Global

Feature Downside Risks Haven't Gone Away We downgraded risk assets to neutral in last month's Quarterly Portfolio Outlook,1 citing an increasing number of risks to the equity bull market. Specifically, we warned about the slowdown and desynchronization of global growth, rising U.S. inflation, further deterioration in the trade war, and the ongoing slowdown in China. Markets - particularly in the U.S. - have stabilized somewhat over the past few weeks on the expectation that these risks are not particularly grave, that global growth remains robust, and that central banks will be slow to tighten. We accept that there remain upside risks (which is why we are neutral, not underweight, equities) but think many investors remain too sanguine about the downside risks. On desynchronized growth, it is true that the slowdown in the euro zone seems to have bottomed. The Citi Economic Surprise Indexes (Chart 1) suggest that downward surprises to euro zone and Japanese growth have ended, and that the U.S. is no longer surprising significantly to the upside. However, the likely path of inflation in the two regions looks very different, with U.S. core PCE inflation likely headed towards 2.5% over the next few quarters, while euro zone core inflation is stuck around 1% (Chart 2). Table 1Recommended Allocation Chart 1A Resynchronization Of Growth? Chart 2Core Inflation: Higher In The U.S. Than In The Euro Zone In particular, we think it is only a matter of time before U.S. wages start to accelerate. Unemployment has not been this low since the late 1960s. As happened then, there is typically a lag between the labor market becoming tight and inflation emerging (Chart 3). With the employment/population ratio for the key working-age demographic now back close to its 2007 level (Chart 4), and 601,000 new entrants to the labor force last month alone, that point is probably not far away. Note, too, that people switching jobs are now seeing large wage rises; those staying are not (Chart 5). With strong corporate profit growth, companies will soon start to raise wages to keep staff and fill vacancies. Chart 3Just A Matter Of Time Before Inflation Accelerates Chart 4Little Slack Left In The Labor Market Chart 5Switchers Getting Wage Rises; Stayers Not This all suggests that markets are too nonchalant about the risk of further Fed tightening. The futures market is pricing in only four rate hikes from the Fed over the next 24 months (Chart 6). We think it likely that the Fed will continue to hike by 25 basis points a quarter until something gives. By contrast, the ECB has clearly signaled that it will wait until at least September next year before raising rates; when it does so, it may hike by only 10 basis points. The futures market is close to pricing this correctly (Chart 6, panel 2). We remain concerned about further exacerbation of the retaliatory tariff war. In late July, the European Union and President Trump seemed to agree a truce, especially with regard to auto tariffs. But, even if this proves more than transitory, it is unlikely to be repeated between the U.S. and China. Both sides have raised the stakes so much that it will be politically difficult for either to back down. Further aggressive moves are likely, including a 10% tariff on all USD500 billion of Chinese imports into the U.S, and the Chinese authorities engineering a further depreciation of the Chinese yuan, and making life difficult for U.S. companies that manufacture and sell in China (where their sales total USD350 billion). Businesses around the world have woken up to this risk: capex intentions among U.S. companies have slipped recently and, in the Global ZEW survey, future expectations are now the lowest relative to current conditions since 2007, a bearish indicator (Chart 7). Chart 6Fed Is Likely To Hike more Than This Chart 7Businesses Expect Things To Get Worse Moreover, we don't see China launching a massive reflationary stimulus, as it did in 2009 and 2015. In the past few weeks, it has announced some minor easing of monetary policy, targeted tax cuts, and an acceleration of this year's fiscal spending. This will be enough to cushion the downside. But interest rates have not fallen anything like as much as in previous episodes (Chart 8). The authorities have reiterated that structural reform remains the priority. Given the significant slowdown in credit growth over the past year, we expect a further deceleration in the Chinese industrial economy (and, therefore, in imports) through the end of the year. If our macro outlook is correct, it is likely to have the following consequences for financial markets: further rises in long-term interest rates (we forecast 3.3-3.5% for the 10-year U.S. Treasury bond yield by early 2019), a further appreciation of the U.S. dollar (as monetary policy divergences with the euro area and Japan widen further), and negative performance for emerging market assets (hurt by higher U.S. rates, the rising USD, and the slowdown in China). This points to small negative returns from global government bonds over the next 12 months. Equities are more complicated. Earnings growth remains strong. If S&P500 companies really achieve the 20% EPS growth this year and 10% next year that analysts (and BCA's models) are forecasting, the forward multiple will fall from 16.5x now to 14.0x by end-2019. We would expect to see low single-digit positive returns from global equities over the rest of the year. We accordingly remain neutral on equities, where we can see both upside and downside risks. One key is the timing of the peak in profit margins. This has typically come a few quarters before the start of a recession. Currently margins continue to improve (Chart 9). They are likely to peak around the end of this year, when wages (and input prices, partly because of higher import tariffs) begin to rise faster than sales. We expect to move underweight equities around that time, when this and other recession indicators start to flash warning signals. Chart 8Not 2015 Redux In China Chart 9Watch For The Peak In Profit Margins Currencies: The outlook for the USD remains the key to the performance of other asset classes, particularly emerging markets and commodities. We see the risk of a short-term pullback, since long speculative positions in the dollar have recently built up (Chart 10). But differences in growth, inflation, monetary policy, and long-term rates between the U.S. and other developed economies suggest further moderate dollar appreciation over the coming 12 months. We remain very negative on EM currencies. Central banks in many emerging markets have been forced to raise rates sharply in recent weeks to defend their currencies. This is likely to slow growth over coming quarters. Those central banks that have resisted hiking (for example, Turkey and Brazil) are likely to see sharp rises in inflation. Equities: We prefer developed market equities over emerging ones. Our two overweights are the U.S. and Japan. The U.S. is a defensive market, with a beta to global equities of only 0.9 over the past 20 years. But, if there were to be a last-year equity market melt-up (along the lines of 1999), it is likely to be led by internet stocks, in which the U.S. is particularly overweight, and so the U.S. overweight also acts as a hedge against this upside risk. Our overweight in Japan is based on our view that the Bank of Japan will continue its ultra-accommodative monetary policy (bolstered by the recent tweaks to the operation of the policy), even while other DM central banks are moving towards tightening. There are also some signs of wage growth picking up, which should be positive for consumer sectors. Fixed Income: We remain underweight bonds and, within the asset class, are neutral between government bonds and spread product. U.S. junk bonds continue to have some attraction as long as economic growth remains strong (and the oil price does not fall). But junk bonds typically peak one or two quarters before equities. And, in this cycle, U.S. corporate leverage began to rise rather early, which suggests that at the start of the next recession leverage will be worryingly high (Chart 11) and that junk bonds will, therefore, perform particularly poorly. Chart 10Dollar Long Positions Building Up Again Chart 11Leverage Is High For This Stage Of The Cycle Commodities: Oil has become much harder to forecast in recent weeks, with downside risk to the price of crude coming from the recently announced OPEC production increases, but upside risk from Iran (which is threatening to close the straits of Hormuz in the face of renewed U.S. sanctions) and the collapse in Venezuelan production. BCA's energy strategists see Brent falling a little to average USD70 a barrel in 2H, and at USD75 on average next year, with greater risk of upside surprises than downside.2 Industrial metals prices are likely to remain under pressure if the USD appreciates and China slows further, as evidenced by significant downside moves in copper, iron ore and other metals over the past few weeks. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Global Asset Allocation Quarterly Portfolio Review, "Lowering Risk Assets To Neutral," dated 2 July 2018, available at gaa.bcaresearch.com 2 Please see Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated 19 July 2018, available at ces.bcaresearch.com GAA Asset Allocation

Highlights Chart of the WeekTrade Fears Weighing On Ag Complex Bearish sentiment in ag markets is overdone. We believe prices have bottomed. But we are not yet ready to get bullish, given the elevated trade-policy uncertainty dominating markets at present. The evolution of grains and bean prices from here will depend on whether ongoing trade disputes between the U.S. and some of its largest ag markets are transitory or permanent (Chart of the Week). Highlights Energy: Overweight. We closed our Dec18 Brent $65 vs. $70/bbl call spread last week with a net gain of 80%. We remain long call spreads along the Brent forward curve in 2019, which are down an average 2.7%, and the SP GSCI, which is up 12.1%. Base Metals: Neutral. Aluminum prices are down ~ 1.6% in the past week, following indications from U.S. Treasury Secretary Steven Mnuchin sanctions against Russian aluminum supplier Rusal could be removed. Precious Metals: Neutral. Gold prices recovered slightly over the past week, but remain under pressure, given continued strength in the broad trade-weighted USD and real U.S. interest rates. We remain long gold as a portfolio hedge, nonetheless. Ags/Softs: Underweight. Fundamentals support higher grain and bean prices. However, trade-policy uncertainty - particularly re Sino - U.S. relations - will keep them under pressure (see below). Feature Weather-related uncertainty typically is center stage when it comes to forecasting ag prices during the growing season. This year, trade-policy uncertainty emanating from Washington will contend with weather risk as the dominant influence on prices. We do not expect ag-related trade policies to become more hostile. This means the path of ag prices will be contingent on whether the current trade disputes - primarily between the U.S. and China - are transient or permanent features of international trade. Given what we've seen already, we can expect American farmers will fare poorly in the ongoing trade spats. U.S. agricultural exports have been disproportionately hard hit by tariffs from their most important foreign consumer markets, levied in retaliation against U.S. tariffs (Chart 2). BCA Research's Geopolitical Strategy analysts assign a high probability to the escalation of current tensions into a full-blown trade war.1 Nevertheless, we believe the negative sentiment in ag markets is overdone, and that there is not much further downside from here. It is unsurprising that agriculture is a natural first target in this trade dispute. More than a quarter of U.S. crops are exported, with the share rising above 50% in many cases (Chart 3). This provides foreign consumers with ammunition in the dispute. Furthermore, these exports account for a large chunk of global ag trade, in some cases making American exports price makers in the global market. Importantly, many farmers and farm-belt voters cast ballots for Donald Trump. Chart 2American Ags Hit Hard##BR##By Trade Barriers... Chart 3...Because They Are Exposed##BR##To Foreign Markets The USDA's plans announced earlier this week to spend as much as $12 billion between September and end of harvest to help soften the impact of tariff retaliations against U.S. farm states loyal to Trump are not unexpected. The measures will entail (1) direct payments to soybean, sorghum, cotton, corn, wheat, dairy and pork farmers, (2) the procurement and subsequent re-distribution of ag products to nutrition programs, and (3) working with the private sector to promote trade and develop new export markets.2 Trade Spats Hit Grain Markets Hard Grain markets have been especially hard hit in the cross-fire between the U.S. and some of its key trade partners (Table 1). China's retaliatory tariffs are especially consequential, due to its outsized role as a main ag demand market. Table 1Ags Caught In The Crossfire All in all, the Thomson Reuters Equal Weight Grains & Oilseeds Index is down ~ 10% since end-May on the back of these tariffs. Soybeans lead the decline with a 17% loss. We have been foreshadowing this since the beginning of the year.3 Now that it's played out consistent with our previous expectations, it leaves us wondering "now what?" We see three potential scenarios unfolding in the ongoing trade skirmish: Scenario 1: The current tariffs remain in place with no significant increase in ag-relevant trade barriers.4 Scenario 2: The disputes peak soon, and de-escalate. In this scenario, tariffs imposed since the beginning of the year are reversed, ultimately leading to a free and now-fairer global trade order. Scenario 3: A complete breakdown in global trade. This scenario can take on a soft outcome whereby tariffs are increased, or to a more aggressive scenario, resulting in a seismic collapse in world trade agreements. The first two scenarios are clearly more optimistic. In Scenario 1, near-term downside to prices would be restrained, contingent on the responses of major ag consumers. We discuss their four main options and potential courses of action below. Scenario 2 is the most bullish, with price formation once again a function of supply-demand-inventory fundamentals. In this scenario, exogenous risks primarily stem from weather and U.S. financial variables. However, Scenario 3, in which a prolonged trade war pushes the global economy into a recession, would intensify the pain. This would lead to a contraction in the global flow of goods and services, reducing access to foreign markets. Additionally, it would hurt ag demand through the income channel. Consumption growth of ags is correlated with income growth. If the trade war bears down on incomes, it will reduce per-capita demand for ag commodities, which ultimately depresses prices. This is especially true in the case of lower income and emerging economies, where demand is more elastic. Impact Of Tariffs In face of higher costs brought on by U.S. tariffs, foreign buyers are essentially faced with four options: Reduce imports from the U.S., and opt to purchase more from other major producers; Reduce consumption of particular crops by substituting with others; Consume out of inventory, or Continue purchasing U.S. crops, but at a higher price. Chart 4Soybean Farmers Are Most Vulnerable Given the heightened risks surrounding the Sino-American trade dispute, we analyze these possibilities with reference to China. In addition, since soybeans are the most vulnerable of the crops hit by the trade dispute, we focus on beans, arguing that in most cases similar courses of action can be taken for other crops (Chart 4). Chinese authorities have already communicated that they plan to use options 1 - 3, and, as such, have assessed the impact of these restrictions on Chinese buyers to be minimal. Furthermore, according to a comment earlier this month by Lu Xiaodong, deputy general manager of state stockpile Sinograin, China is capable of fully meeting its needs without importing soybeans from the U.S.5 The extent to which buyers are successful in doing so will ultimately determine the overall impact of the trade dispute on U.S. ag markets. We expect China's solution will be a mélange of these four options. Below we assess these possibilities. Option 1: Chinese Buyers Are Turning To Other Major Producers An oft-noted change in Chinese purchasing behavior in reference to U.S. soybeans has been cited as the rationale for the negative sentiment towards U.S. ags. While it is true that Chinese buyers have been shunning American beans, the conclusion fails to recognize a few key points (Chart 5). Chart 5U.S. Soybean Exports Down On Weak Sales To China First, due to the difference in crop calendars - South American beans are harvested in spring while the U.S. crop is harvested in the fall - there is a clear seasonal pattern in China's purchasing behavior (Chart 6). Thus, greater Chinese imports of Brazilian soybeans are typical for this time of year. In addition, agricultural commodities are fungible, which means a reduction of China's imports of U.S. crops does not mean the U.S. crops will go to waste. While American crops are clearly trading at a disadvantage from the perspective of a Chinese buyer, there are still other foreign markets open to American ag exports. Now that these crops are selling at a discount, they have become much more competitive, incentivizing a shift in trade flows. This has already started - the U.S. has increased exports to consumers such as Egypt and Mexico, and even found soybeans buyers in Argentina and Brazil, both major producers of soybeans (Chart 7)! Chart 6Seasonality Is Partly To Blame Chart 7New Markets Opening Up For American Beans Option 2: China Will Adjust Its Feed Recipe China's decision to remove import tariffs on animal feed ingredients from Asian suppliers also highlights another policy route. To the extent possible, Chinese consumers will attempt to find substitutes for the now-more-costly U.S. imports. This includes supplies from alternative producers, and imports of substitute products. The potential from this option depends on the availability of close substitutes to replace ags exports affected by the Sino - U.S. trade dispute. In the case of soybeans, Chinese bean imports are crushed to produce meal and oil. The former is then used as a primary protein in livestock feed, while the latter is refined to be used in foods. Similarly, the majority of corn is also used as a critical ingredient in animal feed. As such, in face of higher costs, bean crushers will likely turn to meal from other protein substitutes such as rapeseed, peanuts and sunflower seeds. Nevertheless, soybean meal remains the optimal source of protein for livestock. Thus, while China will attempt to reduce its consumption of the tariff-laden U.S. ags, alternatives are not perfect substitutes. Consequently, this option does not completely eliminate the need for soybean imports. Option 3: Eat Into Ag Inventories Chart 8Chinese Stocks Will - Partially -##BR##Cushion The Blow Chinese ag inventories are relatively high and can cushion the blow to supply, at least temporarily (Chart 8). This means we may see a decline in Chinese stocks, on the back of drawdowns to fill in the gap left by lower imports from the U.S. While Beijing's stocks are notoriously large, there are reports that, in some cases, they are of low quality, and are unfit for human and animal consumption. Thus, this policy may appear more feasible on paper than in reality. Without accurate information regarding the size and quality of China's ag inventories, it is impossible to determine the potential of this option. Option 4: Absorb the Price Hike: Continue Importing - Now Pricier - U.S. Ags Chinese buyers likely will attempt to exhaust options 1 - 3 above, before resorting to purchasing now-pricier U.S. grains and beans. Nevertheless, it is inevitable - some U.S. ags will continue to flow to China. The relevant question - admittedly extremely difficult to quantify - is with regards to the magnitude of the impact. This essentially will depend on China's ability to use options 1 - 3, to avoid the now-higher import costs. While in the case of soybeans, U.S. exports have been shunned for now, the true test will come in the fall after the Brazilian harvest is over, and the market is flooded with the American crops. Furthermore, the 25% increase in costs due to the tariffs will, to some extent, be offset by the discount in the price of the American crops. Fundamentals Imply Higher Ag Prices While ag markets have taken several direct hits recently, we believe global fundamentals are not as bearish as current pricing conditions suggest. In the event there is a de-escalation of trade disputes - Scenario 2 above - prices will rebound to levels implied by fundamentals. While soybeans are expected to record a small surplus in the 2018 - 19 crop year, wheat and corn will be in a global deficit (Chart 9). Furthermore, global inventories - measured in stocks-to-use terms - are expected to come down. In the case of corn and soybeans, this will be the second consecutive annual decline (Chart 10). Chart 9Bullish Fundamentals On Back##BR##Of Corn And Wheat Deficits... Chart 10...And Falling##BR##Inventories In the corn market, the inventory drawdown is , to a large extent, driven by Chinese policy which is incentivizing the consumption of stocks by offering lower subsidies to corn farmers vs. soybeans, and through measures to encourage corn use for ethanol. This is expected to bring stocks down to levels last witnessed in the 1960s! On the other hand, U.S. soybean stocks are expected to continue increasing in line with lower demand for American beans by the world's largest soybean consumer (China). As always, weather is the biggest source of near term supply-side uncertainty. Wheat prices are supported by weather concerns in Europe - particularly the Black Sea region - which is damaging crops there. This is especially important given the expectation of a smaller crop there this year. Some Final Notes A couple of distinctions within the ags space reveals some ags are more vulnerable to the ongoing dispute than others. These are the number of sellers and the number of buyers in these markets. For instance, U.S. soybean exports have fewer foreign markets than corn, making them relatively more susceptible to downward price movements as supplies back up and are forced to find alternative markets. This is especially true since China is the single largest consumer of soybeans (Chart 11). Chart 11Global Wheat Market Relatively Insulated From Trade Frictions On the other hand, the global wheat market resembles a perfectly competitive market. This means that there are many buyers and sellers, each with limited ability to influence prices. Given that both the U.S. and China are price takers in this market, wheat prices will be relatively more insulated from trade headwinds. As such, we favor wheat in the current environment. Bottom Line: American farmers will be the losers in the still-evolving Sino - American trade disputes, as barriers are imposed on their exports, rendering them uncompetitive for their most significant foreign consumer. However, this will open markets for other global producers - most notably Brazil, Argentina, and the Black Sea region - making farmers there the winners in this dispute. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report titled "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 2 Please see "Factbox: USDA's $12 billion farmer relief package," dated July 24, 2018, available at reuters.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Reports titled "Ags Could Get Caught In U.S. Tariff Imbroglio," dated March 15, 2018, page 9 from "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, and "Ag Price Volatility Will Pick Up," dated May 3, 2018. 4 Our colleagues at BCA's Geopolitical Strategy team expect the trade dispute to intensify, especially before the mid-terms. However, tariffs already have been placed on most ag commodities we follow. This leaves little room for further risk from this direct channel, unless tariff rates are increased. 5 Please see "China does not need U.S. soybeans for state reserves: Sinograin official," dated June 12, 2018, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights President Trump has taken the next step in the trade war by charging some of America's major trading partners with outright currency manipulation. However, we are not headed for Plaza Accord 2.0, because neither the ECB nor the PBOC will re-orient policy until their own economic and inflation dynamics warrant it. Moreover, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. With the labor market showing signs of overheating, the Fed will stick with its current game plan and ignore President Trump's tweets. The worsening trade dispute is the key risk that investors face and there are growing signs that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Risk tolerance should be no more than benchmark. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that most risk assets will outperform bonds and other defensive sectors in the near term. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. The flattening U.S. yield curve is also worrying. We would not ignore the signal if the curve inverts, although there are reasons to believe that it is not as good a recession signal as it has been in the past. We wish to see corroborating evidence from our other favorite indicators before trimming risk asset exposure to underweight. A peak in the S&P 500 operating margin would be a strong sign that the end of the cycle is drawing close. Even if trade tensions soon die down and global growth holds up, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. High-quality bonds will of course outperform in the next recession, but yields are likely to rise in the meantime. We believe that U.S. Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields. We also like Agency CMBS. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. Feature We warned in last month's Overview that investors had not yet seen "peak pessimism" on the global trade front. Right on cue, President Trump raised the stakes again in July by threatening to impose tariffs on virtually all imports of Chinese goods. Congress is pushing the President to be tough on China because American voters have soured on trade. China will not easily back down with the authorities responding in kind to the U.S. President's trade threats. They have also allowed the RMB to depreciate to cushion the trade blow (Chart I-1). It is not clear whether the authorities purposely depressed the RMB or whether they simply failed to lean against market pressures. Either way, it is a dangerous approach because it has clearly raised the U.S. President's ire. Chart I-1RMB Is Much Weaker Across The Board President Trump has taken the next step in the broader trade war by charging some major trading partners with outright currency manipulation. The script appears to be following previous times that the U.S. sought trade adjustment via tariffs and currency re-alignment: the early 1970s and the 1985 Plaza Accord. Adjusting currencies on a sustained basis requires much more than simply "talking down" the dollar. There must be major changes in relative monetary and/or fiscal policies vis-à-vis U.S. trading partners. On the fiscal front, expansionary U.S. policy is working at cross purposes with the desire to have a weaker dollar and a smaller trade gap. We do not foresee the U.S. President having any success in changing the broad thrust of monetary policy either. Europe and Japan enjoyed booming economies in the early 1970s and mid-1980s, and thus had the luxury of placating the U.S. by adjusting monetary policy and thereby appreciating their currencies. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that generates major bull markets in their currencies. Neither the ECB nor the People's Bank of China (PBOC) will re-orient policy until their own economic and inflation dynamics warrant it.1 It is also unlikely that the Bank of Japan will raise the 10-year yield target to either strengthen the yen or to help bank profits. This is not Plaza Accord 2.0. Powell Isn't Arthur Burns As for the Fed, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. The Fed is more open and independent today than in the 1970s and 1980s. Even if Fed Chair Powell were amenable, any hint that he is being politically manipulated to change course would result in a bond market riot that would rattle investors to their core. More likely, the Fed will stick with its current game plan and ignore President Trump's tweets. Powell could not be any clearer in his July Congressional Testimony: "With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that-for now-the best way forward is to keep gradually raising the federal funds rate." Investors should not be fooled by the uptick in the U.S. unemployment rate in June. The rise reflected a pop in the labor force participation rate. However, the labor force figures are volatile and there is no upward trend evident in the participation rate. The real story is that the labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. The Employment Cost Index for private-sector workers shows that wage growth is accelerating. Moreover, the New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already jumped to almost 3 ½% (Chart I-2). Small businesses are increasingly able to pass on cost increases to consumers (Chart I-3). Chart I-2U.S. Inflation Is Percolating Chart I-3U.S. Pricing Power On The Rise The Minutes from the mid-June FOMC meeting included a lengthy discussion of the growing signs of inflation pressure and labor shortage. Firms are responding to the lack of qualified labor by offering training, automating, and boosting wages. Anecdotal evidence suggests that bottlenecks and other cost pressures are boiling over in the transportation sector. Despite an acute shortage of truck drivers, the average hourly earnings data do not show any acceleration in their wages (Chart I-4, second panel). However, these data do not include bonuses, which have been on the rise. The PPI for truck transportation services was up 7.7% year-over-year in June, while the Cass Freight Index that tracks full-truckload prices rose 15.9% year-over-year. The latter does not even include fuel costs. These pipeline cost pressures have implications not only for the Fed, but for corporate profit margins as well (see below). Chart I-4U.S. Transportation Is Boiling Over The U.S. Yield Curve: A Red Flag? The FOMC expects that the fed funds rate will continue to rise and will temporarily exceed its 2.9% estimate of the neutral rate. If the true neutral rate is higher than the Fed's estimate, then the FOMC could find itself hiking too slowly and the economy could severely overheat. And vice versa if the true neutral rate is below 2.9%. We are keeping a close eye on the yield curve as an indication of policy tightness. If the curve inverts with a few more Fed rate hikes, it would signal that the market believes that policy is turning restrictive. It is possible that the yield curve is not as good a recession signal as it has been in the past. First, there is a lot of uncertainty regarding the neutral fed funds rate in the post-GFC world. The collective market wisdom on this could be wrong. Indeed, BCA's Chief Global Strategist, Peter Berezin, makes the case that the neutral rate is rising faster than most investors believe.2 Structural factors have depressed the neutral rate, including population aging and low productivity growth. However, these structural tailwinds for bond prices are now slowly turning into headwinds. Moreover, as Peter argues, cyclical pressures are acting to lift the neutral rate. Private credit growth is rising faster than nominal GDP growth again. The same is true for housing and equity wealth, at a time when the personal saving rate is falling. All this implies strong desired spending which, in turn, suggests a higher neutral rate of interest. It will be important to watch the housing market; if it remains healthy in the face of rate hikes, it means that the neutral rate is still north of the actual fed funds rate. Chart I-5 presents today's market expectation for the real fed funds rate, based on the forward OIS curve and the forward CPI swaps curve. Technical issues may be distorting forward rates in 2019, but we are more interested in expectations further into the future. The real fed funds rate is expected to hover in the 55-75 basis point range until 2024. It then rises to about 1%, but not until almost the end of the next decade. This appears overly complacent to us, suggesting that the risks are to the upside for market expectations of the terminal, or neutral, short-term interest rate. If the neutral rate is indeed higher than the market is currently discounting, then an inverted curve may be premature in signaling that policy is too tight and that an economic slowdown is on the horizon. Moreover, the term premium on long-term bonds may still be depressed by asset purchases by the Fed and the other major central banks, again suggesting that the curve will more easily invert than in the past. There is much disagreement on this issue, even among FOMC members and among BCA strategists. This publication is sympathetic to the work done by the Fed Staff which suggests that the term premium has been substantially depressed by quantitative easing. Chart I-6 shows the annual change in the size of G4 central bank balance sheets (inverted), along with an estimate of the term premium in the 10-year government bonds of the major countries. The chart is far from conclusive, but it is consistent with the view that QE has depressed term premia worldwide. Moreover, forward guidance and the low level of inflation since the GFC have undoubtedly dampened interest-rate volatility, which theory suggests is a key driver of the term premium. Chart I-5Policy Rate Expectations Chart I-6Depressed Term Premiums ##br##Distort Yield Curves The factors that have depressed the term premium are beginning to reverse, including G4 central bank balance sheets. Still, the premium will trend higher from a low starting point, suggesting that an inverted curve today may not necessarily signal a recession. That said, it would be wrong to completely dismiss a U.S. curve inversion, given its excellent track record. Historically, the 3-month/10-year Treasury slope has worked better than the 2/10 yield slope in terms of calling recessions. An inversion of the 3-month/10-year curve has successfully heralded all seven recessions in the past 50 years with one false positive signal. Nonetheless, the curve tends to be very early, inverting an average of almost 12 months before the recession. And, given the possible distortion to the term premium, we would want to see corroborating evidence before jumping to the conclusion that an inverted curve is sending a correct recession signal. For example, the U.S. and/or global Leading Economic Indicator would need to turn negative. The bottom line is that a curve inversion would not be enough on its own to further trim risk asset exposure to underweight. Nonetheless, we are not dismissing the message from the yield curve either, especially in the context of a trade war that could prematurely end the expansion. Trade War Hitting Economy? Estimates based on macro models suggest that the damage to global GDP growth from higher tariffs would be quite small. Nonetheless, these models do not incorporate the indirect, or second-round, effects of rising tariff walls. Business leaders abhor uncertainty, and will no doubt hold off on major capital expenditure plans until the trade dust settles. The uncertainty can then ripple through the economy to industries that are not directly affected by the trade action. The extensive use of global supply chains reinforces this ripple effect. Labor is not free to move between countries or between industries to facilitate shifts in production that are required by changing tariffs. Capital is more mobile, but it is still expensive to shift machinery. Some of the world's capital stock could become "stranded", raising the cost of the tariffs to the world economy. Finally, important economies-of-scale are lost when firms no longer have access to a single large global market. This month's Special Report, beginning on page 18, sorts out the U.S. equity sector winners and the losers from a trade war with China. Spoiler alert: there are not many winners! The bottom line is that the trade threat for the global economy and risk assets is far from trivial. The negative trade headlines have not had a meaningful economic impact so far, but there are some worrying signs. A number of indicators suggest that global growth continues to slow, including the BCA Global Leading Economic Indicator diffusion index, the Global ZEW sentiment index and the BCA Global Credit Impulse index (Chart I-7). The softness in these indicators predates the latest flaring of trade tensions. Nonetheless, business confidence outside the U.S. has dipped (fourth panel). Growth in capital goods imports for an aggregate of 20 countries continues to decelerate, along with industrial production for capital goods and machinery & electrical equipment in the major advanced economies (production related to energy, consumer products and IT remain strong; Chart I-8). Chart I-7Global Growth Is Still Moderating... Chart I-8...In Part Due To Capital Spending None of these data are flagging a disaster, but they all support the view that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Even if trade tensions soon die down, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Late Cycle Investing Some of our economic and policy analysis over the past year has focused on previous late-cycle periods. Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment). This month we look at asset class returns during late cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart I-9). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM manufacturing index. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table I-1 presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the following recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in the margin to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart I-9Margin Peak Signals Very Late Cycle Table I-1Late-Cycle Asset Returns We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cases the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a six month horizon. Similar to Treasurys, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasurys after margins peaked and into the recession. High-yield bonds followed a similar pattern, but suffered negative absolute returns after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but relative performance was mixed after margins peaked. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value stocks before and after margins peaked, but tended to outperform in the recessions. Dividend Aristocrats performed well relative to the overall equity market after margins peaked and into the recessions on average, but the performance was not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge Funds are supposed to be able to perform well in any environment, but returns were a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured Product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns were attractive across all periods and cycles, except for Timberland during one of the recessions. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The historical return analysis underscores that it is dangerous to remain aggressively positioned late in an economic cycle because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears prudent. Based on this approach, investors should generally remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investors should scale back in most of these areas as soon as margins peak. For fixed income, investors should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. There are some assets other than government bonds that generated a positive average return late in the cycle and during the recession periods, suggesting that they are good late-cycle assets to hold. However, this is misleading because in some cases they experienced a significant correction either during or slightly before the recession (see the maximum drawdown columns in Table I-1; blank cells indicate that the asset did not experience a correction). These include IG credit, CMBS, ABS, Gold and Dividend Aristocrats. The only assets in our list that provided both a positive return across all the phases in Table I-1 and avoided a correction during the recessions, were mortgage-backed securities, Timberland and Farmland. A Special Report from BCA's Global Asset Allocation service found that Timberland is a superior inflation hedge to Farmland, but the latter is a superior hedge against recessions and equity bear markets.3 We believe that Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields (as long as the Treasury selloff is not extreme). Our fixed income team also likes Agency CMBS.4 When Will U.S. Margins Peak? It is impressive that S&P 500 after-tax operating margins are extremely elevated and still rising. The trend has been aided by tax cuts, but corporate pricing power has improved and wage growth has not yet accelerated enough to damage margins. Chart I-10 presents some indicators to monitor as we await the cyclical peak in profit margins. These are generally not leading indicators, but they do provide some warning when they roll over late in the cycle. The first is the BCA Margin Proxy, which is the ratio of selling prices for the non-financial corporate sector to unit labor costs. Margins have tended to fall historically when the growth rate of this ratio is below zero. The same is true for nominal GDP growth minus aggregate wages. The aggregate wage bill incorporates both changes in wages/hour and in total hours worked. We are also watching a diffusion index of the changes in margins for the industrial components of the S&P 500, as well as BCA's Corporate Pricing Power indicator. The latter takes into consideration price changes at the detailed industry level. Chart I-10U.S. Profit Margin Indicators To Watch None of these indicators are signaling an imminent top in margins, but all appear to have peaked except the Corporate Pricing Power indicator. An equally-weighted average of these four indicators, labelled the U.S. Composite Margin Indicator in Chart I-10, is falling but is still above the zero line. We would not be surprised to see S&P 500 margins peak for the cycle late early in 2019. Conclusions: The S&P 500 has so far been largely immune to shocking trade headlines with the help of a solid start to the U.S. Q2 earning season. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that investors should remain fully-exposed to most risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. These risks include a possible hard economic landing in China, crises in one or more EM countries, and an escalation in the trade war among others. Some investors appear to believe that the U.S. can "win" the trade war, but there are no winners when tariff walls are rising. We are not yet ready to go underweight on risk assets, but risk tolerance should be no more than benchmark. This includes equities, corporate bonds, EM assets and other risky sectors. An inversion of the yield curve could trigger a shift to underweight, although this signal would have to be corroborated by our other favorite U.S. and global indicators. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. The first statements by Jay Powell as FOMC Chair underscored that it is too early to hide in Treasurys. Market expectations for real short-term interest rates are overly benign out to the middle of the next decade. Moreover, the Fed is not in a position to be proactive in leaning against the negative impact of rising tariffs because inflation is near target and the labor market is showing signs of overheating. This means that bond yields are headed higher until economic pain is clearly evident. Keep duration short of benchmark. Long-term rate expectations for the Eurozone appear even more complacent than they do for the U.S. The real ECB policy rate is expected to remain in negative territory until 2028 (Chart I-5)! At some point there will be a convergence of real rate expectations with the U.S., which will boost the value of the euro. Nonetheless, we believe that it is too early to position for rate convergence. Core inflation is still well below target and Eurozone economic growth has softened recently, suggesting that the ECB will be in no hurry to lift rates once asset purchases have ended. ECB policymakers will be disinclined to cater to President's Trump's desire for tighter monetary policy in Europe, which means that the U.S. dollar has more upside versus the euro and in broad trade-weighted terms. An escalation in the trade war would augment upward pressure on the greenback. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. tend to attract capital inflows into the safe-haven Treasury market. Emerging market assets are particularly vulnerable to another upleg in the dollar because of the high level of U.S. dollar-denominated debt. Favor DM to EM equity markets and currencies. Mark McClellan Senior Vice President The Bank Credit Analyst July 26, 2018 Next Report: August 30, 2018 1 For more information on why a replay of the 1985 Plaza Accord is unlikely, please see BCA Geopolitical Strategy Weekly Report "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available on gps.bcaresearch.com 2 Please see BCA Global Investment Strategy Weekly Report "U.S. Housing Will Drive the Global Business Cycle...Again," dated July 6, 2018, available on gis.bcaresearch.com 3 Please see BCA Global Asset Allocation Service Special Report "U.S. Farmland & Timberland: An Investment Primer," dated October 24, 2017, available on gaa.bcaresearch.com 4 Please see BCA's U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem," dated July 17, 2018, available on usbs.bcaresearch.com II. U.S. Equity Sectors: Trade War Winners And Losers In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) Table II-3China Tariffs On U.S. Goods What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State Chart II-3Value Of U.S. Products Tariffed By China (By State) Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors Appendix Table II-2 Exports By U.S. Red States Appendix Table II-3 Exports By U.S. Swing States Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs III. Indicators And Reference Charts Our equity-related indicators flashed caution again in July, despite robust U.S. corporate earnings indicators. Forward earnings estimates continued to surge in July. The net revisions ratio and the earnings surprises index remained well above average, suggesting that forward earnings still have upside potential in the coming months. However, several of our indicators suggest that it is getting late in the bull market. Our Monetary Indicator is approaching very low levels by historical standards. Equities are still close to our threshold of overvaluation, at a time when our Composite Technical Indicator appears poised to break down. An overvalued reading is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Equity sentiment is close to neutral according to our composite indicator, but the low level of implied volatility suggests that investors are somewhat complacent. Our U.S. Willingness-to-Pay (WTP) indicator has fallen significantly this year, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a ‘sell’ signal in July. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. This month’s Overview section discusses the upside potential for the term premium in the yield curve and for market expectations of the terminal fed funds rate. This year’s dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but we still believe it has some upside while market expectations for the terminal fed funds rate adjust upward. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights FTSE100 = Overweight global Oil and Gas in pounds. Eurostoxx50 = Overweight global Banks in euros. Nikkei225 = Overweight global Industrials in yen. S&P500 = Overweight global Technology in dollars. Of these four sector and four currency components, we have more conviction right now on the four sectors than on the four currencies. Through the summer, our preferred ranking of the four sectors is: Technology, Banks and Industrials (tied), Oil and Gas. Which necessarily means that our preferred ranking of the major equity markets is: S&P500, Eurostoxx50 and Nikkei225 (tied), FTSE100. Chart I-1FTSE100 Vs. S&P500 = Global Oil And Gas In Pounds Vs. Global Tech In Dollars Feature Many investors cling to the notion that the relative performance of equity markets hinges on the relative economic performance of their regions of domicile. This might have been true thirty or forty years ago when the companies that dominated the mainstream indexes had an outsize exposure to the local economy. But those days are long gone. Today, the leading companies in the mainstream equity indexes are multinationals, whose sales and profits depend on the fortunes of the global economy rather than on the local economy. Equity Market Allocation Is All About Sectors And Currencies Let's face it, BP is not really a U.K. company, it is a global company which happens to be headquartered and listed in the U.K. Likewise, Apple is not really a U.S. company, it is a global company headquartered and listed in the U.S. And so on for the vast majority of mainstream index constituents. However, BP is most certainly an oil and gas company which moves in lockstep with the global energy sector; and Apple is most certainly a technology company which moves with the global tech sector. Hence, by far the most important performance differentiator for any mainstream equity index is the sector fingerprint that distinguishes the equity index from its peers. The sector fingerprints for the four major equity markets are: overweight oil and gas for the FTSE100, overweight banks for the Eurostoxx50, overweight industrials for the Nikkei225, and overweight technology for the S&P500 (Table I-1). Table I-1The Sector Fingerprints Of The Four Major Equity Markets To complete the story, there is another matter to consider: the currency. A multinational oil company like BP receives its revenues and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, there is a mismatch between BP's global business, denominated in multiple currencies, and the BP stock price, denominated in just one currency: the pound. The upshot is that if the pound strengthens, and all else is equal, the company's multi-currency profits will translate into fewer pounds and drag down the stock price. Conversely, if the pound weakens, the multi-currency profits will translate into more pounds and boost the BP stock price. Therefore, the channel through which the domestic economy can impact its stock market is the currency channel, but in a counterintuitive way: a strong economy tends to lift the currency and hinder the local stock market; a weak economy tends to depress the currency and help the local stock market. Combining the sector and currency drivers of equity market selection, we can summarize: FTSE100 = Overweight global Oil and Gas in pounds. Eurostoxx50 = Overweight global Banks in euros. Nikkei225 = Overweight global Industrials in yen. S&P500 = Overweight global Technology in dollars. The Proof Charts I-1 - I-6 show all six permutations of relative performances taken from the S&P500, Eurostoxx50, Nikkei225 and FTSE100 over the last decade. These charts should leave you in no doubt that the sector plus currency effect is all that you need to get right to allocate between these four major indexes. Chart I-2FTSE100 Vs. Nikkei225 = Global Oil And Gas In Pounds ##br##Vs. Global Industrials In Yen Chart I-3FTSE100 Vs. Eurostoxx50 = Global Oil And Gas In Pounds ##br##Vs. Global Banks In Euros Chart I-4Eurostoxx50 Vs. S&P500 = Global Banks In Euros ##br##Vs. Global Tech In Dollars Chart I-5Eurostoxx50 Vs. Nikkei225 = Global Banks In Euros ##br##Vs. Global Industrials In Yen Chart I-6S&P500 Vs. Nikkei225 = Global Tech In Dollars ##br##Vs. Global Industrials In Yen More recently also, the ranking of the four equity markets has tracked the ranking of the four 'fingerprint' sectors denominated in the respective currency. For example, at the end of May when oil and gas was briefly the top performing global sector this year, the FTSE100 was briefly the top performing major index. But both oil and gas and the FTSE100 have subsequently lost their leadership (Chart I-7 and Chart I-8). Chart I-7The Ranking Of The Four Major Sectors... Chart I-8... Explains The Ranking Of The Four Major Equity Markets One important implication of sectors and currencies driving stock market allocation is that the head-to-head comparison of stock market valuations is a meaningless exercise. Two sectors with vastly different structural growth prospects - say, oil and gas and technology - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Likewise, if investors anticipate the pound to ultimately strengthen - because they see that the pound is structurally cheap today - they might downgrade BP's multi-currency profit growth expectations in pound terms and trade the stock at an apparent discount. But allowing for the anticipated decline in other currencies versus the pound there is no discount. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. Another implication is that simple 'value' indexes may not actually offer value! In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem is that the whole concept of standard deviation assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations are 'non-stationary': they undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange. The Eight Components Of Equity Market Allocation So how to allocate right now? First, break down the allocation decision into its eight components comprising the four sectors: oil and gas, banks, industrials and technology, plus the four currencies: pound, euro, yen and dollar. Then focus on where you have the highest conviction views among these eight components. Through the summer, we have more conviction on the four sectors than on the four currencies. Classically growth-sensitive sectors are closely tracking the downswing in the global 6-month credit impulse which started early this year. Such mini-downswings consistently last around eight months which suggests that our successful underweight stance to the classical cyclicals remains appropriate through the summer (Chart I-9). Of the four sectors, this implies a relative preference for technology, which is the least sensitive to a global mini-downswing. But how to rank the remaining three cyclical sectors - banks, industrials and oil and gas? Since April there has been a very unusual directional divergence between the oil and gas sector which has rallied while banks and industrials have sold off (Chart I-10). Chart I-9The Underperformance Of Cyclicals ##br##Is Closely Tracking The Global 6-Month Credit Impulse Chart I-10Oil And Gas Has Diverged From Banks And Industrials The proximate cause is that oil's supply dynamics, rather than demand dynamics, are dominating its price action. Ultimately though, a higher price based on supply constraints without stronger demand is precarious - because the higher price threatens demand destruction. On the other hand, if global economic demand does reaccelerate, it is the beaten-down industrials and bank equity prices that have the catch-up potential. On this basis, our preferred ranking of the four sectors through the summer is: Technology Banks and Industrials (tied) Oil and Gas Which necessarily means that our ranking of the major equity markets is: S&P500 Eurostoxx50 and Nikkei225 (tied) FTSE100 A final point: you might have slightly (or very) different views on the four sectors and the four currencies. That's fine. But whatever those views are, plug them into the sector and currency based approach described in this report, as this is the right - and most successful - way to allocate among the major equity markets. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week, but we have six open positions. 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 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 Interest Rate

Highlights Global Yields: Flattening government yield curves in the developed world have raised concerns about a potential future growth slowdown. Yet real policy rates will need to move into positive territory before monetary policy becomes truly restrictive and curves invert. This means global bond yields have not yet peaked for this cycle. UST-Bund Spread: The U.S. Treasury-German Bund spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). UST Technicals: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains bearish. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Feature In most years, investment professionals can look forward to taking some well-deserved time off in July to hit the beach and read a good book. This year, those same investors are forced to keep an eye on their Bloombergs while responding to the public musings of Donald Trump. The president made comments late last week that threatened the independence of the Federal Reserve, while also accusing China and Europe of currency manipulation. While those headlines can briefly move markets on a sunny summer day, they represent more Trump-ian bluster than any potential change in the conduct of U.S. monetary or currency policy. Chart of the WeekCan Policy Be Truly "Tight"##BR##With Negative Real Rates? The underlying dynamic remains one of mixed global growth (strong in the U.S., slowing almost everywhere else) but with low unemployment and rising inflation in most major economies. That means that independent, inflation-fighting central bankers must focus on their inflation mandates. In the U.S., that means more Fed rate hikes and a firm U.S. dollar, regardless of the desires of President Trump - the author of the large fiscal stimulus, at full employment, which is forcing the Fed to continue hiking rates. In other countries, however, the economic backdrop is leading to varying degrees of central banker hawkishness. That ranges from actual rate hikes (Canada) to tapering of bond buying (Europe, Japan) to merely talking up the potential for rate increases (U.K., Sweden, Australia). The aggregate monetary policy stance of the major developed market central banks is now tilted more hawkishly. So it is no surprise that global government bond yield curves have been flattening and returns on risk assets have been underwhelming (Chart of the Week). Yet the reality is that all major global curves still have a positive slope, even in the U.S. and Canada where central banks have been most actively tightening, while real policy interest rates remain below zero. It would be highly unusual for yield curves to invert before real rates turned positive, especially if central bankers must move to an outright restrictive stance given tight labor markets and rising realized inflation. This implies that there is more scope for global bond yields to rise over the next 6-12 months. We continue to recommend that investors maintain a defensive overall duration stance ... and to focus more on that good book on the beach and less on Trump's Twitter feed. Where To Next For The Treasury-Bund Spread? Chart 2A Pause In The Rising Yield Trend,##BR##Not A Reversal The rise in bond yields in both the U.S. and euro area seen in the first quarter of 2018 has been partly reversed since then. One of the culprits has been a stalling of the rally in oil markets, which has prompted a pause in the rise of inflation expectations on both sides of the Atlantic (Chart 2). Yet another factor has been the larger decline in real bond yields, which have fallen around 20bps in the both the U.S. and euro area since the peak in mid-May (bottom two panels). A potential driver of those lower real yields is the growing concern over the potential hit to global growth from rising trade tensions between the U.S. and China (and Europe, Canada, Mexico, etc). This comes at a time when China's economic growth was already slowing and acting as a drag on global trade activity and commodity prices. There has been significant weakness in China's currency and equity market of late, which raises the specter of another broader global selloff as occurred during the Chinese turbulence of 2015/16. Yet the declines in industrial metals prices and emerging market corporate debt have been far more modest so far in 2018 (Chart 3). A big reason for that has been the more subdued performance of the U.S. dollar this year, unlike the massive surge in 2015/16 that crushed risk assets worldwide (Chart 4). A more likely driver of the recent drop in real yields in the U.S. and core Europe was the slump in euro area economic data earlier in 2018. That move not only drove yields lower, but also pushed out the market-implied timing of the first ECB rate hike (Chart 5) and drove the spread between U.S. Treasuries and German Bunds to new wides. In our last Weekly Report, we updated our list of indicators in the U.S. and euro area that we have been monitoring to assess if our below-benchmark duration stance was still appropriate.1 The conclusion was that the underlying trends in growth and inflation on both sides of the Atlantic still supported higher bond yields on a cyclical basis, although the pressures were greater in the U.S. Yet at the same time, the gap between U.S. and euro area government bond yields has remained historically wide, with the 10-year Treasury-German Bund spread now sitting at 255bps - the highest level since the late 1980s. Chart 3Slowing Growth##BR##In China... Chart 4...But Not Yet Enough To Threaten##BR##Global Financial Stability Monetary policy differences have historically been the biggest driver of that spread. Today, the Fed is well into an interest rate hiking cycle that began nearly three years ago, and is now in the process of unwinding its balance sheet. Meanwhile, the ECB has been keeping policy rates at or below 0% while engaging in large-scale bond buying (Chart 6). Chart 5A Turn In European Yields##BR##On The Horizon? Chart 6Wide UST-Bund Spread Reflects##BR##Monetary Policy Divergences When looking at more typical fundamental drivers of the Treasury-Bund spread, many of the cross-regional differences are already "in the price". The spread appears to have overshot relative to the three main factors that go into our Treasury-Bund spread valuation model (Chart 7): The gap between Fed and ECB policy rate The ratio of the U.S. unemployment rate to the euro area equivalent The gap between headline inflation in the U.S. and euro area The Fed's rate hikes have now widened the policy rate differential versus the ECB equivalent (the short-term repo rate) to 200bps. At the same time, the rapidly improving situation in the euro area labor market now means that the unemployment ratio has been constant over the past couple of years, while euro area inflation has also caught up a bit toward U.S. levels in recent months. Adding it all up together in our Treasury-Bund valuation model - which also includes the sizes of the Fed and ECB balance sheets to quantify the impact on yields of bond-buying programs - and the conclusion is that the current spread level of 255bps is 50bps above "fair value" (Chart 8). Chart 7UST-Bund Spread Overshooting Fundamentals Chart 8UST-Bund Spread Looks Wide On Our Model Importantly, fair value is still rising, primarily because of the widening policy rate differential. We have consistently argued that the true cyclical peak in the Treasury-Bund spread will occur when the Fed is done with its rate hike cycle. Yet there are opportunities to play that spread more tactically, based on shorter-term indicators. For example, the gap between the data surprise indices for the U.S. and euro area has been a correlated to the momentum of the Treasury-Bund spread, measured as the 13-week change of the level of the spread (Chart 9). Data surprises are now bottoming out in the euro area while they continue to drift lower in the U.S. As a result, the Treasury-Bund spread momentum has begun to fade, right in line with the narrowing of the data surprise differential. Also from a more technical perspective, the deviation of the Treasury-Bund spread from its 200-day moving average is at one of the more stretched levels of the past decade. Combined with the extended spread momentum, this suggests that the Treasury-Bund spread should expect to see a period of consolidation in the next few months (Chart 10). Chart 9Relative Data Surprises No Longer##BR##Support A Wider UST-Bund Spread Chart 10UST-Bund Spread Momentum##BR##Got To Stretched Extremes We have been recommending both a structural short U.S./long core Europe position in our model bond portfolio for over a year now. We also entered into a trade that directly played for a wider 10-year Treasury-Bund spread in our Tactical Trade portfolio. We initiated that recommendation on August 8th, 2017 when the spread was at 162bps. With the spread now at 255bps, we are now closing out that recommendation this week, taking a profit of 7% (inclusive of the gains from hedging the Bund exposure into U.S. dollars).2 At the same time, we feel that it is too early to position for a narrowing of the Treasury-Bund spread. The large U.S. fiscal stimulus will continue to put upward pressure on U.S. bond yields over the next year, both through higher U.S. inflation and the associated need for tighter Fed policy. Already, the Treasury-Bund spread reflects both the relatively larger dearth of spare capacity in the U.S. economy (Chart 11) and the expected widening of the U.S. federal budget deficit compared to reduced deficits in the euro area (Chart 12). Much like the rise in the fair value of the Treasury-Bund spread, this suggests that there is limited downside for the spread on a more medium-term basis. Chart 11UST-Bund Spread Narrowing Will Be##BR##Limited By Faster U.S. Growth... Chart 12...The Result Of Looser##BR##U.S. Fiscal Policy We are taking profits on our tactical spread based on our read of all of our relevant indicators. There is a good chance, however, that we could consider re-entering a spread widening trade on any meaningful narrowing of the spread or adjustment in our indicators. Bottom Line: The fundamental drivers of the 10-year U.S. Treasury-German Bund spread continue to point to the spread staying wide over the next 6-12 months. Yet the spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). A Quick Update On U.S. Treasury Market Technicals One of the overriding aspects of the U.S. Treasury market over the past few months has been the stretched technical backdrop. The combination of oversold price momentum, bearish sentiment and aggressive short positioning have helped keep yields in check, even as U.S. growth and inflation accelerate and the Fed continues to signal more future rate hikes. Back in March, we presented a study of previous episodes of an oversold U.S. Treasury market since the year 2000.3 Our goal was to determine how long it typically took for a resolution of oversold Treasury market conditions. Unsurprisingly, we concluded that the longest episodes of oversold Treasuries occurred when U.S. economic growth and core inflation were both accelerating, and vice versa. At the time of that report, all of the technical indicators that we looked at were signaling that Treasury bearishness was deeply entrenched (Chart 13). Now, four months later, there has been some change in those indicators: Chart 13UST Technical Indicators##BR##Are More Mixed Now The 10-year Treasury yield relative to its 200-day moving average: then, +43bps; now, +18bps The trailing 26-week total return of the Bloomberg Barclays U.S. Treasury index: then, -4.3%; now, -0.6% The J.P. Morgan client survey of bond managers and traders: then, very large underweight duration positioning; now, positioning is neutral The Market Vane index of bullish sentiment for Treasuries: then, near the bottom of the range since 2000; now, still near that same level The CFTC data on speculator positioning in 10-year U.S. Treasury futures: then, a large net short of -8% (scaled by open interest); now, still a large net short of -11%. Therefore, the message from the technical indicators is more mixed now than in March. Price momentum and duration positioning is now neutral, while sentiment and speculative positions remain stretched. The former suggests that there is scope for Treasury yields to begin climbing again, while the latter implies that there may still be room for some counter-trend short-covering Treasury rallies in the near term. In our March study, we defined the duration of each episode of an oversold Treasury market by the following conditions: The start date was when the 10-year Treasury yield was trading at least 30bps above its 200-day moving average and the Market Vane Treasury bullish sentiment index dipped below 50; The end-date was when the yield declined below its 200-day moving average. The details of each of those episodes can be found in Table 1. This is the same table that we presented back in March, but we have now added the current episode. At 150 days in length, this is already the fourth longest period of an oversold Treasury market since 2000. Yet perhaps most surprising is the fact that Treasury yields are essentially unchanged since the start date of the current episode (March 20th, 2018). There is no other period in our study that where yields did not decline while the oversold market resolved itself. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market Perhaps this can be interpreted as a sign that there is still scope for a final short-covering Treasury rally before this current oversold episode can truly end. Yet as we concluded in our March study, it took an average of 156 days for an oversold market to be fully corrected if U.S. growth was accelerating (i.e. the ISM manufacturing index was rising) and core PCE inflation were both rising at the same time - as is currently the case (Chart 14). Chart 14U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing The longest such episode in 2003/04 lasted for 203 days before the 10-year yield fell below its 200-day moving average. Yet the second longest episode (196 days) occurred in 2013/14, and Treasury yields ended up climbing to a new cyclical high before eventually peaking. Given the underlying positive momentum in both U.S. economic growth and inflation, but with a mixed message from the technical indicators, we suspect that this current oversold episode may have further to run. Yet as we concluded back in March, and still believe today, it will prove difficult to earn meaningful returns betting on a counter-trend decline in yields this time, as any such move will likely be modest in size and lengthy in duration. Bottom Line: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains very bearish and there are large speculative short positions. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Trendless, Friendless Bond Market", dated July 17th 2018, available at gfis.bcaresearch.com. 2 The return on this trade is calculated using the Bloomberg Barclays 7-10-year government bond indices for the U.S. and Germany, adjusted for duration differences between the indices. The German return is hedged into U.S. dollars, as this trade was done on a currency-hedged basis. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering From Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Chart 11Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Chart 13Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights Rising non-OPEC production and the Trump administration's successful efforts at jawboning OPEC into increasing oil production - including a not-so-subtle threat that American protection of the Cartel's Gulf Arab producers would be withheld if production weren't ramped - will keep oil prices under pressure in 2H18. Markets could become chaotic in 2019: Iran's capacity to close the Strait of Hormuz - discussed below in this Special Report written jointly by BCA's Commodity & Energy Strategy and Geopolitical Strategy - cannot be dismissed. An extended closure of the Strait - our most dire scenario - could send prices on exponential trajectories: In one simulation, above $1,000/bbl. We are keeping our forecast for 2H18 Brent at $70/bbl, unchanged from June, and lowering our 2019 expectation by $2 to $75/bbl. We expect WTI to trade $6/bbl below Brent. Rising geopolitical uncertainty will widen the range in which oil prices trade - i.e., it will lift volatility. Energy: Overweight. We are moving to a tactically neutral weighting, while maintaining our strategic overweight recommendation. We are closing our Dec18 Brent $65 vs. $70/bbl call spread but are retaining long call-spread exposures in 2019 along the Brent forward curve. Base Metals: Neutral. Contract renegotiations at Chile's Escondida copper mine are yet to be resolved. The union rejected BHP's proposal late last week, and threatened to vote for a strike unless substantial changes were made. Failure to reach a labor deal at the Escondida mine led to a 44-day strike last year, and an extension of the contract. This agreement expires at the end of this month. Precious Metals: Neutral. Increasing real rates in the U.S. and a stronger USD are offsetting safe-haven demand for gold, which is down 10% from its 2018 highs of $1360/oz. Ags/Softs: Underweight. The Chinese agriculture ministry lowered its forecast for 2018/19 soybean imports late last week to 93.85 mm MT from 95.65 mm MT. This is in line with its adjustment to consumption this year, now forecast at 109.23 from 111.19 mm MT. Tariffs are expected to incentivize Chinese consumers to prefer alternative proteins - e.g., rapeseed - and to replace U.S. soybean imports with those from South America. Feature U.S. President Donald Trump jawboned OPEC Cartel members - particularly its Gulf Arab members - into raising production. This was accompanied with a none-too-subtle threat implying continued U.S. protection of the Gulf Arab states was at risk if oil production were not lifted.1 OPEC, particularly KSA, responded by lifting production and pledging to keep it at an elevated level. In addition, non-OPEC production growth has been particularly strong this year, and will remain so. These combined production increases will contribute to a modest rebuilding of inventories in 2H18, as markets prepare for the loss of as much as 1 MMb/d of Iranian oil exports beginning in November (Chart of the Week). Chart of the WeekOECD Inventory##BR##Depletion Will Slow Chart 2Global Balances Will Loosen,##BR##As Higher Supply Meets Steady Demand Estimated 2H18 total OPEC production rose a net 130k b/d, led by a 180k b/d increase on the part of KSA, which will average just under 10.6 MMb/d in the second half of the year. Non-OPEC production for 2H18 was revised upward by 180k b/d in our balances models - based on historical data from the U.S. EIA and OPEC - led by the U.S. shales, which were up close to 700k b/d over 1Q18 levels. This led to a combined increase in global production of 310k b/d in 2H18. With demand growth remaining at 1.7 MMb/d y/y for 2018 and 2019, we expect the higher output from OPEC and non-OPEC sources to loosen physical balances in 2H18 (Chart 2 and Table 1).2 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) In and of itself, increased production will reverse some of the depletion of OECD inventories targeted by OPEC 2.0 in its effort to rebalance the market. All else equal, this would be bearish for prices. However, we are keeping our price forecast for 2H18 unchanged from last month - $70/bbl for Brent in 2H18 - and lowering our expectation for Brent to $75/bbl in 2019. This adjustment in next year's expectation reflects our belief that this round of increased production by OPEC 2.0 arguably is being undertaken specifically to rebuild storage ahead of the re-imposition of export sanctions by the U.S. against Iran. Re-imposing sanctions unwinds a deal negotiated by the U.S. and its allies in 2015, which relaxed nuclear-related sanctions against Iran in exchange for commitments to scale back its involvement across the Middle East in the affairs of Arab states with restive Shia populations.3 The re-imposition of sanctions by the U.S. against Iran has set off a round of diplomatic barbs and thrusts on both sides. President Trump declared he wanted Iran's oil exports to go to zero, which was followed by Iran's threat to close the Strait of Hormuz. This set oil markets on edge, given that close to 20% of the world's oil flows through the Strait on any given day.4 Geopolitics Reasserts Itself In The Gulf Oil prices will become increasingly sensitive to geopolitical developments, particularly in the Gulf, now that the U.S. and its allies - chiefly KSA - and Iran and its allies are preparing to square off diplomatically, and possibly militarily. This will lead to a wider range in which oil will trade - i.e., we expect more significant deviations from fundamentally implied values, as markets attempt to price in highly uncertain outcomes to political events.5 Tensions around the Strait of Hormuz - discussed below - will remain elevated post-sanctions being re-imposed, even if we only see threats to traffic through this most-important oil transit. Chart 3 shows that in periods when the error term of our fundamental econometric model increases, it typically coincides with higher implied volatilities. Specifically, the confidence interval around our fundamental-based price forecast widens in times of heightened uncertainty and volatility. The larger the volatility, the larger the squared deviation between our fitted Brent prices against actual prices.6 This indicates the probability of ending 2H18 exactly at our $70/bbl target is reduced as mounting upside - e.g. faster-than-expected collapse in Venezuelan crude exports, rising tensions around the Strait of Hormuz or larger-than-expected Permian pipeline/production bottlenecks - and downside - e.g. escalating U.S.-Sino trade war tensions, increasing Libyan and Nigerian production - risks push the upper and lower bounds around our forecast further apart. Chart 3Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range This directly translates into a wider range in which prices will trade - uncertainty is high, and, while it is being resolved, markets will remain extremely sensitive to any information that could send prices on an alternative path (Chart 4). Chart 4Greater Geopolitical Uncertainty Widens Oil Price Trading Range Risks related to a closure of the Strait are not accounted for in our forecasts. However, given the magnitude of the risks implied by even the remote possibility of a closure, we expect markets will put a risk premium into prices. In an attempt to frame out price estimates from a short (10-day) and long (100-day) closure, we provide some cursory simulation results below.7 Can Iran Close The Strait Of Hormuz? The Strait of Hormuz, through which some 20% of global oil supply transits daily, is the principal risk that will keep markets hyper-vigilant going forward.8 A complete closure of the Strait of Hormuz (Map 1) would be the greatest disruption of oil production in history, three times more significant than the supply loss following the Islamic Revolution in 1979 (Chart 5). By our estimate, a 10-day closure at the beginning of 2H19 could pop prices by ~ $25/bbl. A 100-day closure could send prices above $1,000/bbl in our estimates. Map 1Iran Threatens Gulf Shipments Again Chart 5Geopolitical Crises And Global Peak Supply Losses So, the question naturally arises, can Iran's forces close the Strait? Iran's ability is limited by structural and military factors, but it could definitely impede traffic through the globe's most crucial energy chokepoint. There are two scenarios for the closure of the Strait: (i) Iran does so preemptively in retaliation to crippling economic sanctions; or (ii) Iran does so in retaliation to an attack against its nuclear facilities. Either scenario is possible in 2019, as the U.S. intends to re-impose sanctions against Iranian oil exports on November 9, a move that could lead to armed conflict if Iran were to retaliate (Diagram 1).9 Diagram 1Iran-U.S. Tensions Decision Tree SCENARIO I - Preemptive Closure In the past, Tehran has threatened to preemptively close the Strait of Hormuz whenever tensions regarding its nuclear program arose. The threats stopped in mid-2012, as U.S. and Iranian officials engaged in negotiations over the country's nuclear program. However, on July 4 of this year, Iran's nominally moderate President Hassan Rouhani pledged that Tehran would retaliate to an oil export embargo by closing the Strait. Rouhani's comments were reinforced on July 5 by the commander of Iran's elite Revolutionary Guards, whose forces patrol the Strait, Mohammad Ali Jafari. Could Iran actually impede traffic through the Strait of Hormuz?10 Yes. Our most pessimistic scenario posits that Iran could close the waterway for about three or four months. This is based on three military capabilities: mines, land-based anti-ship cruise missiles (ASCM), and a large number of small boats for suicide-like attack waves. In our pessimistic scenario, we assume that Iran would be able to deploy about 700 mines and threaten the Strait by firing only one anti-ship cruise missiles (ASCM) operated via land-based batteries or ship per day, in order to prolong the threat.11 In that way, Iran could draw out the threat indefinitely. The length of closure is based on how long it would take the U.S. naval assets in the region to clear the mines, establish a Q-route - corridor within which the probability of hitting a mine is below 10% - and locate ASCM radars and batteries. The pessimistic scenario is unlikely to occur because of several countermeasures that the U.S. and its regional allies could employ - anti-mine operations, meant to clear a so-called Q route allowing safe passage of oil tankers under U.S. naval escort; punitive retaliation, which would inflict punitive damage on Iran's economy and infrastructure; and, lastly, Iran would not want to risk exposing its radar-guided anti-ship missiles to U.S. suppression of enemy air-defense (SEAD) operations that seek and destroy radars. Despite Iran's growing capability, we still posit that its forces would only be able to close the Strait of Hormuz for between three-to-four months. However, the more likely, "optimistic," scenario is that the closure itself lasts 7-10 days, while Iran then continues to threaten, but not actually close, the Strait for up to four months. It would be worth remembering that the U.S. has already retaliated against a potential closure, precisely 30 years ago. Midway through the Iran-Iraq war, both belligerents began attacking each other's tankers in the Gulf. Iran also began to attack Kuwaiti tankers after it concluded that the country was assisting with Iraq's war efforts. In response, Kuwait requested U.S. assistance and President Ronald Reagan declared in January 1987 that tankers from Kuwait would be flagged as American ships. After several small skirmishes over the following year, the USS Samuel B Roberts hit a mine north of Qatar. The mine recovered was linked to documents found by the U.S. during an attack on a small Iranian vessel laying mines earlier in 1987. The U.S. responded by launching Operation Praying Mantis on April 18, 1988. During the operation, which only lasted a day, the U.S. navy seriously damaged Iran's naval capabilities before it was ordered to disengage as the Iranians quickly retreated. Specifically, two Iranian oil platforms, two Iranian ships, and six gunboats were destroyed. The USS Wainwright also engaged two Iranian F-4s, forcing both to retreat after one was damaged. From this embarrassing destruction of Iran's naval assets, the country realized that conventional capabilities stood little chance against a far superior U.S. navy. As a result, Iran has strengthened its asymmetrical sea capabilities, such as the use of small vessels, and has made evident that the use of mines would be integral to its engagements with foreign navies in the Gulf. However, the switch to asymmetrical warfare means that Iran would likely threaten, rather than directly close, the Strait. From an investment perspective, the threat to shipping would have to be priced-in via higher insurance rates. According to research by the University of Texas Robert S. Strauss Center, the insurance premiums never rose above 7.5% of the price of vessel during the 1980s Iran-Iraq war and actually hovered around 2% throughout the conflict. Rates for tankers docking in Somali ports, presumably as dangerous of a shipping mission as it gets, are set at 10% of the value of the vessel. A typical very large crude carrier (VLCC) is worth approximately $120 million. Adding the market value of two million barrels of crude would bring its value up to around $270 million at current prices. If insurance rates were to double to 20%, the insurance costs alone would add around $30 per barrel, $15 per barrel if rates stayed at the more reasonable 10%. This is without factoring in any geopolitical risk premium or direct loss of supply of Iran's output due to war. Bottom Line: Iran's military capabilities have increased significantly since the 1980s when it last threatened the shipping in the Strait. Iran has also bolstered its asymmetric capabilities since 2012, while the U.S. has largely remained the same in terms of anti-mine capabilities. If Iran had the first-mover advantage in our preemptive closure scenario, the most likely outcome would be that it could close the Strait for up to 10 days and then threaten to close it for up to four months in total. SCENARIO II - Retaliatory Closure A retaliatory closure is possible in the case of a U.S. (or Israeli) attack against Iran's nuclear facilities. Following from the military analysis of a preemptive closure, we can ascertain that a retaliatory closure would be far less effective. The U.S. would deploy all of its countermeasures to Iranian closure tactics as part of its initial attack. If Iran loses its first-mover advantage, it is not clear how it would lay the mines that are critical to closing the Strait. Iran's Kilo class submarines, the main component of a covert mine-laying operation, would be destroyed in port or hunted down in a large search-and-destroy mission that would "light up" the Strait of Hormuz with active sonar pings. The duration of the closure could therefore be insignificant, even non-existent. The only potential threat is that of Iran's ASCM capability. Iran would be able to use its ASCMs in much the same way as in the preemptive scenario, depending on the rate of fire and rate of discovery by U.S. assets. Bottom Line: It makes a big difference whether Iran closes the Strait of Hormuz preemptively or as part of a retaliation to an attack. The U.S. would, in any attack, likely target Iran's ability to retaliate against global shipping in the Persian Gulf. As such, Tehran's asymmetric advantages would be lost. Putting It All Together - Can Iran Close The Strait? Our three scenarios are presented in Table 2. Iran has the ability to close the Strait of Hormuz for up to three-to-four months. That "pessimistic" scenario, however, is highly unlikely. The more likely scenarios are the "preemptive optimistic" and retaliatory scenarios. Table 2Closing The Strait Of Hormuz: Scenarios Assessing the price implications of these scenarios is extremely difficult. Even though the "preemptive optimistic" and the "retaliatory" scenarios are short-lived, up to 20% of the world's daily demand would be removed from the market in the event the Strait of Hormuz was closed. Of course, the U.S. would release barrels from its 660mm-barrel Strategic Petroleum Reserve (SPR) - likely the full maximum of 30 million barrels authorized under law, released over 30 days for a 1 MMb/d release - and Europe would also release ~ 1 MMb/d or so from its crude and product stocks. China likely would tap its SPR as well for 500k b/d. In addition, there is ~ 2 MMb/d of spare capacity in OPEC, which could be brought on line in 30 days (once the Strait is re-opened), and delivered for at least 90 days. How and when a closure of the Strait of Hormuz occurs cannot be modeled, since, as far as prices are concerned, so much depends on when it occurs, and its duration. For this reason, and the extremely low probability we attach to any closure of the Strait, we do not include these types of simulations in our analysis of the various scenarios we include in our ensemble. That said, it is useful to frame the range implied by the scenarios above. We did a cursory check of the impact of scenarios 1 and 2 above, in which we assume 19 MMb/d flow through the Strait is lost for 10 days and 100 days due to closure by Iran in July 2019. We assume this will be accompanied by a 2 MMb/d release from various SPRs globally. In scenario 1, the 10-day closure of the Strait lifts price by $25/bbl, and is resolved in ~ 2 months, with prices returning to ~ $75/bbl for the remainder of the year. In scenario 2, the Strait is closed for 100 days, and this sends prices to $1,500/bbl in our simulation. This obviously would not stand and we would expect the U.S. and its allies - supported by the entire industrialized world - would launch a powerful offensive to reopen the Strait. This would be extremely destructive to Iran, which is why we give it such a low probability. Bottom Line: While the odds of a closure of the Strait of Hormuz are extremely low - to the point of not being explicitly modeled in our balances and forecasts - framing the possible outcomes from the scenarios considered in this report reveals the huge stakes involved. A short closure of 10 days could pop prices by $25/bbl before flows are restored to normal and inventory rebuilt, while an extended 100-day closure could send prices to $1,500/bbl or more. Because the latter outcome would result in a massive offensive against Iran - supported by oil-consuming states globally - we view this as a low-probability event. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 President Trump's tweets calling for higher oil production have consistently been directed at the original OPEC Cartel, as seen July 4: "The OPEC monopoly must remember that gas prices are up & they are doing little to help. If anything, they are driving prices higher as the United States defends many of their members for very little $'s. This must be a two way street. REDUCE PRICING NOW!" Since the end of 2016, we have been following the production and policy statements of OPEC 2.0, the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 We will be exploring the rising risks to our demand projections in future research. Still, we are in broad agreement with the IMF's most recent assessment of global economic growth, which remains at 3.9% p.a. Please see "The Global Expansion: Still Strong but Less Even, More Fragile, Under Threat," published July 16, 2018, on the IMF's blog. 3 We discuss this at length in the Special Report we published with BCA's Geopolitical Strategy on June 7, 2018, entitled "Iraq Is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. 4 In an apparent recognition of what it would mean for world oil markets if Iran's exports did go to zero - particularly with Venezuela so close to collapse, which could take another 800k b/d off the market - U.S. Secretary of State Mike Pompeo announced waivers to the sanctions would be granted, following Trump's remarks at the beginning of July. See "Pompeo says US could issue Iran oil sanctions waivers" in the July 10, 2018, Financial Times. The Trump administration, however, is keeping markets on their toes, with Treasury Secretary Steven Mnuchin telling the U.S. Congress, "We want people to reduce oil purchases to zero, but in certain cases, if people can't do that overnight, we'll consider exceptions." See "Iran sues US for compensation ahead of re-imposition of oil sanctions," published by S&P Global Platts on July 17, 2018, on its spglobal.com/platts website. 5 Technically, this means the confidence interval around the target is now wider, which implies high probability of going above $80/bbl as well as the probability of going under $70/bbl. Still, the 2019 risks are skewed to the upside, in our view. 6 Given that our model is based solely on a variety of fundamental variables - i.e. supply-demand-inventory - the deviations can be interpreted as movements in the risks premium/discount. 7 This exercise does not include any estimate of oil flows through KSA's East-West pipeline, and possible exports therefrom. The rated capacity of the 745-mile line is 5 MMb/d, possibly 7 MMb/d. KSA's Red Sea loading capacity and the capacity of the Suez Canal and Bab el Mandeb under stress - i.e., the volumes either can handle with a surge of oil-tanker traffic - is not considered either. 8 This is the U.S. EIA's estimate. The EIA notes that in 2015 the daily flow of oil through the Strait accounted for 30% of all seaborne-traded crude oil and other liquids. Natural gas markets also could be affected by a closure: In 2016, more than 30% of global liquefied natural gas trade transited the Strait. Please see "Three important oil trade chokepoints are located around the Arabian Peninsula," published August 4, 2017, at eia.gov. 9 We encourage our clients to read our analysis of potential Iranian retaliatory strategies, penned by BCA's Geopolitical Strategy team. Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Analysis of Iran's military strategy and U.S. counterstrategy used in this paper relies on research from three heavily cited papers. Eugene Gholz and Daryl Press are skeptical of Iran's ability to close the Strait in their paper titled "Protecting 'The Prize': Oil and the National Interest," published in Security Studies Vol. 19, No. 3, 2010. Caitlin Talmadge gives Iran's capabilities far more credit in a paper titled "Closing Time: Assessing the Iranian Threat to the Strait of Hormuz," published in International Security Vol. 33, No. 1, Summer 2008. Eugene Gholz also led a project at the University of Texas Robert S. Strauss Center for International Security and Law that published an extensive report titled "The Strait of Hormuz: Political-Military Analysis of Threats to Oil Flows." 11 In the Strauss Center study, the most likely number is 814 mines, if Iran had a two-week period to do so covertly. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2018

Highlights Duration Checklist: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A below-benchmark overall portfolio duration stance is still warranted - even after our recent move to downgrade spread product exposure. Canada: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Feature Chart of the WeekStagflation Keeping Yields Afloat Developed market bond yields are lacking direction at the moment, pulled by competing forces. Overall global economic activity has lost some momentum and is now less synchronized. Yet the majority of major countries in the developed world are still growing at an above-potential pace that is keeping unemployment low and slowly boosting wages. This is helping underpin inflation, both realized and expected, while keeping government bond yields elevated despite increasing concerns about the future path of the global economy (Chart of the Week). The growing worries about a potential "U.S. versus the world" trade war are weighing on growth expectations, although not yet by enough to cause a meaningful pullback in global equity markets which remain supported by current solid earnings growth. Credit spreads have increased for both developed market corporate debt, but are still at historically narrow levels suggesting that investors are not overly concerned about default/downgrade risk. Emerging market (EM) debt has seen more significant spread widening in recent months, with a stronger U.S. dollar playing a large role there, but there has been little spillover from weaker EM markets into developed market credit valuations. We recently downgraded our recommended allocation to global corporate debt to neutral, while also upgrading our weighting on government bonds to neutral. Yet we maintained our below-benchmark overall duration stance, given our view that bond markets were still underpricing the potential for faster global inflation and tighter monetary policies given the persistent underlying strength of economic growth (especially in the U.S.). In light of that change in our view, an update of one of more reliable tools over the past eighteen months - our Duration Checklist - is timely. The Duration Checklist Is Still Bearish We have maintained our strategic below-benchmark stance on duration exposure for some time now, dating back to January 2017. Shortly afterward, we introduced a list of indicators to monitor going forward to determine if that defensive duration posture on U.S. Treasuries and German Bunds was still justified.1 We called that list our "Duration Checklist", and it contains elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The Checklist is meant to be a purely objective read on the data and how it relates to the likely future path of bond yields. We last updated the Checklist back on January 30th of this year.2 The conclusion was that the underlying economic and inflation backdrop was still indicating more upside for yields on a 6-12 month horizon in both the U.S. and Europe. There was a risk, however, that the bond selloff could pause given heightened bullishness on risk assets and extremely oversold conditions in government bond markets. Since that last update of the Checklist, the 10-year U.S. Treasury yield is higher (2.86% vs. 2.72%) while the 10-year German Bund yield is lower (0.36% vs. 0.70%). Although yields in both markets did climb to even higher levels - 3.12% and 0.78%, respectively - in February and March before pulling back to current levels. As we update the Checklist once again this week, we see that the backdrop is still conducive to rising bond yields in the U.S. and Europe, but with differing risks compared to six months ago (Table 1). Note that the Checklist was designed to assess if we should maintain our duration tilt, thus we apply a checkmark ("check") to any indicator that points to potentially higher bond yields, and an "x" to any element that could signal a bond market rally. Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds Global growth momentum is decelerating. The OECD's global leading economic indicator (LEI) is in a clear downtrend, having fallen for five consecutive months (Chart 2). That weakening is broad based, as shown by the depressed level of our LEI diffusion index. The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has been falling sharply since March of this year and now sits at the lowest level since January 2012. The Citigroup Global Data Surprise index peaked at the beginning of 2018 and has fallen steadily to below zero, although it may be in the process of bottoming out. Meanwhile, our global credit impulse - a reliable leading indicator of global growth - has noticeably slowed. We are giving an "x" to all these elements of our Duration Checklist, indicating that the current "soft patch" of global growth represents a risk to the performance of our below-benchmark duration stance. U.S. growth remains solid, but Europe is cooling a bit. The U.S. economy is firing on all cylinders at the moment (Chart 3). The ISM manufacturing index is near 60, while both consumer and business confidence are above the mid-2000s peak of the previous business cycle. Corporate profits are growing around 20% and our models suggest that this trend can continue over the rest of 2018. All these indicators earn a "check" on the U.S. side of our Duration Checklist. Chart 2Global Growth Indicators Are##BR##No Longer Bond Bearish Chart 3U.S. Growth##BR##Remains Strong The growth story is mixed in the euro area, however (Chart 4). The manufacturing PMI has been steadily falling since February of this year, but still remains well above the 50 line indicating an expanding economy. Consumer and business confidence are both at cyclical highs, but the upward momentum has stalled. Corporate profits are growing at a robust pace, but our models suggest that earnings should slow over the remainder of this year. In our Duration Checklist, the momentum of the growth indicators is the relevant measure and not the level. So we are now placing an "x" on the manufacturing PMI, which is giving a clear signal on slowing growth, while maintaining a "check" next to confidence and profit growth but with a question mark given that both may be in the process of rolling over. Inflation pressures are strengthening on both sides of the Atlantic. Back in January, the inflation elements of the Checklist were providing the most mixed signals. That is no longer the case (Charts 5 & 6). Oil prices are accelerating in both U.S. dollar and euro terms, which suggests upside risks on headline inflation in the U.S. and euro area. Unemployment rates are now below the OECD estimates of full employment, and wage inflation is accelerating, in both regions. Thus, all the inflation components of our Duration Checklist earn a "check". Chart 4Is Euro Area Growth Peaking? Or Just Cooling? Chart 5U.S. Inflation Backdrop Is Bond Bearish Chart 6Euro Area Inflation Backdrop Is Bond Bearish Both the Fed and European Central Bank (ECB) are biased to tighten monetary policy. The Fed continues to signal that additional rate hikes are coming given the underlying strength of the U.S. economy and rising trend in U.S. inflation. The ECB has announced that it will taper its net new bond purchases to zero by year-end in its asset purchase program, and has provided forward guidance on the timing of a first rate hike in 2019. Both policies are credible given falling unemployment and rising core inflation rates in both the U.S. and euro area. Thus, we are keeping the "check" on both sides of the policy portion of the Checklist. Investor risk appetite has grown more cautious. This element of our Checklist was a potential headwind to our below-benchmark duration stance back in January, but is much less of an impediment to higher yields now (Charts 7 & 8). Chart 7U.S. Investor Risk Appetite##BR##Has Cooled Off A Bit Chart 8European Investor Risk Appetite##BR##Has Also Cooled Off The cyclical advances of both the S&P 500 and EuroStoxx 600 have stalled, and both indices are now back close to their 200-day moving averages, suggesting that equity markets are not overstretched (and, therefore, ripe for a correction that could drive down bond yields in a risk-off move). The VIX and VStoxx volatility indices remain at low levels, even after the spike that occurred in early February and the more modest volatility shock in the aftermath of the Italian election in May. This implies that investors still prefer owning risky assets over risk-free government bonds. These elements warrant a "check" on both sides of our Duration Checklist. Corporate bond spreads, however, have widened over the past few months, suggesting that investors are pricing in some increased uncertainty over future creditworthiness. While the overall level of spreads is still historically low, the rising trend justifies an "x" in our Checklist as a possible headwind to rising Treasury and Bund yields from waning investor risk appetite. Treasuries and Bunds are not as oversold compared to January, but large short positions remain an issue. The 10-year U.S. Treasury yield is now trading just above its 200-day moving average, while the deeply oversold price momentum seen earlier in the year has eased up a bit but remains negative (Chart 9). The combined signal is a neutral one but, in our Checklist framework, neither of these measures is stretched enough to suggest that yields cannot move higher. Thus, we are giving a weak "check" to both momentum elements on the U.S. side. There is still a large short position in 10-year Treasury futures according to the CFTC data, however, and this remains an impediment to higher Treasury yields - we are keeping the "x" for this piece of the Checklist. For Bunds, yields are now trading just below the 200-day moving average while price momentum has turned slightly positive (Chart 10). While neither indicator is stretched from an historical perspective, they are not sending a message that Bunds are oversold. Thus, we are giving a weak "check" to both technical elements on the European side of our Checklist (note that due to a lack of available data, we exclude investor positioning when evaluating the technical backdrop for Bunds). Chart 9USTs Not Oversold,##BR##But Large Short Positions Remain Chart 10Bund Technicals##BR##Are Neutral The majority of indicators in our Duration Checklist continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, we conclude that a continued below-benchmark duration stance is warranted for both markets. Not all of the news is bond bearish, however. The cooling of global growth indicators, the euro area manufacturing PMI, the widening of corporate credit spreads and the persistent short position in the Treasury market remain potential headwinds to a renewed period of rising bond yields. Yet without evidence that U.S. or European capacity constraints are loosening up, triggering a dovish shift from the Fed and ECB, the upward trend in inflation will prevent any meaningful decline in yields from current levels. Bottom Line: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A continued below-benchmark overall portfolio duration stance is warranted - even after our recent move to downgrade spread product exposure. Canada Delivers Another Rate Hike, With More To Follow Chart 11The BoC & The Fed: Follow The Leader The Bank of Canada (BoC) hiked its policy rate last week by 25bps to 1.5%, once again delivering a tightening in lagged response to U.S. rate increases over the past year. The hike was not a surprise, as the Canadian economy is operating at full capacity and core inflation is at the midpoint of the BoC's 1-3% target band. Overnight Index Swap (OIS) markets are now pricing that both the BoC and the Fed will raise rates by another 75bps over the next twelve months, and we see the potential for even more increases than that - even with the Canadian economy cooling from the very rapid growth seen last year (Chart 11). The current spread between 2-year government bond yields in the U.S. and Canada is the widest since 2008, which is weighing on the level of the Canadian dollar versus the greenback (3rd panel). The latter is helping to ease financial conditions in Canada (bottom panel), especially at a time when the country is benefitting from the positive terms of trade impact of strong oil prices. The loonie is also being impacted by worries about future U.S. trade policy. The Trump administration has already imposed tariffs on Canadian steel and aluminum exports and is demanding serious concessions in the renegotiation of the North American Free Trade Agreement (NAFTA). In their latest Monetary Policy Review (MPR) that was released after the BoC policy meeting last week, the central bank provided an estimate of the impact of the steel and aluminum tariffs that went into effect on June 1st. The conclusion was that the 25% tariff on U.S. imports of Canadian steel, and 10% levy on U.S. aluminum imports, would have little net impact on the Canadian economy once the Canadian response was factored in. The BoC concluded that the level of total real Canadian exports would be reduced by -0.6% by year-end, but that Canadian real imports would also decline by a similar amount as the Canadian government slapped its own tariffs on U.S. exports of steel, aluminum and various consumer products. This neutral view on U.S.-Canada trade tensions appeared throughout the BoC's updated economic forecasts, as its projections on the growth of Canadian exports, imports and U.S. real GDP growth (the critical driver of Canadian trade) were all increased from the previous MPR published in April. That may be an overly optimistic assessment of the potential impact of a trade dispute with the U.S. Yet the BoC did admit that it can only estimate the impact of tariffs once the precise details are known, thus it cannot adjust its forecasts based on what might happen in the NAFTA negotiations. The BoC can only base its forecasts on what they can observe now, which is that Canada's overall economy remains in decent shape, even though the composition of growth is shifting. The BoC's latest Business Outlook Survey indicates that Canadian firms continue to see robust demand and are facing increasing capacity constraints. This is boosting hiring plans and keeping capital spending intentions reasonably firm even with the uncertainties over NAFTA that is causing some firms to delay investment (Chart 12). The BoC is projecting that overall Canadian real GDP will only grow by 2% in 2018, even with a smaller contribution to growth from consumer spending and housing. The year-over-year rate of change in retail sales volumes has already dipped into negative territory and is now at the lowest since the end of 2009 (Chart 13). The BoC has attributed this to some slowing in interest-sensitive spending in response to tighter BoC monetary policy. At the same time, household debt growth has been slowing and house price inflation has plunged over the past year (although most of this decline occurred in the overheated Toronto market). The BoC is not concerned about the impact of its rate hikes on the interest burden for households, despite the high level of household debt, given the accelerating pace of wages and income growth. The BoC is likely happy to see a shift away from overheating consumption fueled by speculative increases in house prices, but there is a risk that additional rate hikes could finally trigger the long-awaited bursting of the Canadian housing bubble. Chart 12Canadian Businesses Are Optimistic,##BR##Even With Trade Worries Chart 13Higher BoC Rates##BR##Do Have An Impact (On a related note - the topic of housing bubbles will be discussed at the upcoming BCA Investment Conference in Toronto on September 23-25 by Hilliard Macbeth of Richardson GMP, who has written several books on the topic of global asset bubbles and has some particularly strong views to share on Canadian housing.) Yet the BoC will have to take the risk that additional rate increases could cause a bigger shakeout in the Canadian housing market, given that Canadian inflation is trending higher. Headline CPI inflation is now above the midpoint of the BoC's 1-3% target band, while all the various measures of core inflation that the BoC monitors are hovering around 2% (Chart 14). The BoC estimates that the output gap in Canada is now closed, and that the tight labor market will continue to boost inflation. Chart 14Inflation On The Rise In Canada Chart 15Market Is Underpricing The BoC Already, the average hourly earnings measure of wage inflation is growing close to 4% on a year-over-year basis, although the BoC has noted in recent research that other measures of labor costs are not growing as fast.3 Nonetheless, with 10-year inflation expectations in the Canadian inflation-linked government bond market now trading just below the BoC's 2% target (bottom panel), and with a high number of Canadian businesses reporting increasing difficulties in sourcing quality labor, the inflationary message sent by the surging rate of average hourly earnings growth will likely prove to be correct. Even though the Canadian OIS curve is now discounting another 75bps of rate hikes over the next year, that would only take the BoC policy rate to 2.25% - still below the central bank's estimate of the neutral policy rate, which is between 2.5-3% (Chart 15). Given the likely need for the BoC to eventually move to a restrictive stance to cool off an overheating economy and keep inflation around the 2% target, we see more potential upside for Canadian bond yields, especially with very little increase currently priced in the forwards. Stay underweight Canada in hedged global bond portfolios. Bottom Line: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th, 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Some Thoughts On The Treasury-Bund Spread", dated January 30th, 2018, available at gfis.bcaresearch.com. 3 https://www.bankofcanada.ca/wp-content/uploads/2018/01/san2018-2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Investors are too complacent about the risks of a trade war. Standard economic models understate the potential economic damage that a trade war could cause. Global equities would suffer mightily from a trade war. Deep cyclical sectors would be hardest hit. Financial equities would also fare poorly. Regionally, European and EM stock markets would underperform. A trade war would benefit Treasurys and other safe-haven government bonds. A contained trade war would likely be somewhat dollar-bearish. In contrast, a full-out war could send the greenback soaring. Feature From Phony War To Real War? After months of posturing, Trump's trade war is starting to heat up. The U.S. imposed tariffs of 25% on $34 billion of Chinese goods last Friday. Tariffs on another $16 billion of goods are set to go in effect on July 20th. China has stated that it will retaliate in kind. On Tuesday, Trump further upped the ante, announcing that he will levy a 10% tariff on an additional $200 billion of Chinese imports by August 31. He also threatened tariffs on another $300 billion on top of that if China still refuses to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than what China exported to the U.S. last year! China is not the only country in Trump's crosshairs. The Trump administration levied tariffs of up to 25% on steel and aluminum from the EU, Canada, Mexico, and other U.S. allies on June 1, 2018. The affected regions have retaliated with their own tariffs. As Marko Papic, BCA's chief geopolitical strategist, has repeatedly stressed, there is little reason to think that trade tensions will ease over the coming months. Protectionism is popular with the American public (Chart 1). Trump ran on a protectionist platform and now he is trying to fulfill his campaign promises. It does not help that Trump is accusing foreign governments of doing things they are not doing. Chart 2 shows that U.S. tariffs are actually higher than in most other G7 economies. As we have argued in the past, the U.S. runs a persistent current account deficit because it has a higher neutral real rate of interest - otherwise known as r-star - than most other countries.1 Standard interest rate parity equations imply that a country with a relatively high neutral rate will have an "overvalued" currency that is expected to weaken over time, whereas a country with a low neutral rate will have an "undervalued" currency that is expected to strengthen over time. Intuitively, this must happen because investors will only hold low-yielding bonds if they expect a currency to strengthen. The result is a current account deficit for countries with overvalued currencies such as the U.S., and a current account surplus for regions with undervalued currencies such as the euro area (Chart 3). Chart 1Free Trade Is Not In Vogue In The U.S. Chart 2Tariffs: Who Is Robbing The U.S.? Chart 3Interest Rates And Current Account Balances The Economic Costs Of A Trade War How much damage could a trade war do to the global economy? As it turns out, this is a surprisingly difficult question to answer. Standard economic theory offers little guidance on the matter. By definition, global exports are always equal to imports. In a conventional Keynesian model, countries with trade deficits would gain some demand from a trade war, while countries with surpluses would lose some demand. However, the contribution of net exports to global demand would always be zero. Granted, there would be some efficiency losses, but in the standard Ricardian model of comparative advantage, they would not be that large. As Box 1 explains, the deadweight loss from a tariff can be computed as one-half times the change in the tariff rate multiplied by the percentage-point decline in imports that results from the tariff. Suppose, for example, that a trade war leads to a 10% across-the-board increase in U.S. tariffs, which causes U.S. imports to fall by 30%.2 Given that imports are 15% of U.S. GDP, the resulting deadweight loss would be 0.5*0.1*0.3*15=0.225% of GDP. That's obviously not a lot. The True Cost Of A Trade War Is Likely To Be High Our sense is that the true cost of a trade war would be much greater than these simple models suggest. There are at least six reasons for this: Most simple models assume that labor and capital are completely fungible and that the economy is always at full employment. In practice, it is doubtful that workers could easily move to companies that would benefit from tariff protection from those that would suffer from retaliatory measures. Workers have specialized skills. Likewise, a piece of machinery that is useful in one sector of the economy may be completely useless in another. Industries are often concentrated in particular regions. As such, a trade war could severely degrade the value of the existing stock of human and physical capital. This would result in lower potential GDP. It would also result in temporarily higher unemployment as workers, laid off from firms which have been adversely affected by tariffs, are forced to scramble for a new job elsewhere. Comparative advantage is not the only source of trade gains. Arguably more important are economies of scope and scale. A firm that has access to a global market can spread fixed costs over a larger quantity of output, thus lowering average costs (and ultimately prices). The existence of large global markets also allows companies to offer niche products that might not be worthwhile to develop for smaller markets. Modern trade is dominated by the exchange of intermediate goods within complex supply chains (Chart 4). This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. U.S. firms are particularly vulnerable to supply-chain disruptions because the Trump administration has dotardly chosen to levy tariffs mainly on intermediate and capital goods (Chart 5). This stands in contrast to China and the EU, which have raised tariffs mainly on final goods in a politically strategic manner (agricultural products in Trump-supporting rural areas and Harley Davidson bikes, which are manufactured in Paul Ryan's home district in Wisconsin). Chart 4Trade In Intermediate Goods Dominates Chart 5The U.S. Is Not Very Smart In ##br## Implementing A Protectionist Agenda Uncertainty over the magnitude and duration of a trade war could cause companies to postpone new investment spending. A vast economic literature pioneered by Avinash Dixit and Robert Pindyck has shown that firms tend to defer capital expenditure decisions when faced with rising uncertainty.3 Furthermore, as I discussed in an academic paper which was published early on in my career, business investment is typically higher when firms have access to larger markets.4 Higher tariffs could lead to an implicit tightening in fiscal policy. If the U.S. raises tariffs by an average of ten percentage points across all imports, a reasonable estimate is that this would imply a tightening in fiscal policy by around 1% of GDP - enough to wipe out the entire stimulus from Trump's tax cuts. Of course, the tariff revenue could be injected back into the economy through more tax cuts or increased spending. However, given the possibility that gridlock will increase in Washington if the Republicans lose the House of Representatives in November, it is far from obvious that this would happen. A trade war would lead to lower equity prices and higher credit spreads. This would translate into tighter financial conditions. Historically, changes in financial conditions have been highly correlated with changes in real GDP growth (Chart 6). Changes in financial conditions have, in turn, led the stock market. The S&P 500 index has risen at an annualized pace of 10% since 1970 when BCA's Financial Conditions Index (FCI) was above its 250-day moving average, while gaining only 1.5% when the FCI was below its 250-day average (Chart 7). Given today's elevated valuations across many asset markets, the risk is that a trade war triggers a sizable correction in asset prices. Chart 6Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Chart 7The Link Between Financial Conditions ##br##And The Stock Market Protecting Your Equity Portfolio From A Trade War We think investors are understating the risks of a trade war. This, along with a host of other reasons, prompted us to downgrade global risk assets from overweight to neutral on June 20.5 As bad as a trade war would be for Main Street, it would be even worse for Wall Street. The mega- cap companies that comprise the S&P 500 have a lot more exposure to foreign markets and global supply chains than the broader U.S. economy. The "beta" of corporate profits to changes in GDP growth is also quite high (Chart 8). Chart 9 shows how U.S. equity sectors performed during days when the S&P 500 suffered notable losses due to heightened fears of protectionism. We identified seven separate days, including Wednesday's selloff, which was spurred by Trump's threat to impose tariffs on another $200 billion of Chinese imports. Chart 8Profits Are Much More Volatile Than GDP Chart 9This Is How Markets Trade When They Are Worrying About Trade Wars The chart shows that deep cyclical sectors such as industrials, materials, and energy fared badly during days of protectionist angst. Financials also underperformed, largely because such days saw a flattening of the yield curve. Tech, health care, and telecom performed broadly in line with the S&P 500. Consumer stocks outperformed the market, but still declined in absolute terms. Utilities and real estate were the only two sectors that saw absolute price gains. Considering that the sector composition of European and EM bourses tends to be more tilted towards cyclicals than the U.S., it is not surprising that the former have underperformed during days of increased protectionist worries. Bonds: Yields Likely To Rise, But A Trade War Is A Risk To That View In contrast to equities, a trade war would benefit Treasurys and other safe-haven government bonds. Admittedly, the imposition of tariffs would push up import prices. However, the effect on inflation would be temporary. Just as the Fed tends to disregard one-off increases in commodity prices, it will play down any transient boost to inflation stemming from a trade war. Instead, the Fed will focus on the growth impact, which is likely to be negative. To be clear, trade jitters are not the only thing affecting bond yields. Judging by numerous business surveys, the U.S. economy is starting to overheat (Chart 10). Last week's employment report does not alter this conclusion. While the unemployment rate rose by 0.2 percentage points, this was mainly because of a jump in the participation rate. Considering that the number of workers outside the labor force who want a job is near a record low, the ability of the economy to draw in additional workers is limited (Chart 11). Chart 10The U.S. Economy Is Overheating Chart 11A Small Pool Of People Want ##br##To Jump Into The Labor Market Historically, continuing unemployment claims have closely tracked the unemployment rate over time (Chart 12). The fact that continuing claims have dropped by 9% since the end of January, while the unemployment rate has dipped by only 0.1 percentage points, suggests that the unemployment rate will fall further over the coming months. On balance, we continue to maintain our bearish recommendation on Treasurys, but acknowledge that a trade war is a risk to that view. Trade Wars And Currencies Unlike safe-haven bonds, whose yields are likely to decline in proportion to the magnitude of the trade war, the impact on the dollar is more difficult to predict. On the one hand, a modest trade dispute is likely to be somewhat dollar bearish, inasmuch as it hurts U.S. growth and forces the Fed to slow the pace of rate hikes. Since most other major central banks are not in a position to cut rates, expected rate differentials between the U.S. and its trading partners would narrow. On the other hand, a severe trade war would probably be dollar bullish. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. still tend to attract capital inflows into the safe-haven Treasury market. The U.S. is a fairly closed economy, and hence would be relatively less affected by a breakdown in global trade. Commodities are also likely to suffer if trade flows decline (Chart 13). Lower commodity prices tend to be bullish for the greenback. Moreover, as we discussed in our latest Strategy Outlook, a tit-for-tat trade war with China could force the Chinese government to devalue the yuan. That would have a knock-on effect on other emerging market currencies. Chart 12Unemployment Can Fall Further Chart 13Commodities Are A Potential Victim Of Trade War Notably, the greenback has fared better recently than it did earlier this year during days when protectionist rhetoric intensified. On Wednesday, the broad trade-weighted dollar gained 0.3% while the DXY picked up 0.6%. This supports our view that the dollar will strengthen over the remainder of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 2 This assumes an elasticity of import demand of 3, which is broadly consistent with most academic estimates. 3 Avinash K. Dixit, and Robert S. Pindyck, "Investment Under Uncertainty," Princeton University Press, (1994). 4 Peter Berezin, "Border Effects Within A Dynamic Equilibrium Trade Model," The International Trade Journal, 14:3 (2000), 235-282. 5 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. BOX 1 The Deadweight Loss From A Trade War Box Chart 1Tariffs Increase Budget Revenues, But Lead To A Bigger Loss In Consumer Surplus In the simplest models of international trade, an increase in tariffs leads to higher prices, resulting in a loss of consumer surplus. This is depicted by the blue region (ABCE) in Box Chart 1. The government collects revenue from the tariff shown by the red-colored rectangle (ABDE). The difference between the loss in consumer surplus and the gain in revenue - often referred to as the "deadweight loss" from a tariff - is depicted by the green-colored triangle (BCD). Arithmetically, the area of the triangle can be calculated as: Deadweight loss = 0.5 x Tariff x (Pre-tariff level of imports - Post-tariff level of imports) If one divides both sides by GDP, the formula reduces to: Deadweight loss/GDP = 0.5 x Tariff x Percentage Point Change In Import Share of GDP Resulting From Tariff There are many things in the real world that are not captured by this equation. For example, if the country that imposes the tariff is sufficiently large, this could push down the international price of the goods that it imports. The country would then benefit from an improvement in its terms of trade. As Robert Torrens showed back in the 19th century, if a country has any degree of market power (i.e., it is not a complete price-taker on international markets), there will always be a level of tariffs that makes it better off. The caveat is that this "optimal tariff" only exists if other countries do not retaliate. If everyone retaliates against everyone else, everyone will be worse off from a trade war. Moreover, as discussed in the main text, there are many factors that this simple model does not capture which could result in significant economic damage from raising tariffs even when retaliation does not take place, especially in cases where the tariffs are imposed on intermediate and capital goods. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The fundamental case to buy the dollar and sell non-U.S. risk assets is currently extremely obvious. This suggests that investors likely have already placed their bets. As such, the case for a counter-trend correction espoused last week has grown. The impact of tariffs on the dollar seems more dependent on the dollar's momentum than economics. As a result, getting a handle on how the greenback's momentum will evolve seems crucial. The behavior of Chinese assets, various currency pairs and other assets suggests the dollar may experience a significant loss of momentum that could prompt a correction of DXY to 92. The Canadian dollar seems the best place to take advantage of this move. Feature The currency market does not feel right. We do not mean that it is sick; however, we cannot help but feel a great level of discomfort right now. The economic environment clearly supports a stronger dollar. Global liquidity is weak, global growth has weakened, the yuan has been very soft and trade wars are on the front page of newspapers as the Trump administration has announced an additional $200 billion of potential new tariffs on Chinese exports. Hence, the bullish-dollar negative-EM story seems like a "no brainer." However, there rarely, if ever, is such thing as a "no-brainer" in the FX market. When fundamentals point as obviously in one direction as they do today, the narrative is likely to be appreciated by the vast majority of market participants. As a result, the bets are likely to have been placed. This risk seems especially acute today. Hence, we recommend investors temporarily move away from the dollar-bullish thesis. Occam's Razor At first glance, the recent wave of strength in the dollar seems to have been prompted by the new wave of trade war intensification. While China has not announced new tariffs on the U.S., the renminbi has continued to depreciate, evocating memories harkening back to August 2015 and the emerging market calamity that culminated in January 2016. While the risk created by a lower CNY is real, the dollar has had a schizophrenic approach to pricing in the impact of tariffs. In the first half of 2018, announcements of tariffs were greeted by a weaker dollar. However, since May, the same type of news has been greeted by a stronger dollar. An economic argument can be made as to why this is the case. In early 2018, global rates were still at rock-bottom levels, with the GDP-weighted average policy rate in the G-10 outside the U.S. being at 0.2%. Moreover, U.S. inflation was still tepid, but the fed funds rate was 1.5%. As result, if tariffs were to slow growth, only the Fed had room to ease. Moreover, since as of early 2018 global growth still looked to be on the upswing, it was argued that global monetary conditions were still accommodative enough than non-U.S. growth would barely be affected. Today, global growth is already showing signs of sagging, with weakness in Korean exports vindicating this analysis (Chart I-1). This means that growth outside the U.S. is perceived as more vulnerable to tariffs than was the case back in the first quarter of this year, especially as the amount of tariffs imposed on the world has grown. While the U.S. will also suffer from these tariffs, it is in better position to weather their impact. As such, since FX determination goes beyond just rate differentials and is also affected by growth differentials, the greater risk to non-U.S. growth is what is lifting the dollar. This narrative makes sense and is probably playing a role in the dollar's strength. However, we suspect something much simpler is exerting an even greater influence on the greenback: momentum. As we have long been arguing, the dollar is the epitome of momentum currencies in the G-10 (Chart I-2).1 Chart I-1Global Growth Slowdown Chart I-2USD Is A Momentum Currency Among all the momentum strategies we have tested, the one that works best at capturing the momentum continuation effect in the USD is tracking crossovers of the 20-day and 130-day moving averages. When the 20-day moving average is above the 130-day one, the dollar has an upward bias that is tradeable, and vice versa when the faster moving average lies below the slower one. Through most of 2017 all the way until May 9, 2018, the 20-day moving average for the dollar was in fact underneath the 130-day moving average. However, since May 10, it has been above (Chart I-3). Here is where things get interesting. When the moving average crossover strategy was sending a bearish signal for the greenback, tariff announcements would weaken the dollar; but since the crossover has been in bullish territory, tariff announcements have been lifting the dollar (Chart I-4). Chart I-3Favorable Momentum ##br##Backdrop On The Dollar Chart I-4Momentum Drives The Dollar's ##br##Reaction To Tariffs What does this mean for investors going forward? So long as the dollar is in a bullish momentum configuration, trade announcements will support the greenback. However, on this front we could expect a period of temporary calm after the storm (a low-conviction call, to be clear). The Trump team just announced an enormous tariffs package, Europe and Canada have put in place their own retaliation tariffs, the NATO meeting is over and the CNY has fallen by 6.4% since April 11. For the dollar to strengthen further, the onus thus falls back on momentum itself and market signals. But, as we highlighted last week, we are concerned that the dollar momentum could actually weaken from current levels. Bottom Line: Trade war risks seem to have been supporting the USD and weakened EM assets. However, the picture is not that clear-cut. Until May, moving average crossovers for the dollar were sending a bearish signal; during that time frame, tariff announcements were welcomed by a weak dollar. Since May, the dollar's moving average crossovers have been sending a bullish signal; since that time, tariff announcements have been welcomed by a strong dollar, which in turn has weighed on non-U.S. risk assets. Thus, with a likely period of calm on the trade front in the coming weeks, the outlook for momentum is likely to determine the trend in the dollar and in the price of risk assets outside the U.S. Reading The Market Tea Leaves At this point, having a sense of how momentum is likely to evolve is crucial. This is where that sinking feeling comes into play. Fundamentals seem to give a clear picture, but when the picture is so clear, a trap often lies ahead. The first clue to this trap comes from the Zew expectations survey. The Zew is a survey of market professionals, asking them their view on growth, and so on. These views are likely to be reflected in current market pricing. What is interesting is that this global growth survey has been tanking violently. The perception is thus that global growth is decelerating fast. Indeed, global growth has slowed, but as the global PMI illustrates - a variable that moves coincidently with the global Zew - it is not falling nearly as fast as expectations are (Chart I-5). This creates a risk for the dollar bulls - bulls who need further growth weakness to justify additional dollar strength. China is at the epicenter of the global growth slowdown. Interestingly, the Shanghai Composite Index is already testing the lows it experienced in early 2016 (Chart I-6). However, the Chinese economic picture is not as dire as was the case back then. PPI inflation is at 4.6% today, while it hit -5.9% at its nadir in November 2015. Thus, real interest rates faced by borrowers are 9.9% lower than they were back then. Moreover, the Li-Keqiang index of industrial activity is rebounding smartly. Finally, while FX reserves are contracting, they are not falling at the pace of US$108 billion a month endured in the worst months of 2015, which means that liquidity conditions in China are not experiencing the same tightening as back then. In fact, the Chinese repo rate is currently falling, supporting this notion (Chart I-7). This combination of economic indicators and financial market prices suggests that ample bad news is already priced into Chinese assets and thus China-linked assets for now. Chart I-5Analysts Know Growth Is Slowing Chart I-6Chinese Shares As Sick As In Early 2016 Chart I-7Some Reflation In China? Chinese shares expressed in USD-terms are also interesting. Not only are they re-testing their 2016 lows, but by the end of June their RSI oscillator had hit more deeply oversold levels than in January 2016 (Chart I-8). Very saliently, despite this week's announcement of a potential $200 billion of new tariffs imposed on China, Chinese shares expressed in U.S. dollars are not making new lows, and the RSI is slowly rebounding. This resilience is surprising, considering the magnitude of the bad news. Copper too is interesting. It seems that Dr. Copper has had a bit of a hangover lately, as its response speed has slowed considerably. Copper used to be a very reliable leading indicator, but since 2015 it seems to have become a coincident indicator of EM equities (Chart I-9). The recent 16% decline in the price of copper seems to be a catch-up to the weakness already evident in EM assets and EM currencies more than an early signal of additional problems to come for these markets. In fact, it may even indicate an intermediate capitulation in the price of these assets. Chart I-8Chinese Shares In USD: A Rebound Soon? Chart I-9Dr. Copper Is Hungover Other than these assets directly linked to China, since the end of June Treasury yields have also not been able to fall lower, and have proven very resilient in the face of the latest wave of CNY weakness and Trump tariffs (Chart I-10, top panel). Additionally, the euro/yen exchange rate, which is normally very levered to global growth conditions, has not only been rallying but breaking out of a downward trend in place since the beginning of 2018 (Chart I-10, second panel). Moreover, the extraordinarily pro-cyclical AUD/JPY cross bottomed in March and looks barely affected by the recent tumult (Chart 10, third panel). Finally, the growth-sensitive EUR/CHF is currently also strengthening, not weakening (Chart I-10, bottom panel). The behavior of all these market prices is inconsistent with an imminent new upswing in the dollar. The behavior of these variables is instead consistent with the movement of our favorite leading indicator of global growth: EM carry trades. We have used the EM carry trade to flag risks to global growth that have gripped the dollar and non-U.S. risk assets in recent months. However, despite the bad news piled onto the global economy, the performance of EM carry trades funded in yen seems to be trying to form a bottom (Chart I-11). This could indicate that we may be in for a period of temporary stabilization in global growth - a phenomenon that would weigh on the dollar's momentum. Without this ally, the dollar should correct meaningfully and non-U.S. risk assets should stage a rally. When thinking of a target for the dollar, a correction toward 92 on the DXY, implying a rebound of just under 1.20 on EUR/USD, seems very likely. At these levels, it will be time to re-evaluate whether the thesis we espoused last week - that this correction is a counter-trend move - is still valid or not. Also, we would expect commodity currencies to benefit even more than the euro in the context of this correction. Commodity currencies are especially levered to China, and Chinese stocks seem well positioned for a significant rebound. Moreover, as Chart I-12 illustrates, commodity currencies have been stronger than the relative performance of Swedish stocks vis-à-vis U.S. ones suggests, implying some underlying support. Finally, the yen and Swiss franc should prove the greatest losers in this environment. Chart I-10Despite Bad News, These Pro-Cylical Prices Are Resilient Chart I-11Stabilization In EM Carry Trades Chart I-12Important Divergence In terms of factors we continue to monitor, the price of gold remains a key variable. While the trend line we flagged last week has been re-tested, the yellow metal has not been able to punch through it. Meanwhile, EM bonds and junk bonds too have not suffered much in the face of the recent tariffs, and the rebound that has materialized since early July still seems in place. If any of these development change, the rebound in EM assets will peter off, and the dollar greenback will continue its march higher without much of a pause. Bottom Line: Fundamentals are making an extremely clear case that the dollar will strengthen further in the coming months, and that non-U.S. risk assets are in for a dive. However, when fundamentals are as clear as they are today, especially after the market moves we have seen in recent months, they rarely translate into the price action one would anticipate. The behavior of Chinese shares, of bond yields and of various currency pairs, including EM carry-trades, suggests instead that the dollar is likely to lose momentum. However, the life blood of any dollar rally is this very momentum. As such, we worry that despite apparently massively favorable fundamentals, the dollar could experience a correction toward 92 before being able to move higher as the fundamentals currently suggest. Commodity currencies could enjoy the greatest dividend from this counter-trend move. A Few Words On The CAD The Bank of Canada was anticipated to deliver a dovish hike this week, increasing rates to 1.5%, but also downgrading the path of additional expected rates. The BoC did deliver a hike, but it stuck to its guns and did not temper future interest rate expectations. Within the BoC's analytical framework, this move makes sense. Despite incorporating both tariff and NAFTA risks into its forecast, the BoC has barely changed its growth expectations for Canada. Essentially, the hit to Canadian exports will be balanced out by the hit to Canadian imports created by Canada's own retaliatory tariffs on the U.S. This means that the lack of excess capacity in the Canadian economy remains as salient a problem for the BoC as it was before NAFTA risks entered the picture. This warrants higher rates. The economic backdrop seems to indeed be in agreement with the BoC. This summer's Business Outlook Survey showed that Canadian businesses continue to find it increasingly difficult to meet demand and that labor shortages are still prevalent and becoming more intense, highlighting the upside risk to wages (Chart I-13). Higher wages are thus likely to buffet Canadian households from the risk created by higher policy rates. Moreover, higher wages also stoke inflationary pressures, while core inflation is already at target. In this environment, a real short rate at -0.4% makes little sense. The CAD looks like the best vehicle to take advantage of a rebound in commodity currencies. The CAD is currently trading at a deep discount to its fair value (Chart I-14) and the Canadian dollar proved surprisingly resilient in the face of a 7% decline in Brent prices on Wednesday. Additionally, speculators have accumulated large short bets on the Canadian currency. With the BoC being the only central bank among G-10 commodity producing nations that is lifting rates, this would create an additional impetus for the loonie to rebound and outperform other commodity currencies. Chart I-13Canadian Capacity Pressures ##br##Point To A Hawkish BoC Chart I-14Loonie Is ##br##Cheap Bottom Line: The BoC has resumed its hiking campaign because the economy is at full capacity and inflationary pressures continue to build up, while monetary policy remains too accommodative. As a result, the cheap CAD currently seems the best G-10 currency to take advantage of the correction in the USD. We are selling USD/CAD this week. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was positive: JOLTS Job Openings climbed to 6.638 mn in May, beating expectations; Headline producer prices increased by 3.4% annually, the most in 11 years; Core producer prices increased by 2.8% in annual terms; Core consumer prices increased by 2.3% annually in June, in line with expectations, however, the month-on-month number was a bit soft; Continuing jobless claims underperformed, while initial jobless claims came in lower than expected. New threats from the White House of tariffs for USD 200 billion worth of Chinese imports circulated the media networks. At this point in time, almost 90% of U.S. imports from China are under threat of tariffs. The risks surrounding these tariffs going forward is likely to add substantially more pressure on emerging markets and commodity currencies down the road. Meanwhile, the U.S. is experiencing a robust economy with higher inflation supported by more expensive raw materials, higher lumber and housing prices, and a tight trucking market. This should keep the Fed in line with its hawkish bias, and the greenback afloat, even if on the short-run, much of this seem well discounted, raising the risk of a tactical correction in the DXY. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: The German trade balance increased to EUR 20.3 billion on the back of a 1.8% annual export growth and a 0.7% annual import growth; The Sentix Investor Confidence increased to 12.1 in July from 9.3 in June, and beating the expected 8.2; French and Italian industrial output both underperformed expectations, coming in at -0.2% and 0.7% in monthly terms, respectively; The Economic Sentiment from the ZEW Survey came in less than expected for both Germany and the euro area, at -24.7 and -18.7 respectively; A slight misunderstanding between policymakers at the ECB emerged as the interpretation of interest rates being held "through the summer of 2019" proved contentious. Some officials say an increase as early as July 2019 is possible, while others rule out a move until autumn. We believe the latter is more likely, given the euro's negative reaction to the U.S.' announcement of additional tariffs of USD 200 billion imports from China, and also due to the current slowdown within the common area. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Machinery orders yearly growth outperformed expectations, coming in at 16.5%. Moreover, labor cash earnings yearly growth also surprised to the upside, coming in at 2.1%. Finally, housing starts yearly growth also outperformed expectations, coming in at 1.3%. USD/JPY has rallied by more than 1.4% this week. Even amid the increasing trade tensions and risk-off sentiment, the yen has been unable to rally against the dollar, as the momentum for the greenback is too strong for the yen to overcome. Overall, we favor the yen over the euro, however if the dollar were to correct at current levels, EUR/JPY would likely suffer in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Manufacturing production yearly growth underperformed expectations, coming in at 1.1%. Moreover, Industrial production yearly growth also surprised negatively, coming in at 0.8%. However, mortgage approvals outperformed expectations, coming in at 64.526 thousand. Finally, Markit Services PMI also surprised positively, coming in at 55.1. GBP/USD has remained flat this week. Overall, we expect cable to continue to fall, as the dollar should continue its upward momentum for the time being. That being said, on the remainder of 2018, the pound will probably outperform the euro, as the U.K. is less exposed to the effects of Chinese tightening than Europe. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: NAB Business Confidence and Conditions both underperformed expectations, coming in at 6 and 15 respectively; Westpac Consumer Confidence increase to 3.9% in July from 0.3%; Home Loans grew by 1.1%, much better than the expected -1.9%. The Aussie sold off substantially as the U.S. threatened China with further tariffs amounting to USD 200 bn worth of goods. Adding to the sell-off were copper prices, which fell by almost 3%, also triggered by the tariff announcement. Furthermore, as the Australian economy remains mired in slack, the RBA is unlikely to hike in an environment with no real wage growth. As such, the AUD is unlikely to see much durable upside this year and is likely to lag other commodity currencies in the event of a dollar correction. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. Even if it can rebound on the back of USD correction, we expect this currency to ultimately fall, given that the current environment of trade tensions and Chinese tightening will weigh on high yielding currencies like the NZD. Additionally, the policies implemented by the new government like lower immigration and a dual mandate will structurally lower the neutral rate in New Zealand, which will create further downside on the NZD. However, the NZD should outperform the AUD cyclically, as Australia is more exposed to a slowdown in the Chinese industrial cycle, given that copper has a higher beta than dairy products. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was decent: Housing starts grew by 248,100 year-on-year, beating expectations of 210,000; Building permits increased by 4.7% in monthly terms. The Bank of Canada this week hiked interest rates to 1.5%. The Bank displayed quite a hawkish stance in its statement and Monetary Policy report, noting a stronger than expected U.S. economy, high export growth, robust inflation, and a tight labor market. In addition, the Bank incorporated the newly implemented tariffs into its policy function. Nevertheless, recent comments by Governor Poloz imply a "data dependent" approach, which is consistent with policy responses to internal inflationary pressures. We therefore expect the CAD to continue to outperform all G10 currencies except USD. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator outperformed expectations, coming in at 101.7. Moreover, the SVME PMI also outperformed expectations, coming in at 61.6. However, the unemployment rate underperformed expectations, coming in at 2.6%. Finally, headline inflation came in at 1.1%, in line with expectations. EUR/CHF has been flat since last week. Overall, we expect this cross to continue to go up, given that the SNB will keep intervening in the currency markets to keep the franc low enough for the economy to reach the central bank inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales yearly growth outperformed expectations, coming in at 1.8%. Moreover, headline inflation surprised positively, coming in at 2.6%, while core inflation came in at 1.1%, in line with expectations. Finally, registered unemployment, came in at 2.2%, in line with expectations. USD/NOK has gone up by roughly 0.6% this week. While it has short-term downside, we continue to be cyclically bullish on this cross, as the upside to oil prices is limited at this point, while a tightening fed should continue to put upward pressure on the U.S. dollar. That being said, the NOK will likely outperform the AUD and the NZD, given that the constrained supply of oil will help it to outperform other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The minutes from the July meeting highlighted some reservation by officials given the current economic background. The forecast is that slow rate rises will be initiated towards the end of the year. However, the majority of the Executive Board emphasized that monetary policy proceeds cautiously with hikes, given the volatile development of the exchange rate and the increased risks associated with Italy and trade protectionism. The majority also advocated for the extension of the mandate that facilitates foreign exchange intervention. However, Governors Ohlsson and Flodén argued against this view, even supporting hikes earlier as inflation is already at target. The SEK is very cheap on several valuation metrics, and thus is ripe for an up move, which is likely when the majority of the Riksbank officials aligns with a hawkish view. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades