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Feature It no longer pays to be underweight the BCA aerospace index considering the long profit growth runway and potential trade easing catalysts. Accordingly, we are moving to a benchmark allocation in this sector. There are two pillars supporting the BCA aerospace index and its relative performance: global trade sentiment and execution-driven profit performance. Despite a tangible easing in trade tensions between the U.S. and China, the global trade environment remains uncertain in the near term as economic weakness has permeated beyond U.S. shores and new trade issues seem likely to pop up (including potential tariffs on EU- or Japan-produced autos) to replace those being resolved. Aerospace profits are soaring to new heights and have been underpinning an aerospace bull market in 2019; a robust order environment suggests this may continue. However, a debt-fueled change in corporate capitalization and stratospheric valuations should keep investor expectations grounded. The Canary In The Coal Mine  The ebb and flow of the trade dispute with China has been reflected partially in the relative performance of industrials1 in general (top panel, Chart 1), aerospace in particular (middle panel, Chart 1) and Boeing specifically (bottom panel, Chart 1). This is due in large part to Boeing taking on the mantle of a global trade bellwether and also dominating our index. Chart 1Aerospace Is Leading The Way Considering the global nature of the firm, this role seems appropriate. Chart 2 shows the company’s order backlog by region; the domestic market represents only 25% of the next several years of production while all of the DM represents only 40%. The bulk of Boeing’s production backlog, and hence future revenues, are derived from the EM. Boeing is also particularly unique in that it has virtually no currency exposure as its products are invariably priced in U.S. dollars, as is the case with the bulk of U.S. aerospace firms. Examining relative performance with global leading indicators provides some insight. The global manufacturing PMI shares an exceptionally tight directional relationship with aerospace’s relative performance (second panel, Chart 3). Though the current message is negative, BCA’s Global Leading Economic Indicator (GLEI) diffusion index has already started to recover (bottom panel, Chart 3), signaling that global growth is likely putting in a bottom and aerospace outperformance may resume anew. Chart 3Global Indicators Lead Relative Performance Nevertheless, from a sentiment perspective, aerospace investors are focused squarely on weakness in the Chinese economy. On this front, we think there are three reasons to be modestly hopeful. First, negativity has been prominent in the media narrative (second panel, Chart 4) but this seems now fully priced in to the market. Second, China’s efforts to reflate the economy and the resulting rising odds of a soft landing is a boon to U.S. aerospace stocks (third panel, Chart 4). Lastly, as we have highlighted repeatedly in previous research, resolution of the trade spat between the U.S. and China would provide a significant catalyst for U.S. equities with particular emphasis on the trade-geared aerospace stocks. Chart 4Aerospace Is An EM Bellwether Net, though we remain optimistic for global trade, aerospace’s role as the wind vane for how trade winds are blowing should add both a greater degree of volatility and unpredictability to the index. Earnings Are Increasing Thrust In Aerospace  Despite the above section, the reason why aerospace stocks went vertical at the end of January of this year was not easing trade relations. Rather, it was Boeing’s release of blowout earnings which was followed by earnings beats across the sector. Industry sales have pushed into double-digit growth territory (second panel, Chart 5) while margins are reaching into the stratosphere, hitting record levels (third panel, Chart 5). Chart 5Aerospace Margins At Record Highs We think the reason why earnings are so elevated has much to do with the age of the order book. In Chart 6, we show Boeing’s order backlog and the years of production in backlog. Following a meltdown in 2008, Boeing’s backlog consistently represented between six and eight years of production. The implication is that the portion of the backlog currently being delivered was booked in the 2012 to 2014 period (circled in Chart 6) which happened to be the best order growth period in Boeing’s history and, in the context of this exceptionally powerful demand, likely built in particularly wide margins. This is compounded to the upside by being that much further along the production curve, particularly for some airliner programs that were troubled at the time, notably the 787 program. Nevertheless, it stands to reason that the bookings added to backlog in the difficult period during and immediately post the GFC and the resulting weak margin performance of 2016-2017 has largely been worked through. Investors should now focus on the current margin profile as being the new status quo and current bookings as an indication of future earnings growth. Can Orders Sustain This Trajectory?  New orders in aerospace are driven, as with all capex decisions, by growth and margin considerations. With respect to the latter, the obvious driver is jet fuel prices which are usually the largest cost line item in an airline’s P&L. In 2010, jet fuel prices spiked and stayed elevated for the next five years (jet fuel prices shown advanced by nine months, top panel, Chart 7). Global airlines responded by splurging on new orders to replace older, less efficient aircraft with more modern and highly efficient types. Chart 7Fare Growth & Input Costs Drive Orders Though jet fuel prices are off the heights that spurred the extraordinary order growth in the early part of this decade, they are also above the lows of the energy price crash in 2015. If BCA’s bullish oil view comes to fruition, order flow should continue to be well supported by the refleeting theme. At the same time as fuel prices were spiking in 2010, DM consumer confidence was climbing out from beneath the recession (G7 consumer confidence shown advanced by one year, bottom panel Chart 7), giving airlines the demand push to add capacity to global fleets. The rapid increase in aerospace orders has been revealing itself in global airline capacity growth, which has been increasing by mid-single digits for the past six years (top panel, Chart 8). Interestingly, global load factors (the ratio of revenue-paying passengers to available seats, the airline industry measure of capacity utilization) have been rising despite this increase in capacity, implying global demand has been outstripping supply growth. This data is echoed in the core domestic market where the load factor has plateaued at a record high level, approximating the global average (bottom panel, Chart 9), while capacity has grown mostly uninterrupted since the GFC. Chart 9Few Barriers To Domestic Capacity Expansion In sum, we expect upbeat aerospace orders on the back of firming passenger demand driving capacity growth combined with the pursuit of ever more efficient aircraft to drive profits. However, given the long lead times, order growth should be used only as a guide; profit growth has driven relative performance (bottom panel, Chart 10) to a much greater degree than order growth (middle panel, Chart 10). Chart 10Earnings Drive Performance Over Orders Changing Financial Structure And Costly Equities Notwithstanding the rapid increase in sales and, hence, production in the aerospace sector, capex has been in decline for the last couple of years (second panel, Chart 11). However, industry debt levels have been rapidly increasing (third panel, Chart 11), begging the question: where has the industry been deploying capital? Chart 11Debts Levels Are Rising... The answer is in share buybacks. Our share count proxy (middle panel, Chart 12) shows that industry share counts have been roughly halved over the past decade, which partially underlies the outperformance of sector equities. In late-2018, Boeing announced a new $20 billion stock buyback plan, representing roughly 10% of its market capitalization, implying share buybacks in the aerospace sector are not fading anytime soon. Chart 12...As Share Counts Are Shrinking At the same time, profit growth has not kept pace with the ramp up in leverage and leverage ratios have worsened to their highest point since the aviation crises of the early-2000’s (bottom panel, Chart 12). While still reasonable relative to the broad market, net debt / EBITDA has reached a level where further deterioration would likely add an incremental risk premium to aerospace stocks, denting valuations. With that in mind, valuations bear close examination. The exceptionally robust stock price run over the past two years and ballooning balance sheets has resulted in sector enterprise values skyrocketing (second panel, Chart 13). Relative to sector EBITDA, equities in the aerospace sector are as expensive as they have ever been (bottom panel, Chart 13). Chart 13Sky-High Valuations... This message is echoed by our valuation and technical indicators (Chart 14) which indicate that aerospace stocks are at least one standard deviation overvalued and overbought, respectively. Chart 14...Across Multiple Measures A Word On Defense Few of the stocks in our aerospace index are pure-play commercial aerospace investments. Rather, most of the companies rely, to a certain extent, on defense revenues either as a primary supplier of defense goods or as a part of defense production supply chains. Boeing, for example, averaged more than 20% of its revenues in the last three fiscal years from its defense segment. United Technologies, the next largest constituent firm, will likely generate an even greater proportion of its revenues from defense once its spinoff of its commercial & industrial businesses are complete, though at 14% of sales last year, defense is clearly a significant driver. Late last year we reiterated our secular overweight in the BCA defense index2 and we take this opportunity to do it again. We believe defense remains on a structural growth trajectory, driven by rising competition between the world's great nations, the decline of globalization and the resumption of a global arms race. Domestic defense spending has been rocketing higher since the Trump administration took the reins (second and third panels, Chart 15). Further, the non-partisan Congressional Budget Office projects this rapid buildup in defense spending to continue apace for the foreseeable future (bottom panel, Chart 15). With little political will to pare this growth from either side of the aisle, we see no reason to expect these estimates to falter. As such, our positive view on defense equities stands in support of our more sanguine view of their aerospace peers. Chart 15Defense Spending Is Accelerating A Long Runway For Aerospace But Risks Are Elevated Overall, aerospace sales and earnings growth look assured for a reasonable forecast horizon, considering the upbeat commercial aerospace demand over the past five years as well as the current robust order environment. Add to this the powerful catalyst that relief in trade wars represent, at least from a sentiment perspective, and aerospace equities are on a solid footing. Nevertheless, that same trade sentiment pendulum swings both ways and we believe elevated trade tensions will increase volatility and decrease predictability. Further, aerospace firms have been blowing out their balance sheets to retire debt and currently enjoy record valuations. Net, we think it no longer pays to be underweight the BCA aerospace index and we are moving to a benchmark allocation. The ticker symbols for the stocks in the BCA aerospace index are: BA, UTX, HON, TXT.   Chris Bowes, Associate Editor chrisb@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Reflationary Or Recessionary?,” dated February 25, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Icarus Moment?,” dated October 22, 2018, available at uses.bcaresearch.com.

Highlights All the U.S. data look broadly similar to us, …: The data series are decelerating, one by one, but they generally remain at a fairly high level relative to history. … and we have begun sounding like a broken record in our morning meetings, … : “There’s no doubt that [insert data series name here] is slowing, but it’s still nowhere close to heralding a recession. As a matter of fact, it remains at a level consistent with above-trend growth. That’s what we should expect given the pattern of fiscal thrust across last year and this year, combined with still-accommodative monetary policy.” … so we’re revisiting our checklists to see if we should change our bearish rates and bullish equities views: We periodically review our checklists, which we rolled out in the fall, to assess whether or not our positioning rationale still applies. Our recommendations may still be the same, but at least we put them to the test: The business cycle, the inflation outlook, the Fed’s reaction function, the corporate profit outlook, and valuations have not changed enough to dictate changing our views. We continually seek out evidence that we’re getting it wrong, but we haven’t found any in the current data. Feature We have become a bit self-conscious about offering our take on the latest U.S. economic data releases at BCA’s daily morning meetings. It’s one thing to be out of step with the prevailing view, or to offer a novel theory that fails to achieve much traction in the room. (Strategists who don’t get shot down by their peers every once in a while aren’t pushing the conventional wisdom enough.) It’s quite another to keep recycling the same narrative, and we’re at something of a loss for a way to maintain our colleagues’ interest. Beep. You’ve reached the voicemail box of the U.S. Investment Strategy team. We believe today’s (insert series name here) release indicates that while the U.S. economy is decelerating, it continues to be on a path to grow at, if not above, trend in 2019. This is consistent with the 60-basis-point decline in fiscal thrust from 2018 to 2019. That decline is large enough to ensure deceleration in 2019, but the 40 bps that’s still going to be deployed this year is also sufficient to ensure that the economy will be able to grow above its 2% trend rate, provided the rest of the world does not fall apart. Thank you for your call, and please do not hesitate to call again if we can be of any further assistance. Beep. We created our bond upgrade and equity downgrade checklists last fall to help guard against sticking with our views beyond their sell-by date. Both checklists have a negative bias, in that they’re meant to help reveal the points at which the underpinnings of our views no longer apply. The bond checklist is broadly geared to identifying either, one, the presence of slack in the economy that might call for easier policy, or, two, a convergence of the fixed-income markets’ views with ours that would limit the potential payoff from maintaining below-benchmark duration positioning.1 Our equity downgrade checklist looks out for signs of an approaching recession, pressure on corporate earnings, inflation pressures that might inspire the Fed to remove accommodation in a hurry, or signs of euphoria that can’t be sustained.2 Reviewing the data series that comprise the checklists did not lead us to change our views. The exercise does help us adhere to a process, however, and we think they help keep us from falling into an analytical rut. We will revisit them with increasing frequency as the cycles we’re trying to track approach their inflection points, while keeping an eye out for any new indicators that might broaden their insights. Is A Bearish Rates View Still Appropriate? The first section of our bond checklist (Table 1) focuses on market perceptions of the Fed. Following our U.S. Bond Strategy service’s golden rule, if the Fed hikes more than it is expected to hike, long-duration positions will underperform. If it hikes less than expected, long-duration positions will outperform. As implied by the overnight index swap (OIS) curves, the money market now expects that the fed funds rate has peaked at 2.5%, and that a rate cut will likely bring it down to 2.25% by the end of 2020 (Chart 1). Table 1Bond Upgrade Checklist Chart 1Markets Are Pricing In A Rate Cut We beg to differ. With little to no slack remaining in the economy as a whole (the output gap is closed), and unemployment well below its natural level and poised to fall further, we think inflation pressures are percolating below the surface. Once they begin to reveal themselves, we expect the Fed will have no choice but to resume its tightening campaign. Our estimate of the equilibrium rate (3% now, rising to about 3⅜% by year-end) appears to be well above the financial markets’ estimate, and we therefore believe the Fed has plenty of room to hike without capsizing the economy. An inverted yield curve has historically been a reliable sign that the Fed has gone too far in its efforts to prevent overheating, and we are watching it now for hints that the fed funds rate may be done rising. Though the curve flattened considerably as the 10-year Treasury yield plunged in the fourth quarter (Chart 2), we think it’s very unlikely to invert while the Fed is on hold. An on-hold Fed implies that the 3-month bill rate will remain in the mid-to-high 2.40s and that the 10-year Treasury yield would have to dip below 2.5% for the curve to invert. Such an outcome would be completely incompatible with below-target inflation and above-trend economic growth. Chart 2The Yield Curve Has Flattened, But Inversion Is A Stretch Inflation is not yet an issue on most investors’ radar screens because it has been conspicuously missing in action around the developed world for the last ten years. In the U.S., headline measures rolled over upon oil’s slide, masking the fact that the core measures are hovering around 2% and remain in uptrends (Chart 3). Inflation break-evens have plunged, and are well below the 2.3-2.5% level that is consistent with the Fed’s 2% inflation target, but their decline was nearly entirely a function of the decline in oil prices (Chart 4). Our Commodity & Energy Strategy service is calling for higher crude prices across the rest of this year, so even though we’ve checked the break-evens box, we expect we’ll be unchecking it as the break-evens reverse in step with oil. Chart 3Headline Inflation's Decline ... Chart 4... Is An Oil Story The labor market remains quite tight. Although the unemployment rate ticked up in December and January, it came down again in February and remains below the estimated natural rate of unemployment where upward wage pressures typically begin to take hold (Chart 5, top panel). Unemployment ticked higher in December and January, despite robust job gains, because the share of working-age Americans participating in the labor force rose. The exodus of the baby boomers from the work force will make it very difficult for the participation rate to keep rising, however (Chart 5, middle panel), and the elevated level of workers quitting their jobs (Chart 5, bottom panel) indicates that employers are poaching workers from one another, driving wages higher. Chart 5The Labor Market Is Tight And Getting Tighter Instability is a double-edged sword as it relates to monetary policy. The Fed is likely to return to hiking rates if it believes it can cut off rising instability before it goes too far. If instability is far enough advanced that it threatens the economy, however, the Fed may well ease policy to try to counteract it. For now, it appears to us that the key cyclical segments of the economy are on track to keep warming up, but are nowhere near overheating (Chart 6). We are not overly concerned about the frisky lending climate that Governor Brainard called out in September, but ongoing anecdotal reports of bond-market froth will presumably keep the Fed alert to the need to dial back accommodation. Acutely bad conditions elsewhere in the global economy would make the Fed consider rate cuts, but if the rest of the world perks up by mid-year, in line with BCA’s base case, the Fed will feel less urgency to indemnify the U.S. against foreign distress. Chart 6Cyclical Segments Are Warming Up Should We Still Be Constructive On Equities? Every box in our equity downgrade checklist remains unchecked, starting with our silent recession alarms (Table 2). The yield curve has not inverted, and as we noted in the review of our rates checklist, we do not believe it will while the Fed remains on hold. Growth has come off the boil, but the LEI is not close to contracting on a year-over-year basis (Chart 7). The fed funds rate remains below our estimate of equilibrium, as we expect it will for the rest of the year, and the three-month moving average of the unemployment rate has not risen by a third of a percentage point from its current cyclical bottom. Table 2Equity Downgrade Checklist Chart 7The LEI May Be Decelerating, But It's Still A Ways From Contracting Labor market tightness will eventually manifest itself in higher wages, which will squeeze corporate profit margins, but until real wage gains begin to outstrip productivity growth (i.e., until labor starts capturing a bigger piece of the pie), corporate earnings will not be at risk (Chart 8). The dollar has spent the last several months going sideways, and BBB corporate yields are now below their level when we rolled out the equity checklist in mid-October (Chart 9). The savings rate has backed up to near the top of its six-year range, and we would check the box if it were to break out of it (Chart 10). There have been no blowups in EM or anywhere in the rest of the world that cast a shadow over U.S. corporate earnings. Chart 8Wage Growth Doesn't Cut Into Profits Until It Outstrips Productivity And Inflation Chart 9Round Trip Chart 10The Savings Rate Has Risen, But Not Enough To Check The Box As noted in our bond checklist comments, above, core inflation measures have dipped below 2% but remain in an uptrend. Both headline CPI and the inflation break-evens relapsed with oil prices, but we expect that a crude recovery will help restore inflation expectations. Bull markets tend to end amid a general feeling of euphoria, and we therefore continue to keep an eye out for signs of over-exuberance. Valuations are elevated but hardly extreme, and we don’t see anecdotal indications of widespread silliness, or suspension of disbelief. Investment Implications From our perspective, overheating in the U.S. remains a very real possibility. Since that is a distinctly minority view, the potential reward for underweighting Treasuries and holding all bond exposures below benchmark duration is alluring. We reiterate our recommendations that investors underweight Treasuries and maintain below-benchmark-duration across their fixed-income portfolios. We expect we will continue to do so until the U.S. economy weakens, or the Treasury curve begins to price in some of our bearish rates view. We reiterate our cyclical recommendation to overweight equities despite the tactical caution we expressed last week.3 We simply expect that the S&P 500 will have to consolidate some of its rapid year-to-date gains before moving on to an eventual new cycle high at 3,000 or above. Stocks don’t go straight up, even if they did for nearly all of January and February, and it is reasonable to expect elevated volatility in the latter stages of a bull market. We thought that the 2,800 level might provide some technical resistance, offering tactically oriented sellers an attractive point to reduce equity exposures, while tactically oriented buyers were likely to find better entry points going forward.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?,” published September 17, 2018. Available at usis.bcaresearch.com. 2 Please see the U.S. Investment Strategy Weekly Report, “Introducing Our Equity Downgrade Checklist,” published October 15, 2018. Available at usis.bcaresearch.com. 3 Please see the U.S. Investment Strategy Weekly Report, “How Much Do U.S. Equities Have Left?,” published March 4, 2019. Available at usis.bcaresearch.com.

Prefer Large Caps To Small Caps (High-Conviction) Small caps have been underperforming their large cap brethren this month as the latter internationally-exposed group has been benefitting disproportionally from news of a potential trade deal ending the U.S. - China dispute. While this transitory benefit of an easing in trade tensions was expected, we think the focus should remain sharply on the diverging fundamentals of the groups. Large cap operating margins are at levels not far from record highs while small cap profits have fallen off a cliff (second panel). Though small cap margins have recovered somewhat in the last year, investors could be forgiven for expecting more, considering their profligacy in expanding their balance sheets, particularly when compared to the relative discipline shown by large caps (third panel). At the same time, small caps trade at a 30% premium to large caps on a cyclically-adjusted P/E basis, making them particularly prone to a fall should investors decide that equity risk premiums do not reflect the much-worsened leverage ratios. Bottom Line: We reiterate our high-conviction call favoring large over small caps.

Highlights The deceleration in global growth that began in 2018 is entering a transition phase. The bottoming out process could prove to be volatile, warning against betting the farm too early on pro-cyclical currencies. Tactical short USD bets should initially be played via the euro1 and Swedish krona. The poor Canadian GDP report last week could be a harbinger for more data disappointments down the road. Meanwhile, the dovish shift by the ECB could paradoxically be bullish for the euro beyond the near term. Go short USD/SEK and buy EUR/CAD for a trade. Feature A currency exchange rate is simply a measure of relative prices between two countries. As such, the starting point for any currency forecast should be how those values are likely to evolve over time. For much of 2018, U.S. growth benefited from the impact of the Trump tax cuts, a boost to government spending agreed in January of that year, and the lagged effect of an easing in financial conditions from December 2016 to January 2018. Outside the U.S., what appeared to be idiosyncratic growth hiccups in both Europe and Japan finally morphed into full-blown slowdowns. Slower Chinese credit growth and the U.S.-China trade war were the ultimate straws that broke the camel’s back, deeply hurting global growth (Chart I-1). Consequently, the greenback surged. Chart I-1The Global Growth Slowdown Persists Fading U.S. Dollar Tailwinds At first glance, the picture remains largely similar today, with global growth still slowing and U.S. growth still outperforming. However, a key difference from last year is that U.S. growth leadership is set to give way to the rest of the world. The U.S. ISM manufacturing PMI peaked last August and has been steadily rolling over relative to its trading partners. The U.S. economic surprise index tells a similar story, with last month’s disappointing retail sales numbers nudging the series firmly below zero. Relative leading economic indices also suggest that U.S. growth momentum has slowed relative to the rest of the world. Historically, the relative growth differential between the U.S. and elsewhere has had a pretty good track record of dictating trends in the dollar (Chart I-2). Chart I-2U.S. Growth Leadership Might Soon End Whether or not these trends persist beyond the first quarter will depend on the sustainability of China’s recent stimulus efforts. On the positive side, typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices have perked up in response to a nascent upturn in the credit impulse. On the other hand, policy shifts affect the economy with a lag, suggesting it is too early to tell whether the latest credit injection has been sufficient to turn around the Chinese economy, let alone the rest of the world. What is clear is that the bottoming processes tend to be volatile and protracted, suggesting it is still too early to bet the farm on pro-cyclical currencies. In the interim, investors could track the following indicators to help time a definitive turning point: Whether or not easing liquidity conditions will lead to higher growth is often captured by the CRB Raw Industrial index-to-gold, copper-to-gold, and oil-to-gold ratios. It is encouraging that these also tend to move in lockstep with the U.S. bond yields, another global growth barometer. The power of the signal is established when all three indicators peak or bottom at the same time, as is the case now (Chart I-3). The next confirmation will come with a clear break-out in these ratios. Chart I-3Reflation Indicators Are Perking Up Chinese M2 relative to GDP has bottomed. Historically, this ratio has lit a fire under cyclical stocks and, by extension, pro-cyclical currencies (Chart I-4). The growth rate is still at zero, meaning excess liquidity is not accelerating on a year-over-year basis. Meanwhile, our Emerging Markets team argues that broad credit growth is still decelerating.2 A break above the zero line, probably in the second half of this year, could be a catalyst to shift fully to a pro-cyclical currency