Developed Countries

Overweight (High Conviction) America's largest banks are set to kickstart earnings season at the end of this week/beginning of next week and, with a 25% improvement in EPS forecast by sell side analysts this year, expectations are high. We think deservedly so. Our high-conviction overweight thesis remains unchanged; bank profits should outperform the broad market as the price of credit, loan growth and credit quality are all tailwinds in 2018. Rising inflation expectations (second panel) should support the 10-year yield, driving improving net interest margins. Positive sentiment should mean that bankers keep the credit taps open to sustain the broad capex upcycle (third panel). Combined with record low unemployment and the associated low default rates, margins should widen. Our banks EPS model (bottom panel) incorporates these factors and continues to point to significant earnings upside in the year to come. Accordingly, we reiterate our high conviction overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.

Highlights The ECB admits that its policy is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro will eventually correct. And German consumer services will structurally outperform the consumer goods exporters. Feature Let's begin with some facts, which are difficult to dispute. Fact 1: The euro area is running a €400 billion trade surplus with the rest of the world, equivalent to 4% of euro area GDP. €300 billion of this surplus resides in Germany.1 Fact 2: The trade surplus is a direct result of the undervaluation of the euro (Chart of the Week). This we know, because the surplus has evolved as a perfect mirror image of the euro's undervaluation as calculated by the ECB itself. The central bank admits that the euro is undervalued by around 10%2 (Chart I-2). Chart of the WeekThe Euro Area's Huge Trade Surplus Is Due To The Undervalued Euro Chart I-2The Euro Is Undervalued By 10% Fact 3: The substantial undervaluation of the euro is the unavoidable result of the of the ECB's extreme experiment with bond buying and zero and negative interest rates. This we know, because the euro's undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3 and Chart I-4). Chart I-3The Euro Is Undervalued Because Of The ##br##ECB's Ultra-Accommodative Policy Chart I-4The Euro Has Tracked Expected##br## Relative Monetary Policy Nevertheless, a reasonable riposte to facts 1-3 is that the ECB does not target the euro exchange rate. The ECB sets policy to achieve its price stability mandate, which it defines as an inflation rate of "below, but close to, 2%", the same definition as the Federal Reserve uses. Given that the ECB is further from its price stability mandate than the Fed is, the ECB has to set much more accommodative policy. And there the story might end. 2% Inflation In The Euro Area Is Different To 2% Inflation In The U.S. Except that the story has a twist. The price stability mandates of the ECB and Fed appear very similar, but they are not. The ECB mandate is much harder to achieve, because of two further facts. Fact 4: The definitions of consumer prices in the euro area and the U.S. are quite different. The euro area's Harmonized Index of Consumer Prices (HICP) excludes the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes it at a very substantial 25% weight. The omission of owner-occupied housing costs - which consistently tend to rise faster than other prices - makes it much more difficult for overall inflation to reach 2%. Indeed, excluding shelter, core inflation in the U.S. today is running at 1.2%, the same rate as in the euro area (Chart I-5 and Chart I-6). Chart I-5Core Inflation Is Higher##br## In The United States... Chart I-6...But On A Like-For-Like Basis, Core Inflation##br## Is Not Higher In The United States Fact 5: The ECB has a single mandate of price stability, whereas the Fed has a dual mandate of price stability and maximizing employment. Some people even argue that the Fed has a triple mandate which includes financial stability. The point is that for Fed policy, price stability is only one of several considerations, creating flexibility; whereas for ECB policy, price stability is the only consideration, creating inflexibility. Nevertheless, a reasonable riposte to facts 4-5 is that we must just accept that the ECB and Fed operate within different frameworks. If the ECB's framework necessitates ultra-accommodative monetary policy today, then so be it. And there the story might end. Why Should Americans Pay For European Integration? Except that the story has another twist. The ECB framework wasn't always what it is today. Fact 6: On May 8 2003, the ECB changed its definition of price stability from "inflation below 2%" to "inflation below, but close to, 2%". Thereby, the addition of three small words transformed the flexibility of a 0-2% inflation range to the inflexibility of a 2% point target. Why did the ECB change its objective and make it so much more difficult? Here is the answer, straight from the horse's mouth: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%" - Mario Draghi So there you have it - the ECB admits that it changed its objective to ease the integration burden on weaker euro area economies. The undisputed consequence is structurally easier monetary policy than would be the case without the integration burden. The ECB also admits that an unavoidable result is a structurally undervalued euro, meaning a substantial competitive advantage for the euro area versus its major trading partners, including the United States. To which President Trump might rightly ask: why should American competitiveness shoulder the burden for European integration? Trump's crosshairs may be trained on Germany, which is running the largest export surplus. But he should redirect his focus to the ECB. The majority of German export hyper-competitiveness is no fault of Germany, it is due to the structural undervaluation of the euro (Chart I-7). Moreover, while an undervalued euro benefits exporters, it hurts euro area household real incomes by raising the prices of dollar-denominated energy and food imports, whose demand is inelastic. German households are also deeply unhappy about the negligible interest on their savings. Chart I-7The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Way Forward, And Some Investment Considerations Ultra-accommodative policy was not the game changer that is sometimes claimed. The euro area's strong recovery started more than a year before the ECB even mooted its extreme accommodation. The turning point came in 2013 when euro area banks stopped aggressively de-levering their balance sheets ahead of the bank stress test (Chart I-8). Chart I-8The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering Mario Draghi admits that policy today is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The ECB has a legal obligation to achieve price stability as its sole objective, but the precise definition of price stability is up to the central bank. To reintroduce some flexibility, it has two options: 'cross-sectional' flexibility, by reintroducing an inflation target range; or 'longitudinal' flexibility by a more relaxed interpretation of the 'medium term' timeframe required to achieve its point target. Of these two options, we expect a gradual move to greater longitudinal flexibility, especially as 'medium term' is already open to considerable interpretation. This will create three structural investment opportunities. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro - as calculated by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually corrects, the decade-long outperformance of consumer goods exporters versus consumer services will reverse, especially in Germany (Chart I-9 and Chart I-10). Overweight German consumer services versus consumer goods exporters. Chart I-9Consumer Services Have ##br##Underperformed In Europe... Chart I-10...But Are Starting To Turn ##br##Around In Germany Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Q4 2017 at an annualised rate. 2 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model* This week, we note that the rally in the Spanish 10-year government bond is extended and ripe for a countertrend reversal. Implement this as a pair-trade: short the Spanish 10-year bond, long the German 10-year bund. The profit target and symmetrical stop-loss is 1%. Lever up to increase potential return. We are also pleased to report that our short Helsinki OMX / long Eurostoxx600 trade achieved its 3% profit target and is now closed. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##Br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights There is more downside risk ahead as the geopolitical calendar is packed in May; Protectionism remains in play, but markets could also fall on Iran-U.S. tensions, military intervention in Syria, and Russia-West confrontation; Investors should expect volatility to go up as we approach a turbulent summer; We were wrong on Russia-West tensions peaking and are closing all of our Russian trades for now, but may look for new entry points soon; Go long a basket of NAFTA currencies versus the Euro and expect reflation to remain the "only game in town" in Japan. Feature "I'm not saying there won't be a little pain, but the market has gone up 40 percent, 42 percent so we might lose a little bit of it. But we're going to have a much stronger country when we're finished. So we may take a hit and you know what, ultimately we're going to be much stronger for it." President Donald Trump, April 6, 2018 Chart 1Teflon Trump There are times when conventional wisdom is spectacularly wrong. Last week was such a moment. Since Donald Trump became president, the "smart money" has believed that he was obsessed with the stock market. Therefore, the view went, none of his policies would threaten the bull market. We have pushed back against this assumption because our view is that geopolitical risks - specifically the lack of constraints on the executive branch in foreign and trade policy - would become investment relevant.1 This view has been correct thus far: we called the volatility spike and trade protectionism in 2018. Not only have President Trump's tariff pronouncements produced stock market drawdowns, but his popularity appears to be unaffected. Astonishingly, President Trump's approval rating collapsed as the stock market went up in 2017 and recovered as the stock market went in reverse this year (Chart 1)! It is therefore empirically incorrect that President Trump is constrained by the stock market. His actions over the past month, as well as his approval ratings, suggest that he is quite comfortable with volatility. There are two broad reasons why we never bought into the media hype. First, there is no real correlation, or only a weak one, between equity declines of 10% and presidential approval ratings (Chart 2). Generally, presidential approval rating does decline amidst market drawdowns of 10% or greater, but the effect on the presidency is only permanent if the momentum of the approval rating was already heading lower, otherwise the effect is minimal and temporary. Second, the median American does not really own stocks (Table 1). President Trump considers blue collar white voters his base and they care more about unemployment and wages, not their equity portfolios. At some point, equity market drawdowns will affect hard data and the real economy. This is the point at which President Trump will care about the stock market. Given that the market is already down 10% from the peak, we are not far away from this pain threshold. But in this way, President Trump is no different from any other president. Chart 2AThe Stock Market Mattered For Eisenhower, JFK, Bush Sr., And Obama... Chart 2B...But Not For Johnson, Nixon, Ford, Carter, Reagan, And Bush Jr. The pessimistic view on trade protectionism risk, that there is more downside to equities ahead, is therefore still in play. Investors should be careful not to overreact to positive developments, such as President Xi's speech at the Boao Forum where he largely reiterated previous Beijing promises to open up individual sectors to foreign investment. In fact, it is the investment community itself that is the target of President Trump's rhetoric. In order to convince Beijing that his threat of protectionism is credible, President Trump has to show that he is willing to incur pain at home, which explains the quote with which we began this report. Table 1Stock Ownership Is Concentrated Amongst The Wealthiest Households This is not dissimilar to President Trump's doctrine of "maximum pressure" which, when applied to North Korea, produced a significant bond rally last summer. The 10-year Treasury yield topped 2.39% on July 7 and then collapsed to a low of 2.05% in September.2 The vast majority of the yield decline, at the time, came from falling real yields as investors flocked into safe-haven assets amidst North Korean tensions and not lower inflation expectations. It is therefore dangerous to rely on conventional wisdom when assessing the limits of volatility or equity drawdowns. Any buoyant market reaction may in fact elicit a more aggressive policy from Washington. As if on cue, President Trump shocked the markets on April 7 by suggesting that he would impose another round of tariffs on a further $100bn worth of Chinese imports, bringing the total under threat to $160 billion. The announcement came after the market closed 0.89% up on April 6. Perhaps President Trump was irked that the market was so dismissive of his trade threats and decided to jolt it back to reality. In addition to trade, there are several other reasons to be bearish on risk assets as we approach May: Chart 3Inflation Will Pick Up In 2018 Chart 4Service Sector Wage Growth Is At A Cyclical Peak Inflation: Unemployment is low, with wage pressures starting to build (Chart 3). Meanwhile, teacher strikes in Red States like Oklahoma, Kentucky, West Virginia, and Arizona are signalling that public service sector wage pressures are building in the most fiscally prudent states. Service sector wages cannot be suppressed through automation or outsourcing and are therefore likely to add to inflationary pressures (Chart 4). The Fed remains in tightening mode, despite the mounting geopolitical risks. "Stroke of pen risk:" Another sign that President Trump is comfortable with market drawdowns is his increasingly aggressive rhetoric on Amazon. There is a rising probability that the current administration decides to up the regulatory pressure on the technology and retail giant, as well as a possibility that other technology companies like Facebook and Google face "stroke of pen" risks. Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions.3 Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks, new Secretary of State Mike Pompeo and National Security Advisor John Bolton. Meanwhile, tensions in Syria are building with potential for U.S. and Iranian forces to be directly implicated in a skirmish. The U.S. is almost certain to militarily respond to the alleged chemical attack by the Syrian government forces against the rebel-held Damascus suburb of Douma. Throughout it all, investors appear to remain unfazed by the rising probability that Iran's 2 million barrels of oil exports come under renewed sanction risk, mainly because the media is ignoring the risk (Chart 5). Chart 5The Media Is Ignoring Iran As A Risk Russia: As we discuss below, tensions between the West and Russia appear to be building up anew. Particularly concerning is the aforementioned chemical attack in Syria, which Moscow considers a "false flag operation." The Russian government hinted in mid-March that precisely such an attack may occur and that the U.S. would use it as a pretext to attack Syrian government forces and structures.4 Our view that tensions have peaked, elucidated in a recent report, therefore appears to have been spectacularly wrong. Chinese reforms: Now that Xi Jinping has finished setting up his new government, his initiatives are starting to be implemented. While some slight tax cuts are on the docket, and interbank rates have eased significantly, there is no sign of broad policy easing or economic recovery (Chart 6). Rather, both Xi and his economic czar Liu He have continued to stress the "Three Battles" of systemic financial risk, pollution, and poverty - the first two requiring tighter policy. Xi has stated that deleveraging will focus on state-owned enterprises (SOEs) and local governments. SOEs will have debt caps and will not be allowed to lend to local governments. Instead, local governments will have to borrow through formal bond markets, giving the central government greater control. Meanwhile, the Ministry of Housing says property restrictions will remain in place. All in all, the risk of negative surprises in China this year remains significant, with a likely negative impact on global growth.5 There is also a fundamental reason for equity market weakness: the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, which our colleague Anastasios Avgeriou of BCA's U.S. Equity Strategy has highlighted in recent research, will be turbulent.6 In addition, Anastasios has pointed out that stocks are reacting to a more bearish mix of soft and hard data (Chart 7), suggesting that not all of the market volatility is due to headline risk. Chart 6China Will Slow Down Further In 2018 Chart 7Trade Is Not The Only Risk To The Market How should investors make sense of these budding risks? Going forward, we would fade any enthusiasm or narratives of "peak pessimism" on trade protectionism. It is in the interest of the Trump administration that investors take his threats seriously. President Trump literally needs stocks to go down in order to show Beijing that he is serious. The summer months could be volatile as market confusion grows amidst the upcoming event risk (Table 2). This may be a good time to be risk-averse, with the old adage "sell in May and go away" appropriate this year. Table 2Protectionism: Upcoming Dates To Watch There are several reasons why protectionism is a much bigger deal than it was in the 1980s when investors last had to price a trade war between two major economies (Japan and the U.S. at the time): Chart 8This Time Is Different... Because Of Supply Chains... Chart 9...Globalization... Supply chains are a much bigger deal today than thirty years ago (Chart 8); The share of global exports as a percent of GDP is much higher today (Chart 9); Interest rates are much lower, leaving little room for policymakers to ease (Chart 10); Stock market valuations are higher, leaving stocks exposed to drawbacks (Chart 11); Unlike 1981-88, when Japan and the U.S. waged a nearly decade-long trade war while remaining allies in the Cold War, China and the U.S. are outright rivals. This increases the probability that Beijing's reprisal, given its constraints in retaliating against U.S. exports (Chart 12), could take a geopolitical turn. Chart 10...Policymaker Ammunition... Chart 11...And Valuations Chart 12China May Run Out Of U.S. Exports To Sanction Investors should therefore prepare for volatility of volatility. Amidst the confusion, there could be some not-so-positive news that the market overreacts to with optimism, and some not-so-negative news that the market reacts to with pessimism. In our six years of publishing geopolitically driven investment strategy, we have not seen a similar period where a confluence of risks and tensions are building up at the same time. May should therefore be a busy month. Mexico: A Silver Lining Amidst Mercantilism Risk? Mexico began the year with clouds over its head due to the Trump team's tough negotiating line on NAFTA. The third round of negotiations, in September 2017, ended on a bad note. The peso tumbled and headline and core inflation soared, portending both tighter monetary policy and weaker domestic demand.7 Today, however, the odds of renewing NAFTA have improved significantly. We have reduced our probability of Trump abrogating the trade deal from 50% to 20%. The administration appears to be focused on China and therefore looking to wrap up the NAFTA negotiations quickly over the summer. This would give time to send the new deal to the Mexican and U.S. congresses prior to the September changeover in Mexico's legislature and January changeover in the U.S. legislature. The U.S. has reportedly compromised on an earlier demand that NAFTA-traded automobiles have a U.S. domestic content of 50%.8 Meanwhile, inflation has peaked and the peso has firmed up (Chart 13), which will help buoy real incomes and boost purchasing power. Economic policy has been prudent, with central bank rate hikes restraining inflation and government spending cuts producing a primary budget surplus (and a much-reduced headline budget deficit of -1% of GDP) (Chart 14).9 Chart 13Mexico: Peso & Inflation Chart 14Mexico: Improved Macro Fundamentals In this more bullish context, the Mexican elections on July 1 are market-neutral. True, it is hard to present a strong pro-market outcome. The public is shifting to the left on the economic spectrum while the outgoing "pro-market" administration of Enrique Pena Nieto has lost credibility. The latest polling suggests that Andres Manuel Lopez Obrador (AMLO) is polling in the lower 30-percentile (around 33%), above his next competitors, Ricardo Anaya (PAN) at 26% and Jose Antonio Meade (PRI) at 14% (Chart 15). However, the latest data point of the admittedly volatile polling gives AMLO a much less commanding lead of 6-7% over Anaya than he had before. AMLO is polling around his performance in the 2006 and 2012 elections (35% and 32%, respectively), has increased his lead over the other candidates, and his National Regeneration Movement (MORENA) and "Together We'll Make History" coalition are also polling with double-digit leads (Chart 16). The general shift to the left is also apparent in the fact that Ricardo Anaya's PAN has been forced to combine with the left-wing PRD in order to garner votes. Chart 15AMLO's Lead Is Not Insurmountable Chart 16Likely No Majority In Congress Nevertheless, political risk is overstated for the following reasons: AMLO is not Hugo Chavez:10 True, he is a leftist, a populist, and has a reputation for egotism. He is Mexico's fitting anti-Trump. Nevertheless, he is also a known quantity, having run for president and engaged with the major parties for over a decade. While he elevates headline political risk, we would fade the risk based on the fact that Mexico is a relatively right-wing country (Chart 17), and his movement will probably not garner a majority in Congress (see next bullet). Notably, AMLO's rhetoric on Trump and NAFTA has been restrained, and his personnel decisions have been competent and orthodox. He has not suggested he will revoke new private Mexican oil concessions, under the outgoing government's privatization scheme, but only halt the auctions. AMLO will be constrained by Congress: The trend in Mexico is towards "pluralization" or fragmentation in Congress (see Chart 18), meaning that ruling parties will have to share power. This is not a negative development. As we recently pointed out, political plurality engenders stability by drawing protest parties into centrist coalitions and by allowing establishment parties to coopt protest narratives without having to actually protest or revolt.11 At this point in time, it is difficult to see how AMLO's MORENA garners enough support to get a majority in Congress. AMLO's closest challenger is right-wing and pro-market: If AMLO loses the election, Ricardo Anaya of PAN will not be scorned by financial markets. In 2006, AMLO looked like he would win the election but then lost to Felipe Calderon (PAN). Of course, a victory by Anaya is not very market positive either, as PAN is in an unstable coalition with the left-wing PRD and would also be constrained in Congress. Still, there would be a lower probability of reversing the outgoing PRI administration's policies than under AMLO. AMLO is unlikely to repeal NAFTA: Mexico's exports to NAFTA partners comprise 30% of GDP, and it would be exceedingly dangerous for a Mexican leader to provoke Trump on the issue. A plurality of the Mexican public (44%) supports the ongoing NAFTA negotiations as they have been handled by the current government (Chart 19), as of late February polling by the Wilson Center. The same polling shows that Mexicans are generally aware of how important NAFTA is for their economy. This is despite the polls showing that a majority of Mexicans have a negative view of the U.S., due largely to Trump's rhetoric (though that majority has fallen considerably since last year to 56%). In other words, anti-American sentiment is not turning the Mexican public against compromising on a new NAFTA deal. Chart 17Mexicans Lean Right Chart 18Mexico's Rising Political Plurality Finally, Mexico is more exposed to U.S. growth (which is charged with fiscal stimulus), and to BCA's robust outlook on oil prices (as opposed to our weaker metals outlook), while it is less exposed to weakening Chinese demand than other EMs (such as South Africa or Brazil).12 The peso looks particularly attractive relative to the latter two currencies (Chart 20). Chart 19Mexicans Want NAFTA To Survive Chart 20A Major Bottom In MXN's Cross? None of the above should suggest that the Mexican election will be a smooth affair. The rise of AMLO will create jitters in the marketplace, particularly as he faces off against Trump, who will continue to try to pressure Mexico over immigration and border security even once NAFTA negotiations are squared away. Nevertheless, the cyclical backdrop has improved while the major headwind of NAFTA abrogation seems to be abating. Bottom Line: Mexico's presidential campaign, election, and aftermath will give rise to plenty of occasion for volatility, particularly as President Trump and a likely President Obrador will not shy from a war of words. Nevertheless, Mexico's economic policy is stable and the NAFTA headwind is abating. We recommend going long Mexican local currency bonds relative to the EM benchmark. We also recommend that clients go long a NAFTA basket of currencies - the peso and the loonie - versus the euro. Our currency strategist - Mathieu Savary - has recently pointed out that the euro has moved ahead of long-term fundamentals and is ripe for a near-term correction.13 Japan: Abe Will Survive Japanese Prime Minister Shinzo Abe has come under rising public criticism in recent that is dragging down his approval ratings (Chart 21). Three separate scandals are weighing on his administration: one relating to the government's sale of land at knockdown prices to a nationalist school, Moritomo Gakuen, tied to Abe's wife; another relating to the discovery of "lost" journals of Japan Self-Defense Force activity during the Iraq war; another tied to the mishandling of statistics in promoting the government's new revisions to the labor law. Abe's popularity has tested lower lows in the past, but he is approaching the floor. And while Abe is still polling in line with the popular Prime Minister Junichiro Koizumi at this stage in his term (Chart 22), nevertheless he is approaching his 65th month in office when Koizumi stepped down. Chart 21Abe's Approval Testing The Floor Chart 22Abe Holding At Koizumi's Levels Of Support More importantly, the all-important September leadership election is approaching. The challenges arising today are at least partly motivated by factions within the LDP that want to challenge Abe's leadership. Koizumi stepped aside in September 2006 because he could not contend for the LDP's leadership due to party rules that limited the leader to two consecutive three-year terms. Abe is not constrained on this front. He has already revised those rules to three terms, giving him until September 2021 to remain eligible as party leader. He wants to run again and incumbents are heavily favored in party elections. Abe also secured his second two-thirds supermajority in the House of Representatives, in October 2017. This was a remarkable feat and one that will make it difficult for contenders to convince the rank and file in Japan's prefectures that they can lead the party more effectively. While Abe's 38% approval is now slightly below the psychologically important 40% level, and below the LDP's overall approval rating (Chart 23), there is no alternative to the LDP heading into July 2019 elections for the House of Councillors. This is manifest from the October election result. Chart 23Still No Alternative To LDP What happens if Abe's popularity sinks into the 20-percentile range? Financial markets will selloff in anticipation that he will be ousted. He could conceivably survive a scrape with the upper 20% approval range, but markets will assume the worst once he dips beneath 30% in the average polling on a sustainable basis. Markets will also assume that the remarkably reflationary period in Japanese economic policy is coming to an end. Even when Abe's successor forms a government, investors may believe that the best of the reflationary push is over. We think that the market would be wrong to doubt Japan's inflationary push. First, if Abe is ousted, the LDP will remain in power: it has until October 2021 before it faces another general election that could deprive it of government control. (A loss in the upper house election in 2019 can prevent it from passing constitutional changes but not from running the country.) This ensures that policy will be continuous in the transition and that any changes in trajectory will be a matter of degree, not kind. Second, the phenomenon of "Abenomics" is not only Abe's doing but the LDP's answer to its first shocking experience in the political wilderness, from 2009-12. This experience taught the LDP that it needed to adopt bolder policies. The result was dovish monetary policy under Haruhiko Kuroda, who just began his second five-year term on April 9 and whose faction has the majority on the monetary policy board. Looser fiscal policy was another consequence - and ultimately it came to pass.14 It will be hard for a new LDP leader to tighten policy. Factions that are criticizing Abe or Kuroda today will find it harder to phase out stimulus once they are in office. Abe's successor will, like him, have to try policies that boost corporate investment, wages, the fertility rate, immigration, social spending and military spending.15 Without such initiatives, Japan will sink back into a deflationary spiral. As for BoJ policy, over the next 18 months the biggest challenges are meeting the 2% inflation target while the yen is rising due to both China's slowdown and trade war risks.16 Tokyo is also ostensibly required to hike the consumption tax in October 2019. This is more than enough to convince Kuroda to stand pat for the time being.17 In the meantime, Abe's push to revise the constitution is a significant factor in encouraging persistently loose monetary and fiscal policy. The national referendum on the matter could be held along with the early 2019 local elections or the July 2019 upper house election. It will be hard to win 50%+ of the popular vote and nigh impossible if the economy is failing. What should investors look for to determine if Abe's downfall is imminent? In addition to Abe's approval rating we will watch to see if the ongoing scandal probes produce any direct link to Abe, or if top cabinet ministers are forced to resign (like Finance Minister Taro Aso or Defense Minister Itsunori Onodera). It will also be a telling sign if Abe's "work-style" reforms to liberalize the labor market, which have received cabinet approval, wither in the Diet due to lack of party discipline (not our baseline view).18 But even granting Abe's survival, we would expect that China's slowdown and the U.S.-China trade war will keep the yen well bid. We are sticking with our tactical long JPY/EUR trade, which is up 2.6% thus far. Bottom Line: Shinzo Abe is likely to be re-elected as LDP leader in September and to lead his party in the charge toward the 2019 upper house election and constitutional referendum. Should he fall into the 20% of popular approval, the markets should sell off. His leadership and alliances have been remarkably reflationary and the policy tailwind could dwindle. We would fade this risk, but we still think the yen will remain buoyant due to China's internal dynamics and the U.S.-China trade war. We remain long yen/euro until we see signs that Washington and Beijing are able to defuse the immediate trade war. Russia: Tensions With The West Have Not Peaked Our view that tensions between Russia and the West would peak following President Putin's reelection has been spectacularly wrong.19 We still encourage clients to review the report, penned in early March, as it sets out the limits to Russia's aggressive foreign policy. The country is geopolitically a lot more constrained then investors think, and thus there are material limits to how far the Kremlin can take the rivalry with the West. What we did not account for is that such weakness is precisely the reason for the tensions. Specifically, the Trump administration - riding high following the success of its "maximum pressure" doctrine in the Korea imbroglio - smells blood. President Trump is betting that the view of Russian constraints is correct and therefore the time to pressure Putin - and prove his own anti-Kremlin credentials - is now. But has the market gotten ahead of itself? The expanded sanctions target specific individuals and companies - EN+ Group, GAZ Group, and Rusal - and yet the broad equity market in Russia has tumbled.20 Sberbank, which is nowhere mentioned in the sanctions, fell by an extraordinary 16% since the announcement. On one hand, there does appear to be a material step-up in sanctions. Despite being focused on specific companies, the new restrictions are designed to make the entire Russian secondary bond market "not clearable." The targeting of specific companies, therefore, was merely a shot-across-the-bow. The implication for the future - and the reason that Sberbank fell as much as it did - is that U.S. investors could be forbidden - or the compliance costs could rise by so much that they might as well be forbidden - from participating in Russian debt and equity markets in the future. On the other hand, our Russia geopolitical risk index has not priced in the renewed tensions (Chart 24). This means that either our currency-derived measure is wrong or the sell off in equity and debt markets is not translating into bearishness about the overall economy. Given our bullish oil outlook and our view of the limits of Russian aggression investors should expect, the index may actually be signaling that these tensions are an opportunity to buy Russian assets. Chart 24The Russia GPI Says No Risk That said, we have learned our lesson. There is no point in trying to catch a falling knife as the Kremlin and the White House square off over Syria and other geopolitical issues. As such, we are closing all of our Russia trades until we find a better entry point to capitalize on our structural view that there are material limits to geopolitical tensions between the West and Russia. The long Russia equities / short EM equities has been stopped out at 5% loss. Our buy South African / sell Russian 5-year CDS protection is down 20 bps and our long Russian / short Brazilian local currency government bonds is up 1.07 bps. Investment Implications In April 2017, we penned a report titled "Buy In May And Enjoy Your Day!," turning the old "sell in May and go away" adage on its head.21 At the time, investors were similarly facing a number of geopolitical risks, from the second round of French elections to concerns about President Trump's domestic agenda. However, we had a very high conviction view that these risks were overstated. This time around, we fear that the markets are mispricing constraints on President Trump. Geopolitical risks ahead of us are largely in the realm of foreign policy, where the U.S. Constitution gives the president large leeway. This includes trade policy. As such, it is much more difficult to have a high conviction view on how the Trump administration will act towards China, Iran, and Russia. Furthermore, the success of the "maximum pressure" doctrine has emboldened President Trump to talk tough, worry about consequences later. Investors have to understand that we are the target of President Trump's rhetoric. There is no better way for the White House to show China, Iran, and Russia that it is serious - that its threats are credible - than if it strongly counters the view that it will do nothing to harm domestic equities. We therefore expect further volatility in the markets. We propose that clients hedge the risks this summer with our "geopolitical protector portfolio" - equally-weighted basket of Swiss bonds and gold - which is currently up 1.46%, although adding 10-Year U.S. Treasurys to the mix may make sense as well. We would also recommend that clients expect both a spike in the VIX and a rise in the volatility of the VIX (volatility of volatility). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com; and Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see "Russia says U.S. plans to strike Damascus, pledges military response," Reuters, dated March 13, 2018, available at reuters.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 8 Please see "US drops contentious demand for auto content, clearing path in NAFTA talks," Globe and Mail, March 21, 2018, available at www.theglobeandmail.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, available at ems.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Should Investors Fear Political Plurality?" dated November 29, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA's Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. 15 Please see "Japan: Abe Is Not Yet Dead, Long Live Abenomics," in BCA Geopolitical Strategy Weekly Report; "The Wrath Of Cohn," dated July 26, 2017; and "Japan: Abenomics Will Survive Abe," in Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018; and "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 17 Please see Cory Baird, "BOJ Chief Haruhiko Kuroda Begins New Term By Vowing To Continue Stimulus In Pursuit Of 2% Inflation," Japan Times, April 9, 2018, available at www.japantimes.co.jp. 18 Please see "Work style reform legislation gets Abe Cabinet approval," Jiji Press, April 6, 2018, available at www.the-japan-news.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com. 20 Please see Department of the Treasury, "Ukraine Related Sanctions Regulations - 31 C.F.R. Part 589," dated April 7, 2018, available at treasury.gov. 21 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com.

Overweight (High Conviction) As highlighted in this week's Weekly Report, we are moving to a benchmark allocation in the S&P information technology sector. The way we are executing the upgrade is by lifting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. We are also adding this index to our high conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel). Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (third panel). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (bottom panel) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Bottom Line: Boost the S&P THSP index to an overweight stance and add it to the high-conviction overweight list. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.

Highlights Duration: The balance of risks does not suggest that we should abandon our cyclical below-benchmark duration stance. Positioning is stretched and global growth is no longer accelerating, but U.S. growth is firm and the Fed is less sensitive to tighter financial conditions than in the past. Inflation: The biggest risk for bond markets is that investors wake up to the fact that core inflation is trending quickly back to the Fed's 2% target. The re-anchoring of inflation expectations will pressure the 10-year Treasury yield higher by 23 - 43 basis points. Labor Market: A forecast for stronger wage growth at this stage of the cycle relies on relatively modest assumptions about future gains in employment. Feature Chart 1Bond Bear On Pause It's risky out there. Confronted with pain in the equity market, increasingly hawkish trade rhetoric from Washington and some moderation in global economic data, investors have hit pause on the bond bear market. Yields at the front-end of the curve have leveled-off during the past few weeks and the 10-year yield is refusing to take out its 2013 peak (Chart 1). But could any of these risks actually derail the cyclical bear market in bonds? This week we stress test our cyclical below-benchmark duration recommendation by re-considering the three risks we outlined in February, plus one additional risk for good measure.1 Risk 1: Positioning Investors have been overwhelmingly short bonds for the past few months and this consensus has not wavered even as yields declined. Whenever there is widespread consensus around a trade it is often a signal of overbought/oversold conditions. Case in point, since the financial crisis extreme net short bond positions have often coincided with lower Treasury yields during the subsequent three months (Chart 2). This has been particularly true for net speculative positions in 10-year Treasury futures and the All Clients portion of the J.P. Morgan duration survey. The Active Clients portion of the survey has not displayed as consistent a relationship with yield changes, but much like the other two positioning indicators in Chart 2, it currently sits deep in "net short" territory. Chart 2Bond Market Looks Oversold Interestingly, a survey of sentiment shows that investors have mostly been bullish on bonds since 2010, with only a few brief exceptions when more than 50% of respondents indicated that they were bearish. All of the cases when investors turned bearish coincided with a subsequent decline in yields, and sentiment is currently consistent with those prior episodes (Chart 2, bottom panel). In short, widespread consensus around the "short bond" trade was a risk that we flagged in February and it remains a risk today. Risk 2: Unrealistic Expectations Chart 3Data Surprises Still Positive Related to the widespread consensus around the "short bond" trade is the risk that investors might also be overly optimistic about the pace of U.S. economic growth. U.S. economic data have been consistently surprising to the upside since the middle of last year (Chart 3). The risk is that, in the face of strong data, investors start to revise up their expectations for future economic growth. Eventually those expectations become unrealistically high and the economic data are bound to disappoint. This is why the economic surprise index is mean-reverting. In prior research we showed that if the data surprise index is below zero it is very likely that Treasury yields fell during the prior 30 days, and vice-versa.2 At the moment, the surprise index is still deep in positive territory, and our simple auto-regressive model predicts that it will remain in positive territory for the next 30 days. For now, positioning is consistent with lower yields in the near-term but data surprises are consistent with higher yields. We would likely recommend a tactical above-benchmark duration positioning if we received a consistent bond-bullish message from both our positioning indicators and our data surprise model. Risk 3: Global Growth Slowdown Chart 4Global Growth Has Peaked While U.S. economic growth is on a firm footing, growth outside of the U.S. appears to be peaking. As evidence, we note that the fair value reading from our 2-factor Treasury model - a model of the 10-year Treasury yield based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar - has fallen during the past few months and now sits at 2.78%, roughly consistent with the current 10-year yield (Chart 4).3 While the Global Manufacturing PMI fell back to 53.4 in March, down from its December peak of 54.5, it's important to note that the index is still elevated compared to recent history. Also, the U.S. contribution to the global index continues to rise, with the bulk of the decline concentrated in the Eurozone (Chart 4, panel 4). Even in the Eurozone we note that the PMI remains healthy, though not at the gaudy levels seen earlier in the year. Another important caveat about our 2-factor model is that it does not contain a variable to capture the degree of resource utilization in the economy.4 Logically, as slack dissipates in the economy and inflationary pressures mount, then the same level of global growth should be associated with a higher Treasury yield, all else equal. This means that at some point, as we approach the end of the cycle, we expect the model to break down and consistently produce fair value readings that are too low. It is unclear whether that point has been reached. Nevertheless, it is clear that global growth is no longer accelerating higher. For now the slowdown appears benign and consistent with continued economic recovery, but that could change if the Global PMI continues to fall in the coming months. Risk 4: Tighter Financial Conditions The decline in Treasury yields during the past few weeks is small potatoes compared to the steep drop in equity prices. This raises the possibility that continued weakness in the equity market will drive a flight-to-quality into bonds, leading to lower yields. Indeed, as we have often pointed out, the Fed has a strong track record of responding dovishly to periods of tightening financial conditions. This dynamic, which we have dubbed the Fed Policy Loop, explains why equity prices and bond yields are positively correlated when inflation is low, but also why this correlation reverses when inflation is high.5 When inflation is far below the Fed's target, the Fed needs the economic recovery to continue because it needs inflation to rise. Because the Fed also believes that sufficiently tight financial conditions lead to slower economic growth, it must respond dovishly whenever financial conditions tighten. This leads to a positive correlation between bond yields and equity prices - equity prices being a main driver of financial conditions. However, if we consider an environment where economic growth is strong and inflation is well above target, as was the case in the 1980s, then the Fed would actually encourage tighter financial conditions. In this instance you would expect a negative correlation between equity prices and bond yields (Chart 5). Chart 5The Fed's Reaction Function Explains The Stock/Bond Correlation With inflation still below target, the Fed cannot tolerate a severe tightening of financial conditions. But the Fed's tolerance for tighter financial conditions also increases as inflationary pressures mount. As of today our sense is that the correlation between bond yields and equity prices is still positive, though weaker than we have become accustomed to in recent years. Turning to the data, we see that the recent equity sell-off has caused the financial conditions component of our Fed Monitor to fall quite sharply, though it still suggests that financial conditions are "easy" on balance (Chart 6). This squares with Fed Chairman Jerome Powell's interpretation. He described financial conditions as "accommodative" in a speech last Friday.6 Chart 6Fed Monitor Still Suggests Tighter Money But most importantly, the top panel of Chart 6 shows that the recent tightening in financial conditions caused only a small tick down in our overall Fed Monitor. This is because tighter financial conditions have been offset by the accelerating economic growth and inflation components of our monitor (Chart 6, panels 3 & 4). This means that the Fed will need to see a more severe sell-off in the equity market or a slow-down in U.S. economic growth before it adopts a more dovish tilt. Unless this occurs, the impact of tighter financial conditions on bond yields will be relatively small. Bottom Line: As of yet we do not see the balance of risks as suggesting that we should abandon our cyclical below-benchmark duration stance. Positioning is stretched and global growth is no longer accelerating, but U.S. growth is on a firm footing and the Fed is less sensitive to tighter financial conditions than it has been in recent years. In fact, at the current juncture we think the biggest mispricing in the bond market is that yields do not adequately compensate investors for the risk of inflation. That could change very soon as inflation starts to print higher, as is explained in the next section. Inflation: The Biggest Risk Chart 7Higher Inflation Is Just Around The Corner As of last Friday, the compensation for inflation protection priced into the 10-year Treasury yield was 2.07%. The same measure for the 5-year/5-year forward yield was 2.13%. During periods when core inflation is well-anchored around the Fed's target, both measures tend to trade in a range between 2.3% and 2.5% (Chart 7). This means that the re-anchoring of inflation expectations will impart another 23 bps to 43 bps of upside to the nominal 10-year Treasury yield. We think this re-anchoring could occur relatively soon. The main reason we think this could play out soon is that investors do not seem to appreciate how strong inflation has been in recent months. The Bloomberg consensus economic forecast currently calls for year-over-year core PCE inflation of 1.84% by the end of this year and of 2% by the end of 2019. Given that year-over-year core PCE inflation is currently 1.6%, it seems like investors are forecasting a significant jump (Chart 7, panel 2). But we think these forecasts under-appreciate the impact that base effects will have on core inflation during the next few months. Core inflation dropped sharply in March 2017 (Chart 7, bottom panel), a decline caused by a one-off re-pricing of cellphone data plans. This large negative print will fall out of the year-over-year calculation when the March PCE inflation data are reported later this month. In fact, we calculate that even if core inflation rises only 0.1% in March - well below recent readings - year-over-year core PCE inflation will rise to 1.85%, already above the Bloomberg consensus forecast for the end of the year. If core PCE inflation rises 0.2% in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will rise to 1.95%, almost back to the Fed's 2% target. Bottom Line: The biggest risk for bond markets is that investors wake up to the fact that core inflation is trending quickly back to the Fed's 2% target. The re-anchoring of inflation expectations will pressure the 10-year Treasury yield higher by between 23 bps and 43 bps. Wage Growth Near An Inflection Point Chart 8Wage Growth And Labor Market Slack Last week's employment report disappointed expectations with a nonfarm payroll gain of only 103k. The unemployment rate was flat at 4.1% for the sixth consecutive month, and the employment-to-population ratio for prime age (25-54) workers dropped one tick to 79.2%, from 79.3% in February. For bond investors, the main reason to track the monthly employment report these days is to get a read on the amount of slack remaining in the labor market and how that might translate into stronger wage growth and thus higher inflation and bond yields. This makes the prime age employment-to-population ratio particularly important because it has displayed the most consistent relationship with wage growth during the past 25 years (Chart 8). Based on the historical relationship and the current prime age employment-to-population ratio of 79.2%, the employment cost index for wages & salaries should be rising at a year-over-year pace of 2.8%. This is not too far from the current year-over-year wage growth rate of 2.61%, most recently updated for Q4 2017. Further, the historical relationship shown in Chart 8 suggests that we are quite close to an inflection point where smaller gains in the prime age employment-to-population ratio will lead to larger gains in wage growth. This is one reason why we think inflation will continue to surprise to the upside this year. The other advantage of tracking the prime age employment-to-population ratio instead of the headline unemployment rate is that it is easier to forecast because it does not depend on trends in labor force participation. As is shown in Chart 9, the labor force participation rate for the 25-54 age group has risen considerably since early 2016, suggesting that the headline unemployment rate overstated the tightness in the labor market in early 2016. While it is unclear how much further cyclical upside remains in prime age labor force participation, a focus on the prime age employment-to-population ratio allows us to set that question aside. For example, using demographic forecasts from the Census Bureau, we calculate that if nonfarm payrolls increase by 110k per month on average, then the prime age employment-to-population ratio will stay flat at its current level. With payroll gains currently averaging +211k on a trailing 6-month horizon and +188k on a trailing 12-month horizon (Chart 10), we think it is safe to assume that the prime age employment-to-population ratio will continue to rise in the coming months. Chart 9Prime Age Workers Are Re-Entering The Labor Force Chart 10Monthly Employment Growth Table 1 shows how different assumptions about monthly employment growth translate into the prime age employment-to-population ratio, and also how the prime age employment-to-population ratio translates into wage growth. For example, we see that if payroll gains average +160k or higher for the next 12 months, then we should see the employment cost index for wages & salaries grow by 2.94% during the next year. Table 1Mapping Employment Growth To Wage Growth Bottom Line: A forecast for stronger wage growth at this stage of the cycle relies on relatively modest assumptions about future gains in employment. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 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 At the time of publication the 10-year Treasury yield was 2.77%. 4 The model was originally conceived to capture the impact of both the magnitude and the breadth of global growth on U.S. bond yields. For further details please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 1, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 6 https://www.federalreserve.gov/newsevents/speech/powell20180406a.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Q1 Performance Breakdown: The GFIS recommended model bond portfolio returned -0.55% (hedged into U.S. dollars) in the first quarter of 2018, underperforming the custom benchmark index by -11bps. The overweight to U.S. corporate bonds was the main drag on performance. Stress Test & Scenario Analysis: We introduce a simple framework to conduct scenario analysis and stress testing of the model bond portfolio. Our conclusion is that some shifting in our corporate bond allocations - reducing exposure to U.S. investment grade, increasing exposure to euro area and emerging market corporates - can actually help eliminate expected losses in scenarios that run counter to our base case. Feature This week, we present our regular quarterly report on the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is a departure from the usual BCA macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. This framework also gives us a vehicle to discuss many of the typical bond portfolio management issues that our clients face on a daily basis. In that vein, we are introducing a new element to our framework in this report - estimating future portfolio performance using scenario analysis, and conducting stress testing of outcomes that are contrary to our base case expectations for global bond markets. Q1/2018 Model Portfolio Performance Breakdown: An Unexpected Hit From U.S. Corporates Chart of the WeekShifting Correlations Hurt##BR##The Model Portfolio In Q1 The surge in global market volatility in the first quarter of the year weighed on the returns for the GFIS model bond portfolio. The portfolio had a total return of -0.55% (hedged into U.S. dollars), which lagged that of our custom benchmark index by -11bps.1 The quarter started out on a good note, with the portfolio outperforming by +12bps in January, as gains from our below-benchmark duration stance offset some underperformance from our overweight on global spread product. The story changed in early February, however, as the U.S. wage inflation "scare" and the associated VIX spike resulted in wider U.S. corporate bond spreads. This counteracted the gains on the government bond side of the portfolio as bond yields continued to climb. After yields peaked in mid-February, the portfolio gave back much of the outperformance from duration, with no recovery of the early February losses from spread product (Chart of the Week). In terms of the breakdown between the government bond and spread product allocations in our model portfolio, the former generated +9bps of outperformance versus our custom benchmark index while the latter underperformed by -19bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight U.S. Treasuries (+16bps) Underweight emerging market (EM) U.S. dollar (USD) denominated corporate debt (+5bps) Overweight Japanese government bonds (JGBs) with maturities of ten years or less (+4bps) Underweight EM USD-denominated sovereign debt (+2bps) Biggest underperformers Overweight U.S. investment grade (IG) Financials (-14bps) Overweight U.S. IG Industrials (-8bps) Underweight JGBs with maturities beyond ten years (-8bps) Overweight U.S. Ba-rated high-yield (HY) corporates (-4bps) Table 1GFIS Model Bond Portfolio Q1-2018 Overall Return Attribution Chart 2GFIS Model Bond Portfolio Q1-2018 Government Bond Performance Attribution By Country Chart 3GFIS Model Bond Portfolio Q1-2018 Spread Product Performance Attribution By Sector The hits from the overweight positions in U.S. corporate debt were the most surprising, given that the U.S. economy and corporate profits are still expanding at a solid pace. That would typically keep corporate credit spreads well-behaved, especially when U.S. Treasury yields are rising or stable as was the case in the first quarter. Yet volatility has spiked and stayed elevated in response to heightened uncertainty over slowing global growth momentum, rising U.S. inflation and worries about future U.S. trade policy. Investors have demanded moderately higher credit risk premiums in the U.S. as a result, to the detriment of U.S. corporate bond performance. This can be seen in Chart 4, which presents the returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market.2 On this "apples-for-apples" basis, U.S. IG corporates were the worst performing fixed income market in the first quarter of 2018. Chart 4Ranking The Winners & Losers From The Model Portfolio In Q1 Looking ahead, we see no need yet to get out of our recommended overweight in global spread product or underweight in global government bond exposure (Chart 5). While there are some signs of slowing growth momentum in major economies (euro area, China), a deeper slowdown is not being heralded by leading economic indicators, which continue to rise. Much of the global economy continues to operate at or beyond full employment, which will continue to put moderate upward pressure on inflation rates. This will force central banks to maintain a relatively hawkish bias, despite more elevated financial market volatility. The most likely outcomes are still more bearish for government bonds than for corporate credit. Chart 5We're Sticking With Our##BR##Spread Product Overweight Having said that - the higher volatility environment does argue for some reduction in the size of the spread product overweight in the model portfolio. Especially after we consider some scenario analysis on returns, as we discuss in the next section. Bottom Line: The GFIS recommended model bond portfolio returned -0.55% (hedged into U.S. dollars) in the first quarter of 2018, underperforming the custom benchmark index by -11bps. The overweight to U.S. corporate bonds was the main drag on performance, thanks to the more elevated level of market volatility and spread widening during the quarter. Stress Tests & Scenario Analysis A common analytical tool used by professional fund managers is to perform "stress tests" on their portfolios. This is done to estimate the size of potential losses that could occur after major market moves, typically those that went against current positioning in a portfolio. Those estimates are critical to the effective risk management of a portfolio. As part of the ongoing development of the infrastructure for our model bond portfolio framework, we are introducing scenario analysis and stress testing of our current recommended allocations. The goal is to determine the magnitude of potential returns that could be expected under our base case and alternative scenarios. This is meant to complement the main risk management tool that we added last year, a "risk budget" based on the tracking error (i.e. volatility difference) of the portfolio versus our custom benchmark.3 We have deliberately been targeting a modest tracking error for our model portfolio, given the historical richness (low yields, tight spreads) of so many parts of the global bond universe. Yet our estimate of the GFIS model bond portfolio's tracking error has fallen even below the low end of the 40-60bp range that we have been targeting (Chart 6).4 Chart 6Lower Tracking Error Through Higher##BR##Corporate Bond Volatility This appears to be due to an odd development. The model bond portfolio's volatility was running below that of its benchmark index over the past year, but with the increase in the return volatility of U.S. IG corporate debt - the biggest overweight within spread product - the portfolio's volatility has been converging to that of the benchmark from below, hence lowering the tracking error. In other words, being overweight U.S. IG was a portfolio diversifier last year, but that is no longer the case. This obviously highlights some of the limitations of using tracking error as the sole risk management tool for a bond portfolio. Shifting cross-asset correlations and volatilities can wreak havoc on any "guesstimate" of a portfolio's underlying risk. A more simple solution is to conduct scenario analysis of expected returns, then shock the analysis for changes in the underlying assumptions. The key is having a reasonable framework for estimating returns for various asset classes. For our purposes in the model portfolio, we are using a simple approach to forecast the expected returns. We use a factor-based framework that models changes in global bond yields as a function of changes in the following four variables: the U.S. dollar, the price of oil, the fed funds rate and the VIX index. We show the regression results of our factor-based modeling of yield changes for each spread sector in our model bond portfolio in Table 2A. We ran the regressions for different time horizons, but we decided on using the post-crisis period since 2009 in all cases. We also attempted to model the yield changes of government bonds using those same four factors, but the R-squareds for all those regressions were far too low to make them useful. We instead used a simple approach of calculating the beta since 2009 of changes in individual bond yields to changes in U.S. Treasury yields for each corresponding maturity bucket. We present those yield betas in Table 2B. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To U.S. Treasuries With these tools, we can forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios. In Tables 3A & 3B. We show three differing scenarios, with all the following changes occurring over a one-year horizon: Table 3AScenario Analysis For The GFIS Model Portfolio Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis Our Base Case: the Fed delivers another 75bps of rate hikes, the U.S. dollar rises by 5%, oil prices rise by 20% (the non-consensus view of BCA's commodity strategists), the VIX index stays unchanged at current elevated levels and there is a modest bear steepening of the U.S. Treasury curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by 10%, oil prices fall by 10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve. Chart 7U.S. IG Corporates Have A##BR##High Yield Beta (a.k.a. Duration) A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by 5%, oil prices fall by 5%, the VIX index increases by five points from current levels and there is a modest bull steepening of the U.S. Treasury curve. In Table 3A, we also show the expected yield changes generated by our regressions for each spread product sector and the yield betas to U.S. Treasuries for each government bond market. This produces expected returns for the GFIS model bond portfolio, which are shown in the top part of the table. In our base case, the portfolio is expected to outperform the benchmark by +42bps, but underperform by nearly equivalent amounts in both alternative scenarios. In the bottom part of the table, we show expected returns where we reduce our large overweight to U.S. IG corporates. The latter has a high sensitivity to rising global government bond yields compared to some of our other significant overweights like Japanese government debt and U.S. high-yield (Chart 7). We then take that reduced U.S. IG weighting and increase the exposure to euro area and EM corporate bonds. This adjusted portfolio results in higher excess returns not only in our base case (now +78bps) but even in the "very hawkish Fed" scenario (now +8bps). The "very dovish Fed" scenario produces a similar loss in this scenario (now -37bps), but that is to be expected since this includes a fall in global bond yields that would hurt our current underweight duration stance (Chart 8). Importantly, this adjusted portfolio would not alter the positive carry of the model portfolio (i.e. the portfolio yield remains at 16bps above that of the custom benchmark index, Chart 9) Chart 8Flattening Yield Curves##BR##Have Also Hurt Returns Chart 9Some Help From##BR##Positive Carry Based on this scenario analysis, we are going to implement the changes in the bottom half of Table 3A. We are cutting our overweight to U.S. IG corporates in half (which still leaves us overweight), raising euro area IG and HY corporate exposure to neutral and reducing the size of our EM corporate underweight. The changes to the model portfolio can be found on Page 14. These changes will reduce our exposure to a sector that not only has become riskier, but which also looks relatively expensive to U.S. high-yield (Chart 10) and which has been underperforming euro area (Chart 11) and EM equivalents (Chart 12). Chart 10U.S. IG Looks More##BR##Expensive Than U.S. HY Chart 11An Unexpected Underperformance##BR##Of U.S. IG vs. European Corporates Chart 12An Unexpected Underperformance##BR##Of U.S. IG Vs. Versus EM Corporates Bottom Line: We introduce a simple framework to conduct scenario analysis and stress testing of the model bond portfolio. Our conclusion is that some shifting in our corporate bond allocations - reducing exposure to U.S. investment grade, increasing exposure to euro area and emerging market corporates - can actually help eliminate expected losses in scenarios that run counter to our base case. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 For Italy & Spain, the bars have two colors since the portfolio weights were changed in mid-February, when we upgraded Italian debt to neutral at the expense of a reduction in Spanish government bond exposure. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcaresearch.com. 4 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Neutral We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral. The core driver of our upgrade is to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel). There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel). Despite the good news, crucial sector risks, including a bounce in the U.S. dollar, higher interest rates (another key BCA theme for 2018) and regulatory/political risks (the source of the recent tech sector wobble) prevent us from turning outright positive. Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral; see yesterday's Weekly Report for more details.

Highlights Q1 earnings season looks robust, but trade policy is an uncertainty. Sizeable shifts in equity technicals and sentiment since the start of the year; valuation still stretched. Global growth may have peaked but fiscal, monetary and legislative backdrop remains supportive. The market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. Feature Chart 1Despite Setback In March, ##br## U.S. Labor Market Remains Strong U.S. equity prices fell last week as trade policy remained on the front pages. Gold was one of the few beneficiaries of the tariff talk. Investors hope to turn the page this week as the Q1 2018 earnings season kicks into high gear, but trade-related market volatility is here to stay. The bar is high for 2018 earnings growth, and the focus may shift to the prospects for 2019 sooner rather than later. The modest selloff in the S&P 500 since late January led to a shift in sentiment, but the technical picture for U.S. equities is mixed. Global growth may be rolling over, but we find that risk assets perform well anyway, if fiscal, monetary and legislative policy is aligned. Trump's actions on tariffs do not mean that we are necessarily headed for a trade war. The tariffs proposed but both sides have not yet been implemented and there is still time for compromise. We do not see March's modest 103,000 increase in non-farm payrolls as signaling a weaker labor market. First, the monthly data can be volatile. The soft increase in March follows an outsized 326,000 gain in February. The 3-month average, more reflective of the underlying trend, is a solid 202,000. Second, average hourly earnings increased by 0.3% m/m, which nudged the annual wage inflation rate to 2.7% from 2.6%. Firming earnings growth is a sign of a strong labor market (Chart 1). Despite the soft increase in March payrolls, the U.S. labor market and economy are on a firm footing. Aggregate hours worked increased by 2.0% at a quarterly annualized rate in Q1. Such a pace is consistent with about 3% GDP growth. Firm growth will allow inflation to head back to the 2% target and allow the Fed to continue with its gradual rate hikes. S&P 500 Earnings: Q1 2018 The consensus expects an 18% year-over-year increase in the S&P 500's EPS in Q1 2018 versus Q1 2017, and 20% in 2018. Energy, materials, financials and technology will lead the way in earnings growth in Q1, while real estate and consumer discretionary will struggle. Excluding the energy sector, the consensus expects a stout 17% increase in profits. The robust profit environment for Q1 2018 and the year ahead reflects sharply higher oil prices compared with early 2017 and the impact of last year's Tax Cut and Jobs Act. Moreover, improved global growth and still modest labor costs will support the Q1 results. Trade policy will likely replace tax cuts as a key topic when corporate managements report Q1 outcomes and provide guidance for Q2 and beyond. While no tariffs have yet been imposed, analysts will want to understand the impact that the proposed actions will have on input costs and margins. Moreover, investors must gauge to what extent trade policy-related uncertainty is weighing on business sentiment (details below in "Trade Skirmish...Or Trade War?"). Market volatility, rising interest rates and the modest upswing in U.S. labor costs will also be discussed during the Q1 earnings calls. As always, guidance from corporate leaders for Q2 2018 and ahead are more important than the actual results for Q1 2018. The markets probably have already priced in a robust 2018 earnings profile due to the Tax Cut and Jobs Act, and are looking ahead to 2019 (Chart 2). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 20% increase expected this year. Chart 2The Bar Is High For 2018 EPS, But The Focus Is On 2019 Chart 3 shows that elevated readings on the ISM provide a very favorable backdrop for EPS in 2018. As indicated in Chart 4, industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Industrial production growth may be peaking, but we don't expect it to soften much on a year-over-year basis. Chart 3Elevated ISM Good News For 2018 EPS Growth Chart 4Stout Readings On IP Support S&P 500 Revenue Gains Global GDP growth estimates for 2018 and 2019 continue to move steadily higher in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 5). Chart 5U.S. And Global Growth Estimates Are Still Accelerating... ##br## But For How Much Longer? Chart 6The Dollar Should Not Be A Big Concern ##br## In Q1 Earnings Season The greenback should not be an issue for corporate results in Q1 2018 based on minimal references to a robust dollar in the past six Beige Books. This significantly differs from 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, a modestly weaker dollar has allowed profit and sales gains of global firms to rebound and outpace those of domestic businesses (Chart 7). Margins for U.S. companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but rebounded last year and are higher than margins of domestic companies. Nonetheless, a slowdown in growth outside the U.S. may reverse these trends (Please read below, "Global Growth Has Peaked, Now What?"). Investors are skeptical that margins can advance in Q1 2018 for the seventh consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. Chart 7Global EPS, Margins Outpacing Domestic Chart 8Strong S&P Growth Ahead, Will Start To Slow Soon Bottom Line: BCA expects that the earnings backdrop will be supportive of equity prices in 2018 (Chart 8). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on 2019 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Technical, Sentiment And Valuation Update BCA's Technical Indicator is not at an extreme (Chart 9, panel 1) and the 7.8% pullback in the S&P 500 since January 26, 2018 leaves the index in the middle of its recovery trend channel (panel 2). The failure of the index to break out of this channel earlier this year suggests that a period of consolidation for equities awaits. Moreover, the upward slope in the NYSE advance/decline line (panel 3) is in jeopardy. The final panel of Chart 9 shows that stocks are no longer extremely overvalued, but they remain overvalued nonetheless. Stretched valuations say more about medium- and long-term returns than near-term performance.1 Chart 9Technicals And Valuations For U.S. Equities Chart 10Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated The shift in the equity sentiment since the market top in January is notable. BCA's investor sentiment composite index, which hit an all-time high at the end January, has pulled back in the past few months (Chart 10, panel 1). However, this metric has not yet returned to its long-term average (solid line on top panel of Chart 10). The drop in sentiment is broadly based; individual investors and advisors who serve them (panels 2 and 4) along with traders (panel 3) have lately curtailed their bullishness. Recent shifts in several other sentiment surveys are also worth noting: The American Association of Individual Investors, a contrary indicator of sentiment, turned bullish in recent weeks. The percentage of respondents who were bearish moved above 30%, while the percentage of bulls dipped to 32%. Neither measure is at an extreme (Chart 11). The National Association of Active Investment Managers (NAAIM) says that active managers have reduced equity risk since the beginning of Q4 2017 (Chart 12). At 52%, the average equity exposure of institutional investors is at the lowest level since March 2016 and is nearly half the 102% exposure at the start of 2017. In contrast, the March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. As in previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and has remained there. The index is at its highest point since the 2000 market peak (Chart 13, panel 1). Moreover, net speculative positions of S&P 500 stocks are roughly in balance, but have turned net short in recent weeks. Nonetheless, this metric is not at an extreme (panel 3). Chart 11Individual Investors Have Turned More Bearish Chart 12Active Managers Still Overweight Equities... Chart 13Equity Speculation Is High... Chart 14Pullback Has Relieved Some Technical Pressure The S&P 500 is close to its 200-day moving average. In late 2017, this indicator was at the upper end of its post-2000 range (Chart 14, panel 1). BCA's composite technical measure is in the middle of the 2007-2017 range and is not a concern (Chart 14, panel 5). Moreover, the percentage of NYSE stocks above their 10- and 30-week highs are below average and at the low end of their recent ranges. Furthermore, new highs minus new lows is at neutral (panel 2). Bottom Line: The 7.8% pullback in the S&P 500 since January 26 has relieved some technical pressure on the market, and sentiment levels are less stretched than at the late January 2018 peak. Moreover, institutions have cut their equity exposures. Nonetheless, stock speculation is rampant and valuations are elevated, which suggests lower returns in the coming decade. Moreover, a slowdown in global growth in ongoing trade tensions suggest that the risk/reward balance for equities has deteriorated. Global Growth Has Peaked, Now What? Chart 15Is Global Growth Peaking? In last week's report we stated that while BCA expects global growth to be solid this year, there are signs that global growth may near a top.2 March's PMI data support that view. Chart 15 shows that the Markit Global PMI dipped to 53.4 in March from 54.1 in February; the 0.7 drop was the largest since February 2016 (panel 2). Last month,3 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. BCA expects the ongoing era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. However, some investors wonder if the peak in global growth changes our view of how risk assets will perform during periods of harmonized policy. We do not expect the peak in global growth to lead to a recession this year or next. Chart 16 and Table 1 show the performance of U.S.-based financial assets, gold, oil, the dollar and S&P 500 earnings when Fed, fiscal and legislative policies are stimulative and global growth is rolling over but still positive. There has been only a handful of such episodes, so investors should be cautious when interpreting these results. The S&P 500 beats Treasuries, investment-grade and high-yield credit outperforms Treasuries, and small caps outpace large caps. Gold and oil perform well in these periods, perhaps aided by a weaker dollar. S&P 500 earnings are positive. Chart 16Positive Policy Backdrop As Global Growth Is Rolling OverTable 1Three Periods Where Global Growth Rolled Over But Policy Backdrop Was Stimulative Bottom Line: A peak in global growth reduces the risk/reward balance for risk assets, and provides another reason to be cautious. Equity valuation, although improved recently, is still stretched. Central banks are slowly removing the punchbowl, margins have limited upside and the economic cycle is at a late stage. Long-term investors should already be scaling back on risk. Short-term investors should stay overweight risk for now, on the view that fiscal stimulus will provide a tailwind for earnings for the remainder of the year. Trade Skirmish...Or Trade War? BCA's Geopolitical Strategy service notes4 that the market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down by 5.7% since the White House announced tariffs on steel and aluminum and 2.34% since it declared impending levies against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets, the U.S. demands on China justify the moniker of a trade skirmish, rather than a full-on war. In view of our position, we think the 5.7% drawdown is appropriate, if a bit sanguine. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. Therefore, it is appropriate for the market to price in a 20%-30% probability of a trade war developing. Given that the market drawdown in such a scenario could be 20% or more, the market is appropriately discounting the risks. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities when a similar confrontation in the 1980s between Japan and the U.S. did not? First, the overvaluation of stocks is much greater today. Secondly, interest rates are much lower, restricting how much policymakers can react to adverse risks. Thirdly, supply chains are much more integrated, both globally and between China and the U.S. The U.S. Administration's trade policy is not haphazard. President Trump and U.S. Trade Representative Robert Lighthizer are on the same page: they have made China, and not NAFTA trade partners or South Korea, the target of U.S. protectionism (Chart 17). Chart 17China, Not NAFTA, In The Crosshairs Table 2U.S. Gradually Exempting Allies From Tariffs The rapid pace at which the Administration pivoted from global tariffs to targeting China is an indication of what lies ahead. The U.S. uses the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 2). This strategy can work, as outlined last week,5 but there is plenty of room for mistakes. Trump also wants to change the U.S. policy on immigration and he may use NAFTA negotiations to gain leverage over Mexico. Therefore, there is a slight probability that Trump may trigger Article 2205 to leave NAFTA, but we believe the risk has declined substantively since our 50% estimate in November 2017. Bottom Line: The Trump Administration has pursued a well-considered but tough trade policy toward China. Nonetheless, Trump's actions do not mean that we are necessarily headed for a trade war. The tariffs proposed by both sides have not yet been implemented and there is still time for compromise. The U.S. Treasury will release a list of exemptions on May 1. On May 21, Treasury will reassess its list of China's investments in the U.S. and China will likely retaliate. June 5 marks the end of a 60-day negotiation period when the Administration must decide whether to implement the announced tariffs. There still is a 30% chance that the trade skirmish will morph into a trade war. Trump could significantly escalate matters if he declares a national emergency on trade in June. Expect more trade-related volatility in U.S. financial markets until that time. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Asset Allocation Special Report, "What Returns Can You Expect?", dated November 15, 2017, available at gaa.bcaresearch.com. 2 Please see BCA U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", dated April 2, 2018, available at usis.bcaresearch.com. 3 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", dated March 12, 2018, available at usis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan", dated March 30, 2018, available at gps.bcaresearch.com.

Highlights Portfolio Strategy The capex upcycle, a soft U.S. dollar and improving end demand signal that it no longer pays to underweight the S&P tech sector. Lift exposure to neutral. Firming domestic and global final demand, the synchronized global capex upcycle, an overly pessimistic sell-side analyst community and cheap valuations compel us to upgrade the S&P tech hardware, storage & peripherals index to overweight. Recent Changes S&P Technology - Upgrade to neutral today. S&P Tech Hardware, Storage & Peripherals - Boost to overweight and add to the high-conviction overweight list today. Table 1 Feature The S&P 500 seesawed last week, and continues to absorb the early February drawdown. While global growth cannot continue its breakneck pace indefinitely and a soft patch is inevitable, global output growth remains significant and above trend. Our constructive cyclical equity market view remains intact, premised upon the longevity of the business cycle, at least for the next 9-12 months. In the U.S. specifically, the ISM manufacturing survey is perched closer to 60 than to 50, unemployment insurance claims hover near 50-year lows and the muted 10-year Treasury yield moves all signal that generalized fear has yet to grip markets (Chart 1). In fact, if one looks back at the 2015, 2011 and 2010 global growth scares, investors took shelter in U.S. Treasuries as the SPX sold off, sending the 10-year UST yield lower by 50, 70 and 70 bps respectively in a very short time span. The fact that the 10-year yield is only 15 bps below its peak should cause us to question whether the recent equity drawdown is really about slowing global growth. On the monetary policy front, while the Fed is increasing the fed funds rate and decreasing the size of its balance sheet and volatility is making a comeback (please see Chart 1 from the March 5th Special Report), the real fed funds rate remains below the zero line and the real 10-year UST yield is also close to nil (Chart 2). Economic slack measures confirm that the Fed remains behind the curve. The output and unemployment gaps have been closed for a while now, and BCA's unemployment diffusion index and the Taylor rule both signal that monetary policy is extremely accommodative (Chart 3). Chart 1Macro Conditions... Chart 2...Remain Conducive... Chart 3...To A Rising SPX The implication is that macro conditions remain conducive to a rising equity market from a cyclical time horizon perspective. Meanwhile, sifting through the noise reveals that the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, as we highlighted in recent research, will be turbulent,1 and likely an earnings validation phase will pave the way higher for the broad equity market. In fact, dissecting the tax relief impact on different sectors is in order. Charts 4 & 5 show the calendar 2018 forward estimates on December 31st, 2017 and what analysts pencil in today, respectively. Charts 6 & 7 highlight the delta in absolute terms and percentage change terms. Chart 42018 EPS Growth On March 30, 2018 Chart 52018 EPS Growth On December 31, 2017 Chart 6Delta Chart 7Delta % Change Telecom services will likely benefit tenfold from the lower corporate tax rate (shown truncated, Chart 7), and consumer discretionary stocks are also prime beneficiaries. But this also means that 2018 after-tax profit data are masking the negative underlying trend growth rate for both of these sectors which also sport grim operating metrics. The S&P telecom services sector is a high-conviction underweight,2 and we reiterate our recent downgrade to a below benchmark allocation in the S&P consumer discretionary sector.3 Industrials, energy and financials, also benefit greatly from tax relief (Chart 7), but higher commodity prices along with improving industry operating metrics contribute to the EPS euphoria for these sectors. Nevertheless, we have identified three key risks to our sanguine equity market view: Escalating geopolitical/regulatory uncertainty Severe global growth slowdown U.S. dollar surge All three risks are intertwined and could infiltrate profit growth in the coming months. As we have posited in recent research, U.S. dollar softness begets higher global growth and the two feed off of each other in a virtuous cycle. A depreciating currency is a profit fillip for SPX constituents with heavy export exposure, the opposite is also true (Chart 8). Chart 8S&P 500: Aggregate Sector International Revenue Exposure (%) If the Trump Administration continues to slap on tariffs with China retaliating, as we experienced last week, eventually triggering a global trade war, then all bets are off on the sustainability of global growth (Chart 9). Such an outcome would weigh heavily on both market sentiment and profits, as our Geopolitical Strategists argued last week.4 Chart 9Don't Throw In The Towel On Global Growth Yet Finally, regulatory clampdown on the tech sector specifically is also on our radar screen, especially given the monopolistic powers that a handful of U.S. tech titans command. This is not only a U.S. risk, but also a global one. However, the 2000s Microsoft and recent Google precedents suggest that a corporate breakup is a low probability event à la "Ma Bell" in 1983, and heavy fines are the most likely outcome (we will be covering this regulatory risk in an upcoming Special Report in conjunction with our sister Geopolitical Strategy publication, stay tuned). Adding it up, we assign low probabilities to all three risks. This week we are taking advantage of recent market weakness and adding some cyclical exposure to our portfolio. Lift Tech To Neutral... We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral.5 Before exploring our thesis on why we are becoming more constructive on the largest S&P sector in terms of market capitalization weight, it is instructive to look back and identify what we missed. Two reasons for the tech sector's outperformance stand out. First, BCA's constructive view on the U.S. dollar has weighed heavily on our underweight positioning in the tech sector, especially since the greenback's peak in level terms in December 2016. U.S. tech firms garner 60% of their total revenues from abroad - the highest among the GICS1 sectors (Chart 8) - and the positive P&L translation gain effects have been a tonic to EPS. Irrespective of where the dollar will end 2018, due to lagged effects, the U.S. dollar's significant depreciation will continue to boost tech sector EPS. Second, the lack of inflation at this stage of the cycle has perplexed economists and presented a goldilocks macro backdrop for the tech sector that thrives in deflation/disinflation. This benign inflation backdrop has also coincided with the V-shaped global growth recovery following the late-2015/early-2016 global manufacturing recession and propelled technology stocks. Nevertheless, in mid-September we lifted the S&P software index to a benchmark allocation and subsequently to a high-conviction overweight in late-November in order to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle. Building on this thesis, the broad tech sector also benefits from rising capex (Chart 10). In fact, there is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. Not only is the tech sector gaining capex market share, largely at the expense of basic resources (Chart 11), but also in absolute terms tech spending is on fire and vaulting to fresh all-time highs (Chart 10). Chart 10Prime Capex Beneficiary Chart 11Sector Capex % Of Total National accounts confirm the stock market-reported capital outlays data and tech investment is firing on all cylinders (middle panel, Chart 12). In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end-demand is upbeat (fourth panel, Chart 12). The San Francisco Fed's Tech Pulse Index encapsulates all this tech optimism underpinning tech stocks (second panel Chart 12).6 On the global demand front, EM Asian exports are climbing at the fastest clip in ten years, despite the smart rebound in the ADXY. Historically, tech sales and EM Asian exports are joined at the hip and the current message is positive (bottom panel, Chart 12). Importantly, a rising revenue backdrop is necessary, especially in the context of rising capital outlays, as they sustain the virtuous upcycle. A simple final demand indicator combining tech exports and new orders is also flashing green (Chart 13). Tack on the sizable losses in the U.S. dollar over the past year and resurgent tech exports will be a boon to tech EPS (bottom panel, Chart 13). Chart 12Firm End-Demand Chart 13Soft U.S. Dollar Helps Our tech profit model does an excellent job capturing all of these positive forces and is pointing to healthy growth for the rest of 2018 (second panel, Chart 14). However, there are also a few headwinds that the tech sector has to contend with and that prevent us from lifting exposure all the way to overweight. First, any knee-jerk bounce in the U.S. dollar is a clear negative for technology stocks. Second, BCA's second key theme we are exploring calls for higher interest rates in 2018 on the back of rising inflation (Chart 15). Were the selloff in the bond market to gain steam in the coming months as inflation rears its ugly head, then tech stocks would come under intense pressure. Third, as we highlighted above, regulatory/political risks have been at the epicenter of the recent tech sector wobble, and heightened regulatory uncertainty will continue to muddy the tech waters. Finally, while tech stocks are nowhere near as overvalued as in late-1999/early 2000, they are more expensive than the broad market on a number of valuation measures (third panel, Chart 14). Chart 14Our Tech Profit Model Flashes Green... Chart 15...But Interest Rates Are A Big Headwind Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral, by augmenting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. ...Via Boosting Tech Hardware To Overweight The way we are executing the upgrade to neutral on the broad S&P tech sector is by lifting the S&P THSP index to an overweight stance. We are also adding this index to our high-conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel, Chart 16). Already, U.S. factories are humming trying to fulfill perky end-demand. Industry production is far outpacing capacity growth and this represents a boon to pricing power that has exited deflation for the first time ever (bottom panel, Chart 16). The implication is that S&P THSP profits will overwhelm. Beyond U.S. shores, global fixed capital formation is also climbing sharply. This synchronized global capex upcycle represents a tailwind for this industry and will continue to underpin U.S. computer exports (Chart 17). Add on the depreciating greenback and U.S. manufacturers are well positioned for export market share gains (third panel, Chart 17). Chart 16Capex To The Rescue Chart 17Enticing Global ... Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. In particular, EM Asian exports are expanding at a healthy clip, in spite of rising EM currencies, underpinning S&P THSP net earnings revisions (middle panel, Chart 18). The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (Chart 18). All of this suggests that S&P THSP sales and profits will shine in 2018, easily surpassing the extremely low relative hurdles that sell-side analysts are penciling in for the coming 12 months (second & third panels, Chart 19). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (Chart 20) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Return on equity is also probing all-time highs. Chart 18...Demand Backdrop Chart 19Unwarranted Pessimism... Chart 20...Given Pristine B/S And Sky-High ROE Finally on the relative valuation front, this tech sub-index trades at a 20% discount to the broad market (and below the S&P tech sector) both on a forward P/E and EV/EBITDA basis, offering an appealing entry point. Bottom Line: Boost the S&P THSP index to an overweight stance for a loss of 16% since inception, and add it to the high-conviction overweight list. This shift also lifts the overall S&P tech sector to a benchmark allocation for a loss of 18% since inception. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com. 6 "The Tech Pulse Index is an index of coincident indicators of activity in the U.S. information technology sector. It can be interpreted as a summary statistic that tracks the health of the tech sector in a timely manner. The indicators used to compute the index are investment in IT goods, consumption of personal computers and software, employment in the IT sector, as well as industrial production of and shipments by the technology sector. The index extracts the common trend that drives these series." https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights R-star is higher in the U.S. than in most other large economies. This includes China, where an elevated savings rate has depressed the neutral rate of interest. Countries with relatively high neutral rates like the U.S. will tend to run structural current account deficits, whereas countries with relatively low neutral rates will tend to run surpluses. The failure of the Trump administration to understand this basic economic lesson could inflame the ongoing trade spat between the two countries, at a time when populism is on the rise and China is challenging the U.S. for global influence. Fortunately, trade protectionism is less attractive when jobs are plentiful, as is the case in the U.S. today. Thus, we continue to see a market-friendly resolution to the ongoing conflict. Our base case remains that another global recession is still about two years away, which should keep the bull market in global equities intact. However, with global growth decelerating, financial conditions tightening at the margin, and the near-term signal from our proprietary MacroQuant model stuck in bearish territory for the second month in a row, the tactical picture for stocks remains rather murky. Feature Blame It On The Neutral Rate If the world of macroeconomics were set in a superhero universe, the real neutral rate of interest, otherwise known as R-star, would undoubtedly be cast as an arch-villain. R-star is the interest rate consistent with full employment and stable inflation. A depressed R-star has made the zero lower-bound constraint on nominal rates a vexing problem for central bankers. Not long after the Global Financial Crisis began, policy rates fell to ultra-low levels. But even this was not enough to engender a strong recovery. Most economies needed negative real rates. However, with inflation stuck at low levels, there was a limit to how far below zero real rates could go. Japan, of course, has been no stranger to this problem. Policy rates have been close to zero for over 20 years, yet inflation remains stubbornly low (Chart 1). Some commentators have dismissed this issue, noting that real per capita GDP has still managed to grow at a reasonably healthy clip. Unfortunately, this misguided optimism ignores the fact that Japan was only able to keep the economy from sinking into a depression by relying on massive budget deficits. With Japanese monetary policy rendered impotent, fiscal policy had to pick up the slack. High levels of excess private-sector savings were absorbed with continued government dissavings (Chart 2). The result is a gross government debt-to-GDP ratio of 240%. A low R-star has also been a major problem in the euro area. Before the European sovereign debt crisis erupted, Germany was able to export its excess savings to the peripheral countries, who were more than happy to load up on cheap debt so that they could live beyond their means (Chart 3). Chart 1Japan: Even Zero Interest Rates ##br##Were Not Enough To Spur Inflation Chart 2Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 3The European Periphery Is No Longer ##br##Absorbing Germany's Excess Savings Those days are over. Today, Germany's current account surplus stands at a gargantuan 8% of GDP, but much of Germany's savings are exported to the rest of the world. Consequently, the euro area current account balance has gone from roughly breakeven in the pre-crisis period to a surplus of 3% of GDP. This likely means that the neutral rate in the euro area has fallen further. R-Star In China Chart 4China Saves A Lot What about China? One might think that China's fast trend GDP growth rate would translate into a high neutral rate. However, the neutral rate is not just a function of trend growth. Most economic models state that the savings rate also affects the neutral rate.1 The more income people wish to save at any given interest rate, the lower the neutral rate will be. For a variety of institutional and cultural reasons, the Chinese save a lot (Chart 4). The national savings rate has averaged 50% of GDP for the past decade. In fact, despite an investment-to-GDP ratio of 44%, China still manages to run a current account surplus (remember the current account balance is just the difference between savings and investment). A Simple Thought Experiment The earth does not trade with Mars. As a result, the global current account balance must be zero; current account surpluses in one set of countries must be offset by current account deficits in another set of countries. Interest rates and exchange rates play a vital role in ensuring that this identity is satisfied. Imagine a bunch of island economies - all with different neutral rates - that do not trade with one another. Now suppose a technological breakthrough occurs that permits free trade and capital mobility. What would you expect to happen? Standard economic theory says that capital will flow towards the islands with relatively high interest rates. As shown in Chart 5, the flood of capital will push down the interest rate in those economies. A lower interest rate, in turn, will discourage saving and encourage investment, leading to a current account deficit. Capital inflows will also drive up the currency, while higher spending will push up consumer prices. Such a "real appreciation" of the exchange rate is necessary to ensure that increased spending falls primarily on foreign-made goods.2 Chart 5Interest Rates And Current Account Balances In An Open Economy On the flipside, capital will flow out of economies with low neutral rates, putting upward pressure on interest rates. A higher interest rate will lead to more savings and less investment, translating into a current account surplus. Countries with relatively low neutral rates will also see a real depreciation of their exchange rates. If there is complete free trade and capital mobility, the final equilibrium will be one where interest rates are equalized across all islands and the current account deficits of the islands with relatively high neutral rates are exactly offset by the current account surpluses of the islands with low neutral rates. In addition, countries with relatively high neutral rates will end up with exchange rates that appear somewhat overvalued relative to their fair value, while those with low neutral rates will have exchange rates that appear somewhat undervalued. U.S.-China Trade Tensions: An Inevitable Conflict There are many structural reasons why the U.S. and China are at loggerheads over trade these days. We predicted that Trump would win the presidency largely because we thought the political/media establishment was underestimating the importance of the populist wave sweeping across the U.S. and much of the world. Our geopolitical analysts share this view. They have also argued that China's growing economic, military, and technological prowess will inevitably put it into conflict with the U.S., which has been the world's sole hegemon ever since the Soviet Union collapsed.3 This week's report adds another structural reason to the list. While R-star in the U.S. is fairly low by historic standards, it is higher than in most other countries, reflecting America's favorable demographics, large fiscal deficit, and relatively spendthrift culture. This means that the U.S. must run a structural current account deficit. This, of course, is at odds with the Trump administration's stated objectives. Efforts by China or any other country to "talk up" their currencies in the hopes of placating Trump will fail. The U.S. economy is already operating at close to full employment. A weaker dollar would only shift the composition of spending towards domestically-produced goods. The U.S., however, does not have enough spare labor to produce these additional goods. All that would happen is that inflation would rise, rendering U.S. exporters less competitive. More stimulative fiscal policy will further increase the neutral rate of interest in the United States. Chart 6 shows that the budget deficit is set to widen to nearly 6% of GDP by 2019 even if the unemployment rate continues to decline. A larger budget deficit will drain national savings, shifting the savings schedule in the savings-investment diagram discussed earlier to the left. This will result in a bigger current account deficit (Chart 7). Chart 6The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Chart 7A Bigger U.S. Budget Deficit Will Cause The U.S. Neutral Rate To Rise, ##br## Leading To A Larger Current-Account Deficit Investment Considerations The specter of trade protectionism is here to stay, as is the prospect of escalating U.S.-China geopolitical tensions. Fortunately, beggar-thy-neighbor policies are less attractive when jobs are plentiful, as is the case in the U.S. today. Trump also remains constrained by the stock market's view of his actions. After all, this is a president who likes to measure the success of his economic agenda by the value of the S&P 500. As such, we expect both the U.S. and China to follow a two-pronged approach to trade issues over the coming months. Publicly, they will snipe at one another, threatening each other with tariffs and other trade barriers. Privately, they will seek out a compromise that avoids a full-out trade war. China's announcement this week that it will retaliate in kind to the U.S. decision to impose tariffs on $50 billion in Chinese imports should not have taken anyone by surprise. The Chinese government had repeatedly said that they would do precisely this. Importantly, U.S. tariffs do not kick in until June. Between now and then, negotiators from both sides will try to hammer out a deal. Just as with the steel and aluminum tariffs, the final set of tariffs will be a watered-down version of the original proposal. Political theatre will be the name of the game. As discussed in last week's Q2 Strategy Outlook, our base case remains that another global recession is still about two years away, which should keep the bull market in global equities intact.4 We warned investors to "Take Out Some Insurance" on February 2nd, one day before the VIX spike began.5 Now that the S&P 500 is 7% off its highs, our bet is that the path of least resistance for global equities over the next 12 months is up. Nevertheless, with global growth decelerating, financial conditions tightening at the margin, and the one-month ahead signal from the beta version of our forthcoming proprietary MacroQuant model stuck in bearish territory for the second month in a row, the tactical picture for stocks still looks rather murky (Chart 8). For the time being, short-term investors should sell the rallies and buy the dips. Chart 8MacroQuant Model: Tactical Picture For Stocks Still Looks Rather Challenging Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 2 The real exchange rate can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services. Mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in domestic prices relative to foreign prices. 3 Please see Geopolitical Strategy Special Report, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015; and Global Investment Strategy Special Report, “The Looming Conflict In The South China Sea,” dated May 29, 2012. 4 Please see Global Investment Strategy Q2 Strategy Outlook, “It’s More Like 1998 Than 2000,” dated March 30, 2018. 5 Please see Global Investment Strategy Weekly Report, “Take Out Some Insurance,” dated February 2, 2018, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades