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Underweight The S&P cable & satellite index was under intense pressure last week as the quarterly release of subscriber churn numbers for the constituent companies came out worse than expected. In particular, CHTR saw its stock fall by nearly 12% when it reported a subscriber loss nearly triple what analysts had forecast. Cord cutting is far from a new theme and investors have grown accustomed to subscriber losses, though the trend clearly appears to be accelerating. This is in spite of price inflation, which had been the savior of cable & satellite P&L's last year, falling off a cliff (bottom panel). The logical conclusion is to expect continued top line declines and margin contraction amplifying the downward trend for sector earnings. With the broad market posting prime time earnings, the S&P cable & satellite index should be moving to an unappealing slot; stay underweight. The ticker symbols for the stocks in the cable & satellite index are BLBG: S5CBST - CMCSA, CHTR, DISH.

Highlights Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Chart 3GOP Retirements Are Unprecedented Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of April 30, 2018. There are no significant changes in the model's allocation this month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD, %) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 20 bps in April, largely driven by the Level 2 model which outperformed by 44 bps while the Level 1 model outperformed only by 2 bps. Since going live, the overall model outperformed the MSCI World by 156 bps, due to the 493 bps of outperformance from the Level 2 model which allocates funds among 11 non-U.S. countries. The Level 1 model (which allocates funds between U.S. and the non-U.S.) is on par with the MSCI world benchmark.Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Text below For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of April 30, 2018. For the third consecutive month, the model maintains a defensive positioning generating an alpha of 60 bps for the month of April. Following the end of trade threats (for now), the growth component of the model has stabilized. But, overall the model maintains the same weights from last month with an aggregate tilt of 1.3% towards defensive sectors. Energy remains the only cyclical sector with an overweight on the back of favorable valuations and improving momentum. Among defensive sectors, utilities maintains a large overweight of 5% on the back of better momentum. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com

This week we are raising our cyclical peak SPX target to 3,200. We derive this target via three methodologies: a traditional dividend discount model (DDM), EPS and multiple sensitivity analysis and forward equilibrium equity risk premium (ERP) analysis, and we have included these valuations in the table below. Please see yesterday's Weekly Report for more details on our analysis and, if you would like to receive the excel spreadsheet with the three models so you can tweak our inputs/assumptions, please click here.

Highlights Bond Bear Market: TIPS breakeven inflation rates are still below target, and this gives us high conviction that Treasury yields will increase on a cyclical horizon. If we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will likely occur between 3.35% and 3.52%. Interest Sensitive Spending: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond Yields & Gold: A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Feature Chart 1The Bear Is Back After a brief pause in March, the cyclical bond bear market has resumed. The 10-year Treasury yield even briefly broke above 3% last week, with its 27 basis point rise off the early-April lows evenly split between the compensation for inflation protection and the 10-year real yield (Chart 1). To mark the occasion of the 10-year Treasury yield breaking above 3% for the first time since early 2014, this week we update our roadmap for the Two-Stage Cyclical Bond Bear Market, which we first outlined in late February.1 Specifically, we consider the questions of where the 10-year Treasury yield might be by the end of this year, and where it might ultimately peak for the cycle. On the second question we think bond investors can glean important information from trends in the price of gold. Tracking The Two-Stage Bear Market In our report from February we described how the cyclical Treasury bear market will proceed in two stages. The first stage is characterized by the re-anchoring of inflation expectations. Stage 1: The Re-Anchoring Of Inflation Expectations The 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate currently sit at 2.17% and 2.25%, respectively. Historically, when core inflation is well anchored around the Fed's target, both of those breakeven rates have traded in a range between 2.3% and 2.5% (Chart 2). This means that nominal Treasury yields still have room to rise as the market prices in a more realistic outlook for inflation. That could happen sooner rather than later. Core PCE inflation increased 0.15% in March, causing the 12-month rate of change to jump from 1.57% to 1.88% (Chart 2, bottom panel). Meanwhile, the annualized 3-month and 6-month rates of change remain well above the Fed's 2% target. Looking further out, we see inflationary pressures continuing to build in the U.S. economy. The employment data now clearly show very little slack in the labor market, and this appears to be finally filtering through to wages. The Employment Cost Index for Wages & Salaries rose 0.9% in the first quarter, its largest quarterly increase since 2007. The year-over-year growth rate in the index moved up to 2.7%, from 2.6% in Q4, and is right in line with its predicted value based on the prime age employment-to-population ratio (Chart 3).2 Chart 2Stage 1 Almost Complete Chart 3Faster Wage Growth Ahead As long as TIPS breakeven inflation rates remain below our target range we have high conviction that Treasury yields will increase, driven by a re-anchoring of inflation expectations. Once our TIPS breakeven target is met, the cyclical bond bear market will transition to stage two. Stage 2: The Terminal Fed Funds Rate After inflation expectations are re-anchored around the Fed's target, the most important question for bond investors becomes: How high will the Fed need to lift the policy rate to keep inflation from moving well above target? Or alternatively: What is the terminal (or peak) fed funds rate for this cycle (see Box)? Box: The Terminal Fed Funds Rate & The Equilibrium Fed Funds Rate Please note that in this report we refer to two separate, though related, concepts. We define the terminal fed funds rate as the peak fed funds rate for the business cycle. We also define the equilibrium fed funds rate as the fed funds rate that is consistent with neither an accommodative nor a restrictive monetary policy. The terminal fed funds rate is almost certainly higher than the equilibrium fed funds rate because monetary policy will likely turn restrictive before the end of the economic cycle. Chart 4Treasury Yield Models We can show why this question is so important using a simple model of Treasury yields based on expectations for changes in the fed funds rate and the MOVE index of implied rate volatility. The latter is a proxy for the term premium embedded in Treasury yields (Chart 4). For example, if we assume that the equilibrium fed funds rate - the rate consistent with neither accommodative nor restrictive monetary policy - is approximately 3%, and that by the end of this year the yield curve will price in a return to neutral monetary policy by the end of 2019. That would be consistent with a 10-year Treasury yield between 3.03% and 3.19% by the end of this year, assuming also that the MOVE index ranges between its current level and its historical low. This result can be seen in Table 1 by looking at the rows consistent with three rate hikes in 2018 and a 12-month discounter of 75 bps by year end. We could also assume that the equilibrium fed funds rate is 3%, but that the market will start to price in a restrictive monetary policy by the end of 2019 - i.e. a fed funds rate above its equilibrium level. That result would be consistent with a 10-year Treasury yield between 3.35% and 3.52% by the end of this year, once again assuming that the MOVE index ranges between its current level and its historical low. The bottom line is that with TIPS breakeven inflation rates still below target, we have high conviction that yields will increase on a cyclical horizon. Beyond that, if we assume that a 3% fed funds rate is roughly consistent with a neutral monetary policy stance, then we should expect the cyclical peak in the 10-year Treasury yield to be in a range between 3.35% and 3.52%. Tracking The Equilibrium Fed Funds Rate Using Nominal GDP And Gold It's worth pointing out that both examples in the prior section assumed that the MOVE index will either stay flat or decline. The reason for that assumption is that both examples assume a relatively low equilibrium fed funds rate of 3%. In other words, both examples assume that monetary policy will turn restrictive once the fed funds rate moves above 3%, causing economic growth to slow. If that assumption proves to be correct, and with the 10-year Treasury yield already close to 3%, the yield curve will undoubtedly flatten as the fed funds rate is raised. A flatter yield curve is highly correlated with lower implied rate volatility. In order for implied rate volatility to move meaningfully higher, and for us to see a much higher 10-year Treasury yield (as is shown in the bottom third of Table 1), the market will need to start discounting a higher equilibrium fed funds rate. Put differently, investors would have to believe that the fed funds rate necessary to slow economic growth and inflation is much higher than 3%. It is only in that scenario that the cyclical peak for the 10-year Treasury yield will significantly exceed the 3.35% to 3.52% range posited in the prior section. Table 1Treasury Yield Projections Under Different Scenarios But how can we decide whether or not the equilibrium fed funds rate is higher than 3%? One imperfect way is to simply track economic growth and look for signs that it is about to slow. Cyclical Nominal GDP Growth Chart 5 shows that one good signal of a recession is when nominal GDP growth falls below the fed funds rate. While this is a fairly reliable recession indicator, it is not always a good method for determining when monetary policy turns restrictive. For example, prior to the last recession nominal GDP growth started to wane when it was still far above the level of the fed funds rate. If we had been waiting for the fed funds rate to exceed nominal GDP growth we would have missed the inflection point toward slower growth. The method worked better prior to the 1990 recession when the fed funds rate was lifted above the pace of nominal GDP growth while the latter was still accelerating. That configuration gave a much clearer real-time signal of restrictive monetary policy. Chart 5Cyclical Spending Suggests That Monetary Policy Remains Accommodative A more refined version of this approach is to track only the cyclical sectors of the economy - those sectors that are most sensitive to interest rates. Growth in those sectors - consumer spending on durable goods, residential investment and nonresidential investment for equipment and software - tends to deteriorate prior to major downturns in overall nominal GDP (Chart 5, bottom panel). This method gives us a slightly earlier warning that monetary policy has turned restrictive. On that note, we observe that while cyclical spending as a percent of overall GDP is still in an uptrend, its rate of increase has declined during the past few quarters (Chart 6). This is mostly due to somewhat weaker consumer spending on durables. But we doubt that cyclical spending is in danger of rolling over any time soon. Chart 7 shows that the fundamentals underpinning the key cyclical sectors of the economy remain robust: Consumer sentiment is elevated compared to history, and income growth has started to move higher (Chart 7, top panel). The latter will be helped along by recently enacted tax cuts during the next few months. New orders for core durable goods already display solid growth, and survey indicators give no signal of imminent deterioration (Chart 7, panel 2). On residential investment, homebuilder confidence is near historical highs (Chart 7, panel 3), while mortgage purchase applications so far seem immune from the effects of higher interest rates (Chart 7, bottom panel). Chart 6Cyclical Spending Still Rising... Chart 7...And Fundamentals Remain Sound At the moment, this analysis tells us that monetary policy is probably still accommodative. Once the cyclical sectors of the economy start to slow, that will give us a signal that monetary policy is restrictive and that we are probably near the cyclical peak in Treasury yields. Inflation, Uncertainty And The Price Of Gold But is there another method we can use to track the equilibrium fed funds rate and the stance of monetary policy in real time? We think there is, and it relates to investors' perceptions of inflationary pressures in the economy. First, we recognize that when inflationary pressures are higher, the equilibrium fed funds rate is also higher. In other words, the Fed needs to lift rates further before monetary policy becomes restrictive and inflation starts to flag. This intuition is confirmed by the historical relationship between long-run inflation forecasts and the short-term interest rate (Chart 8). More interestingly, we also observe that uncertainty about the long-run inflation forecast is positively related to implied interest rate volatility, the slope of the yield curve and the price of gold (Chart 9). Once again, this is intuitive. If investors are more uncertain about the long-run inflation outlook they will demand a greater risk premium to bear inflation risk in the long-run, thus driving long-dated bond yields higher. Chart 8Inflation Forecasts &##br## Interest Rates Chart 9Inflation Uncertainty Drives##br## The Term Premium The gold price is positively correlated with inflation uncertainty because gold is in many ways the "anti-Fed" asset. Since it is perceived to be a long-run store of value, investors will bid up the gold price whenever there is a heightened risk that the Fed might "fall behind the curve" allowing inflation to overshoot its target. Conversely, the gold price tends to fall when the perception is that the Fed is "ahead of the curve" and is maintaining an overly restrictive monetary policy. Chart 10Gold Has Led The Fed This is why bond investors would be wise to heed the signal from gold. A sharply rising gold price signals that the fed funds rate is running further below its equilibrium level. This could occur because the Fed is cutting rates to levels that the market deems too low. Or, it could occur because the market now believes that the equilibrium fed funds rate is higher. A sharply falling gold price gives the exact opposite signal. It tells us that either the Fed is lifting the funds rate too far above equilibrium, or that the market is revising down its assessment of the equilibrium rate. This chain of events played out before our eyes during the past few years. The gold price started to fall sharply in early 2013, and continued its decline until late 2015 (Chart 10). A signal that investors were discounting a more restrictive monetary policy stance during that timeframe. But the Fed was not lifting rates during that period. In fact, with hindsight it now seems obvious that the gold price was falling because the market was revising down its assessment of the equilibrium fed funds rate. Investors should also note that the falling gold price signaled a lower equilibrium fed funds rate well before the Fed started to revise down its median forecast for the interest rate that is expected to prevail in the "longer run".3 Tracking the price of gold would have given us a much timelier signal than waiting for the Fed. Chart 10 also shows that the gold price has rebounded since early 2016, but has been confined to a trading range during the past few months. Not coincidentally, this rebound has coincided with the Fed ceasing the downward revisions to its estimate of the equilibrium fed funds rate. Going forward, we think that bond investors would be wise to closely track the price of gold. A significant move higher in the gold price would be a strong signal that the Fed is not tightening policy quickly enough to contain inflationary pressures. In other words, it would signal that the equilibrium fed funds rate should be revised higher. This would drive up implied interest rate volatility, apply steepening pressure to the yield curve, and lead to a higher end-of-cycle target for the 10-year Treasury yield. Bottom Line: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond investors should also track the price of gold. A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 208, available at usbs.bcaresearch.com 2 In a recent report we showed that nonfarm payrolls need to increase by 110k or more per month to drive the prime age employment-to-population rate higher, leading to faster wage growth. For further details please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 018, available at usbs.bcaresearch.com 3 The Fed's projection of the interest rate expected to prevail in the "longer run" is essentially its estimate of the equilibrium fed funds rate. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Duration: The global bond bear market is still intact, although the "leadership" has passed over to the U.S. where growth is the firmest and inflation expectations are rising the fastest. Maintain an overall below-benchmark portfolio duration stance, focusing underweights in countries that can actually tighten monetary policy this year (U.S., Canada, the euro area). ECB: The ECB has started to take notice of the latest batch of softening euro area economic data. Yet it will take a much more prolonged slowdown for the ECB's medium-term economic forecasts to be proven incorrect, which would alter the likely timetable for a tapering of asset purchases by year-end. Canada: The Bank of Canada has adapted a more cautious tone of late, which seems overly pessimistic given the underlying trends in Canadian growth and inflation. Stay underweight Canadian government bonds. Feature We're Sticking With Our Country Allocations One of our key investment themes for 2018 has been that economic growth, monetary policies and bond yields would be far less correlated between countries than was seen in 2017. This would create cross-country fixed income trading and investment opportunities that were much harder to come by last year. With the 10-year U.S. Treasury yield finally reaching the 3% level last week, that story looks to be playing out. Yields are going up elsewhere, but nothing like what is happening in the U.S., where growth remains firm compared to the string of negative data surprises seen in other countries (Chart of the Week). This theme of divergence can also be seen in the recent actions and comments from central bankers. Officials at the U.S. Federal Reserve have continued to signal, with increasing conviction, that additional rate hikes will be needed later this year (although not at this week's FOMC meeting). This is to be expected given that not only is U.S. growth holding up well (Q1 real GDP growth "only" slowed to an above-potential pace of 2.3%), but both core PCE inflation and the Wages & Salaries component of the Employment Cost Index are accelerating at a marginal pace not seen since the 2008 crisis (Chart 2). Chart of the WeekU.S. Economy Outperforming,##BR##USTs Underperforming Chart 2No Reason For The Fed##BR##To Turn Less Hawkish At the same time, policymakers in other major developed countries have turned somewhat more cautious: The Bank of Japan (BoJ) announced that it will no longer provide a specific date when it expects inflation to reach its target The European Central Bank (ECB) took the highly unusual step of holding a monetary policy meeting last week without actually discussing the monetary policy outlook, according to ECB President Mario Draghi Bank of England (BoE) Governor Mark Carney dampened expectations of a rate hike in May that was nearly fully discounted by markets The Bank of Canada (BoC), which had already delivered several rate hikes when inflation was below its 2% target, chose to keep rates on hold despite inflation finally breaching 2% Sweden's Riksbank pushed out the expected timing of its next rate hike (yet again) to the end of 2018, even with inflation now at target With global growth losing some momentum, it is no surprise that policymakers are trying to not sound too hawkish, which could trigger an unwelcome decline in inflation expectations. Here again, divergences between countries have opened up. Rising oil prices are translating into higher market-based inflation expectations in countries like the U.S. and Canada where growth is still above-potential and leading economic indicators are rising (Chart 3). This is not the case in places like the U.K., Australia and Japan where growth is sluggish, leading indicators are slowing, but with markets still pricing in interest rate increases over the next year (Chart 4). This divergence is a critical underpinning of our current recommended country allocation within government bond markets - overweighting the U.K., Australia and Japan where tighter monetary policy will be difficult to achieve; while underweighting the U.S. and Canada, where rate hikes are still in the cards. Chart 3Shifting Oil/Inflation Correlation... Chart 4...In Countries Where Growth Is Slowing The European Duration Call Gets A Bit Trickier The evidence on the euro area is a bit less conclusive on this front, however. The OECD's leading economic indicator has only dipped modestly from its recent peak, and the correlation between oil prices and inflation expectations has not broken down. Draghi stated in his press conference following last week's policy meeting that the ECB Governing Council was focused on "very important" current euro area economic data that had clearly lost momentum in the first quarter of this year. He noted that there were many one-off factors that could have caused the softer growth (weather, labor strikes, the timing of holidays), but that the slump was very broad-based and hit almost all euro area countries. This makes the next few months of data critical to determine the ECB's next policy move, which could be an announcement of a tapering of its asset purchases when the current program ends in September. From our perspective, the sluggish Q1 euro area economic performance looks to be driven by a major slowing of export growth. Industrial confidence remains at a high level and growth in retail sales volumes has remained stable since the middle of 2017 (Chart 5). Yet the annual growth rate of total euro area exports has slumped to less than 3%, with exports to Asia now contracting on a year-over-year basis (bottom two panels). If the export slump continues in the coming months, this could begin to impact hiring activity across the euro area. A rise in unemployment would definitely change the ECB's calculus in altering its policy stance. At the moment, the Governing Council can look at a steadily declining overall euro area unemployment rate - which is approaching the OECD's estimate of the full employment NAIRU - combined with moderate increases in core HICP inflation, wage growth and inflation expectations, as confirmation that trends are still broadly following the path laid out in its latest economic projections (Chart 6). Chart 5An Export-Led Cooling##BR##Of Euro Area Growth Chart 6ECB Will Not Lift Rates Until##BR##Inflation Expectations Move Back To 2% The ECB has made it clear that it views a tapering of its asset purchases and any subsequent interest rate hikes as separate policy decisions. The hurdle to end the bond purchases is much lower than it is for raising interest rates. On the former, as long as unemployment and inflation continue to evolve along the lines of the ECB's projections, then a full tapering of bond purchases will occur by year-end (with an announcement occurring at either of the June or July ECB meetings). On the latter, it will take inflation expectations (as measured by the 5-year EUR CPI swap, 5-years forward) rising back above 2% for the ECB to feel confident that rate increases will be necessary, as was the case during the mid-2000s tightening cycle and the 2011 mini-cycle (bottom panel). For now, we are maintaining our moderate underweight stance on euro area government debt. Looking ahead, we will be watching the correlation between oil prices denominated in euros and inflation expectations, as well as the development of leading economic indicators in the euro area. If the Q1 growth slump widens into a broader downturn, then the ECB could be forced to revise its economic projections lower and continue with the asset purchases into 2019. While that is not our base case scenario, such a development would force us to reconsider our stance on euro area debt. Bottom Line: The global bond bear market is still intact, although the "leadership" has passed over to the U.S. where growth is the firmest and inflation expectations are rising the fastest. Maintain an overall below-benchmark portfolio duration stance, focusing underweights in countries that can actually tighten monetary policy this year (U.S., Canada, the euro area). In Europe, it will take a much more prolonged slowdown for the ECB's medium-term economic forecasts to be proven incorrect, which would alter the likely timetable for a tapering of asset purchases later this year. Canada: Still On Track For More Hikes This Year The BoC has been sending more cautious signals of late regarding its next policy moves, after delivering 75bps of rate hikes since last summer. Some of this simply reflects a more measured tone taken by other central banks in response to signs of global growth losing some momentum, as discussed earlier. Yet in the case of Canada, it is difficult to make a credible case that the central bank should not continue its rate hiking cycle, particularly with inflation now above the midpoint of the BoC's 1-3% target band. Upside Risks To Canadian Growth Versus BoC Projections Yes, the Canadian economy has lost some of the rapid upward momentum seen in 2016 and 2017, led mostly by weakness in exports which are now contracting on a year-over-year basis (Chart 7). This was focused in aircraft, transportation equipment, and energy products. The latter is due to poor weather conditions and transportation bottlenecks involved in getting oil out of Alberta rather than a sign of weakening demand for Canadian oil. The BoC did take a more cautious view on exports in the latest set of economic projections presented in the April Monetary Policy Report (MPR). The central bank now expects real exports to be stagnant in 2018, downgrading the expected contribution to real GDP growth to zero from the +0.6 percentage points presented in the January MPR. This was, by far, the biggest downgrade to any of the GDP growth components in the BoC's forecast, and was main reason why the BoC downgraded its overall 2018 real GDP growth projection to 2.0% from 2.2%. Yet at the same time, the BoC actually upgraded its global growth projection to 3.8% from the 3.6% figure in the January MPR. We suspect that the downgrade to the export contribution to expected 2018 growth was the BoC trying to inject some room for error in its growth forecasts for any negative outcome in the current round of NAFTA trade negotiations with the U.S. and Mexico. Otherwise, it makes no sense to have such a large downgrade without becoming more pessimistic on global growth. Our Geopolitical strategists are now much more optimistic that a NAFTA deal will be reached, rather than having the U.S. exit the agreement as President Trump has threatened. If that happens, the BoC's growth projections may end up being too low. We can see a similar level of "excessive cautiousness" with regards to the BoC's assessment of the Canadian labor market and the outlook for consumption. Consumer spending has also cooled off a bit from very robust levels, although an unusually long and harsh winter likely played a large role there, as evidenced by the suspiciously large plunge in retail sales growth (Chart 8). The fundamental underpinnings for Canadian consumption still look solid, though. Chart 7Canadian Economy Holding Up Well,##BR##Despite Weak Exports Chart 8Solid Income Fundamentals##BR##For The Canadian Consumer Consumer confidence remains near cyclical highs. Wage growth currently sits at 3.2% in nominal terms and 1.5% in real terms. The BoC noted in its Spring Business Outlook Survey that wage pressures are increasing due to greater competition in the labor market (3rd panel) and, to a lesser extent, recent minimum wage increases. The BoC noted in the April MPR that wages were growing "somewhat below what would be expected were the economy operating with no excess labor." Yet that argument appears overly pessimistic - the unemployment rate is currently 0.7 percentage points below the OECD's NAIRU estimate, at a time when nominal wages are growing in excess of 3%. Again, there is a greater chance that the BoC will end up surprised by how strong Canadian wage growth will turn out over the next 6-12 months. Even the persistent structural problems of very high Canadian household debt levels and overheated house prices appear less of an issue at the moment. The household debt/GDP ratio has stabilized as growth in mortgage debt has decelerated since mid-2017 - an outcome that can be attributed to rising mortgage rates, tighter lending standards on mortgage lending and poor housing affordability in the major cities (Chart 9). Meanwhile, the supply side of the housing market is finally improving with housing starts now back to pre-recession levels. National house price inflation has cooled from the overheated 15% growth rates to a more "normal" pace around 5%, according to data from Terranet. There will be a long-term day of reckoning for the highly-indebted Canadian homeowner during the next recession. In the near term, however, the combination of rising supply, lower demand and softer house prices suggest that the Canadian housing market is trending in a direction of becoming less imbalanced. The BoC took note of these developments in the April MPR, using much less cautious language in describing the risk to the inflation outlook from household debt and overheated housing markets. The outlook for Canadian business investment also has the potential to give an upside surprise to the BoC. The Spring Business Outlook Survey showed that firms' capital spending intentions remain very strong (Chart 10), a fact confirmed by the robust growth in import volumes of machinery & equipment (middle panel). Finally, the overall financial condition for Canadian companies is in good shape, according to our new Canadian Corporate Health Monitor (CHM) that was introduced last week.1 The CHM correlates strongly with the overall Business Outlook Survey Indicator (bottom panel), which suggests that the cyclical improvement in the financial health of Canadian companies will support capital spending in the coming quarters - especially if the uncertainty over the NAFTA negotiations fades away. Chart 9A Better Supply/Demand Balance##BR##In Canadian Housing? Chart 10Canadian Capex##BR##Is In Good Shape The BoC Will Be Surprised By Canadian Inflation, Too Chart 11Inflation Now Above The BoC's 2% Target With the economy likely to continue expanding at an above-potential pace in the next 6-12 months, the current uptrend in inflation is should continue. Headline CPI inflation is already above the 2% target and core inflation is right at target (Chart 11). The BoC is forecasting that CPI inflation will only remain modestly above 2% until the end of 2018, and will return back to 2% in 2019. Yet there is essentially no spare capacity left in the Canadian economy, based on output gap estimates of both the BoC and International Monetary Fund (IMF). The BoC has slightly revised its projection for the Q1 2018 output gap, leaving it somewhat wider than the previous forecasts due to positive revisions of potential GDP growth (now 1.8% from 1.6% in the January MPR, based on a faster pace of trend labor productivity). These are small changes, however, and real GDP growth is likely to be faster than the BoC is projecting in 2018. Market-based inflation expectations have been steadily rising along with the increase in global energy prices (bottom panel), and we continue to expect inflation breakevens to widen over the balance of 2018. BoC Will Not Disappoint Market Expectations On Rate Hikes The markets are currently discounting a similar pace of rate hikes in Canada and the U.S. over the next year, according to pricing in the Overnight Index Swap (OIS) markets (Chart 12). The BoC's estimate of the neutral policy rate is between 2.5% and 3.5%, which is well above the current policy rate of 1.25%. The OIS market is discounting 75bps of hikes over the twelve months, which would take the policy rate to 2% - still a below-neutral, accommodative level for an economy that is already at full employment and where inflation has risen back to the BoC's target. We expect the BoC to continue to follow its typical pattern of following moves by the Fed with a lag. This is a sensible strategy given how exposed Canadian growth is to U.S. growth through exports, and also given how responsive the Canadian dollar is to the expected rate differentials between the U.S. and Canada. Given our view that the Fed will deliver at least another 50bps of rate hikes over the course of 2018, with the potential for more if inflation continues to accelerate without any growth slowdown, the BoC will likely deliver on the rate hikes currently discounted by markets. This is the main reason why we are maintaining our underweight stance on Canadian Government bonds (bottom panel). The BoC has a much higher potential to actually hike rates by at least as much as the market is expecting, which is not the case in every other developed market country except the U.S., where we are also underweight. This week, however, we are stopping ourselves out of our recommended Tactical Overlay trade in the Canadian BAX interest rate futures curve (long the Dec/18 contract versus the June/18 contract). We introduced that trade back in January, positioning for more rapid BoC rate hikes in the latter half of 2018 that would flatten the BAX futures curve. The recent dovish turn by the BoC has resulted in a steepening of the BAX futures curve, however, and we are stopping ourselves out at a modest loss of -0.12% (Chart 13). Chart 12Stay Underweight##BR##Canadian Government Debt Chart 13We Are Stopped Out Of##BR##Our BAX Futures Curve Trade Bottom Line: The Bank of Canada has adapted a more cautious tone of late, which seems overly pessimistic given the underlying trends in Canadian growth and 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, "BCA Corporate Health Monitor Chartbook: Growth Is Papering Over The Cracks", dated April 24, 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 Does the 3% level on Treasuries matter to investors? The 2/10 yield curve is typically much steeper when global growth is strong and pro-growth policies are in place. The imperfect inter-relationship between labor market slack, wages and inflation. Feature In last week's report1 we noted that the risk of weakness in equity markets was elevated in the near term. Risks assets balked as the 10-year Treasury yield climbed above 3% early last week. However, easing tensions on the Korean peninsula and another stronger than expected batch of Q1 earnings reports boosted U.S. equity prices later in the week. We will provide a full update on the Q1 earnings season in next week's report. Investors are getting used to a seasonal dip in Q1 U.S. GDP data, and last Friday's release certainly fits the bill. A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this seasonal anomaly are in the private investment and government consumption components of GDP. Output in both categories slowed significantly in Q1 2018. Consumer spending growth exhibited the most significant slow-down, growing at only 1.1% compared to 4% in the prior quarter. But growth in investment spending on equipment also declined sharply, from 11.6% to 4.7%, as did growth in residential investment, from 12.8% to 0% (Chart 1). The latter is due to the sharply accelerating input costs (e.g. lumber prices) faced by homebuilders at the moment. Federal government spending slowed to a 1.7% rate in Q1 from 3.2% in Q4 2017. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target At 2.9% year-over-year in Q1 2018, real economic growth was above the Fed's view of potential GDP (1.8%) for the fifth consecutive quarter. Given the recent seasonal pattern and the substantial fiscal stimulus coming on stream, the Fed will likely see through the weaker Q1 growth data for the time being. Chart 2Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's view is that the 3% level on the 10-Year Treasury yield is not an impediment to higher equity prices. The 10-year yield and U.S. equity prices climbed together in the 1950s. The rise in yields in the '50s primarily reflected better economic growth rather than fears of inflation. The run-up in yields since the lows last year reflect both factors (Chart 2). Nonetheless, investors are concerned that higher yields will flip the positive correlation between bond yields and stock prices. Charts 3 and 4 shows the link between the level of both nominal (Chart 3) and real bond yields and equity prices. The implication is that the relationship between stock prices and bond yields tends to stay positive when the nominal bond yield is below 5%. Furthermore, the correlation between real yields and stock prices remains positive (Chart 4). Moreover, since 1980, a move from 2% to 3% on the 10-year Treasury yield has been accompanied by an average gain of 1.2% in the S&P 500, with a median move of 1.8%.3 On average, the S&P 500 posted a modest decline (24 bps) as the 10-year Treasury elevated from 3% to 4%, but the median return (98 bps) was still positive. Our July 2015 Special Report4 explored the impact of rates and inflation on equity prices. Historically, even the move from 4% to 5% on the 10-year is not an impediment to higher stock prices. Chart 3Stock To Bond Correlations Remain Positive With Nominal Yields Below 5% Chart 4Both Equities And Real Bond Yields Reflect Growth Bottom Line: BCA's stance is that the stock-to-bond ratio will climb this year. Our U.S. Bond Strategy team pegs fair value on the 10-year at 2.78%, but notes that the yield may peak this cycle at between 3.25% and 3.50%.5 BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until at least mid-2019 and that increasing bond yields are not a threat. Yield Curve Dynamics Does BCA's stance on the yield curve change our upbeat view on risk assets beyond the next few months of caution?6 In March,7 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. Although global growth has peaked,8 we expect the era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5% as upward pressure on the short end from Fed rate hikes is offset by the upward thrust of the breakevens on the long end.9 The curve should resume its flattening trend after that, but will not invert this year. The 2/10 curve stands at 45 bps as of April 27, 2018. Chart 5 shows that the curve has spent very little time in the 0-50 range in the past 35 years when fiscal, monetary and regulatory factors were aligned and global growth was positive. A steeper curve (50 to 100 bps) developed alongside a pro-growth policy and solid global growth only once in the past 35 years, over 1983 and 1984, and never when the 2/10 curve was between 0 and 100 bps (not shown). Chart 5The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place Bottom Line: The backdrop of accommodative fiscal and monetary policy, attended by easing regulatory policy and positive global growth, will continue to provide a tailwind for risk assets through next year. However, the 2/10 yield curve is typically much steeper when these policies are all aligned. Thus, investors should continue to favor equities over bonds and remain underweight duration over the cyclical horizon with a tactical cautious stance over the next few months. The Wage Puzzle Chart 6Economy At Full Employment, Theoretically The move higher in the 10-year Treasury yield to 3% for the first time since 2013 (and the 2-year Treasury to 2.5% for the first time since 2008) has diverted attention to the Fed and inflation. Core CPI is now at the Fed's 2% target and the market is concerned that inflation will shoot past 2% and quickly escalate to 3%. BCA's view is that inflation will remain at the Fed's target this year, but drift above that goal in 2019, which would elicit a more aggressive response from the central bank. Tighter monetary policy will ultimately end the expansion in early 2020.10 Until then, the markets will focus on the drivers of inflation, including wages. Our work11 notes that inflation is slow to turn higher in long expansions. The U.S. economy reached full employment in late 2016 (Chart 6). In short- and medium-length expansions, it takes only a few months before inflation turns up. However, in long expansions (1960s, 1980s, and 1990s) prices did not turn meaningfully higher until 26 months after the economy reached full employment. This suggests that a more significant hike in inflation - led by a tighter labor market - is close and supports the recent rise in Treasury yields. There is mixed evidence that view is warranted. Wage inflation has moved higher in recent months, but the link between wages and prices has weakened. Chart 7 shows that before 1985, the correlation between wage growth and prices was above 90%. Since 1984, the relationship has waned. The post-1985 correlation is just under 30%. BCA expects this weaker relationship to persist. Chart 7Link Between Wage Inflation And Consumer Inflation Changed After 1985 The disconnect between labor market tightness and wages has recently widened. Chart 8 shows several measures of wage pressures and labor market slack. Historically, less slack translates into higher wages, but the relationship in this cycle has been muted. Moreover, pay gains for workers who switch jobs are running well ahead of those who stay in their current positions and are either promoted or given merit raises (Chart 9). The gap between compensation gains of job switchers and job stayers tends to broaden as the business cycle ages and slack in the labor market shrinks. Chart 8A Wide Disconnect Between Labor Market Slack And Wage Gains Chart 9Job Switchers Seeing Better Raises Demographics and wage rigidity dynamics are also at play. Chart 10 shows that the labor force participation rate is headed lower due to demographics, but recent trends suggest there may be improvements in the coming years. BCA's view is that the participation rate will be flat in the next 12 months and move lower in the coming decade. Chart 10Decline In Labor Force Participation Is Mostly Demographics Wage inflation is an early career phenomenon. Recent research from the Federal Reserve Bank of New York12 shows that across all education cohorts, rapid real wage growth occurs early in a worker's career, with positive real wage growth ending in his/her forties. This is followed by a period of flat to declining real wages. By age 55, all education categories experience negative real wage growth, on average (Chart 11). Chart 11Wage Inflation Is An Early Career Phenomenon Wage rigidity in this cycle suggests that there will be an upward correction in labor compensation. Chart 12 shows that 14.5% of workers did not have wage increases in 2017. Moreover, 18.9% of hourly workers and 9.2% of non-hourly workers saw no increase in pay in the year ending in December 2017 (Chart 13, top panel.) The bottom panel of Chart 13 shows that more than 20% of workers with less than a high school education received no pay increases in the past year; only 10% of college-educated workers experienced the same end. It is important to note that on balance, measures of wage rigidity have increased over time and are not overly sensitive to the business cycle. Chart 12More Than 14% Of Workers Didn't See A Raise In 2017 Chart 13Wage Rigidity By Type Of Employee Bottom Line: BCA recommends that investors monitor a broad range of inflation indicators. Historical evidence suggests that when the labor market tightens, inflation eventually accelerates. However, wages do not always lead inflation at bottoms and maybe a lagging indicator in this cycle.13 In long economic cycles (1980s and 1990s), wage inflation was a lagging indicator. Most of these indicators show that inflation pressures are building, but only gradually. We expect the Fed to raise rates gradually in the next 12 months, but it may turn more aggressive in 2019 as pressures on inflation, driven in part by a tighter labor market, begin to mount. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 2 https://www.clevelandfed.org/newsroom-and-events/publications/economic-commentary/2017-economic-commentaries/ec-201706-lingering-residual-seasonality-in-gdp-growth.aspx 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Yellen's Last Week," published February 5, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Special Report, "Stock-To-Bond Correlation: When Will Good News Be Bad News?", published July 6, 2015. Available at usis.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Report, "It's Still All About Inflation", January 16, 2018. Available at usis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", March 12, 2018. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Peril?", April 9, 2018. Available at usis.bcaresearch.com. 9 Please see BCA U.S. Bond Strategy Weekly Report, "Back To Basics", April 17, 2018. Available at usbs.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000", published March 30 2018. Available at gis.bcaresearch.com. 11 Please see BCA Research's The Bank Credit Analyst Monthly Report, March 2017. Available at bca.bcaresearch.com. 12 FRBNY: Liberty Street Economics, "U.S. Real Wage Growth: Slowing Down With Age," September 28, 2016. 13 Please see BCA Research's The Bank Credit Analyst, September 2017. Available at bca.bcaresearch.com.

Highlights Portfolio Strategy Reviving global machinery end-demand alongside a global capex upcycle, are the key pillars of our high-conviction overweight call in the S&P construction machinery & heavy truck index. The current macro backdrop is unforgiving for defensive insurance stocks. Leading indicators of pricing power warn that softening prices coupled with expanding headcount will weigh on insurance profits in the coming quarters. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities moved laterally last week and continued to consolidate the early-February tremor, unimpressed by better than expected profit growth across the board. The SPX has been oscillating in a 10% range over the past three months and has been a trader's (and bank's) paradise. There are high odds that this trading range will stay in place and the market will churn until the summer before breaking out (Chart 1). Chart 1Breakout Looming? Nevertheless, the anemic equity market response to solid earnings is slightly unnerving. Soft EPS guidance and perky input cost inflation are two thorny issues revealed this earnings season. With that in mind, we have identified three key brewing equity market headwinds: EPS growth deceleration toward 10%. Rising interest rates. U.S. dollar reflex rebound. Chart 2Monitoring The Correlation 20% profit growth is this cycle's peak rate, and we have been flagging in recent research1 that, beneath the surface, investors are slowly starting to revise expectations lower toward the 10% growth projection for calendar 2019 EPS. Simultaneously, interest rates continue their ascent and may cause some consternation in stocks. Not only does a higher discount rate weigh on valuations, but also the Fed's tightening cycle will eventually slam the brakes on the economy, with housing and the consumer feeling the higher interest rate knock-on effects most intensely. As we highlighted recently,2 we are closely monitoring the correlation between stocks and the 10-year Treasury yield and looking out for a collapse into negative territory to signal an economic (and market) choke point (Chart 2). Finally, recent ECB and BoJ chatter of easy monetary policies for as far as the eye can see, may have put a floor on the greenback, at least temporarily, with the Fed going it alone and lifting the fed funds rate into 2019 and beyond. While all three headwinds suggest that the market may have trouble breaking out of its funk in the next few months, on a cyclical 9-12 month horizon we remain upbeat on equity return prospects. Any U.S. dollar advance is likely a bear market rally and will take time to filter negatively through to earnings. Rising interest rates are also a consequence of higher economic growth which is a positive, i.e. real rates are rising alongside inflation expectations. And, if the SPX attains 10% EPS growth in 2019 as we expect, that is an above trend EPS growth rate and twice as high as nominal GDP growth, an impressive feat at this stage of the cycle. This week we are updating our SPX target to 3,200. We first came up with our SPX end-of-cycle target last July using three different methods:3 a traditional dividend discount model (DDM), EPS and multiple sensitivity analysis and forward equilibrium equity risk premium (ERP) analysis. As a reminder, this 3,200 SPX level is a peak number before the next recession hits and Table 2 summarizes our updated results (if you would like to receive the excel spreadsheet with the three models so you can tweak our inputs/assumptions please click here). In our DDM, our discount rate assumptions remain intact and very conservative. We use an up-to-date annual dividend per share number and back out dividends in U.S. dollars via the updated SPX divisor and make a conservative assumption of no buybacks in the coming years. The recession-related 10% dividend cut has moved to 2020, in line with BCA's view. Finally, we rolled over our estimates to 2023 resulting in a roughly 3,200 SPX peak value estimate. Our EPS and multiple sensitivity analysis starting point is $191 EPS in 2020 (this is in line with the sell-side bottom up estimate according to IBES data) and a 16.5 multiple. That equates to an SPX ending value of near 3200. Table 2SPX Target Using Three Different Methods With regard to the ERP analysis (Chart 3), our forward ERP equilibrium remains at 200bps. 2020 EPS come in at $191, and we also pencil in 100bps selloff in the bond market, resulting in an SPX 3,200 estimate. Chart 3ERP Has Room To Fall This week we are updating a high-conviction overweight call in a deep cyclical index, and reiterate a below benchmark allocation in a financials sub-index. The CAT Is Roaring, Is The Market Listening? Early last October we upgraded the S&P construction machinery & heavy truck (CMHT) index to overweight, and two months later we added it to the high-conviction overweight call list. On January 29th, right after the broad market hit its all-time highs, we managed to book impressive 10% relative gains as we introduced a risk management tool and instituted trailing stops to the high-conviction calls that cleared the 10% relative return mark. Subsequently, we reinstated the S&P CMHT index to the high-conviction overweight call list, at a deflated price point, as our constructive cyclical backdrop never wavered. Currently, our thesis remains intact: reviving global machinery end-demand alongside a global capex upcycle are a harbinger of sustained profit outperformance. While some leading indicators of global growth have recently crested, global output will remain brisk and above trend. When global growth is expanding, machinery demand typically demonstrates its high beta characteristics. Our global machinery exports proxy is firing on all cylinders rising to multi-year highs and sell side analysts have taken notice: S&P CMHT net earnings revisions are as good as they get (bottom panel, Chart 4). Encouragingly, the softening dollar suggests that U.S. exports have the upper hand and are grabbing market share. BCA's global machinery new orders proxy corroborates the trade data and underscores that machinery profits will overwhelm (middle panel, Chart 4). Dissecting global machinery demand is revealing. Importantly, previously moribund Chinese loan demand has reversed course and is now gaining traction. Tack on the recent steep fall in interest rates and factors are falling into place for a durable pick up in Chinese machinery consumption. Indeed, hypersensitive Chinese excavator sales continue to expand at a breakneck pace (Chart 5). Elsewhere in Asia, highly-cyclical Japanese machine tool orders likewise defy gravity vaulting to fresh all-time highs (Chart 5). The commodity complex also confirms the enticing global machinery end-demand backdrop. The broad commodity index in general and crude oil prices in particular have been reaccelerating of late. The energy space is a key end-customer for the machinery industry and $75/bbl global oil prices have reignited a fresh drilling cycle (Chart 6). Chart 4Global Machinery End-Demand Is Upbeat... Chart 5...And Asia Is Leading The Pack Chart 6Commodities Give The All Clear Sign Even the U.S. machinery demand backdrop is vibrant. The V-shaped recovery in U.S. machinery order books remains intact. Fiscal easing is reviving animal spirits and CEOs are voting with their feet: overall capital outlays are rising at a healthy clip, positively contributing to GDP growth, with machinery fixed capital formation growth recently clearing the 20%/annum hurdle (Chart 7). Capex intentions according to the regional Fed surveys are also holding near recent cyclical highs, and were Congress to pass an infrastructure bill that would be an additional boon to machinery top and bottom line growth (Chart 7). On the domestic operating front, machinery factories are humming and given that capacity is contracting, the industry is regaining its pricing power footing (Chart 8). The upshot is that this high-operating leverage industry should continue to enjoy outsized profit gains. Chart 7Even U.S. Machinery Demand Is Firming Chart 8Operating Metrics Flashing Green Nevertheless, there are two key risks to our otherwise bullish machinery thesis that we are closely monitoring. First, input costs are on the rise both in terms of labor and raw commodities (bottom panel, Chart 9). If the industry fails to pass this input cost inflation down the supply chain, then a margin squeeze is likely. Second, and most importantly, a hard landing in China would put our constructive machinery view offside, but we assign low odds to a gap down in Chinese economic activity (middle panel, Chart 9). Finally, given the recent consolidation phase, the S&P CMHT index has a valuation cushion as per the neutral reading in our relative valuation indicator. Similarly overbought conditions have been worked out and our technical indicator is also hovering near the neutral zone offering a compelling entry point to commit fresh capital (Chart 10). Chart 9Two Risks To Bullish View Chart 10Compelling Entry Point Bottom Line: We reiterate our high-conviction overweight call in the S&P construction machinery & heavy truck index. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Insurance Expiry Notice While we continue to recommend a core portfolio overweight in the S&P financials index via the banks (high-conviction), asset managers and investment banks sub-indexes, the S&P insurance index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Fairly stable, recurring and, most of the time, predictable revenue streams are sought after attributes when economic growth is scarce. Currently, the U.S. and global economies are expanding above trend, the global capex upcycle is running at full steam and CEOs and consumers alike exude confidence. Under such a backdrop, investors have historically avoided insurance equities. Chart 11 drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, Chart 12). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Chart 11Insurance Is Defensive Chart 12Higher Yields Hurt More Than Help On the pricing front, there seems to be a bifurcated market. Auto insurance pricing is hardening, but home insurance is moving in the opposite direction (Chart 13). The slingshot recovery in auto loans versus residential real estate loans partially explains the big delta in pricing as subprime auto loans excesses have, at the margin, boosted new and used vehicle sales. This is not sustainable and there are high odds that this extra demand will level off in the coming months as the subprime auto credit screws inevitably tighten, eventually dampening car insurance prices. Worrisomely, the latest Fed Senior Loan Officer Survey revealed that not only is demand for auto loans waning, but also bankers are no longer willing extenders of auto related credit. Taken together, momentum in housing and auto sales is nil, warning that insurance top line growth will trail the broad market (Chart 14). Unsurprisingly, relative consumer outlays on insurance remain moribund, and a far cry from the previous cyclical peak, warning that it is premature to expect a valuation re-rating (second panel, Chart 15). Chart 13Margin Trouble? Chart 14Softening Demand Chart 15Insurance Indicator Message: Shy Away With regard to input costs, insurance labor additions continue unabated, trumping overall non-farm payrolls and the broad financial services industry since the GFC trough. Our insurance wage bill proxy is closing in on 4%/annum (bottom panel, Chart 13), warning that a margin squeeze looms. Our Insurance Indicator does an excellent job encapsulating all of these different signals and has recently taken a turn for the worse (third panel, Chart 15), underscoring that the path of least resistance is lower for relative share prices in the coming months. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)

Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment Chart 3The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey Chart 17Only The Best Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Underweight As recently as three months ago, the U.S. legacy air carriers were being feted for not diving headfirst into fuel hedges, as they had done in earlier cycles to mixed results. Now, with jet fuel prices hitting 3 year highs, the shine has come off the market (top panel). AAL, who saw spectacular benefits as the price of fuel was falling, reduced their full year earnings guidance by 10% yesterday as pricing has failed to keep pace with the rising costs. Even LUV, who still maintain a modest hedge portfolio, lowered expectations, though they have some fairly specific challenges following a fatal engine incident. Rising jet fuel prices are coming at an inopportune time; the industry is binging on new capacity which has spurred a price war. Predictably, such a strategy has been stretching balance sheets (second panel). At a time when valuations have appeared to turn a corner (bottom panel), we think an excellent selling opportunity has emerged. We reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK.