BCA Indicators/Model

Highlights 2018 YTD Summary: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Sector Portfolios: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Looking Ahead: We are maintaining a neutral level of target spread risk (i.e. duration-times-spread equal that of the benchmark index) in our sector model portfolios for the U.S., euro area and U.K. We will look to reduce that spread risk on signs of a deeper global growth slowdown, which we expect will unfold in 2019. Feature Chart of the WeekReversal Of Fortune Reversal Of Fortune Reversal Of Fortune The performance of investment grade (IG) corporate bonds in the developed markets, as an asset class, has been underwhelming so far in 2018. Using the total return indices from Bloomberg Barclays, IG corporates in the U.S., euro area and U.K. - the regions with the three largest corporate bond markets among the developed economies - have lost -2.0%, -0.3% and -1.1%, respectively. The numbers do not look much better when shown on an excess return basis versus duration-matched government bonds: U.S. IG -0.8%, euro area -1.2% and the U.K. -1.3%. The sluggish performance for IG corporates is a mirror image of the strong showing in 2017 when looking at credit spreads, which reached very tight levels at the end of last year (Chart of the Week). The 2017 rally left global corporates exposed to any negative shocks, of which there have been many so far in 2018 (the February VIX spike, the Q1 global growth slowdown, intensifying U.S.-China trade tensions, ongoing Fed tightening, a strengthening U.S. dollar, less dovish non-U.S. central banks, Italian politics, emerging market turmoil). Given the more challenging environment for overall corporate bond performance, the role of sector selection as a way to generate alpha, by mitigating losses from beta, is critical. In this Weekly Report, we take a brief look at IG sector performance so far this year and update our sector allocations based on our relative value models for IG corporates in the U.S., euro area and U.K. 2018 YTD Global Corporates Performance: A Down Year The major IG sector groupings for the U.S., euro area and U.K. are presented in Table 1, ranked by the 2018 year-to-date excess returns (all are shown in local currency terms). The overall index return for each region is also shown (highlighted in gray) in the table, to highlight how individual sectors have performed relative to the overall IG index. Table 12018 Year-To-Date Investment Grade Sector Returns For The U.S., Euro Area & U.K. A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors As is always the case with IG corporates, the performance of the broad Financials grouping (which includes banks, insurance companies, REITs, etc.) heavily influences the returns of the overall IG index given the large weighting of Financials within the Corporates index across all three regions. In both the euro area and U.K., the sharp underperformance of Financials seen year-to-date (-1.3% and -1.4%, respectively) has created a somewhat odd situation where the majority of sectors have outperformed the overall index. That could only happen given the large weight of Financials in the euro area index (40%) and U.K. index (43%). Financials are also a big part of the U.S. index (32%), but there is more balance in the U.S. IG index which has helped boost the "beta" return from U.S. corporates. Specifically, the weightings of the top three largest U.S. broad sector groupings - Energy (9%), Technology (8%) and Communications (9%) - are a combined 26% of the overall U.S. IG index. Those three sectors are also among upper tier of the 2018 performance table in the euro area and U.K., but only represent a combined 15% and 8%, respectively, of each region's IG index. The conclusion is that index composition has flattered the performance of U.S. IG corporates versus European equivalents, given the latter's heavier weighting in Financials. The poor performance of Financials can be attributed to flattening global government bond yield curves (which is a negative for banks) and poor returns from global credit, especially in emerging markets (which is a negative for insurers that invest in spread product). We do not anticipate either of those trends reversing anytime soon - particularly the ongoing selloff in emerging market assets - thus Financials are likely to remain a drag on corporate bond performance for at least the next 3-6 months. One other factor that has weighed on overall IG corporate performance has been the steepening of credit spread curves. The gaps between credit spreads for Baa- and A-rated corporates have widened since the end of January, most notably in the euro area and the U.K. where growth has been slower than in the fiscal-policy fueled U.S. economy (Chart 2). With Baa-rated debt now representing one-half of the IG index for the U.S., euro area and U.K. (Chart 3) - a function of rising corporate leverage - continued underperformance of lower quality sectors will negatively impact the future overall returns from IG corporates. Chart 2Spread Curves Are##BR##Steepening In Europe Spread Curves Are Steepening In Europe Spread Curves Are Steepening In Europe Chart 31/2 Of Investment Grade Corporate Indices##BR##Are Now Baa-Rated 1/2 Of Investment Grade Corporate Indices Are Now Baa-Rated 1/2 Of Investment Grade Corporate Indices Are Now Baa-Rated Looking ahead, credit investors should be wary of the potential for downgrade risk in their portfolios given the high proportion of Baa-rated debt in the IG benchmark indices. This risk will become more acute when the global business cycle runs out of steam (a 2019 story, at the earliest, in our view). Bottom Line: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Corporate Sector Valuation Models: Winners & Losers Our recommended IG sector allocations come from our relative value model, which measures the valuation of each individual sector compared to the overall Bloomberg Barclays corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all other sectors in each region. The dependent variables in the model are each sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that panel regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 13. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. We then apply individual sector weights based on the model output and our desired level of overall spread risk in our recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. That target portfolio DTS is the first decision in our discretionary allocation process, which is informed by our strategic views on corporate credit in each region. For example, if we were recommending an overweight allocation to U.S. IG corporates, then we would target a portfolio DTS that was greater than the index DTS. If we then became a bit more cautious on U.S. corporates, we could reduce the target DTS (spread risk) of our model sector portfolio while maintaining an overall overweight allocation to U.S. corporates versus U.S. Treasuries. That is exactly what we did one year ago, when we began to target a weighted DTS of all our individual sector tilts that was roughly equal to the overall IG corporate index DTS for each region (U.S. euro area, U.K.) while maintaining an overall overweight stance on global corporate credit versus government debt. More recently, we have downgraded our stance on global spread product to neutral, while continuing to favor the U.S. over Europe, in response to growing tensions from emerging markets and the brewing U.S.-China trade war.1 Chart 4Performance Of Our IG Sector Allocations A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors We last presented a performance update for our global IG corporate sector allocations back on April 12th of this year. Since then, our recommended tilts have modestly underperformed the benchmark index in excess return terms by a combined -3bps (Chart 4). This came entirely from the euro area, with both the U.S. and U.K. sector allocations simply matching the benchmark index. Year-to-date, our IG sector allocations have underperformed the benchmark by a combined -9bps in excess return terms, split equally among the U.S., euro area and U.K. This is a result entirely consistent with our long-standing stance to overweight Financials in all three regions, which continue to appear cheap in our valuation framework. Also, an increasing number of sectors had become expensive within that framework, in all three regions, so some portion of that overweight to global Financials was "by default" given that our model portfolios must be fully invested (finding value has been a persistent problem for credit investors over the past year). The return numbers for our U.S. sector allocations can be found in Table 2. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have all been underweights: Pharmaceuticals (+1.2bps), Electric Utilities (+1.1bps), Retailers (+0.6bps), Health Care (+0.6bps), Diversified Manufacturing (+0.5bps) and Chemicals (+0.4bps). These were fully offset, however, by underperformance from our large overweights to Energy (-4.1bps) and Financials (-2.7bps). Table 2U.S. Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors The return numbers for our euro area sector allocations - shown here hedged into U.S. dollars as is the case when we present all our model portfolio returns - can be found in Table 3. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been underweights to Transportation (+2.0bps) and Electric Utilities (+0.6bps), with underperformance coming from our underweight to Food/Beverage (-2.4bps) and overweight to Life Insurers (-3.1bps). Table 3Euro Area Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors The return numbers for our U.K. sector allocations (again, hedged into U.S. dollars) can be found in Table 4. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been our underweight to Utilities (+2.0bps) and Consumer Non-Cyclicals (+0.9bps), but this was nearly fully offset by our large overweight to Financials (-2.6bps). Table 4U.K. Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Despite the underperformance of our sector portfolios year-to-date, the cumulative alpha from the portfolios since we began tracking the performance of the recommendations remains positive (+2bps in the U.S., +9bps in the euro area, +42bps in the U.K.). Bottom Line: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Changes To Our Sector Model Portfolios As mentioned earlier, the first choice we make when determining the recommended sector allocations within our model portfolios is how much spread risk (DTS) to take. For the U.S., euro area and U.K., we have already been maintaining a portfolio DTS that is close to the index DTS since August 2017. After our recent decision to downgrade global spread product allocations to neutral versus government bonds, we do not feel a need to further reduce our spread risk by targeting a below-index DTS. That would likely be our next decision when we wish to get more defensive on credit, which would await evidence that global leading economic indicators are sharply slowing and/or global monetary policy is becoming restrictive. Within that neutral level of spread risk, we are making the following portfolio changes based on the updated output from our valuation models presented in the Appendix Tables on pages 13-18. The goal is to favor sectors that have a DTS close the index DTS but have positive valuation residuals from our model: U.S.: We downgrade Tobacco and Wireless to Neutral; we downgrade Paper to Underweight. Euro Area: We upgrade Transportation, Other Industrials, Natural Gas, Brokerages/Asset Managers and Finance Companies to Overweight; we upgrade Automotive, Retailers and Tobacco to Neutral; we downgrade Wireless to Neutral; we downgrade Diversified Manufacturing & Media Entertainment to Underweight. U.K.: We upgrade Health Care, Transportation and Other Industrials to Overweight; we upgrade Integrated Energy to Neutral; we downgrade Technology & Wireless to Neutral; we downgrade Metals & Mining and Supermarkets to underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 31, 2018. The quant model has further lifted its U.S. allocation to overweight from neutral, and the U.K. underweight has also been reduced by half. On the other hand, Italy is downgraded and the overweight in Spain, Germany and the Netherlands are all significantly reduced, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 32 bps in August, largely driven by Level 2 model which underperformed its benchmark by 75 bps. expected, the model did not catch the "Turkey Effect" which drove deep losses in the Italian and Spanish markets. The Level 1 model slightly unperformed its MSCI World benchmark by 2 bps in August. Since going live, the overall model has outperformed its benchmarks by 87bps, driven by the Level 2 outperformance of 260 bps offset by the 5 bps of Level 1 underperformance. Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. 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 Dear Client, The GAA Equity Sector Selection Model has been live since July 2016, and has outperformed the benchmark over this period in line with our back-testing. However, GICS will make significant changes to sector compositions at the end of September, most notably creating a new "Communication Services" sector, dominated by internet-related companies, to replace "Telecommunication Services". However, MSCI has not yet made available the final details of membership or historical performance of the revised sectors. Accordingly, after this update we are temporarily suspending publication of this model until full data is available and we have been able to rebuild the model using the newly constituted sectors. The GAA Equity Sector Selection Mode (Chart 4) is updated as of August 31, 2018. Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates Chart 4Overall Model Performance Overall Model Performance Overall Model Performance The model continues to have a negative outlook on global growth and consequently has a net underweight on cyclical sectors. However, the magnitude of this tilt was reduced from 5.8% to 2.8%. The biggest move was a downgrade of consumer staples from a 2.5% overweight to a 1.4% underweight on the back of unfavorable momentum indicators. The only two sectors with favorable momentum are healthcare and technology. Finally, energy stocks also saw a 0.8% boost in its overweight recommendation on the back of attractive valuations. 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

Feature Desynchronization To Continue This year has been characterized by strong growth and asset performance in the U.S., and weakness everywhere else. While U.S. stocks are up by 10% year-to-date, those in the rest of the world have fallen by 3% in dollar terms (Chart 1). GDP growth in Q2 was 4.2% QoQ annualized in the U.S., compared to 1.6% in the euro area and 1.9% in Japan. Leading economic indicators point to this continuing and, therefore, to the U.S. dollar strengthening further (Chart 2). This has already put significant pressure on emerging markets, where equities have fallen by 7% this year in USD terms. Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Chart 1U.S. Has Outperformed U.S. Has Outperformed U.S. Has Outperformed Chart 2...And Leading Indicators Suggest This Will Continue ...And Leading Indicators Suggest This Will Continue ...And Leading Indicators Suggest This Will Continue There are many reasons why the desynchronization is likely to continue: U.S. growth continues to be boosted by tax cuts and increased fiscal spending which, according to IMF estimates, will add 0.7% to GDP growth this year and 0.8% next. The peak impact from the stimulus will not come until around Q1 next year. Further protectionist tariff increases. Despite August's tentative agreement between the U.S. and Mexico, the Trump administration still plans to implement 10-25% tariffs on $200 billion of Chinese imports, and also possibly 25% tariffs on auto imports, in September. This will - initially at least - be more negative for global exporters, such as China, the euro area and Japan, than for the U.S. China is unlikely to implement the sort of massive stimulus that it carried out in 2009 and 2015.1 It has recently cut interest rates and brought forward fiscal spending to cushion downside risk. But, given the Xi administration's focus on deleveraging and structural reform, we do not expect to see a substantial increase in credit creation (Chart 3). This indicates that emerging markets, and capital goods and commodities exporters, will continue to struggle. European banks will stay under pressure because of the problems in Italy (which will fight this fall with the European Commission over its fiscal stimulus plans) and Turkey. Euro zone equity relative performance is heavily influenced by the performance of financials, even though the sector is only 18% of market cap (Chart 4). The euro zone and Japan are also far more sensitive to a slowdown in EM growth: exports to EM are 8.4% and 6.4% of GDP in the euro zone and Japan respectively, but only 3.6% in the U.S. Chart 3China Unlikely To Repeat 2009 and 2015 China Unlikely To Repeat 2009 and 2015 China Unlikely To Repeat 2009 and 2015 Chart 4Banks Drive European Equity Performance Banks Drive European Equity Performance Banks Drive European Equity Performance Eventually, however, strong growth in the U.S. will become a headwind for U.S. assets too. Already, there are some signs of wage growth ticking up (Chart 5), suggesting that the labor market is finally becoming tight. Fed chair Jerome Powell, in his speech at Jackson Hole last month, reiterated that a "gradual process of normalization [of monetary policy] remains appropriate", suggesting that the Fed will continue to hike by 25 basis points a quarter. But the futures market is pricing in only 75 basis points in hikes over the next two years (Chart 6). And, if core PCE inflation were to rise above the Fed's forecast of 2.1% (it is currently 2.0%), the Fed would need to accelerate the pace of tightening. This all points to further dollar strength which will hurt emerging markets, given the consistent inverse correlation between U.S. financial conditions and EM asset performance (Chart 7). Chart 5Is Wage Growth Finally Accelerating? Is Wage Growth Finally Accelerating? Is Wage Growth Finally Accelerating? Chart 6Markets Pricing In Only Three More Fed Hikes Markets Pricing In Only Three More Fed Hikes Markets Pricing In Only Three More Fed Hikes Chart 7Tightening Financial Conditions Are Bad For EM Tightening Financial Conditions Are Bad For EM Tightening Financial Conditions Are Bad For EM We continue for now, therefore, to remain overweight U.S. equities in USD terms within a global multi-asset portfolio, despite their strong performance this year. We are neutral on equities overall and expect to move to negative perhaps early next year, when we will see some of the classic warning signs of recession (inverted yield curve, rise in credit spreads, peak in profit margins) starting to flash. Profit expectations are one key to the timing of this. Analysts forecast 22% YoY EPS growth for S&P 500 companies in Q3 and 21% in Q4, slowing to 10% in 2019. Those are strong numbers. But if companies are unable to beat these forecasts, what would be the catalyst for stocks to continue to rise? Moreover, analysts' expectations for long-term earnings growth are more optimistic currently than any time since 2000 (Chart 8). It would not take much of a downside earnings surprise - perhaps caused by the strength of the dollar, or regulatory change for internet companies - to disappoint the market. Equities: Our strongest conviction call remains an underweight on emerging markets. Emerging markets are entering what is likely to be a prolonged period of deleveraging, given their elevated levels of debt relative to GDP and exports (Chart 9). That makes them very vulnerable to the stronger U.S. dollar and higher interest rates that we expect. While EM equities have already fallen significantly, they are not yet cheap and investors have mostly not capitulated: outflows from EM funds have been small relative to inflows in previous years (Chart 10). Among developed markets, we keep our overweight on the U.S.: not only does its lower beta mean it should outperform in the event of a sell-off, but if markets were to see a last-year-of-the-bull-market "melt-up" (similar to 1999), this would likely be led by tech and internet stocks, where the U.S. is overweight. Chart 8Analysts Too Optimistic About Long-Term Earnings Growth Analysts Too Optimistic About Long-Term Earnings Growth Analysts Too Optimistic About Long-Term Earnings Growth Chart 9Long Period Of Deleveraging Ahead For EM Long Period Of Deleveraging Ahead For EM Long Period Of Deleveraging Ahead For EM Chart 10No Signs Of Capitulation In EM Yet No Signs Of Capitulation In EM Yet No Signs Of Capitulation In EM Yet Fixed Income: Higher inflation, and more Fed tightening than the market is pricing in, suggest that long-term rates have further to rise. Fed rate surprises have historically been a good indicator of the return from U.S. Treasury bonds (Chart 11). We expect to see the 10-year yield reach 3.3-3.5% by early next year. We therefore remain underweight duration, and prefer TIPS over nominal bonds. We recently lowered our weighting in corporate credit to neutral (within the underweight fixed-income category). Junk bonds have continued to perform well, thanks to their 250 basis point default-adjusted spread over Treasuries. But spreads typically start to widen one to two quarters before equities peak, so we think caution is already warranted, particularly in the light of the higher leverage, longer duration, and falling average credit rating which currently characterize the U.S. corporate credit market. Currencies: As described above, mainly because of divergent growth and monetary policy, we expect the U.S. dollar to strengthen further, but more against emerging market currencies than against the yen or euro. Short-term, however, the dollar may have overshot and speculative positions are significantly dollar-long (Chart 12), so a temporary pullback would not be surprising. Chart 11More Fed Hikes Means Higher Long-Term Rates More Fed Hikes Means Higher Long-Term Rates More Fed Hikes Means Higher Long-Term Rates Chart 12Are Investors Too Dollar Bullish? Monthly Portfolio Update Monthly Portfolio Update Chart 13Dollar And China Hurting Commodities Dollar And China Hurting Commodities Dollar And China Hurting Commodities Commodities: Industrial metals prices have declined sharply over the past few months, on the back of the stronger dollar and slowdown in China (Chart 13). We expect this to continue. Gold, we have long argued, has a place in a portfolio as an inflation hedge. But it is also negatively impacted by rises in the dollar and real interest rates, and these are likely to continue to be a drag on performance. The oil price is currently being driven by supply dynamics: How much more oil will Saudi Arabia produce? Will the E.U. and Japan follow the U.S. in imposing sanctions on Iran? Will Venezuelan production fall further? These will make the crude oil price more volatile, but our energy strategists see Brent softening a little to average $70 in H2 this year, but with potential upside surprises taking it up to an average of $80 in 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For details on why we think massive stimulus is unlikely, please see BCA Geopolitical Strategy Special Reports, "China: How Stimulating Is The Stimulus?" Parts One and Two, dated 8 August 2018 and 15 August 2018, available at gps.bcaresearch.com GAA Asset Allocation

Highlights The global 6-month credit impulse is likely to turn up in the fourth quarter. This warrants profit-taking in some pro-defensive equity sector, regional, and country allocation... ...for example, in the 35 percent outperformance of European healthcare versus banks in just seven months. But do not become aggressively pro-cyclical until the 10-year yield on the Italian BTP (now at 3.2) moves closer to 3... ...and the sum of the 10-year yields on the U.S. T-bond, German bund and JGB (now at 3.4) also moves closer to 3. Chart Of The WeekThe Cycle Is About To Turn The Cycle Is About To Turn The Cycle Is About To Turn Feature One of the most common questions we get is, when will the cycle turn? And our response is always, which cycle? The cycle that most people focus on is the so-called business cycle, which describes multi-year economic expansions punctuated by recessions. However, the business cycle - to the extent that it is a cycle - is very irregular. Its upswings and downswings vary greatly in length (Chart I-2). This irregularity is one reason why economists are useless at calling the turns. Nevertheless, investors still obsess with calling the business cycle because they think this is the only cycle that drives the financial markets. Chart I-2The Business Cycle Is Very Irregular The Business Cycle Is Very Irregular The Business Cycle Is Very Irregular We disagree. Nature bestows us with a multitude of cycles with different periodicities: the daily tides, the monthly phases of the moon, the annual seasons, and the multi-year climate cycles. So it would be unnatural, and somewhat arrogant, to assume the economy and financial markets possess only one cycle. In fact, just as in nature, the economy and financial markets experience a multitude of cycles with different periodicities. There Is Not One Cycle In The Economy, There Are Many If you plotted yearly changes in temperature, you would get a flat line and you would think there were no seasons! The point being that you cannot see a yearly cycle if you look at yearly changes. To see the cyclicality of the seasons, you must plot 6-month changes in temperature. Likewise, you cannot see the shorter-term cycles in the economy and financial markets using analysis, such as yearly changes, designed to see longer-term cycles. Once you grasp this basic maths, the mini-cycles in the economy and financial markets will stare you in the face (Chart I-3), and a whole new world of investment opportunities will open up. Chart I-3The Mini-Cycle Is Very Regular The Mini-Cycle Is Very Regular The Mini-Cycle Is Very Regular As we advised on January 4: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging eight months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half, contrary to what the consensus is expecting... Pare back exposure to cyclicals and redeploy to defensives" The advice proved to be very prescient. The global economy did enter a mini-downswing sourced in the emerging markets (Charts I-4 - I-6). Chart I-4The U.S. Mini-Downswing Was Muted... The U.S. Mini-Downswing Was Muted The U.S. Mini-Downswing Was Muted Chart I-5...The Euro Area Mini-Downswing Was Also Muted... ...The Euro Area Mini-Downswing Was Also Muted... ...The Euro Area Mini-Downswing Was Also Muted... Chart I-6...But The China Mini-Downswing Was Severe ...But The China Mini-Downswing Was Severe ...But The China Mini-Downswing Was Severe Nevertheless, the global nature of financial markets meant that the German 10-year bund yield declined by 40 bps, while European healthcare equities outperformed banks by a mouth-watering 35 percent, and materials by 15 percent (Chart I-7 and Chart I-8). Some of these performances are as large as can be gained in a full business cycle begging the question: Why obsess with the impossible-to-predict business cycle when there are equally rich pickings in the easier-to-predict mini-cycle? Chart I-7Banks Vs. Healthcare Tracks The Mini-Cycle Banks Vs. Healthcare Tracks The Mini-Cycle Banks Vs. Healthcare Tracks The Mini-Cycle Chart I-8Materials Vs. Healthcare Tracks The Mini-Cycle Materials Vs. Healthcare Tracks The Mini-Cycle Materials Vs. Healthcare Tracks The Mini-Cycle Furthermore, if you get the equity sector calls right, you will get the equity regional and country calls right too. As cyclicals have underperformed, the less cyclically-exposed S&P500 has been the star performer of the major regional indexes. And cyclical-heavy stock markets like Italy's MIB have strongly underperformed defensive-heavy stock markets like Denmark's OMX (Chart I-9). Chart I-9Italy Vs. Denmark = Banks Vs. Healthcare Italy Vs. Denmark = Banks Vs. Healthcare Italy Vs. Denmark = Banks Vs. Healthcare It follows that the evolution of the global economic mini-cycle is pivotal in every investment decision (Box 1). BOX 1 The Theory Of Economic And Market Mini-Cycles The academic foundation of the global economic mini-cycles is a model called the Cobweb Theorem.1 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a lag. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a lag. The lag occurs because credit demand leads credit supply by several months. As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months and the regularity creates predictability. Moreover, as most investors are unaware of this predictability, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the existence and predictability of these cycles. The Mini-Cycle Will Soon Turn Up The global 6-month credit impulse entered its current mini-downswing in January. Given that mini-downswings tend to last around eight months, we should expect the global economy to exit its mini-downswing in September, the escape valve being the recent decline in bond yields (Chart Of The Week). The caveat is that bond yields were slow to react to the mini-downswing and the decline in 10-year yields, averaging around 40 bps from the peak, has been pretty shallow. It follows that the next mini-upswing could be delayed to October/November, and be somewhat muted. Nevertheless, the surprise could be that global growth will stabilise in the fourth quarter of 2018, contrary to what the consensus is expecting. And this would suggest taking some of the most mouth-watering profits in pro-defensive equity sector, regional, and country allocation - for example, in the 35 percent outperformance of European healthcare versus banks (Chart I-10). Chart I-10Banks Have Severely Underperformed Healthcare Banks Have Severely Underperformed Healthcare Banks Have Severely Underperformed Healthcare Would we go a step further and become pro-cyclical? Not yet. One reason is that there is a limit to how far bond yields can rise before destabilising the very rich valuations of all risk-assets. This is captured in our 'rule of 4' which says that when the sum of the 10-year yields on the U.S. T-bond, German bund, and Japanese government bond (JGB) exceeds 4 - which broadly equates to the global 10-year yield exceeding 2 percent - it is time to go underweight equities. With the sum now equal to 3.4, yields can rise by only 25-30 bps before hurting risk-assets. Another reason for circumspection is that the investment landscape is still scattered with a large number of landmines, one of which has its own rule of 4. The Other 'Rule Of 4': The Italian 10-Year Bond Yield When Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this basis, the largest Italian banks now have €160 billion of equity capital against €130 billion of net NPLs, implying excess capital of €30 billion (Chart I-11). It follows that the markets would start to worry about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of around a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4 percent (Chart I-12).2 Chart I-11Italian Banks' Equity Capital Exceeds Net NPLs By 30 Bn Euro Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn Chart I-12Italian Banks' Solvency Would Be In Question If The 10-Year Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year Yield Breached 4% Today the 10-year BTP yield stands just shy of 3.2 percent, but it is about to enter a testing period. The Italian government must agree its 2019 budget by September and present a draft to the European Commission by mid-October. The budget must tread a fine line. Cutting the structural deficit to appease the Commission would diminish the credibility of the populist government. It would also be terrible economics, making it harder for Italy to escape its decade-long stagnation.3 On the other hand, locking horns with Brussels and aggressively increasing the structural deficit might panic the bond market. The optimal outcome would be to leave the structural deficit broadly where it is now. To sum up, the global 6-month credit impulse is likely to turn up in the fourth quarter, warranting some profit-taking in pro-defensive positions. But we do not advise aggressive pro-cyclical sector, regional, and country allocation until the 10-year yield on the Italian BTP (now at 3.2) - and the sum of the 10-year yields on the U.S. T-bond, German bund and JGB (now at 3.4) - both move closer to 3. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. 2 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 3 Please see the European Investment Strategy Special Report 'Monetarists Vs Keynesians: The 21st Century Battle' July 12 2018 available at eis.bcaresearch.com. Fractal trading Model* In support of the preceding fundamental analysis, the outperformance of healthcare versus banks is technically extended. Its 130-day fractal dimension is at the lower bound which has reliably signalled previous trend exhaustions. On this basis we would position for a 10% reversal with a symmetrical stop-loss. In other trades, long PLN/USD reached the end of its 65-day holding period comfortably in profit, and is now closed. This leaves six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Long Global Basic Resources, Short Global Chemicals Long Global Basic Resources, Short Global Chemicals * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The indicators that led the EM selloff continue to point to more downside. Meanwhile, broader EM valuation and positioning indicators have not yet bombed out to warrant bottom fishing. In China, policymakers are not yet embracing stimulus of the same magnitude as in 2015-2016. Consequently, the odds for now favor staying put on China-leveraged plays. Feature Calling market bottoms and tops is an art -not a science - as there is no formula that works at all times, in all markets. The fundamental case for EM/China remains negative, as credit excesses of previous years have not been unwound, and commodities prices remain at risk. However, to avoid being part of a herd and to maintain investment discipline, it is vital to re-visit market indicators from time to time. In this week's report, we explore directional market indicators and valuations, and offer some thoughts on investor sentiment and positioning in EM. Putting all of these together with our fundamental analysis, we still see meaningful downside in EM risk assets, and continue recommending a defensive strategy. A Review Of Indicators The indicators that led this EM selloff continue to point to additional downside. Meanwhile, valuation and positioning indicators have not yet bombed out. Chart I-1 illustrates that EM corporate U.S. dollar bond yields continue to rise (shown inverted on the chart), entailing lower EM share prices. The message is the same whether we consider EM high-yield or investment-grade corporate or EM sovereign U.S. dollar bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise We have repeatedly highlighted1 that EM share prices correlate with EM borrowing costs rather than risk-free rates. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under selling pressure. Chart I-2 illustrates that a similar relationship exists between China's onshore AA- corporate bond yields and A share prices. AA- corporate bond yields have not yet dropped, and, thereby, they still point to lower share prices ahead. Even though risk-free and interbank rates have plummeted on the mainland, corporate borrowing costs have not. If the Chinese authorities do indeed eradicate the perception of implicit government guarantees for the majority of corporate borrowers - one of the most important items on the government's structural reforms agenda - the odds are that corporate bond yields will rise further to price in higher risk of defaults. This would be a bad omen for corporate borrowing costs, capital spending and share prices. Our risky to safe-haven currency ratio is making new lows. Given it has historically been highly correlated with EM stocks, odds are that EM share prices will continue to drop (Chart I-3). Chart I-2China: On-Shore Corporate Bond (AA-) ##br##Yields And A-Share Market China: On-Shore Corporate Bond (AA-) Yields and A-Share Market China: On-Shore Corporate Bond (AA-) Yields and A-Share Market Chart I-3Risky To Safe-Haven Currencies ##br##Ratio And EM Stocks Risky To Safe-Haven Currencies Ratio And EM Stocks Risky To Safe-Haven Currencies Ratio And EM Stocks Notably, this ratio is also agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the greenback's general trend. Hence, it addresses the question of the direction of EM equity prices, irrespective of the dollar's trajectory. Industrial metals prices correlate with EM corporate earnings growth as demonstrated in Chart I-4. The basis is that both are affected by global growth. Presently, falling metals prices are signaling further deceleration in EM non-financials corporate EBITDA growth. We want to emphasize again that the EM selloff this year has primarily been due to the growth slowdown in EM/China rather than higher U.S. bond yields. If anything, the opposite has been occurring: the EM turmoil and growth slowdown have capped U.S. bond yields since April. Moreover, the currency selloff in EM ex-China has led to rising local currency interest rates in many developing economies. Looking forward, higher local rates entail a capital spending slump, which will weigh on EM and global growth. EM risk assets are highly sensitive to global trade growth. The poor performance of global cyclical equity sectors corroborates weakening world trade. In particular, global mining, steel, chemicals, industrials and semiconductor stocks have all broken below their 200-day moving averages (Chart I-5). Chart I-4More Deceleration In EM Corporate Profits More Deceleration In EM Corporate Profits More Deceleration In EM Corporate Profits Chart I-5Global Equities: Cyclical Sectors Have Broken Down Global Equities: Cyclicals Have Broken Down Global Equities: Cyclicals Have Broken Down EM equity valuations are currently roughly neutral, down from being one standard deviation above fair value in January (Chart I-6). Hence, EM stocks are not expensive, but they are not cheap either. When equity valuations are neutral rather than at extremes, the market can either rally or sell off. In brief, when equity valuations are not at extremes, the direction of share prices is contingent on the profit cycle. The outlook for EM corporate earnings at the moment is downbeat (as shown in Chart I-4 on page 3), presaging a market selloff. With respect to high-yielding EM currencies, Chart I-7 demonstrates that the aggregate real effective exchange rate for EM ex-China, Korea and Taiwan has dropped quite a bit, but still stands above its historical lows. Chart I-6EM Stocks Are Not Cheap EM Stocks Are Not Cheap EM Stocks Are Not Cheap Chart I-7EM Currencies Are Only Moderately Cheap EM Currencies Are Only Moderately Cheap EM Currencies Are Only Moderately Cheap Regarding credit market valuations, EM corporate credit spreads are still below their post-2009 mean (Chart I-8, top panels). EM sovereign spreads are above their post-2009 mean, but this is due to crisis-stricken outliers. Some pockets of EM, such as Argentina or Turkey,2 might be undervalued for a reason. However, sovereign spreads for EM ex-Venezuela, Argentina and Turkey are still at their post-2009 mean (Chart I-8, bottom panel). On the whole, EM market valuations have improved, but EM assets are not yet cheap to warrant bottom-fishing. Finally, investor sentiment towards EM is no longer wildly bullish as it was last year, but our sense is that the average investor believes this EM selloff will not develop into an extended major bear market. Consistent with this, investors may have hedged some of their bets, or are reducing their exposure, but they have not capitulated or gone bearish/underweight on EM assets. For example, Chart I-9 illustrates that leveraged investors - who have little tolerance for volatility - have substantially reduced their net long positions in EM ETF equity futures, yet asset managers are still very long. Chart I-8EM Credit Spreads Do Not Yet Offer Value EM Credit Spreads Do Not Yet Offer Value EM Credit Spreads Do Not Yet Offer Value Chart I-9EM Stock Futures: Leveraged Funds Have Sold, ##br##But Asset Managers Have Not EM Stock Futures: Leveraged Funds Have Sold, But Asset Managers Have Not EM Stock Futures: Leveraged Funds Have Sold, But Asset Managers Have Not Besides, investor sentiment on copper - a proxy for EM - is not yet depressed (Chart I-10). As can be seen on this chart, EM share prices bottom when the net bullish sentiment on copper typically drops close to 25%. That is not the case at the moment. Chart I-10Bullish Sentiment On Copper And EM Share Prices Bullish Sentiment On Copper And EM Share Prices Bullish Sentiment On Copper And EM Share Prices Bottom Line: Investors should stay put on EM and underweight EM assets relative to their DM counterparts in general, and the U.S. in particular. China: Juggling Contradictory Objectives China's central bank has substantially eased liquidity in the banking system, as evidenced by the 200-basis-point plunge in interbank rates. In addition, the authorities have instructed local governments to accelerate issuance of the remaining quota of their bonds. What's more, the banking regulator has urged banks to lend more to infrastructure development and to the export sector. We offer several comments and observations regarding China's current round of policy stimulus: First, there has so far been no additional fiscal stimulus announced. General government spending growth for 2018 is planned at 3%, and managed funds spending at 24.1%. Altogether public (fiscal and quasi-fiscal) spending in 2018 is projected to be 8% compared to 8.6% in 2017 and 8.1% in 2016 (Table I-1). Table I-1China: Fiscal And Quasi-Fiscal Spending (Annual Nominal Growth Rates) EM: Do Not Catch A Falling Knife EM: Do Not Catch A Falling Knife With no new announced public spending, front-loading previously planned spending could alter the near-term growth trajectory, but it will not affect the economy's cyclical outlook. Second, the key risk to our downbeat view is an acceleration in credit origination.3 Our baseline scenario is that regulatory tightening for banks and shadow banking as well as the ongoing anti-corruption campaign in the financial sector - both components of the broader structural reforms agenda - will continue, and will curb credit growth despite more liquidity provision by the People's Bank of China and lower interbank rates. Importantly, so far there has been little deleveraging. If the authorities allow a credit acceleration, it would negate their adherence to structural reforms in general, and deleveraging in particular. In such a case, China's growth will revive and the negative view on China-leveraged markets will prove to be wrong. Furthermore, a revival in credit growth would go against the policy priority of containing financial risks - code for not allowing bubbles to inflate further. In fact, property sales and starts have recently accelerated (Chart I-11). Stimulating money and credit now would mean inflating the real estate bubble further. Third, broad money (official M2 and our measure of M3) impulses have ticked up, but the credit impulse has not (Chart I-12, top panel). Chart I-11China: Housing Is Proving Resilient China: Housing Is Proving Resilient China: Housing Is Proving Resilient Chart I-12China: Money/Credit Impulses China: Money/Credit Impulses China: Money/Credit Impulses Importantly, the broad money impulses rolled over in the second half of 2016, yet EM/China markets and commodities prices remained resilient until early 2018 (Chart I-12, bottom panel). There was roughly an 12-month plus time lag between the rollover in the money/credit impulses and the peak in China-related financial markets. Hence, there will likely be an interval of at least six months before financial markets react to the recent improvement in the money impulses. As such, it is probably too early to bottom-fish EM/China plays. There could be considerable downside in financial markets in the next six months or so, notwithstanding short-term rebounds. Finally, the PBoC's ability to keep money market rates down will be constrained by its appetite for further weakness in the RMB exchange rate. Chart I-13 illustrates that the drop in the interest rate differential between China and the U.S. has coincided with the latest down-leg in the RMB's value. Chart I-13China: Lower Interest Rate Differential = Weaker RMB China: Lower Interest Rate Differential = Weaker RMB China: Lower Interest Rate Differential = Weaker RMB The interest rate differential between China and the U.S. is now only 100 basis points. Given that U.S. short interest rates are bound to rise further, we expect one of the following scenarios to unfold: If the PBoC opts to lower rates further or keep them at current levels, the yuan will continue to depreciate versus the U.S. dollar. This will be negative for China/EM financial markets; If the PBoC prefers to stabilize the RMB exchange rate versus the dollar, it will need to push up money market rates, thereby undoing its liquidity easing of the past several months. If this takes place, the odds of a credit revival will drop considerably and chances of an economic growth recovery will diminish. Given the above and the fact that EM financial markets have reacted poorly to the RMB's recent depreciation, staying negative on EM risk assets appears to be the more prudent course. We are not sure which option the PBoC will choose in the near term, but in the long run China will have to drop interest rates to soften the deleveraging process. Bottom Line: Chinese policymakers are attempting to simultaneously achieve contradictory objectives: On one hand, they want to deleverage the system and contain the property and credit bubbles. On the other hand, they are not ready to tolerate weaker growth, and have lately opted for stimulus as soon as growth has downshifted. It will be very hard to achieve these contradictory objectives at the same time. For now, policymakers are not yet embracing stimulus of the magnitude that was implemented in 2015-2016. Consequently, the odds for now favor staying put on China-leveraged plays. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "On EM Blues, Brazil And Malaysia," dated May 17, 2018, a link available on page 13. 2 Please see Emerging Markets Strategy Special Alert "Turkey: Booking Profits On Shorts," dated August 15, 2018, a link available on page 13. 3 Underestimating the recovery in credit growth was the reason why we misjudged the magnitude and duration of 2016-17 recovery in China. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The persistent weakness of the RMB appears to be one important factor weighing on Chinese stocks, particularly the domestic market. CNYUSD may have some upside from current levels if the Trump administration applies only 10% rate to the second round of planned tariffs, but on balance is likely to come under further market pressure. This explains the PBOC's decision to try to support the currency. Interestingly, July brought some hopeful (albeit early) macro signals from China among the data that we track, some of which appear to have been overlooked by investors. Still, a neutral stance towards Chinese investable stocks versus the global benchmark continues to be warranted, at least until some clarity emerges about the magnitude and disposition of the export shock. Feature Economic and financial market conditions in China have not meaningfully improved since the publication of our last weekly report. Chart 1 highlights that China's economic surprise index remains in negative territory, and Chart 2 shows that Chinese investable and domestic stocks remain 22% and 29%, respectively, below their rolling 1-year high in local currency terms. In US$ terms, domestic Chinese stocks are 34% below their January peak, owing to the significant decline in CNYUSD. The BCA China Play Index and the relative performance of domestic infrastructure stocks versus global equities are two additional market indicators that we are watching closely as proxies for reflation, and neither is signaling a significant improvement (Chart 3). Chart 1Persistently Negative Economic Surprises... Persistently Negative Economic Surprises... Persistently Negative Economic Surprises... Chart 2...And Still In A Bear Market ...And Still In A Bear Market ...And Still In A Bear Market Chart 3Reflation Proxies Are Not Signaling A Major Economic Upturn Reflation Proxies Are Not Signaling A Major Economic Upturn Reflation Proxies Are Not Signaling A Major Economic Upturn The RMB Factor The persistent weakness of the RMB appears to be one important factor weighing on Chinese stocks, particularly the domestic market. While a weaker currency will actually help offset some of the export shock, Chart 4 shows that domestic stocks have not responded positively to the decline: the rolling 3-month correlation between the two has soared even further into positive territory over the past month, which may explain recent actions from the PBOC to help stabilize the currency. In short, the RMB appears to be acting as the "panic barometer" for domestic equity investors. Chart 4The RMB Is Acting As A "Panic Barometer" For Domestic Stocks The RMB Is Acting As A "Panic Barometer" For Domestic Stocks The RMB Is Acting As A "Panic Barometer" For Domestic Stocks Chart 5Some Evidence Of PBOC-Driven Depreciation Some Evidence Of PBOC-Driven Depreciation Some Evidence Of PBOC-Driven Depreciation The PBOC continues to maintain that it is not actively manipulating the RMB, arguing that both last year's appreciation and Q2's depreciation have occurred due to market supply and demand. Chart 5 casts some doubt on this claim, suggesting that at least some of the recent decline has been purposeful. The chart shows the standardized 1-month percent change in official reserves, measured in SDRs to help remove the impact of currency fluctuations. It highlights that the change in currency-neutral reserves has been quite elevated over the past three months relative to recent history, which is what would be expected (absent major capital outflow) if the PBOC was buying foreign currency assets to push down the exchange rate. But we agree that the extent of the decline is now probably more than what policymakers are comfortable with, which raises the question of how much more market-based pressure the RMB is likely to come under. In attempting to answer this question, it is interesting to note that the magnitude of the decline in CNYUSD over the past two months seems to have been closely aligned with the share of proposed tariffs as a share of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Chart 6 illustrates the magnitude of the decline in CNYUSD that would be implied by this framework in a variety of tariff scenarios. The chart shows that the RMB has some upside from current levels if the rate on the second round of tariffs is limited to 10% (instead of the 25% that has been threatened), and no additional tariffs are levied. But it also shows that further market pressure on the exchange rate is likely if the Trump administration simply follows through with their stated plans, and especially if the U.S. moves to tariff all imports from China. Notably, in the scenarios showing a further RMB decline, all of them fall below the psychologically important level of 7 yuan to the dollar. Chart 6More Pressure On RMB To Come If Trump Merely Follows Through With His Threats More Pressure On RMB To Come If Trump Merely Follows Through With His Threats More Pressure On RMB To Come If Trump Merely Follows Through With His Threats Given this, it is easy to see why investors feel that they are in limbo regarding the outlook for Chinese stock prices. They can observe the reflationary outlook of Chinese policymakers, but they are also factoring in: A looming export shock of still uncertain magnitude A strong signal from authorities that the campaign to control leverage and crackdown on shadow banking will not be abandoned Persistent RMB volatility An ongoing "old economy" slowdown that was already underway prior to the imposition of tariffs Domestic Economy Crosscurrents Chart 7Closely Watched Data Releases Negatively Surprised In July Closely Watched Data Releases Negatively Surprised In July Closely Watched Data Releases Negatively Surprised In July Concerning the last of these factors, we have written about a slowdown in China's old economy for the better part of the past year, a view that is now sharply in the market's focus given the negative external outlook. Last week's disappointing release of the July retail sales, industrial production, and fixed asset investment data certainly did not help improve investor sentiment towards China's economy (Chart 7). Interestingly, however, July did bring some hopeful (albeit early) macro signals from China, some of which appear to have been overlooked by investors. Table 1 presents the dashboard of select macro series that we have showed in several reports over the past few months. It highlights the evolution of the key six components of our BCA Li Keqiang index Leading Indicator, four housing market series that we have found to have strongly leading properties, as well as the NBS and Caixin manufacturing PMIs. Credit growth and the PMIs are currently providing the most negative signals, in that they declined in July and are below their 12-month moving average. In the case of credit growth, this is a continuation of an almost 2-year downtrend, but the PMI weakness has been much more recent (in response to the worsening export outlook). But several indicators that we track ticked up in July, including 4 out of 6 components of our leading indicator for the Li Keqiang index (LKI). The fact that monetary conditions indexes have risen should not be surprising given the recent weakness in the currency, but growth in the money supply also ticked up non-trivially last month (possibly due to the PBOC's apparent manipulation of the RMB). In the case of M2, the tick up technically pushed the YoY growth rate (modestly) above its trend for the first time in 2 years. Table 1Some Hopeful Signs, But Credit Remains Weak In Limbo In Limbo There are two other points from Table 1 worth highlighting, the first of which is negative. While the LKI itself has looked reasonably strong over the past few months (in contrast to our slowing domestic demand view), it ticked down in July for the second time. In addition, the LKI has recently been propped up by two, presumably unsustainable, factors: a spurt of rail cargo volume growth that appears to be strongly linked to trade front-running in advance of the U.S. import tariffs, and a surge in electricity consumption from the services industry (which is not investment-intensive). Chart 8 controls for the second factor by presenting an alternative measure of the LKI that replaces overall electricity production with consumption in primary and secondary industries; the difference in the recent trend between the two measures is clear. Chart 8The LKI Is Being Held Up By Trade Front Running And Services The LKI Is Being Held Up By Trade Front Running And Services The LKI Is Being Held Up By Trade Front Running And Services The second important point from Table 1 is positive: both housing starts and sales accelerated very significantly in July, with sales being particularly notable. BCA's China Investment Strategy service has highlighted that the housing sector represented the best candidate for meaningful acceleration in Chinese economic activity, and the July data was particularly impressive. It remains unclear whether the authorities will continue to follow through with a crackdown on the property sector, despite recent statements suggesting they will: household leverage is not enormously elevated relative to GDP, but it has accelerated very significantly over the past couple of years. But if the recent strength in sales volume continues and policymakers do not respond aggressively with macroprudential measures, our conviction in a sustained residential construction boom in China would rise materially. This will be important for investors to monitor, as it could provide a critical source of investment-driven domestic demand over the coming 6-12 months. Investment Conclusions Despite the crosscurrents buffeting China's economic outlook, we can draw three conclusions that lead us to firm near-term investment strategy recommendations: Market proxies are not signaling that Chinese policymakers will end up overstimulating the economy For now, credit growth, and the domestic "old economy" more generally, continues to decelerate Further RMB weakness may be in the cards To us, these conclusions clearly argue for a neutral stance towards Chinese investable stocks versus the global benchmark, at least until some clarity emerges about the magnitude and disposition of the export shock. We also continue to recommend that investors favor low market beta sectors within the investable universe, such as classical defensives as well as industrials.1 In early-July, we opened a "shadow" trade of being long the MSCI China A Onshore index / short MSCI China index, which we said we would consider implementing in response to a 5% rally in relative dollar performance. Chart 9 highlights that this threshold has not yet been reached, and we continue to warn against trying to catch a falling knife. But Chart 10 underscores how stretched (to the downside) domestic stocks have become: versus the global benchmark, relative stock prices in US$ have fallen to an 11-year low. Panel 2 illustrates that this stretched performance is at least in part driven by the performance of U.S. equities, but domestic stocks prices are still at the very low end of their post-GFC range when compared with global ex-U.S. stocks. Chart 9Still Too Early To Buy A-Shares... Still Too Early To Buy A-Shares... Still Too Early To Buy A-Shares... Chart 10...But The Selloff Seems Extremely Late ...But The Selloff Seems Extremely Late ...But The Selloff Seems Extremely Late In short, the potential for a substantial bounce in relative domestic equity performance is considerable were the economic outlook to stabilize, and we will be watching closely for an opportunity to time a reversal. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Investable industrial stocks in China have become relatively low-beta, owing to the fact that they had already materially underperformed the investable benchmark prior to the emergence of trade frictions with the U.S. Cyclical Investment Stance Equity Sector Recommendations

We published a Special Alert report titled Turkey: Book Profits On Shorts yesterday. The link is available on page 18. This report is Part 2 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of various developing economies. The aim of this report is to provide investors with a quick assessment of where each EM economy stands. In addition, we provide our view on each market. The rest of the countries were covered in Part 1, published last week (the link to it is available on page 18). Chart I-1 bca.ems_wr_2018_08_16_s1_c1 bca.ems_wr_2018_08_16_s1_c1 Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As... CHART 2 CHART 2 Malaysia: Keep Underweight For Now As... CHART 3 CHART 3 Malaysia: Keep Underweight For Now As... CHART 4 CHART 4 ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside CHART 5 CHART 5 ...Bank Shares Have Significant Downside CHART 6 CHART 6 ...Bank Shares Have Significant Downside CHART 7 CHART 7 Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds CHART 8 CHART 8 Indonesia: Underweight Equities & Bonds CHART 9 CHART 9 Indonesia: Underweight Equities & Bonds CHART 10 CHART 10 Indonesia: Underweight Equities & Bonds CHART 11 CHART 11 Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet As Banks' NPL Provisions Rise, Bank Stocks Could Fall CHART 12 As Banks' NPL Provisions Rise, Bank Stocks Could Fall CHART 12 Indonesia: The Sell-Off Is Not Over Yet CHART 14 CHART 14 Indonesia: The Sell-Off Is Not Over Yet CHART 16 CHART 16 Indonesia: The Sell-Off Is Not Over Yet CHART 13 CHART 13 Thailand: Stay Overweight Thailand: Stay Overweight CHART 19 CHART 19 Thailand: Stay Overweight CHART 17 CHART 17 Thailand: Stay Overweight CHART 20 CHART 20 Thailand: Better Positioned To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm CHART 15 CHART 15 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 21 CHART 21 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 18 CHART 18 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 22 CHART 22 Philippines: Inflation Breakout Philippines: Inflation Breakout CHART 28 CHART 28 Philippines: Inflation Breakout CHART 27 CHART 27 Philippines: Inflation Breakout CHART 26 CHART 26 Philippines: Neutral On Equities Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 25 CHART 25 Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 24 CHART 24 Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 23 CHART 23 Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation CHART 29 CHART 29 Central Europe: Labor Shortages & Wage Inflation CHART 30 CHART 30 Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - Overweight CHART 31 CHART 31 Central Europe: Robust Growth - Overweight CHART 32 CHART 32 Central Europe: Robust Growth - Overweight CHART 33 CHART 33 Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities CHART 34 CHART 34 Chile: Robust Growth - Overweight Equities CHART 35 CHART 35 Chile: No Inflationary Pressures Chile: No Inflationary Pressures CHART 36 CHART 36 Chile: No Inflationary Pressures CHART 37 CHART 37 Chile: No Inflationary Pressures CHART 38 CHART 38 Chile: No Inflationary Pressures CHART 39 CHART 39 Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve CHART 40 CHART 40 Colombia: Currency Will Be A Release Valve CHART 41 CHART 41 Colombia: Currency Will Be A Release Valve CHART 42 CHART 42 Colombia: Currency Will Be A Release Valve CHART 43 CHART 43 Colombia: Credit Growth Remains A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral CHART 44 CHART 44 Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral CHART 45 CHART 45 Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral bca.ems_wr_2018_08_16_s1_c46 bca.ems_wr_2018_08_16_s1_c46 Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments CHART 47 CHART 47 Peru: Vulnerable To External Developments CHART 48 CHART 48 Peru: Vulnerable To External Developments CHART 49 CHART 49 Peru: Vulnerable To External Developments CHART 50 CHART 50 Peruvian Equities - Underweight Peruvian Equities - Underweight CHART 51 CHART 51 Peruvian Equities - Underweight CHART 52 CHART 52 Peruvian Equities - Underweight CHART 53 CHART 53

Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace. Maintain below-benchmark portfolio duration. The Neutral Rate: Our indicators of the neutral (or equilibrium) fed funds rate are sending conflicting signals. The economic data suggest that the neutral rate might be above 3%, but this is contradicted by weakness in the price of gold. TIPS: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Remain overweight TIPS versus nominal Treasuries. Feature In February we published a report that outlined how we expect the cyclical bear market in bonds to evolve. Essentially, we view the bear market as consisting of two stages.1 The first stage is characterized by the re-anchoring of inflation expectations and the second stage deals with determining the neutral (or equilibrium) federal funds rate. In this week's report we track how the two-stage Treasury bear market has progressed since February and consider the implications for portfolio strategy. The First Stage Is Nearly Complete Long-maturity TIPS breakeven inflation rates are slightly higher than when we published our February report, but they are still not at levels we would consider "well anchored". We showed in our February report that prior periods when core inflation was close to the Fed's 2% target coincided with both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5%. At present, the 10-year TIPS breakeven inflation rate is 2.10% and the 5-year/5-year forward is 2.19%. As long as TIPS breakeven inflation rates remain below the 2.3% - 2.5% target range, nominal Treasury yields have further cyclical upside due to the re-anchoring of inflation expectations. This re-anchoring will play out as the core inflation data are released and investors come to realize that inflation is no longer consistently undershooting the Fed's target. When that re-anchoring occurs and both the 10-year and 5-year/5-year forward breakevens cross above 2.3%, the first stage of the bond bear market will be complete. One recent development is that TIPS breakevens have risen even as commodity prices have declined (Chart 1). In fact, while breakevens are somewhat higher than when we published our February report, commodity prices - as measured by the CRB Raw Industrials index - are lower. While this shift in correlation is so far only tentative, it could signal that TIPS investors are increasingly influenced by the actual core inflation data and not swings in the global growth outlook. We would not be surprised to see this correlation continue to weaken going forward, especially considering that core inflation looks more and more consistent with the Fed's 2% target. Core CPI for July came in at 2.33% on both a trailing 12-month and 3-month basis, annualized (Chart 2). This is more or less consistent with the pre-crisis period when the Fed's preferred PCE inflation measure was close to the 2% target. Alternative measures of CPI send a similar message (Chart 2, panel 2) and our diffusion index shows that more individual items have accelerated in price than have decelerated in each of the past three months (Chart 2, bottom panel). Taken together, the signals point to further near-term price acceleration. Chart 1Inflation Date Sinking In Inflation Date Sinking In Inflation Date Sinking In Chart 2Inflation Picking Up Steam Inflation Picking Up Steam Inflation Picking Up Steam Digging deeper, we see that the outlook for higher inflation pervades each of the main components of core CPI (Chart 3). The reading from our shelter inflation model has stabilized, core goods inflation continues to track non-oil import prices higher, and the rebound in core services inflation is consistent with rising wage growth. Eventually, we would expect the strengthening dollar to exert a drag on import prices (Chart 4), but it will be some time before this is reflected in the CPI data. Another important development is that, after appearing to have turned a corner in 2016, the residential vacancy rate has dipped back down (Chart 4, bottom panel). Such a low vacancy rate will continue to support strong shelter inflation. Chart 3The Components Of Core CPI The Components Of Core CPI The Components Of Core CPI Chart 4A Headwind And A Tailwind For Inflation Headwing & Tailwind For Inflation Headwing & Tailwind For Inflation Bottom Line: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Nominal Treasury yields have further upside at least until both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We also continue to recommend an overweight position in TIPS relative to nominal Treasury securities. We will remove this recommendation when breakeven rates reach our target range and stage one of the bond bear market is complete. Stage 2 Update: Conflicting Evidence On The Neutral Rate Once inflation expectations are well-anchored at levels consistent with the Fed's target, the cyclical bond bear market will transition into its second stage. How much further Treasury yields rise during this stage will depend on how high the Fed is able to lift interest rates before the economy starts to slow. In other words, the cyclical peak in Treasury yields will be determined by the neutral (or equilibrium) fed funds rate - the level of interest rates where monetary policy is neither accommodative nor restrictive, and which is also consistent with stable inflation near the Fed's 2% target. Unfortunately, the neutral rate can only be known with certainty in hindsight. But in a recent report we presented three factors that investors can track in real time that have forewarned of the shift from accommodative to restrictive monetary policy in the past.2 We review the recent trends in each of these signals below. Signal 1: Nominal GDP Growth Vs The Fed Funds Rate Chart 5The Message From Nominal GDP Growth The Message From Nominal GDP Growth The Message From Nominal GDP Growth A fed funds rate that is above the year-over-year growth rate in nominal GDP is typically a signal (though often a lagging one) that monetary policy has turned restrictive (Chart 5). An intuition that is confirmed by the fact that the spread between nominal GDP growth and the fed funds rate correlates positively with the slope of the yield curve. But while the flattening yield curve has caused some to worry that the Fed is tightening too quickly, the message from nominal GDP growth is that monetary policy is actually becoming more accommodative (Chart 5, bottom panel). If the Fed continues to lift rates at its current pace of 25 basis points per quarter, the fed funds rate will be between 3.25% and 3.5% by the end of 2019. Nominal GDP would have to decelerate fairly substantially from its current 5.4% growth rate to signal restrictive monetary policy by then. Signal 2: Cyclical Spending Another indicator that has historically coincided with restrictive monetary policy and the cyclical peak in bond yields is when growth in the most interest-rate sensitive sectors of the economy (aka the cyclical sectors) slows as a proportion of overall growth (Chart 6). This is especially true for consumer spending on durable goods. Not only is it well below pre-crisis levels as a percent of GDP, but recent data revisions revealed that the personal savings rate is much higher than previously thought. The savings rate looks especially elevated relative to household wealth, which leaves room for spending to accelerate as it falls to more normal levels (Chart 7). Extremely high consumer confidence supports the view that the savings rate will decline (Chart 7, panel 2), and despite recent increases in interest rates and the price of gasoline, consumer spending on essentials is not yet excessive relative to income (Chart 7, bottom panel). Chart 6Signal 2: Cyclical Spending Signal 2: Cyclical Spending Signal 2: Cyclical Spending Chart 7The Outlook For Consumer Spending The Outlook For Consumer Spending The Outlook For Consumer Spending Cyclical spending - which includes consumer spending on durable goods, residential investment and nonresidential investment in equipment & software - is currently rising only slowly as a proportion of GDP, but it remains well below average historical levels. This suggests that further catch-up is likely. Much like consumer spending, residential investment also has a lot of room to play catch-up relative to pre-crisis levels (Chart 6, panel 3). However, growth in residential investment has waned in recent months (Chart 8). The slowdown is likely the result of the housing market coming to grips with higher mortgage rates. But while higher rates have definitely impaired affordability, housing remains quite cheap compared to history (Chart 8, panel 2). A further support for housing is that homebuilders are extraordinarily confident in the outlook (Chart 8, panel 3). This is for good reason. The outstanding housing supply is historically low and continues to contract relative to demand as increases in building permits fail to keep pace with household formation (Chart 8, bottom panel). Unlike consumer spending on durables and residential investment, nonresidential investment in equipment & software is roughly consistent with its average historical level as a proportion of GDP (Chart 6, bottom panel). But so far leading indicators are not pointing to a slowdown. On the contrary, surveys of new orders, capital expenditure plans and CEO confidence suggest that investment growth will stay strong for the next few quarters (Chart 9). At some point, given its higher level relative to GDP, investment could be the cyclical sector that first shows some evidence of weakness. But so far this is not the case. Chart 8The Outlook For Residential Investment The Outlook For Residential Investment The Outlook For Residential Investment Chart 9The Outlook For Non-Residential Investment The Outlook For Non-Residential Investment The Outlook For Non-Residential Investment Signal 3: Gold Chart 10Signal 3: Gold Signal 3: Gold Signal 3: Gold The final signal of restrictive monetary policy we consider is the price of gold. The widely accepted perception of gold as a long-run store of value makes it the ideal "anti-central bank" asset. In other words, gold tends to perform well when monetary policy is perceived to be turning more accommodative relative to its neutral level, and it tends to sell off when policy is perceived to be turning restrictive. Gold is also a useful addition to our suite of indicators because it is a price that is set in financial markets. Compared to our other two indicators which are based on economic data, financial market indicators can provide more of a leading signal. The trade-off, however, is that false signals are far more frequent. Most interestingly, we observe that fluctuations in the price of gold have preceded revisions to the Fed's estimate of the neutral fed funds rate in the post-crisis period (Chart 10). This seems entirely logical. The falling gold price in 2014/15 suggested that the market viewed Fed policy as becoming increasingly restrictive, but market expectations for the near-term path of rate hikes were roughly flat during this period (Chart 10, bottom panel). The only explanation is that investors were revising down their estimates of the neutral fed funds rate during this time, resulting in a de-facto policy tightening. Similarly, around the same time that gold put in a bottom in early 2016, neutral rate estimates from both investors and the Fed started to level-off around the 3% level, where they remain today. Going forward, the implication is that if gold were to break out of its trading range to the upside, it would send a strong signal that the Fed is perceived to be falling behind the curve. Such a price movement would make upward revisions to the neutral fed funds rate, and a higher cyclical peak in Treasury yields, more likely. Conversely, if gold continues its recent slide, it could signal that policy is turning restrictive more quickly than many expect. Bottom Line: Trends in our neutral rate indicators since February are sending conflicting signals. The economic data - nominal GDP growth and cyclical spending - have improved and suggest that we should think about a neutral fed funds rate above the current market consensus of 3%. On the other hand, the weakness in the price of gold suggests that investors view monetary policy as becoming increasingly restrictive. Investment Strategy How best to square these conflicting signals when formulating a portfolio strategy? For the time being we strongly advise investors to maintain below-benchmark duration on a cyclical (6-12 month) horizon. For one thing, the bond bear market remains in its first stage and the market is still not fully convinced that inflation will re-anchor itself around the Fed's 2% target. This alone argues for maintaining below-benchmark duration and an overweight allocation to TIPS versus nominal Treasuries, at least until long-dated TIPS breakevens reach our target range. Beyond that, while the true neutral fed funds rate remains uncertain, the market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace, and is consistent with a neutral rate that is well below 3% (Chart 11). Chart 11The Market Not Buying Into The Fed's Current Rate Hike Pace The Market Not Buying Into The Fed's Current Rate Hike Pace The Market Not Buying Into The Fed's Current Rate Hike Pace In other words, current market pricing tilts the risk/reward trade-off firmly in favor of below-benchmark duration, but we will keep a close eye on our neutral rate signals in the coming quarters to see if a more consistent message emerges. Stay tuned. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Valuation measures and technical indicators are widely followed market gauges, but neither set of metrics dependably warns of impending bear markets. Recessions might, however, as they almost always overlap with bear markets. A simple indicator using just three inputs - the yield curve, the index of leading economic indicators ("LEI") and the state of monetary policy - has correctly called all seven recessions of the last fifty years. Our recession indicator is timely as well as accurate. It turns red an average of six months ahead of a recession, aligning closely with the S&P 500's average cyclical peak. Our indicator is currently giving the all-clear signal, and we do not expect it will sound the alarm for at least another year. We do not foresee downgrading equities to underweight before then unless trade tensions take a turn for the worse, the S&P 500 rises parabolically, or the Fed moves its hiking timetable forward. Feature Investors who get the biggest macro questions right will generally find themselves on the right side of their performance benchmarks. The biggest question right now is how much longer the equity bull market will last. Trying to call a market top is folly, but "close enough" counts for recognizing the beginning of bear markets, and we are confident that our recession indicator gets close enough to provide a practical asset-allocation guide. While our indicator has moved closer to sounding the alarm over the last year, it is not yet signaling any immediate trouble.1 Can We Call Bear Markets? Neither we nor any other investor can consistently call market tops or bottoms with any degree of accuracy. The core problem is that doing so requires pinpointing the moment when a firmly established trend reverses for good - after all, a bear market begins the day a bull market concludes, and vice versa. As our colleague Martin Barnes has pointed out, there are no foolproof guides to identifying these inflection points in real time.2 The most popular rules of thumb - valuation measures, technical indicators and the calendar - are of no help at all in forecasting equity bear markets. Equities are surely more vulnerable when they trade at high multiples than when they trade at low multiples, but conventional valuation measures have been all over the map ahead of the eight bear markets that have occurred over the last 50 years (Box 1). The late-'80-to-early-'82 and 1990 bear markets occurred despite P/E, Shiller P/E and P/B multiples that were all comfortably below their long-run medians (Chart 1, second, third and fourth panels). The dot-com-bubble bear market occurred when every valuation metric was at an all-time high, to be sure, but our composite valuation indicator had spent three solid years in extremely overvalued territory (Chart 1, bottom panel) before the bear finally arrived. BOX 1 50 Years Of U.S. Equity Bear Markets For the purposes of this Special Report, we adhere to the classic definition of a bear market - a peak-to-trough closing price decline of at least 20% - and we confine our analysis to the last 50 years. The result is eight bear markets, as shown in Table 1 (we round the 1990 bear up to 20% from 19.9% but leave out the 1998 and 2011 corrections of 19.3% and 19.4%, respectively). Chart 3 shows the S&P 500, in log scale, with NBER-defined recessions shaded in gray and bear markets shaded in light red. The shaded chart brings two key observations to the fore: recessions and bear markets nearly always travel together (gray and light red only failed to overlap in the opening leg of the double-dip Volcker recessions and 1987's Black Monday), and bull markets (the white space in the chart) are more or less the S&P 500's default condition. The bear markets can be nasty, however, and a process that could help a manager sidestep even a portion of their declines could lead to significant outperformance over time. Technical indicators don't provide consistently reliable advance signals, either. Nearly all of the most overheated technical environments of the last 50 years (Chart 2, bottom panel) worked themselves off without tipping into full-fledged bear-market declines. Our composite technical indicator looks much more like a coincident indicator than a leading one. The calendar is of no help at all; since 1968, bull markets have lasted anywhere from two to nine years, and the current one, within two weeks and a percentage point of becoming the longest of the postwar era, may make it to ten. Chart 1Valuation Is A Poor Guide To Bear Markets ... Valuation Is A Poor Guide To Bear Markets ... Valuation Is A Poor Guide To Bear Markets ... Chart 2... And Technicals Aren't Much Better ... And Technicals Aren't Much Better ... And Technicals Aren't Much Better Table 1U.S. Equity Bear Markets, 1968 -2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Chart 350 Years Of Recessions And Bear Markets 50 Years Of Recessions And Bear Markets 50 Years Of Recessions And Bear Markets Can We Call Recessions? Given the mingling of gray and red in Chart 3, a reliable recession indicator would be nearly as good as an equity bear market indicator. As noted above, only one recession (January to July 1980) passed without an accompanying bear market. Only the fall 1987 bear market occurred outside of a recession, though the two 19% corrections over our sample period also occurred ex-recessions. We submit that these three declines, accompanied by Black Monday's 20% one-day crash, the Russian crisis and the implosion of Long-Term Capital Management, and the U.S. debt-ceiling showdown and the euro crisis, were sparked by exogenous events that nearly defied prediction. Economists have a deservedly poor reputation for foretelling recessions. As the late economist John Kenneth Galbraith put it, "The only function of economic forecasting is to make astrology look respectable." Perhaps the Ph.Ds have overcomplicated matters by trying to pack too many variables into convoluted models. We have found that just three simple measures, in combination, have called all of the recessions in our 50-year sample without a single false positive. Our Recession Indicators Our first recession indicator is the orientation of the yield curve, defined as the sign of the difference between the 10-year Treasury bond yield and the 3-month T-bill rate.3 When the 3-month's rate exceeds the 10-year's yield, the curve is inverted and a recession typically follows. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive (Chart 4). As a standalone indicator, however, it tends to be overly eager, prematurely signaling the onset of a recession by an average of nearly twelve months (Table 2). Chart 4The Yield Curve Has Called 8 Of The Last 7 Recessions... The Yield Curve Has Called 8 Of The Last 7 Recessions... The Yield Curve Has Called 8 Of The Last 7 Recessions... Table 2Inverted Yield Curves, 1968 - 2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Our second recession indicator is the sign of the year-over-year change in the index of the leading economic indicators ("LEI"). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in our sample with just one false positive (Chart 5). The LEI signal tends to flip to red in a more timely fashion than the perpetually early yield curve, leading recessions by an average of six-plus months (Table 3). Chart 5...And So Have Leading Economic Indicators ...And So Have Leading Economic Indicators ...And So Have Leading Economic Indicators Table 3LEI Contractions, 1968 - 2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? The false positives go away once we combine the yield curve and the LEI into a single signal. To confirm that signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's model calculates an estimate of the equilibrium fed funds rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 6). In other words, recessions only occur when monetary policy settings are restrictive. In this case, the old market wisdom really is wise: expansions don't die of old age, they die because the Fed murders them. Chart 6Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient From Recession Indicator To Portfolio Strategy Tool Relative asset-class performance in previous bear markets, as detailed in the initial version of this study, published last summer by our Global ETF Strategy service,4 clearly argues for portfolio de-risking ahead of a recession. Investors would have benefited handsomely from overweighting bonds and cash at the expense of equities, overweighting countercyclical stocks and underweighting cyclicals, and overweighting Treasuries while underweighting high-yield corporates. Timing those defensive shifts is hardly clear-cut, however. The lead times between yield curve inversion, LEI contraction, the onset of restrictive monetary policy and the beginning of a recession vary from cycle to cycle. Fortunately for investors, waiting until all of the indicator components are in agreement dampens much of the variability in lead times. As Table 4 shows, the LEI signal is much less hasty than either the yield curve or the policy signals. It typically is the last component to flip, guiding the composite indicator to issue its recession signal just one week ahead of the S&P 500's average pre-recession peak. Sample averages mask in-sample variability, and the composite indicator does not march in lockstep with the S&P 500, but it is timely enough to have managed to catch about three-fourths of every bear market that coincided with a recession (Table 5). Table 4Lead Times For Indicator Components And Bear Markets How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Table 5Share Of Bear Markets Captured By Recession Indicator How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Why Bother? Some of our colleagues, duly noting forecasting's inherent difficulties, argue that there's little to be gained from attempting to narrow down the potential range of bear-market start dates. Fearful of the consequences of flying too close to the sun, they suggest that investors de-risk when enough common-sense-defying signs of a peak accumulate, and not worry about leaving some performance on the table. Such an approach has the benefits of being flexible and intuitive, but is difficult to apply consistently. Even proponents of former Supreme Court Justice Potter Stewart's legendary I-know-it-when-I-see-it obscenity standard have to concede that its parameters are arbitrary. It is also a concern that licking one's finger and holding it aloft is likely to put one squarely in the midst of the herd. The practicality of Justice Stewart's standard hinges on broad agreement: only if the distribution of opinions within the consensus is very narrow will a good deal of the community be satisfied with decisions based on it. Comity is the enemy of alpha, however, and an investor whose common sense is too common will wind up exiting the market too early and getting back into it too late, underperforming on both sides of the inflection point. The empirical record suggests that there's much to be lost from leaving too early. Bull markets tend to end with a bang, not a whimper (Chart 7 and Table 6). It is unlikely that investors who are willing to forego some returns in the name of security on the way up have the temperament to get back in at the beginning stages of the next rally. Factor in our view that public-market returns will be thin gruel over the next five to ten years compared to what investors have enjoyed since 1982, and one can make a case for trying to capture as much of the current bull market's gains as possible. Chart 7Sprinting To The Finish Line Sprinting To The Finish Line Sprinting To The Finish Line Table 6Finishing In Style How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Investment Implications Our composite recession indicator has done an excellent job of flagging recessions in advance. As recessions and equity bear markets are such steadfast companions, the composite recession indicator holds considerable promise as a tool to help investors capture a greater share of bull-market gains while helping them skirt some bear-market losses. Given a flattening but still positively-sloped yield curve, booming year-on-year growth in the LEI, and a policy rate that looks to be at least a year from becoming restrictive, we see no recession on the horizon. Unless trade negotiations fall apart, the S&P 500 melts up, or the Fed's rate-hiking guidance gets much more aggressive, we do not expect that investors will have cause to put their recession/bear market game plan into place for at least another year. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 This Special Report is adapted from the August 16, 2017 Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," available at etf.bcaresearch.com. 2 Please see BCA Research Special Reports, "Timing The Next Equity Bear Market," and "Timing Equity Bear Markets," published January 24, 2014 and April 6, 2011, respectively, available at www.bcaresearch.com. 3 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed's future actions. 2s/10s also fail to measure up empirically, inverting even earlier than the habitually premature 3-month/10-year. 4 August 16, 2017 Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets."