (86%) are the standout performers during these cycles. Without stagflation present, gold rises by only 13% on average and oil prices fall by 11%. The dollar climbs by 4% on average without stagflation and declines by 5% when stagflation develops. Restricting our analysis to only the more benign bouts of stagflation in the past 20 years we find similar results; stocks, the stock-to-bond ratio, investment grade and high yield credit perform better when there are bouts of benign stagflation. A notable exception is that there has been little difference in the performance of gold in or out of stagflation in the past two decades. Bottom Line: BCA expects inflation to reach the Fed's 2% target this year and accelerate in 2019, prompting more aggressive central bank actions in mid-2019 through mid-2020 than the market currently prices in. Increased rates will send the economy into recession in 2020. Stagflation will likely take hold as the economy recovers from that recession. Stay overweight stocks versus bonds for now, but look to pare back exposures later this year. Investors with longer time horizons should begin to prepare for lower real returns in the 2020s after the end of the recession early in the decade. Inflation: A Longer-Term View Some investors are concerned that rising deficits will immediately lead to higher inflation. We take a longer-term approach based on our analysis of the link between inflation and federal government interest payments, private credit growth, money supply growth and federal budget deficits. There is only a loose relationship between federal government interest payments as a share of GDP and inflation (Chart 10). For example, interest payments were high relative to GDP in the 1990s, but inflation was low. In the 1970s, inflation was high while interest payments as a share of GDP were not at an extreme. However, there is a strong connection between the growth of private credit and money supply, and inflation. Chart 11 shows that elevated rates for private credit growth are associated with increased inflation and vice versa. High inflation in the 1970s was accompanied by strong credit growth. In this decade, we have experienced meager private credit creation and very low inflation. Chart 12 shows a similar relationship between M2 growth and inflation. Note that strong M2 growth in the 1970s coincided with high inflation, while minimal growth in money supply in the 1930s was accompanied by deflation. On the other hand, there is only a tenuous connection between deficits as a share of GDP and inflation (Chart 13). In the inflationary 1970s, deficits averaged just 2% of GDP. However, the 1950s and 1960s saw both exceedingly low inflation and deficits. So far in the 2010s, deficits have averaged near 5% of GDP, but inflation has been muted at barely over 1%. Chart 10Long Run Relationship Between Federal ##br##Net Interest Payments And Inflation Chart 11Long Run Relationship Between ##br##Private Credit Growth And Inflation Chart 12Long Run Relationship Between ##br##M2 Growth And Inflation Chart 13Long Run Relationship Between Federal ##br##Budget Deficits And Inflation Moreover, the fiscal stimulus put in place late last year and early this year is likely to push inflation higher as it adds to aggregate demand in an economy that is already at full employment. Bottom Line: BCA expects inflation to reach the Fed's 2% target based on the core PCE measure this year, and move above that goal next year, which would drive up both short and long rates. Stay short 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 "Serenity Now," published May 15, 2018. Available at gfis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Patience Required," published November 13, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Feedback Loop: Spec Positioning & Oil Price Volatility," published May 10, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Swan Songs," published May 18, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Stressing The Consumer And Housing Sectors," published May 7, 2018. Available at usis.bcaresearch.com. 7 Please see BCA Research's The Bank Credit Analyst, published May 2018 and U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at bca.bcaresearch.com and usis.bcaresearch.com. 8 https://www.cbo.gov/system/files/115th-congress-2017-2018/reports/53651… 9 Please see BCA Research's U.S. Equity Strategy Weekly Report "Earnings Take Center Stage," published October 2, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's The Bank Credit Analyst "2018 Outlook - Policy And The Markets: On A Collision Course," published November 20, 2017. Available at bca.bcaresearch.com. 11 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Stagflation-ish," published April 18, 2018. Available at gfis.bcaresearch.com.

Highlights The Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation is either too high or too low, and the current account position is either too large or too small. The global economy has made significant progress in moving towards both internal and external balance over the past few years, but shortfalls remain. A number of large economies, including Japan, China, and Italy, continue to need stimulative fiscal policy to prop up domestic demand. In Italy's case, investor unease about the country's fiscal outlook is likely to raise borrowing costs for the government, curb capital inflows into the euro area, and push the ECB in a more dovish direction. All this will weigh on the euro. The U.S. should be tightening fiscal policy at this stage in the cycle. Instead, President Trump has pushed through significant fiscal easing. This is the main reason the 10-year Treasury yield hit a seven-year high this week. An overheated U.S. economy will pave the way for further Fed hikes, which will likely result in a stronger dollar. Rising U.S. rates and a strengthening dollar will hurt emerging markets. Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Feature The Dismal Science, Illustrated Last week's report discussed the market consequences of the tug-of-war that policymakers often face in trying to achieve a variety of economic objectives with a limited set of policy instruments.1 In passing, we mentioned that some of these trade-offs can be depicted using the so-called Swan Diagram, named after Australian economist Trevor Swan. This week's report delves further into this topic by estimating where various economies find themselves inside the Swan Diagram, and what this may mean for their currency, equity, and bond markets. True to the reputation of economics as the dismal science, the Swan Diagram depicts four "zones of economic unhappiness" (Chart 1). Each zone represents a different way in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). This amounts to saying that an economy can suffer from one of the following: 1) high unemployment and an excessively large current account deficit; 2) high inflation and an excessively large current account surplus; 3) high unemployment and an excessively large current account surplus; and 4) high inflation and an excessively large current account deficit. Box 1 describes the logic behind the diagram. Chart 1Four Zones Of Unhappiness BOX 1 The Logic Behind The Swan Diagram As noted in the main text, the Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation are either too high or too low, and the current account balance is either too large or too small. A rightward movement along the horizontal axis can be construed as an easing of fiscal policy, whereas an upward movement along the vertical axis can be thought of as an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule, which corresponds to the ideal state where the economy is at full employment and inflation is stable, is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order to keep the economy from overheating. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. A depreciation of the currency via an easing in monetary policy is necessary to bring imports back down. Any point to the right of the internal balance schedule represents too much inflation; any point to the left represents too much unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Note that according to the Swan Diagram, an economy that suffers from high unemployment may still need a weaker currency even if it already has a current account surplus. Intuitively, this is because a depressed economy suppresses imports, leading to a "stronger" current account balance than would otherwise be the case. We use two variables to estimate the degree to which an economy has diverged from internal balance: core inflation and the output gap (Chart 2). If the output gap is negative, the economy is producing less output than it is capable of. If the output gap is positive, the economy is operating beyond full capacity. All things equal, high core inflation and a large and positive output gap is symptomatic of an economy that is showing signs of overheating. Chart 2The Two Dimensions Of Internal Balance When it comes to estimating the extent to which an economy is deviating from external balance, we include both the current account position and the net international investment position (NIIP) in our calculations (Chart 3). The NIIP is the difference between an economy's external assets and its liabilities. If one were to sum all current account balances into the distant past and adjust for valuation effects, one would end up with the net international investment position. If a country has a positive NIIP, it can run a current account deficit over time by running down its accumulated foreign wealth.2 Chart 3The Two Dimensions Of External Balance Policy And Market Outcomes Within The Swan Diagram Chart 4 shows our estimates of where the main developed and emerging markets fall into the Swan Diagram. The top right quadrant depicts economies that need to tighten both monetary and fiscal policy. The bottom left quadrant depicts economies that need to ease both monetary and fiscal policy. The other two quadrants denote cases where either tighter fiscal/looser monetary policy or looser fiscal/tighter monetary policy are appropriate. In order to gauge progress over time, we attach an arrow to each data point. The base of the arrow shows where the economy was five years ago and the tip shows where it is today. Chart 4Policy Prescription Arising From The Swan Diagram From a market perspective, an economy's currency is likely to weaken if it finds itself in one of the two quadrants requiring easier monetary policy. Among developed economies, the best combination for equities in local-currency terms is usually an easier monetary policy and a looser fiscal policy. That is also the configuration that results in the sharpest steepening of the yield curve. Conversely, the worst outcome for developed market stocks in local-currency terms is tighter monetary policy coupled with fiscal austerity. That is also the policy package that is most likely to result in a flatter yield curve. In dollar terms, a stronger local currency will typically boost returns. This is particularly the case in emerging markets, where stock markets are likely to suffer in situations where the home currency is under pressure. A few observations come to mind: The global economy has made significant progress in restoring internal balance over the past five years. That said, negative output gaps remain in nearly half of the countries in our sample. And even in several cases where output gaps have disappeared, a shortfall in inflation suggests the presence of latent slack that official estimates of excess capacity may be missing. External imbalances have also declined over time. Since earth does not trade with Mars, the global current account balance and net international investment position must always be equal to zero. Nevertheless, the absolute value of current account balances, expressed as a share of global GDP, has fallen by half since 2006 (Chart 5). Chart 5Shrinking Global Imbalances The decline in China's current account balance has played a key role in facilitating the rebalancing of demand across the global economy. The current account showed a deficit in Q1 for the first time in 17 years. While several technical factors exacerbated the decline, the current account will probably register a surplus of only 1% of GDP this year, down from a peak of nearly 10% of GDP in 2007. The Chinese economy also appears to be close to internal balance. However, maintaining full employment has come at the cost of rapid credit growth and a massive quasi-public sector deficit, which the IMF estimates currently stands at over 12% of GDP (Chart 6). Thus, one could argue that a somewhat weaker currency and less credit expansion would be in China's best interest. Similar to China, Japan has been able to reach internal balance only through lax fiscal policy (Chart 7). The lesson here is that economies such as China and Japan which have a surfeit of savings - partly reflecting a very low neutral real rate of interest - would probably be better off with cheaper currencies rather than having to rely on artificial means of propping up demand. Chart 6China's 'Secret' Budget Deficit Chart 7The Cost Of Propping Up Demand Germany has overtaken China as the biggest contributor to current account surpluses in the world. Germany's current account surplus now stands at over 8% of GDP, up from a small deficit in 1999, when the euro came into inception. In contrast to China and Japan, Germany is running a fiscal surplus. Solely from its perspective, Germany would benefit from more fiscal stimulus and a stronger euro. The problem, of course, is that a stronger euro would not be in the best interest of most other euro area economies. While external imbalances within the euro area have decreased markedly over the past decade, they have not gone away (Chart 8). Investors also remain wary of fiscal easing in Southern Europe. This week's spike in Italian bond yields - fueled by speculation that a Five-Star/League government will abandon plans for fiscal consolidation - is a timely reminder that the bond vigilantes are far from dead (Chart 9). The Italian government's borrowing costs are likely to rise over the coming months, which will curb capital inflows into the euro area and push the ECB in a more dovish direction. All this will weigh on the common currency. Chart 8The Euro Club: Imbalances Have Been Decreasing Chart 9Uh Oh Spaghettio! The U.S. is the opposite of Germany. Unlike Germany, it has a large fiscal deficit and a current account deficit. The Swan Diagram says that the U.S. would benefit from tighter fiscal policy and a weaker dollar. President Trump and the Republicans in Congress have other plans, however. They have pushed through large tax cuts and significant spending increases (Chart 10). This will likely prompt the Fed to raise rates more aggressively than the market is currently discounting, leading to a stronger dollar. Chart 10The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Rising U.S. rates and a strengthening dollar will hurt emerging markets, particularly those with current account deficits and negative net international investment positions. High levels of external debt could exacerbate any problems (Chart 11). On that basis, Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Chart 11External Debt And Debt Servicing Across EM Investment Conclusions Chart 12The U.S. Economy Is Doing ##br##Better Than Its Peers The global economy is approaching internal balance, but this may produce some unpleasant side effects. Productivity growth is anaemic and the retirement of baby boomers from the workforce will reduce the pace of labor force growth. In such a setting, potential GDP growth in many countries is likely to remain subpar. If demand growth continues to outstrip supply growth, inflation will rise. Heightened stock market volatility this year has partly been driven by the realization among investors that the Goldilocks environment of above-trend growth and low inflation may not last as long as they had hoped. The U.S. economy has now moved beyond full employment, and bountiful fiscal stimulus could lead to further overheating. This is the main reason the 10-year Treasury yield reached a seven-year high this week. Continued above-trend growth is likely to prompt the Fed to raise rates more than the market expects, which should result in a stronger dollar. The fact that the U.S. economy is outperforming the rest of the world based on economic surprise indices and our leading economic indicators could give the dollar a further lift (Chart 12). A resurgent dollar will help boost competitiveness in developed economies such as Japan and Europe. Emerging markets will also benefit in the long run from cheaper currencies, but if the adjustment happens rapidly, as is often the case, this could exact a short-term toll. For the time being, investors should overweight developed over emerging markets in equity portfolios. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 2 To keep things simple, we assume that a country's Net International Investment Position (NIIP) shrinks to zero over 50 years. Thus, if a country has a positive NIIP of 50% of GDP, we assume that it should target a current account deficit of 1% of GDP; whereas if it has a negative NIIP of 50% of GDP, it should target a current account surplus of 1% of GDP. 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Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by global risk appetite, as approximated by corporate spreads and commodity prices. For the next six months, the euro has additional downside, while the dollar's rebound could run further. The CAD also looks attractive. Feature In July 2016, in a Special Report titled, "In Search Of A Lost Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline - a sanity check if you will - to our regular analysis. Additionally, these models can help global equity investors manage their currency exposure, having increased the Sharpe ratio of global equity portfolios vis-à-vis other hedging strategies, and also for a host of base-currencies.2 In this report, we review the logic underpinning these intermediate-term models and provide commentary on their most recent readings for the G10 currencies vis-à-vis the USD. UIP, Revisited The Uncovered Interest Rate Parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is the one that will make an investor indifferent between holding the bonds of Country A or Country B. This means that as interest rates rise in Country A relative to Country B, the currency of Country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of Country B. Chart 1Interest Rate Parity: ##br##Generally Helpful, But... There has long been debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. This debate has regained vigor in the past six months as the dollar has greatly lagged the levels implied by 2-year rate differentials (Chart 1). Research by the Federal Reserve and the IMF suggests incorporating longer-term rates to UIP models increase their accuracy.3 This informational advantage works whether policy rates are or aren't close to their lower bound.4 Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements do not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that, as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of indifference of investors between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.5 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from one another. It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials, as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan immediately comes to mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 2Real Rates Work Better Over The Long Run Chart 3Real And Nominal Rate Spreads Can Differ Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real, not nominal, long-term rate differentials. Global Risk Aversion And Commodity Prices Chart 4The Dollar Benefits From Global Stresses Global risk appetite is also a key factor in trying to model exchange rates. Risk-aversion shocks tend to lead to an appreciation in the U.S. dollar, which benefits from its status as the global reserve currency.6 Literature has often focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power with options-adjusted spreads on junk bonds (Chart 4). Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.7 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resource prices constitute a terms-of-trade shock for them. However, this relationship holds up for the euro as well, something already documented by the European Central Bank.8 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe. Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite, approximated by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. The real rates differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com The U.S. Dollar Chart 5Dollar Back In Line With Fundamentals Chart 6More Upside For Now To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss and Swedish real rates, weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. After a short period when it traded below its FITM, the dollar's recent strength has pushed the greenback back to its equilibrium, suggesting the easy gains are behind us. However, the rising risks in EM along with the continued widening in rate differentials between the U.S. and the rest of the world could put upward pressure on the dollar for a few more months (Chart 5). When the trend in the dollar is included, the greenback also trades in line with the ITTM (Chart 6). This confirms the idea that the dollar could experience some more upside for the remainder of 2018, as periods of undervaluation to the ITTM tend to be followed by overshoots. The return of inflation, along with the injection of large amounts of fiscal stimulus in the U.S., could be the narratives that push the greenback up by another 5%. Despite a positive outlook for 2018, we remain concerned about the dollar's longer-term performance. Not only is it still trading at a 16% premium on a PPP basis, European rates have room to increase substantially once euro area economic slack is fully absorbed. We are not there yet, but continued robust growth in the euro area will let the ECB increase rates more aggressively than the Fed beyond 2020. The Euro Chart 7The Euro Is Not A Bargain Anymore... Chart 8...And Has More Downside Before Year End The FITM for EUR/USD continues to point south, dragged down by widening interest rate differentials in favor of the greenback. However, unlike in early 2017, the euro is no longer trading at a big discount to its fair value (Chart 7). As a result, unlike last year, the euro is not able to avoid the downward gravitational pull of a falling FITM. More worrisome for the euro's performance over the coming six months, EUR/USD is still trading at a premium to its ITTM, which adjusts our FITM by taking account of the euro's trend (Chart 8). Currently, the fair value for EUR/USD stands at 1.15, but the euro tends to undershoot its equilibrium after large overshoots such as when EUR/USD traded around 1.25. Moreover, if China's economic slowdown deepens, commodity prices will suffer, which will drag down both the FITM and the ITTM for the euro. We are not yet willing buyers of the euro at current levels. While we espouse a bearish short-term view on the euro, we will be looking to purchase it once it moves to the 1.15-1.10 range. On longer-term metrics, EUR/USD still trades at a significant discount to its fair value. Moreover, long-term rates could rise in Europe relative to the U.S. once investors begin to lift their expectations for future euro area policy rates more aggressively. As such, we continue to closely monitor the slowdown in both euro area and global growth. Once we see signs of stabilization, the euro should again catch a durable bid. The Yen Chart 9A Dovish BoJ Is Pushing Down ##br##The Yen's Fundamentals Chart 10Tactically, The Yen Is At Risk, But Softening Global ##br##Growth Will Limit Its Downside This Year The FITM for the yen is falling fast, and as a result the JPY cannot rally anymore against the dollar (Chart 9). The ITTM provides a very similar message: the yen still trades at a premium to its short-term equilibrium, and is vulnerable to the dollar's strength (Chart 10). Softness in the yen has materialized despite growing stresses in emerging markets and budding signs of a slowdown in global growth - two normally yen-bullish developments - making it clear that the breakdown between USD/JPY and interest rate differentials could not withstand a period of generalized strength in the dollar. While the yen could weaken against the dollar, it is likely to rally further against the euro. Weakness in global growth is likely to limit the yen's downside to the equilibrium implied by its ITTM. Meanwhile, EUR/USD is likely to undershoot this same equilibrium. This contrast points to further weakness in EUR/JPY. The British Pound Chart 11The Pound Is ##br## At Equilibrium Chart 12GBP/USD May Be Dragged Lower By A Falling ##br## EUR/USD, But Cable Is Less At Risk Than The Euro GBP/USD is in a very different position than EUR/USD. While the pound's FITM points south, driven by interest rate differentials, cable trades below its equilibrium level (Chart 11). For the FITM to move up from this point onward, the U.K. economy needs to stabilize. We do think this will happen as British inflation slows, which will support household real incomes, and thus consumer spending. This message is also confirmed by the fact that unlike EUR/USD, GBP/USD does not trade at a premium to the ITTM, which incorporates the trend in the pair (Chart 12). While investors bid up the pound against the dollar as the greenback weakened in 2017 and early 2018, they are still embedding a risk premium in the GBP, a consequence of the murky political outlook that has shrouded the U.K. ever since the Brexit referendum. The models confirm our analysis of two weeks ago: that the pound could experience some downside against the dollar if the euro were to weaken, but that nonetheless cable will suffer less than EUR/USD.9 As a result, EUR/GBP is likely to experience downside as the correction in EUR/USD unfolds. On a longer-term basis, traditional valuation metrics such as PPP suggest that the GBP remains cheap. However, for this judgment to be true, much will depend on the evolution of the negotiations between the U.K. and the rest of the EU. A British exit from the common market will invalidate the message from PPP models, as the economic relationship between the U.K. and its largest trading partner will change drastically, implying that the models are specified over a sample that is not relevant anymore. However, it remains far from clear what form Brexit will ultimately take. The Canadian Dollar Chart 13NAFTA Risk Premia Evident Here... Chart 14...And Here Not only is the loonie trading well below the levels implied by the FITM, but augmented interest rate differential models for the CAD still point north, suggesting its fundamental drivers are currently very supportive (Chart 13). The ITTM for the Canadian dollar confirms this message; even after adjusting for its trend the CAD still trades at a discount to equilibrium (Chart 14). Both formulations of the models highlight that a risk premium has been embedded into the Canadian dollar, reflecting still-possible hazards and setbacks surrounding NAFTA negotiations. However, BCA expects a benign outcome for Canada in the coming weeks, which should help the loonie down the road. Not only does the absence of a major overhaul to NAFTA imply that trade flows between the U.S. and Canada will avoid a major shock, it also means that the Bank of Canada can resume tightening monetary policy. The biggest risk for the Canadian dollar versus the greenback is global growth. So long as global growth has not stabilized, the CAD will find it hard to rally durably against the USD. As a result, we prefer to buy the CAD versus other currencies, the EUR and AUD in particular. The Swiss Franc Chart 15No Evident Deviation From ##br## Fundamentals In The Franc Chart 16Rising EM Stresses And Better Value Will ##br##Help The Swiss Franc Versus The Euro The FITM for the Swissie continues to move upward (Chart 15). In fact, the franc currently trades at a discount to its ITTM. This suggests that downside for the Swiss franc versus the dollar is limited for the remainder of the year (Chart 16). Since the Swiss franc already trades at a discount to the USD, but the euro does not, logically, the EUR/CHF is currently very pricey. Hence, it will be difficult for the euro to rally further against the franc this year. Moreover, the slowdown in global growth and the trouble facing EM assets and currencies are likely to further contribute to the current deceleration in European economic data. As a result, both short-term valuation metrics and economic considerations argue for selling EUR/CHF on a six-month basis. Longer term, the Swiss franc's strength in recent years has contributed to a sharp deterioration in Swiss competitiveness. Since the Swiss economy is very flexible, this has mostly been translated into strong deflationary pressures in the alpine state. As a result, the Swiss National Bank will continue to fight off any appreciation in the franc, maintaining very easy monetary conditions. Thus, long-term investors should not short EUR/CHF, but instead, they should use any weakness in this cross this year to accumulate larger bets on the long side. The Australian Dollar Chart 17AUD Fundamentals At Risk Chart 18AUD Not Cheap Enough To Flash A Buy Signal The FITM for the Aussie is currently in a holding pattern (Chart 17). Meanwhile, AUD/USD trades at a marginal discount to the trend-augmented version of the model, the ITTM (Chart 18). Do not get lulled into a sense of comfort by these observations. First, AUD/USD never stops a move at the ITTM; it tends to overshoot its equilibrium. In fact, undershoots tends to culminate at an 8% discount to the short-term fair value. Additionally, the global economic environment suggests that both the AUD's FITM and ITTM could experience downside in the coming months. Slowing global activity and budding EM stress weigh on commodity prices - key components of the models. They also weigh on Australian interest rate differentials vis-à-vis the U.S. - especially as the Australian economy is replete with slack - keeping wage pressures, inflationary pressures, and consequently the Reserves Bank of Australia at bay. This picture is in sharp contrast to Canada. Canadian labor market conditions are tight and the BoC is likely to resume its hiking campaign once uncertainty around NAFTA dissipates. Since the CAD trades at a much larger discount to both its FITM and ITTM, the relative economic juncture supports being short AUD/CAD. The New Zealand Dollar Chart 19NZD Weaker Than ##br##Fundamentals Imply Chart 20NZD Is Cheap Enough To Warrant ##br## A Buy Versus The AUD As was the case with the Aussie, the FITM for the kiwi has stabilized (Chart 19). However, unlike with the AUD, the NZD trades at a meaningful discount to the ITTM (Chart 20). The NZD has greatly suffered in response to a deceleration in New Zealand economic data and to investors' worries about the Adern government - a coalition of the left-leaning Labour and populist New Zealand First parties. Investors are especially concerned over limitation to immigration on long-term growth, as well as risks to the Reserve Bank of New Zealand's independence. These concerns are real, and warrant taking a cautious stance on the NZD. New Zealand growth has greatly benefited from decades of a large immigration influx and from a staunchly independent central bank. Moreover, slowing global growth and trade as well as rising EM stresses are also likely to exert downward pressure on the NZD's short-term fair-value estimates. We have been taking advantage of the NZD's discount to its FITM and ITTM by selling the Aussie/kiwi cross. AUD/NZD trades at a premium to its relative ITTM. Moreover, the deceleration in global growth and the stress in EM are likely to exact a greater toll on metals than agricultural prices. This represents a greater negative terms-of-trade shock for Australia than New Zealand. Since Australia displays greater labor market slack than New Zealand, this disinflationary shock will bit the larger of the two economies harder. Therefore, interest rate differentials should move against the AUD, pushing the relative ITTM and FITM down. The Norwegian Krone Chart 21NOK Still A Value Play Among ##br## Commodity Currencies... Chart 22...But It Could Experience Further Downside ##br##Against The Dollar This Year The fundamental model for the Norwegian krone remains in an uptrend, established since the beginning of 2016 (Chart 21). This reflects rallying oil prices, the key determinant of Norwegian terms-of-trade and growth. However, the NOK still trades slightly above its ITTM, its fundamentals adjusted for the trend in the currency pair (Chart 22). Over the next six months, the Norwegian krone could experience further downside versus the USD. Corrections in this pair tends to end when it trades 4% below its ITTM. Additionally, the rise in EM volatility and the great sensitivity of the Norwegian krone to USD fluctuations adds an economic impetus to this risk. Moreover, EUR/USD normally exerts a gravitational pull on the NOK/USD. Since we expects the euro to weaken further, this should drag the krone along for a ride. However, we continue to see downside in EUR/NOK as short-term valuations are not attractive, and as oil is likely to outperform the broad commodity complex. In the longer term, we are positive on the NOK. It is cheap based on long-term models that take into account Norway's stunning net international position of 220% of GDP. Moreover, the high inflation registered between 2015 and 2016 is now over as the pass-through from the weak trade-weighted krone between 2014 and 2015 is gone. This means that the NOK's PPP fair value has stopped deteriorating. The Swedish Krona Chart 23The SEK Has Been Clobbered ##br##Beyond Fundamentals... Chart 24...And Is Becoming Attractive,##br## But Beware The Riskbank The Swedish krona's short-term valuations are attractive. As was the case with the krona, the SEK's FITM remains in an uptrend (Chart 23), and the SEK trades at a sizeable discount to its ITTM (Chart 24). Despite this benign picture, we are reluctant to bet on the SEK. To begin with, the SEK displays the greatest sensitivity to the dollar of all the G-10 currencies; our dollar-bullish stance for the rest of the year thus bodes poorly for the krona, pointing to greater undervaluation ahead. Additionally, despite an economy running 2% above potential GDP, the Riksbank still runs an extremely accommodative monetary policy. In fact, recent communications by the Swedish central bank demonstrate a high degree of comfort with the SEK's weakness. It seems as though Riksbank Governor Stefan Ingves wants to competitively devalue the krona. With global growth softening, the Riksbank is likely to encourage further SEK depreciation as the Swedish business cycle is tightly linked to EM growth. We were long NOK/SEK until two weeks ago, when our target level was hit. While we look to re-open this position, the NOK/SEK currently trades at a small premium to its relative ITTM, and thus the corrective episode could run a few more months. Meanwhile, the relative short-term valuation picture suggests that the recent bout of weakness in EUR/SEK could run a bit further. However, weakening global growth and the Riksbank's dovish proclivities suggest that visibility on this cross remains exceptionally low. 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report titled, "Assessing Fair Value In FX Markets", dated February 26, 2018, available at fes.bcaresearch.com and gis.bcaresearch.com. 2 Please see Foreign Exchange Strategy / Global Asset Allocation Special Reports titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors", dated September 29, 2017, and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com. 3 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound", Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 4 Michael T. Kiley (January 2013). 5 Please see Yin-Wong Cheung and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market", CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 7 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 8 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach", Working Paper No.85, European Central Bank (November 2001). 9 Please see Foreign Exchange Strategy Special Report titled, "A Long, Strange Cycle", dated May 4, 2018, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Underweight While we continue to recommend a core portfolio overweight in the S&P financials index, the S&P insurance sub-index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Currently, the U.S. and global economies are expanding above trend and, under such a backdrop, investors have historically avoided insurance equities. The top panel of our chart drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, second panel). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF.

Underweight - Upgrade Alert Homebuilders took another beating this week, and it seems as if they cannot catch a break. While the latest NAHB sentiment survey reflected homebuilder optimism, survey participants acknowledged that spiking building material costs are now hurting profitability (lumber prices shown inverted, middle panel). Tack on the recent jump in the 10-year Treasury yield that also pushed the 30-year fixed mortgage rate significantly higher and first time home buyers are, at the margin, getting priced out of the new home market (interest rates shown inverted, top panel). When we recently put the S&P homebuilding index on upgrade alert, we thought most of the bad news was already priced into deflated prices and valuations. However, persistent input cost inflation pressures coupled with additional interest rate increases suggest that patience is warranted before crystalizing relative gains to the tune of 25% since our late-November inception. Worrisomely, 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). We would lean against such exuberance and wait for another breakdown in relative share prices before acting on our upgrade alert. Bottom Line: Shy away from homebuilders for now, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.

Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator Chart I-5China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Stay tactically long the SEK. Our preferred expression is long SEK/GBP. Stay tactically short the NOK. Our preferred expression is long AUD/NOK. Take profits in the underweight to Poland... ...and open a tactical countertrend position: long Poland's Warsaw General Index, short Italy's MIB. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both The League and 5 Star Movement have dropped calls for a referendum on Italy's membership of the monetary union. Feature Italy And The U.K. Compete For Political Risk The European political lens is once again focussed on Italy as the two anti-establishment parties - The League and 5 Star Movement - negotiate to form a government. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both parties have dropped calls for a referendum on Italy's membership of the monetary union, and have instead turned their fire on the EU's fiscal rules, specifically the 3 per cent limit on budget deficits. Chart of the WeekThe SEK Is Due A Tactical Rebound The populist demand for some fiscal relaxation is actually smart economics. When the private sector is paying down debt - as it is in Italy - private sector demand shrinks. To prevent a recession, the government must step in to borrow and spend the paid-down debt. And what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. This means that as long as Italian populists correctly push back on the EU's draconian fiscal rules rather than the monetary union per se, the market is right to regard Italian politics as a drama, rather than an existential risk to the euro (Chart I-2). Chart I-2The Market Remains Unconcerned ##br##About Euro Break-Up Risk Maybe the European political lens should be focussed instead on Britain. The Conservative party remains as bitterly divided as ever on its vision for the U.K.'s future trading and customs relationships with the EU and the rest of the world. Paralysed and frightened by this division, Theresa May is delaying the legislative passage of three crucial bills - the EU Withdrawal Bill, the Trade Bill, and the Customs Bill. When these bills eventually reach a vote in the House of Commons later this year, any one of them could result in a humiliating defeat for May - and, quite likely, resignations from the government. Meanwhile, as the government kicks the issue into the long grass, firms are holding fire on long-term spending commitments in the U.K. and rechannelling the investment to elsewhere in Europe. Buy SEKs, Avoid NOKs For all the recent swings in the euro versus the dollar and pound, the trade-weighted euro has remained a paragon of relative stability (Chart I-3). This is because the moves versus the dollar and pound have largely cancelled out (Chart I-4). Earlier this year, euro weakness versus the pound coincided with strength versus the dollar; more recently, euro weakness versus the dollar has coincided with strength versus the pound. Chart I-3The Trade-Weighted Euro Has ##br##Remained Relatively Stable... Chart I-4...Because Moves Versus The Dollar And The ##br##Pound Have Largely Cancelled Out Interestingly, the driver of the trade-weighted euro remains the same as it has been for the past fifteen years - it is simply the euro area's long bond yield shortfall versus the U.K. and U.S. (Chart I-5). With the ECB already at the realistic limit of ultra-loose policy, the path for policy rate expectations cannot go meaningfully lower. This means that the trade-weighted euro has some long-term support given that the BoE and/or the Fed have tightening expectations that could be priced out, while the ECB effectively doesn't. Chart I-5The Trade Weighted Euro Is A Function Of The Euro Area's ##br##Long Bond Yield Shortfall Versus The U.K. And U.S. Put another way, for the trade-weighted euro to drift significantly lower, relative surprises in the economic, financial and political news have to be significantly worse in the euro area than in both the U.K. and the U.S. We think this configuration is unlikely. Nevertheless, the more interesting tactical opportunities lie elsewhere: the Swedish krona and the Norwegian krone. Recent tweaks to monetary policy frameworks in Sweden and Norway are responsible, at least partly, for technically exaggerated moves in their currencies which are likely to reverse. In the case of Sweden, the inflation target is unchanged at 2 per cent but the Riksbank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." Given that Sweden's inflation rate is now close to 2 per cent, the market interpreted this tweak as very dovish - because it permits the continuation of ultra-accommodative policy. The upshot was that the SEK sold off. But our tried and tested indicator of excessive groupthink suggests that the currency may have overreacted (Chart of the Week). Hence, the tactical opportunity is to stay long the SEK, and our preferred expression is long SEK/GBP. In the case of Norway, a Royal Decree on Monetary Policy lowered the Norges Bank inflation target from 2.5 to 2.0 per cent. This followed years of failure to achieve the higher target. The market interpreted this change as hawkish, as it created the scope for tighter - or at least, less loose - policy than was previously expected. The upshot was that the NOK rallied. But again, the market reaction shows evidence of a technical overreaction (Chart I-6). Hence, the tactical opportunity is to stay short the NOK, and our preferred expression is long AUD/NOK. Chart I-6Our Preferred Expression Of Short NOK Is Versus The AUD Financial Markets Are Not Complicated, But They Are Complex The words 'complicated' and 'complex' appear to be interchangeable, but their meanings are quite distinct. The distinction is important because financial markets are not complicated, but they are complex. Something that is complicated is the sum of a large number of separate parts or processes. For example, making a car is complicated. But predicting the performance of financial markets over the medium term - say, a year or longer - is uncomplicated. The philosophy of Investment Reductionism teaches us that investment strategy is not made up of many separate parts or processes. It reduces to just three things: Predicting the evolution of the global economy. Predicting central bank reaction functions. Predicting tail-events: political, economic and financial. For example, this week's lesson in Investment Reductionism is to illustrate that the medium term decision to allocate between emerging market equities and the Eurostoxx600 largely reduces to the prospects for global metal prices (Chart I-7). Chart I-7EM Versus Eurostoxx600 = Metal Prices By contrast, something that is complex is not the sum of its parts, because the parts interact in unpredictable ways. Complexity characterizes the behaviour of financial markets over the short term - say, up to around six months. Therefore, the best way to model the behaviour of any investment over the very short term is to think of it as a complex adaptive system. A complex adaptive system is a system with a large number of mutually interacting agents, which can learn from their interactions and thereby adapt their subsequent behaviour. Examples include traffic flows, crowds in stadiums, and of course financial markets. A crucial property of all such systems is they possess an endogenous tipping point of instability, at which the behaviour undergoes a 'phase-shift'. This is the essence of how we identify likely short-term trend reversals in any investment such as the SEK and the NOK. This week's final trade recommendation uses this idea once again. Poland's equity market has underperformed recently in line with the general underperformance of the emerging market basket - and our underweight in the Warsaw General Index versus the Eurostoxx600 is handsomely in profit. However, looking at the market as a complex adaptive system, the extent of Poland's underperformance is overdone (Chart I-8). Chart I-8The Extent Of Poland's Underperformance Is Overdone Hence we are taking profit on our underweight in Poland and putting on a short-term countertrend position: long Poland's Warsaw General Index, short Italy's MIB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's new trade recommendation is a pair-trade: long Poland's Warsaw General Index, short Italy's MIB. The profit target is 5% with a symmetrical stop loss. Our preferred expression of long SEK is versus the GBP which is already in profit since initiation. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Overweight Quarter-to-date the S&P energy services index is up 12% compared with the 2% rise in the broad market. While the steep rebound in oil prices primarily lies behind such stellar outperformance (top panel), our capex upcycle theme for 2018 should support this nascent recovery. Energy related capital spending budgets are not only rising in the U.S. (primarily in shale oil), but also globally. The global rig count is breaking out, and declining OECD oil stocks suggest that drilling activity will remain robust (second and third panels). Relative share price momentum does not yet fully reflect the rebound in industry investment (using national accounts) that remains in a V-shaped recovery since the Q1/2016 oil market trough (bottom panel). In sum, there are more gains in store for the S&P energy services index. Firming industry demand at a time when global energy capital spending budgets are renormalizing, along with rising crude oil prices, signal that high-beta energy services equities have more running room. Bottom Line: Stay overweight the S&P energy service index and see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5ENRE: NOV, SLB, FTI, BHGE, HAL, HP.