stance. Chart I-4Chinese Excess Liquidity Improving On a similar note, currencies in emerging Asia that sit closer to the epicenter of stimulus appear to have bottomed. If those in Latin America can follow suit, it would indicate that policy stimulus is sufficient, and the transmission mechanism is working (Chart I-5). Chart I-5EM Currencies Are Trying To Bottom Finally, China-sensitive industrial commodities, especially metals and building materials, appear to have troughed and are perking up nicely. There was a supply-related issue with the Vale dam bursting in Brazil and a subsequent surge in iron-ore prices, but it is now clear that the entire industrial commodity complex has stopped falling (Chart I-6). Chart I-6Chinese Industrial Commodities Are Rallying Be Selective On USD Shorts Our strategy is to be selective as U.S. dollar tailwinds shift to headwinds, by initially expressing tactical USD shorts via the euro and the Swedish krona. Last week, we highlighted the fact that investors are currently too pessimistic on Europe’s growth prospects. More importantly, most of the factors that toppled European growth domestically – the implementation of new auto-emission standards in Germany, the rising cost of capital in Italy via exploding bond yields, and the populist Gilets Jaunes protests in France – are mostly behind us. Fiscal policy is also set to be loosened this year, and last year’s weakness in the euro will contribute to easier financial conditions. The improvement in European investor sentiment relative to current conditions could be a harbinger of positive euro area data surprises ahead (Chart I-7). Chart I-7Euro Zone Data Might Surprise To The Upside The European Central Bank left rates unchanged at yesterday’s policy meeting but the decision for a new Targeted Long Term Refinancing Operation (TLTRO III – or in other words, cheap loans), could be paradoxically bullish for the euro. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that this is bearish for the currency. Our Global Fixed Income team nailed the move by the ECB in this week’s report.3 European banks have been in the firing line of sluggish growth, negative interest rates, and increased regulatory scrutiny. In the case of Italy, an NPL ratio 9.4% is nearly triple that of the euro area. And with circa 10% of total bank lending in Spain and Italy funded by TLTROs, re-funding by the ECB is exactly what the doctor ordered. In the case of the Sweden, the undervaluation of the krona has begun to mitigate the effects of negative interest rates – mainly a buildup of household leverage and an exodus of foreign direct investment. The GDP report last week was well above expectations, with year-on-year growth of 2.4%. Encouragingly, this was driven by net exports rather than consumption. The Swedish manufacturing PMI release for February was also very encouraging. Orders jumped from 50.4 to 54.0 while export orders jumped from 51.5 to 53.4. The growth in wages is beginning to catch up to new borrowings, meaning domestic consumption could be increasingly financed through income. This will alleviate the need for the Riksbank to maintain an ultra-accommodative policy. On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, the cross is facing strong resistance at the triple top established from the 2009 highs around 9.45 (Chart I-8). Aggressive investors should begin accumulating short positions, while being cognizant of the negative carry. Chart I-8The Swedish Krona Looks Like A Buy Bottom Line: Our favorite indicator for gauging ultimate downside in the dollar is the gold-to-bond ratio. Ever since the global financial crisis, gold has stood as a viable threat to dollar liabilities, capturing the ebb and flow of investor confidence in the greenback tick-for-tick (Chart I-9). Any sign that the balance of forces are moving away from the U.S. dollar will favor a breakout in the gold-to-bond ratio. For now, USD short positions should be played via the euro and Swedish krona.   Chart I-9Pay Close Attention To The Gold-To-Bond Ratio Buy EUR/CAD For A Trade Last week saw an extremely disappointing GDP report out of Canada, which prompted the Bank of Canada to keep interest rates on hold this week, followed by quite dovish commentary. In a 90-degree maneuver from its January policy statement that rates will need to rise over time, BoC Governor Stephen Poloz said the path for future increases had become “highly uncertain.”   Like many central banks around the world, the BoC has been blindsided by the depth of the negative growth impulse outside its borders, which has begun to seep into the domestic economy. The economy grew at an annualized pace of 0.4% in the fourth quarter, the lowest in over two years. Capital expenditures collapsed at a rate of 2.7%, marking the third consecutive quarter of declines. The forward OIS curve is pricing in no rate hikes for Canada this year, meaning sentiment on the loonie is already depressed. However, our contention is that even if growth bottoms by the second half of this year, the Canadian dollar will offer little value to play this cyclical rebound. Our recommendation is to play the loonie’s downside via the euro. First, valuations and balance-of-payment dynamics favor the euro versus the CAD on a long-term basis. Second, we estimate there is more scope for long-term interest rate expectations to rise in the euro area than in Canada (Chart I-10). European rates are further below equilibrium, and the ECB’s dovish shift will help lift the growth potential of the euro area. Meanwhile, the Canadian neutral rate will be heavily weighed down by the large stock of debt in the Canadian private sector, exacerbated by overvaluation in the housing market. This means that expectations in the 2-year forward market are likely to favor the euro versus the CAD. Chart I-10Buy EUR/CAD For A Trade The biggest risk to this view is the price of oil. The EUR/CAD exchange rate is not as negatively correlated with oil as the USD/CAD, but nonetheless the CAD benefits more from rising oil prices than the euro does. BCA’s bullish oil view is a risk over the next six months. On the downside, the EUR/CAD could potentially test the bottom of the upward trending channel that has existed since 2012. This would put EUR/CAD in the vicinity of 1.45 (currently trading at 1.5049). However, initial upside resistance rests at the triple top a nudge above 1.6 (Chart I-11). Chart I-11EUR/CAD Technicals: Limited Downside Meanwhile, economically, Canada is benefiting less from oil prices today than it has in the past. First, the Canadian oil benchmark trades at a large discount to Brent, and second, Canada is having trouble shipping its own oil at a moderate cost due to lack of pipeline capacity.4  Bottom Line: Investors should buy the EUR/CAD for a trade. The Canadian dollar is likely to outperform its antipodean counterparts, but faces limited upside versus the U.S. dollar. There are better opportunities to play USD downside, namely via the Swedish krona and the euro. Stand Aside On The Australian Dollar For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities is rapidly morphing into a housing crash (Chart I-12). Chart I-12Australia: Anatomy Of A Hard Landing In addition, the upcoming general election could exacerbate the risks to the country’s banks and the housing market.5 The center-left Labour Party, which has moved further to the left in this electoral cycle, has promised several regulatory changes. First, the Labour government would want to get rid of “negative gearing,” the practice of using investment properties that are generating losses to offset one’s income tax bill. Second, the capital gains tax exemption from selling properties will be reduced from 50% to 25%. Third, the Labour government would end the policy of reimbursing investors for the corporate tax paid by the company. This would end the incentive for retirees to own high dividend yielding equities, such as those of Australian banks. This week, the Reserve Bank of Australia kept rates on hold and acknowledged risks to the housing market, but bank stocks suggest they remain well behind the curve (Chart I-13). The futures market is already pricing in 23 basis points of rate cuts by the end of the year, and the contention of our fixed income team is that more might be needed down the road. First, all the preconditions for a rate hike – underemployment below 8%, a rebound in Chinese economic activity and core CPI in the range of 2-3% – have not been met. The reality is that core CPI has lagged the target range since late-2015, and now faces downside risks. Chart I-13Australian Bank Stocks Are Pricing In A Curve Inversion That said, a lot of the bad news already appears priced into the Australian dollar, which is down 14% from its 2018 peak, and 37% from its 2011 peak. This suggests outright short AUD bets are at risk from either upside surprises in global growth, or simply the forces of mean reversion (Chart I-14). Chart I-14Stand Aside On The Australian Dollar For Now Bottom Line: Sentiment on the Aussie dollar is already bearish, warning against putting on fresh shorts. Our short AUD positions, expressed via the NZD and the CAD, are currently 6.74% and 1.99% in the money, respectively. Investors should hold onto these positions, but tighten stops to protect profits.   Chester Ntonifor,  Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report titled “A Contrarian Bet On The Euro,” dated March 1, 2019 available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report titled “EM: A Sustainable Rally Or False Start?,” dated March 7, 2019 available at ems.bcaresearch.com 3 Please see Global Fixed Income Strategy Special Report, titled “The ECB’s Next Move: Taking Out Some Insurance,” dated March 5, 2019, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, titled “Oil Price Diffs: Global Convergence,” dated March 7, 2019, available at ces.bcaresearch.com 5 Please see Geopolitical Strategy Special Report, titled “A Year Of Change In Australia?,” dated December 5, 2018, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed: Annualized Q4 GDP growth came in line with expectations at 2.6%, but both the Atlanta and New York Fed models suggest sub 1% growth in Q1 this year. ISM manufacturing PMI missed expectations, falling to 54.2, while the non-manufacturing PMI increased to 59.7. Q4 unit labor costs increased to 2%, surprising to the upside. The DXY index has gained 1.17% this week. Upside on the dollar will be based on Fed’s capacity to continue tightening monetary policy later this year. However, there are increasing signs pointing to a weakening in leadership of U.S. growth this cycle, which could be a headwind for the counter-cyclical dollar. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area show some specter of stabilization: Yearly consumer price inflation increased to 1.5%, in line with expectations. Q4 GDP growth on a year-on-year basis fell to 1.1%, marginally in line. Encouragingly, the Markit composite PMI increased to 51.9. The manufacturing PMI came in at 49.3, while services PMI came in at 52.8.  Finally, retail sales grew higher than expected, with a reading of 2.2%. EUR/USD has fallen by 1.3% this week. The ECB kept interest rates on hold with a dovish tilt. Paradoxically, this could be bullish for the euro, if it allows growth to definitively bottom. Easing financial conditions in the euro area are reflationary and risks to the periphery have been curtailed. Report Links: A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Yearly inflation surprised to the upside, coming in at 0.6%. The core inflation excluding fresh food also came in higher than expected at 1.1%. January unemployment rate missed expectations, climbing to 2.5%; while the jobs-to-applicants ratio stayed at 1.63. Nikkei manufacturing PMI surprised to the upside, coming in at 48.9. USD/JPY has risen by 0.4% this week. While we are positive on the safe-haven yen on a structural basis, we struggle to see any near-term upside amid significant Japanese stock and bond outflows. We will be discussing the outlook for the yen in an upcoming report. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been improving: February consumer confidence came in at -13, slightly higher than expectations. Markit manufacturing PMI came in at 52, in line with expectations; while the services PMI surprised to the upside, coming in at 51.3. The Halifax house price index surprised to the upside, rising 5.9% mom in February. GBP/USD has fallen by 1.2% this week. During the speech on March 5, the Bank of England governor Mark Carney highlighted the market underestimates the potential for interest rate hikes. Overall, we remain bullish on the pound in the long-term, but volatility is set to rise in the near term as we approach the Brexit March 29 deadline. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been dismal: The RBA commodity price index advanced by 9.1% year-on-year in February, but this was supply related. Building permits continue to contract at 29% year-on-year. Finally, the annualized Q4 GDP growth fell to 0.2%, more than 50% below expectations. AUD/USD fell by 1.2% this week. The RBA kept the interest rate unchanged at 1.5%. Governor Philip Lowe acknowledged the downside risks to the housing market and overall economy, and warned about the “significant uncertainties around the forecast.” That said, AUD/USD has fallen by a 13% since the January 2018 highs, warning against establishing fresh shorts at this juncture. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Seasonally adjusted building permits increased 16.5% month-on-month in January, a huge jump. However, the ANZ activity business confidence dropped to -30.9. Most importantly, terms of trade fell to -3% in the fourth quarter, underperforming expectations. NZD/USD depreciated by 0.9% this week. The key for the Kiwi will be a pickup in agricultural commodity prices, which remain in a definitive bear market. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been disappointing: Q4 current account balance has deteriorated, coming in at C$ -15.48 billion. Moreover, annualized Q4 GDP growth missed analysts’ forecast, coming in at 0.4%. Finally, the Markit manufacturing PMI weakened to 52.6 in February. USD/CAD has gained 2.1% this week. The BoC kept interest rates on hold at 1.75% given that domestic economic conditions have now coupled to the downside with a bleak external picture. The caveat for the Canadian dollar is that rising oil prices could provide some support. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019   Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Annualized Q4 GDP growth missed analysts’ expectations by 50%, coming in at 0.2%.  In addition, the retail sales contracted 0.4% year-on-year. Lastly, CPI was in line at 0.6%, but this is a far cry from the March 2018 peak. EUR/CHF has been flat this week. Overall, we are bullish EUR/CHF on a cyclical basis. Stabilization in global growth will make safe-haven currencies like the franc less attractive. In addition, the foreign direct investment and portfolio investment outflows from Switzerland should put more downward pressure on the franc. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Monthly unemployment rate fell to 2.5%, in line with expectations. However, the Q4 current account balance fell to 46.8 billion from 91.36 billion in Q3. The manufacturing PMI has been stable for a few months now, coming in at 56.3 for the month of February. USD/NOK increased by 2.2% this week. We are optimistic on the NOK on a structural basis, given the positive outlook for oil prices. Moreover, the NOK is undervalued and trading at a large discount to its long-term fair value. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Retail sales was in line with expectations at 0.8% month-on-month. However, annualized Q4 GDP growth was double expectations at 1.2%. The February manufacturing PMI also came in higher at 52.5. In addition, industrial production yearly growth came in higher at 3.4%. Lastly, the Q4 current account balance increased to 39.6 billion. USD/SEK increased by 2% this week. The SEK is still trading at a large discount to its long-term fair value. We remain bearish on USD/SEK on a structural basis as we see many signs pointing to a recovery in the Swedish economy, which is a tailwind for the Swedish krona.   Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Overweight Within our broad-based U.S. equity sector and subsector coverage, we continue to recommend a modest gold-related hedge via being overweight the global gold mining index (given that the S&P gold index only comprises a single stock) versus the MSCI All-Country World Index, expressed through the long GDX:US/short ACWI:US exchange traded funds. Globally there is a slowdown that has infected a number of economies and BCA’s calculated Global ZEW economic sentiment index has lit a fire under gold mining stocks (Global ZEW shown inverted, second panel). The longer the global soft-patch lasts, the longer Central Banks will remain on the sidelines or even ease monetary policy in order to rekindle growth. Moreover, the global policy uncertainty index is perking up given the ongoing U.S./China trade tussle (top panel), recent news of a no deal between the U.S. and North Korea and looming Brexit deadline. All of this underpins global gold stocks. Tack on the recent fear that gripped markets, and skyrocketing equity risk premia, and the ingredients are in place for additional gains in the relative share price ratio (bottom panel). Bottom Line: Stay overweight the global gold miners index (long GDX:US/short ACWI:US); please see Monday’s Weekly Report for more details.