Commodities & Energy Sector

Refiners have taken it to the chin over the past six weeks, underperforming both the SPX and the broad energy complex, and deteriorating industry fundamentals signal that more pain lies ahead. Crack spreads have given way recently, and as the Brent/WTI crude oil spread closes in on the zero line, refining margins will remain under intense downward pressure (second panel). Not only is demand faltering (not shown), but the news is equally grim on refining inventories. In fact, there is no apparent supply side offset: gasoline stocks are rising (gasoline inventories shown inverted, third panel). This supply/demand backdrop will weigh on industry profitability. Adding insult to injury, relative valuations do not offer any cushion in case of any profit mishaps as they are hovering near previous cyclical peaks and significantly higher than the historical mean (bottom panel). Netting it out, decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Bottom Line: We trimmed the S&P oil & gas refining & marketing index to underweight; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV and HFC.

Highlights President Trump is a prisoner of his own mercantilist rhetoric - there is more trade tension and volatility to come; China's depreciation of the RMB can go further - and will elicit more punitive measures from Trump; Gasoline prices are a constraint on Trump's Maximum Pressure campaign against Iran, but only until midterm elections are done; Brexit woes are keeping us short GBP/USD, but Theresa May has discovered the credible threat of new elections - we are putting a trailing stop on this trade at 2%; The EU migration "crisis" is neither a real crisis nor investment relevant. Feature General Hummel: I'm not about to kill 80,000 innocent people! We bluffed, they called it. The mission is over. Captain Frye: Whoever said anything about bluffing, General? The Rock, 1996 As BCA's Geopolitical Strategy has expected since November 2016, the risk of trade war poses a clear and present danger for investors.1 The U.S. imposed tariffs of 25% on $34 billion of Chinese goods on July 6, with tariffs on another $16 billion going into effect on July 20. President Trump announced on July 10 that he would levy a 10% tariff on an additional $200 billion of Chinese imports by August 31 and then on another $300 billion if China still refused to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than China exported to the U.S. last year (Chart 1)! Chart 1President Trump Magically Threatens ##br##Even Non-Existent China Imports Table 1Market's Couldn't Care##br## Less About Tariffs The S&P 500 couldn't care less. Trade-related events - and other geopolitical crises - have thus far had a negligible impact on U.S. equities (Table 1). If anything, stocks appear to be slowly climbing the geopolitical wall of worry since plunging to a low of 2,581 on February 8, which was before any trade tensions emerged in full focus (Chart 2A and Chart 2B).2 Chart 2AStocks Climbing The 'Wall Of Worry' On Trade Tensions... Chart 2B...And On Military Tensions Speaking with clients, the consensus appears to be that President Trump is "bluffing." After all, did he not successfully create a "credible threat" amidst the tensions with North Korea, thus forcing Pyongyang to stand down, change its bellicose rhetoric, free U.S. prisoners, and freeze its nuclear device and ballistic tests? This was a genuinely successful application of his "Maximum Pressure" tactic and he did not have to fire a shot!3 Yes, but the Washington-Pyongyang 2017 brinkmanship caused 10-year Treasuries to plunge 35bps from their July 7 peak to their September 7 low.4 Our colleague Rob Robis - BCA's Chief Fixed Income Strategist - assures us that this move in Treasuries last summer was purely North Korea-related, which suggests that not all investors were relaxed and expecting tensions to resolve themselves.5 President Trump may be bluffing on protectionism, on Iran, and on the U.S.'s trade and geopolitical relationship with its G7 allies. However, we should consider two risks. The first is that his opponents might not back down. Yes, we agree with the consensus that China will ultimately lose a trade war with the U.S. It is a trade surplus country fighting a trade war with its chief source of final export demand (Chart 3). Chart 3China Has More To Lose Than The U.S. Forecasting when China backs down, however, is difficult. If Beijing backs down in 2018, investors betting on stocks ignoring trade risks will be proven correct. We do not see this happening. Instead, we expect Beijing to continue using CNY depreciation to offset the impact of tariffs, likely exacerbating the ongoing USD rally in the process, and eventually putting pressure on U.S. corporate earnings in Q3 and Q4. China does not appear to be panicking about the threat of a 10% tariff. In fact, Beijing may decide to double-down on its structural reform efforts, which have negatively impacted growth in the country thus far, blaming President Trump's protectionist policies for the pain. The other question is whether the U.S. political context will allow President Trump to end the trade war. Our clients, colleagues, and friends in the financial industry seem to have collective amnesia about the "trade truce" orchestrated by Treasury Secretary Steven Mnuchin on May 20. The truce lasted merely a couple of days, with the U.S. ultimately announcing on May 29 that the tariffs on $50 billion of Chinese imports would go forward. President Trump may have wanted to present the Mnuchin truce as a big victory ahead of the midterm elections. His tweets the next day were triumphant.6 However, once the collective American establishment (Congress, pundits, and even Trump's ardent supporters in the conservative media) got hold of the details of the deal, they were shocked and disappointed.7 Why? The American "median voter" is far more protectionist than the political establishment has wanted to admit. Now that this public preference has been elucidated, President Trump himself cannot move against it. He is a prisoner of his own mercantilist rhetoric. President Trump may be dealing with a situation similar to the one General Hummel faced in the iconic mid-1990s action thriller The Rock. Hummel, played by the steely Ed Harris, holed up in Alcatraz with VX gas-armed M55 rockets, threatening to take out tens of thousands in San Francisco unless a ransom was paid by the Washington establishment. Unfortunately for Hummel, the psychotic marines he brought to "The Rock" turned against him when he suggested that the entire operation was in fact a bluff. As such, we reiterate: Whoever said anything about bluffing? China: Beware Beijing's Retaliation Since 2017, we have cautioned investors that Beijing was likely to retaliate to the imposition of tariffs by weakening the CNY/USD.8 June was the largest one-month decline in CNY/USD since the massive devaluation in 1994 (Chart 4). BCA's China Investment Strategy has shown that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar.9 Chart 5 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have reflected the strength in the U.S. dollar until very recently. However, CNY/USD has fallen over the past few days by a magnitude in excess of what would be expected given movements in the greenback, implying that the very recent weakness is likely policy-driven. Chart 4The Biggest One-Month Yuan Drop Since 1994 Chart 5The CNY Is Much Weaker Than The DXY Implies BCA's Foreign Exchange Strategy has pointed out that currency depreciation is also a way to stimulate the economy in the face of the central government's ongoing deleveraging policy.10 Not only does a weaker CNY dull the impact of Trump's tariffs, it also insulates China against a slowdown in global trade volumes (Chart 6). Moreover, China's current account fell into deficit last quarter (Chart 7). A weaker RMB helps deal with this issue, but the PBoC may be forced to cut Reserve Requirement Ratios (RRRs) further if the deficit remains in place, forcing the currency even lower. Chart 6China Needs A Buffer Against Slowing Trade Chart 7Supportive Conditions For A Lower CNY There is no silver lining in this move by Beijing. Evidence that China is manipulating its currency would be a clear sign of an outright, full-scale trade war between the U.S. and China. On one hand, a falling RMB will improve the financial position of China's exporters. On the other hand, it may invite further protectionist action from the U.S., including a threat by the White House to increase the tariff levels on the additional $500 billion of imports from the current 10% rate, or to enhance export restrictions on critical technologies, or to add new investment restrictions. Several of our clients have pointed out that China does not want a trade war, that it cannot win a trade war, and that it is therefore likely to offer concessions ahead of the U.S. midterm election. We agree that China is at a disadvantage.11 But we also reiterate that the concessions have already been offered, in mid-May following the Mnuchin negotiations with Chinese Vice Premier Liu He. China and the U.S. may of course resume negotiations at any time, but it will likely take months, at best, to arrange a deal that reverses this month's actual implementation of tariffs. We think that the obsession with "who will win the trade war" is misplaced. Of course, the U.S. will "win." The problem is that what the Trump administration and what investors consider a "victory" may be starkly different: victory may not include a rip-roaring stock market. In fact, President Trump may require a stock market correction precisely to convince his audience, including those in Beijing, that his threats are indeed credible. Bottom Line: President Trump's promise of a 10% tariff on $500 billion of Chinese imports can easily be assuaged by a CNY/USD depreciation. If we know that Beijing is depreciating its currency, so does the White House. The charge against Beijing for currency manipulation could occur as late as the Treasury Department's semiannual Report to Congress in October, or informally via a presidential tweet at any time before then. While the formal remedies against a country deemed to be officially engaged in currency manipulation are relatively benign in the context of the ongoing trade war, we would expect President Trump to up the pressure on China regardless. Iran: Can Midterm Election Stay President Trump's Hand? We identified U.S.-Iran tensions in our annual Strategic Outlook as the premier geopolitical risk in 2018 aside from trade concerns.12 We subsequently argued that President Trump's application of "Maximum Pressure" against Iran would likely exacerbate tensions in the Middle East, add a geopolitical risk premium to oil prices, and potentially lead to a military conflict in 2019 (Diagram 1).13 Diagram 1Iran-U.S. Tension Decision Tree The Brent crude oil price has come off its highs just below $80/bbl in late May and appears to be holding at $75/bbl. Is the market once again ignoring bubbling U.S.-Iran tensions or is there another factor at play? We suspect that investors are placing their hopes on White House pressure on producers to bring massive amounts of crude online to offset the impact of "Maximum Pressure" on Iran. First, Trump tweeted in April that "OPEC is at it again," keeping oil prices artificially high. He followed this with another tweet at the end of June, directly requesting that Saudi Arabia increase oil production by up to 2 million b/d so that he may continue to play brinkmanship with Tehran. Second, the Libyan media leaked that President Trump sent letters to the representatives of Libya's warring factions, imploring them to restart oil exports or face international prosecution and potential U.S. military intervention.14 The pressure on the Libyan authorities appears to have worked, with the Tripoli-based National Oil Corporation (NOC) ending its force majeure, a legal waiver on contractual obligations, on the ports of Ras Lanuf, Es Sider, Zueitina, and Hariga. Third, Secretary of State Mike Pompeo signaled on July 10 that the U.S. would consider granting waivers to countries seeking to avoid being sanctioned for buying oil from Iran. On July 15, however, the administration clarified the comment by stating that it would only grant limited exceptions based on national security or humanitarian efforts. The White House is realizing that, unlike its brinkmanship with North Korea, "Maximum Pressure" on Iran comes with immediate domestic costs: higher gasoline prices (Chart 8). The last thing President Trump wants to see is his household tax cut trumped by the higher cost of gasoline. Chart 8How Badly Do Americans Want A New Iran Deal? Chart 9Iran Is Not Yet At Peak North Korean Levels Of Threat Applying Maximum Pressure on Iran is tricky. Politically, the upside is limited for President Trump. First, a majority of Americans (62%) do not want to see the U.S. withdraw from the deal, and do not consider Iran to be as critical of a threat as North Korea (Chart 9). That said, 40% believe that Iran is a "very serious" threat - up from just 30% in October, 2017 - and 62% of Americans believe that "Iran has violated the terms" of the nuclear agreement. These are numbers that President Trump can "work with," but not if gasoline prices rise to consumer-pinching levels. As such, the question is whether we should stand down from our bullish oil outlook given President Trump's active role in eking out new supply. We should, if there were supply to be eked out. BCA's Commodity & Energy Strategy believes that global supply capacity will not be sufficient to keep prices below $80/bbl in the event that Venezuela collapses in 2019 or that Iranian export losses are greater than the 500,000 b/d we are currently projecting.15 The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year, to fall to just over 1 mm b/d next year (Chart 10). Our commodity strategists believe that the idle and spare capacity of KSA, Russia, and other core OPEC 2.0 states that can actually increase production would be taxed to the extreme to cover losses of Iranian exports, especially if the losses reached 1 mm b/d. In fact, many secondary OPEC 2.0 producers are struggling to produce at their 2017-2018 production quota, suggesting that lack of investment and natural depletion have already taken their toll (Chart 11). Chart 10Global Spare Capacity##br## Stretched Thin Chart 11OPEC 2.0's Core Producers Would##br## Struggle To Replace Lost Exports Could President Trump back off from the threat of brinkmanship with Iran due to the risk of rising oil prices? Yes, absolutely. We have argued in the past that President Trump appears to be an intensely domestically-focused president. We also see little logic, from the perspective of U.S. interests broadly defined or President Trump's "America First" strategy specifically, in undermining the Obama-era nuclear agreement. As such, domestic constraints could stay President Trump's hand. On the other hand, these constraints would have the greatest force ahead of the November 2018 midterm and the 2020 general elections. This gives President Trump a window between November 2018 and at least the early summer of 2020 to put Maximum Pressure on Iran. As such, we think that investors should fade White House attempts to shore up global supply. Once the midterm election is over, the pressure will fall back on Iran. What about Iran's calculus? Tehran has an interest in dampening tensions ahead of the midterms as well. However, if the U.S. actually enforces sanctions, as we expect it will, we are certain that Iran will begin to ponder the retaliatory action we describe in Diagram 1. In fact, Iran's population appears to be itching for a confrontation, with an ever-increasing majority supporting the restart of Iranian nuclear facilities in response to U.S. withdrawal from the JCPOA nuclear agreement (Chart 12). Iranian officials have also already threatened to close the Straits of Hormuz as we expected they would. Chart 12Iranians Supported Ending Nuclear Deal If The U.S. Did (And It Did!) Bottom Line: Between now and November, U.S. policy towards Iran may be much ado about nothing. However, we expect the pressure to rise by the end of the year and especially in 2019. Our subjective probability of armed conflict remains at an elevated 20%, by the end of 2019. This is four times greater than our probability of kinetic action amidst the tensions between the U.S. and North Korea. Brexit: Has Theresa May Figured Out How Credible Threats Work? We have long argued that a soft Brexit is incompatible with Euroskeptic demands for increased sovereignty (Diagram 2). And, indeed, sovereignty was one of the main demands - if not the main demand - of Brexit voters ahead of the referendum. A large percent, 32% of "leave" voters, said they would be willing to vote "stay" if a deal with the EU gave "more power to the U.K. parliament," an even greater share than those focused on migration (Chart 13). As such, since March 2016, we have expected the U.K. Conservative Party to split into factions regardless of the outcome of the vote on EU membership.16 Diagram 2The Illogic Of ##br##Soft Brexit Chart 13Sovereignty Topped The##br## List Of Brexit Voter Concerns U.K. Prime Minister Theresa May has fought against the inevitable by inviting notable Euroskeptics into her cabinet and by trying to pursue a hard Brexit in practice. The problem with this strategy is that it won't work in Westminster, where a whopping 74% of all members of parliament, and 55% of all Tory MPs, declared themselves as "remain" supporters ahead of the 2016 referendum (Chart 14). Given that the House of Commons has to approve the ultimate U.K.-EU deal, a hard-Brexit deal is likely to fail in Parliament. While such a defeat would not automatically bring up an election, May would be essentially left without any political capital with which to continue EU negotiations and would either have to resign or call a new election. Chart 14Westminster MPs Support Bremain! Theresa May therefore has two options. The first is to trust the political instincts of David Davis and Boris Johnson and try to push a hard Brexit through the House of Commons. But with a slim majority of just one MP, how would she accomplish such a feat? Nobody knows, ourselves included, which is why we shorted the GBP as long as May stubbornly listened to the Euroskeptics in her cabinet. However, it appears that May has finally decided to ditch her Euroskeptic cabinet members and establish the "credible threat" of a new election. While May has not uttered the phrase directly, she hinted at a new election when she suggested that "there may be no Brexit at all." The message to hard-Brexit Tory rebels is clear: back my version of Brexit or risk new elections. From an economic perspective, retaining some semblance of Common Market membership is obviously superior to the hard-Brexit alternative. It is so superior, in fact, that Boris Johnson himself called for it immediately following the referendum!17 From a political perspective, it is also much easier to persuade less than two-dozen committed Tory Euroskeptics that a new election would be folly than it is to convince half of the party that the economic risks of a hard-Brexit are inconsequential. The switch in May's tactic therefore warrants a cautionary approach to our current GBP/USD short. The recommendation is up 5.55% since February 14. However, the GBP could be given a tailwind if investors sniff out fear amongst hard Brexit Tories. We still believe that downside risks exist in the short term. First, there is no telling if the EU will accept the particularities of May's Brexit strategy. In fact, the EU may want to make May's life even more difficult by asking for more concessions. Second, Euroskeptic Tories in the House of Commons may be willing martyrs, rebelling against May regardless of the economic and political consequences. Bottom Line: We are keeping our short GBP/USD on for now, which has returned 5.55% since February 14, but we will tighten the stop to just 2%. We think that Theresa May has finally figured out how to use "credible threats" to cajole her party into a soft Brexit. The problem, however, is that she still needs Brussels to play ball and her Euroskeptic MPs to act against their ideology. Europe: Will The Immigration Crisis End The EU? Chart 15European Migration Crisis Is Over No. There is no migration crisis in the EU (Chart 15). Despite the posturing in Europe over the past several months, the migration crisis ended in October 2015. As we forecast at the time, Europe has since taken several steps ovet the succeeding years to increase the enforcement of its external borders, including illiberal methods that many investors thought beyond European sensibilities.18 Today, EU member states are openly interdicting ships carrying asylum seekers and turning them away in international waters. Chancellor Angela Merkel has become just the latest in a long line of policymakers to succumb to her political constraints - and abandon her preferences - by agreeing to end the standoff with her conservative Bavarian allies. Merkel has agreed to set up transit centers on the border of Austria from where migrants will be returned to the EU country where they were originally registered, or simply sent across the border to Austria. The idea behind the move is to end the "pull" that Merkel inadvertently created by openly declaring that Germany was open to migrants regardless of where they came from. Why wouldn't migrants keep coming to Europe regardless? Because if the promise of a job and a legal status in Germany or other EU member states is no longer available, the cost - in treasure, limb, and life - of the journey through the Sahara and unstable states like Libya, and the Mediterranean Sea will no longer make sense. As Chart 15 shows, potential migrants are capable of making the cost-benefit calculation and are electing to stay put. Bottom Line: The EU migration crisis is not investment-relevant. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see the Appendices for the detailed description of events. 3 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," June 8, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 5 BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 6 His tweets in the immediacy of the deal suggest that this was the case. He tweeted, immediately following Mnuchin's Fox News appearance, "China has agreed to buy massive amounts of ADDITIONAL Farm/Agricultural Products - would be one of the best things to happen to our farmers in many years!" He then tweeted again, suggesting that his deal was superior to anything President Obama got, "I ask Senator Chuck Schumer, why didn't President Obama & the Democrats do something about Trade with China, including Theft of Intellectual Property etc.? They did NOTHING! With that being said, Chuck & I have long agreed on this issue! Trade, plus, with China will happen!" His third tweet suggested that the deal being negotiated was indeed a big compromise, "On China, Barriers and Tariffs to come down for first time." All random capitalizations are President Trump's originals. 7 We reacted to the truce by arguing that it would not "last long." It lasted merely three days! Please see BCA Geopolitical Strategy Weekly Report, "Some Good News (Trade), Some Bad News (Italy)," dated May 23, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. 10 Please see BCA Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World," dated June 29, 2018, available at fes.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 14 Please see "Trump's letter to rivals allegedly results in resumption of oil exports in Libya," Libyan Express, dated July 11, 2018, available at libyanexpress.com. 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf," dated July 5, 2018, available at ces.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 17 Johnson stated right after the referendum that "there will continue to be free trade and access to the single market." Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 18 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. Appendix Appendix 2A Appendix 2B Appendix 2B (Cont.) Geopolitical Calendar

Overweight Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on exploration & production (E&P) stocks along with a bottleneck-induced steep shale oil price discount to WTI. Nevertheless, the sizable recovery in underlying commodity prices has restored some semblance of normality in the E&P space. The second panel of the chart at the side shows that shale oil production is rising at a healthy clip following a long bottoming phase on the heels of reaccelerating WTI crude oil prices. Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (third panel). Rising oil prices are conducive to additional energy-related investments (bottom panel). Adding it up, there are high odds that E&P stocks will continue to outpace the broad energy complex and the SPX on the back of firming capex budgets and sustained oil inflation. Bottom Line: We lifted the S&P oil & gas E&P index to an overweight stance; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, DVN, CXO, MRO, APA, HES, NBL, EQT, COG, XEC and NFX.

Highlights Portfolio Strategy Firming crude oil prices and recovering capex budgets suggest that energy E&P stocks are in a sweet spot and primed for outperformance. Decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Recent Changes Lift the S&P oil & gas exploration & production index to overweight today. Downgrade the S&P oil & gas refining & marketing index to underweight today. Table 1 Feature Equities broke out of their recent trading range last week on the eve of earnings season despite protectionist rhetoric. While Q2/2018 EPS euphoria may serve as a catalyst to catapult the SPX to fresh all-time highs in the coming months, especially given the collapse in stock correlations (CBOE implied correlation index shown inverted, Chart 1), sell-side analysts have now revised down Q1/2019 EPS growth estimates by 300bps to 7%. We view Q1/2019 earnings as critically important, as they will give us the first clean read on trend EPS growth. By that time the one-off impact of tax reform will be filtered out of the data. At present, Q1/2019 EPS estimates are likely suffering for two reasons: delayed P&L FX translation effects from a year-to-date rise in the U.S. dollar and difficult year-over-year comparisons with a blowout Q1/2018 quarter. In recent research, we have been flagging the currency as the single biggest risk to our sanguine equity market view. In other words, a sustainable breakout in equities requires a sideways-to-lower move in the greenback (trade-weighted U.S. dollar shown inverted, Chart 2). Chart 1All-Time Highs Ahead... Chart 2...But Watch The Greenback Drilling beneath the surface, Charts 3 & 4 show net earnings revisions (NER) per sector as a four week average and Chart 5 summarizes the latest data points for an easier comparison. Industrials NER have taken a hit on the back of Trump's tariff rhetoric and recent implementation. Nevertheless, the tech sector shows no signs of infiltration either from a rising currency or Trump's protectionist actions. As a reminder, the IT sector garners 60% of its sales from abroad and remains the most important sector to monitor for any broad market EPS inflection points.1 Chart 3Sector... Chart 4...Net EPS Revisions On the economic front, a softening U.S. dollar would be synonymous with a reacceleration in global growth. We are currently in the seventh month of the economic soft patch and there are high odds that by early fall the tide will turn. The global non-manufacturing PMI is already signaling that a pick up in growth is forthcoming. Historically, the global services PMI has been an excellent leading indicator of its sibling, the global manufacturing PMI, and the current message is to expect an end to the global growth deceleration sometime in the autumn (Chart 6). Chart 5Watch Tech Stocks Chart 6Longest Uninterrupted Payrolls Expansion On Record!!! In the U.S., the ISM manufacturing survey reaccelerated last month despite Trump's protectionist rhetoric with both trade subcomponents of the survey - new export orders and imports - rising smartly. Even the latest employment report came in above expectations, and confirmed that the U.S. economy is firing on all cylinders and remains a key global growth engine. Importantly, non-farm payrolls have been expanding on a month-over-month basis for the longest period on record hitting 93 consecutive months as of June (Chart 7). Similarly, the yield curve has remained positively sloped for a record 134 straight months (please see Chart 2 from our April 16th Special Report titled 'Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening'). Tack on China's recent easing in monetary conditions, as evidenced by both a depreciating currency (steepest month-over-month depreciation since 1994) and falling interest rates (Chart 8), and the likelihood of additional easing measures in the pipeline, and the world's two largest economies will likely lead global growth out of its recent mini-slump. Chart 7Can Services Pull Up Manufacturing? Chart 8China Is Easing Monetary Conditions This week we are refining our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterate its high-conviction status. E&P Is Flaring Up... Exploration & production (E&P) stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 9). There are high odds that a catch up phase looms and we recommend to boost exposure to this late-cyclical energy sub-index to overweight. Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on E&P stocks along with a bottleneck-induced steep shale oil price discount to WTI. Keep in mind that as oil prices were collapsing during the global manufacturing recession of late-2015/early-2016, the U.S. E&P industry went through a clean-up phase where a plunge in free cash flow (FCF) caused a spike in bankruptcies on the back of extreme balance sheet degradation (Chart 10). Chart 9Most Vulnerable Gap Has To Be Filled Chart 10Balance Sheets Getting Repaired Chart 11No Longer Stressed In more detail, E&P FCF got squashed, dropping by 66% from peak to trough as net debt ballooned by 30% during the same time frame. And, in response, independent energy producers' junk bond spreads skyrocketed to over 20%, surpassing even the Great Recession peak (Chart 11). Nevertheless, the steep recovery in underlying commodity prices along with the forgiving debt and equity markets that lent a helping hand to this extremely fragmented industry, has restored some semblance of normality in the E&P space. The second panel of Chart 9 shows that shale oil production is rising at a healthy clip following a long bottoming phase on the heels of reaccelerating WTI crude oil prices. Not only is OPEC 2.0 supporting oil price gains, but sustained domestic inventory draws are also underpinning crude prices. BCA's Commodity & Energy Strategy service remains positive on the oil price backdrop with oil price risks skewed to the upside. The upshot is that the recovery in E&P cash flow growth will continue in the coming months (second & third panels, Chart 10). Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (middle panel, Chart 12). Rising oil prices are conducive to additional energy-related investments (bottom panel, Chart 9). Importantly, there is a sizable divergence between the oil & gas rig count and relative share prices that will likely narrow via a catch up phase in the latter (top panel, Chart 12). National data confirm the Baker Hughes weekly rig count that has been in a V-shaped recovery. Energy related investment has doubled from the depths of the manufacturing recession (bottom panel, Chart 12), and if oil prices even stand pat at current levels, additional drilling will most likely take place in the biggest shale plays (Permian, Eagle Ford, Marcellus and Bakken) where breakeven costs are roughly 30% lower. All of this suggests that U.S. producers will continue to pump oil at a brisk pace, and earnings will likely overwhelm. Sell side analysts have taken notice and relative EPS estimates are following crude oil prices higher. Similarly, S&P oil & gas E&P net EPS revisions are also in positive territory (Chart 13). Chart 12Capex Upcycle Beneficiary Chart 13Following Oil Higher Adding it up, there are high odds that E&P stocks will continue to outpace the broad energy complex and the SPX on the back of firming capex budgets and sustained oil inflation. Bottom Line: We are boosting the S&P oil & gas E&P index to an overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, DVN, CXO, MRO, APA, HES, NBL, EQT, COG, XEC and NFX. ...But Refiners Are Flaming Out While we are warming up to the S&P oil & gas E&P index, the opposite is true for the pure play S&P oil & gas refining & marketing index, and recommend to trim exposure below benchmark. Refiners have taken it to the chin over the past six weeks underperforming both the SPX and the broad energy complex, and deteriorating industry fundamentals signal that more pain lies ahead. The middle panel of Chart 14 shows that crack spreads have given way recently, and as the Brent/WTI crude oil spread closes in on the zero line, refining margins will remain under intense downward pressure. Already, margins are contracting on a six-month rate of change basis and that will continue to weigh on relative share prices (bottom panel, Chart 14). This is an ominous sign for relative profits that will likely follow crack spreads lower. The refining supply/demand backdrop is also waning. Refined products consumption has sunk recently, and the year-to-date steep momentum reversal of 13 percentage points suggests that relative profits will underwhelm (top & middle panels, Chart 15). Not only is demand faltering, but the news is equally grim on refining inventories. In fact, there is no apparent supply side offset: gasoline stocks are rising (gasoline inventories shown inverted, bottom panel, Chart 15). This supply/demand backdrop will weigh on industry profitability. Worrisomely, the sell side's analyst community is extremely optimistic with regard to 12-month forward relative EPS growth estimates (north of 20%, not shown). On a 5-year forward relative EPS basis Wall Street's exuberance is unprecedented: analysts expect refiners to double the SPX's 16% long-term EPS growth rate (Chart 16). We would lean against these great expectations. Chart 14Refiners Rally Has Cracked Chart 15Mind The Supply/Demand Backdrop Chart 16Too Much Optimism Adding insult to injury, relative valuations do not offer any cushion in case of any profit mishaps as they are hovering near previous cyclical peaks and significantly higher than the historical mean (bottom panel, Chart 16). Netting it out, decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Bottom Line: Trim the S&P oil & gas refining & marketing index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Upside risks on base metals are being ignored. The U.S. labor market continues to tighten and businesses face escalating labor and input costs. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Feature Chart 1Core Inflation Creeping Higher Along With Wages Last week, U.S. equity prices reached their highest level since early February. The 1% drop in the trade-weighted U.S. dollar contributed to weakness in both oil and gold prices. 10-year Treasury yields were little changed, despite higher U.S. inflation readings. Base metal prices continued to decline, linked to escalating trade tensions between the U.S. and China and concerns over the health of China's economy. Comments from Fed Chair Powell late in the week on the benefits of fiscal policy for the U.S. economy were welcomed by markets. We discuss base metal prices, trade, inflation, the Fed and the implication of the U.S.'s precarious fiscal position in this week's report. We examine BCA's view on base metals in the context of disruptions to global trade and a slowdown in Chinese economic activity in the next section. The June CPI report suggests U.S. inflation is drifting towards the Fed's target. However, with no serious inflation outburst occurring at the moment, there is no need for the Fed to deviate from its path of gradual rate hikes in the near term. U.S. core CPI rose by 0.16% m/m in June, which is not quite consistent with a 2% annual inflation rate. Nonetheless, the underlying trend still shows a steady creep higher in inflation (Chart 1). The year-over-year core CPI rate ticked up to 2.3% from 2.2%. Core CPI inflation of about 2.5% is consistent with the Fed's 2% target for the core PCE deflator. The main source of upward pressure on U.S. inflation will come from core services (ex-shelter and medical care). We find that this subcomponent of core CPI is the most correlated with the tightness in the labor market and wage pressures. However, it accounts for only 25% of core CPI and, while improving, the acceleration in wages is mild (panel 4). Inflation, the labor market and trade were all discussed at the June FOMC meeting. Below, we assess the central bank's mid-June discussion on these topics as markets brace for the Fed's latest Beige Book (July 18) and the late July FOMC meeting. Fiscal policy was also discussed at the June FOMC meeting. The final section of this week's report examines the long term budget outlook and its implication for the economy and financial assets. Base Metals Update BCA's Commodity & Energy Strategy service notes1 that the London Metal Exchange Index (LMEX) will remain under significant downward pressure until fears of an escalating Sino - U.S. trade dispute are allayed. If this dispute evolves into a full-blown trade war, as our geopolitical strategists expect,2 emerging markets (EM) economies embedded in global supply chains could be hard hit. This would have ramifications for commodity prices in general and base metals in particular. Alternatively, if this trade dispute develops into a more open and free global trading system, EM income growth will significantly drive up commodity demand, especially for metals (Chart 2). However, a more open trading system would take time to develop and is beyond a 6-12 month investment horizon. BCA's view is that the dollar will continue to climb as the Fed boosts rates more than the market expects and as U.S. domestic economic growth outpaces global growth (Chart 3). Moreover, the ongoing trade row will put upward pressure on the dollar. We remain long on the dollar.3 Chart 2EM Macro Variables##BR##Drive LMEX Chart 3Divergent Paths For Growth And##BR##Rates To Drive U.S. Dollar Higher Bottom Line: Fears of a global trade war are punishing the EM economies and weighing on the prices of base metals. However, upside risks, for the most part, are being ignored, according to BCA's Commodity & Energy Strategy service. As a result, our commodity team sees some tactical long trading opportunities in copper, but the prospect of a worsening trade war is not kind for base metals. Oil is a different story.4 The Disappearing Act Data from the National Federation of Independent Business (NFIB) in June and the Job Openings and Labor Turnover Survey (JOLTS) in May support our stance that the slack in the U.S. labor market is disappearing and will ultimately lead to higher wage inflation and a peak in profit margins. Job openings and hiring plans at small businesses are at an all-time high (Chart 4, panel 1). Chart 4 also shows that small business owners' compensation plans (panel 2) remained near record levels in April and that concerns about "quality of labor" have never been higher (panel 3). Moreover, 7% of small firms say that the cost of labor is their most critical problem (panel 4). This concern has more than doubled since 2013. Job openings according to the JOLTS data also hit a new zenith in April, but ticked down a bit in May, which created an even wider gap between openings and hires (Chart 5, panel 1). Moreover, quits minus layoffs, another indicator of labor market slack, reached a record high (panel 2). The implication is that businesses of all sizes face a much tighter labor market. Chart 4Labor Market Slack Is Disappearing... Chart 5... Putting Pressure On Margins Moreover, the robust labor situation is widespread. Charts 6A and 6B show the ratio of job openings to the number of unemployed in 10 sectors of the economy. The ratio is at an all-time high in nine of the sectors. The exception is the information segment, which includes newspapers and magazines, broadcasting and telecommunications. Chart 7 shows that businesses are increasingly worried about the impact of escalating input costs on margins. Firms in the Atlanta Fed region expect a 2% bump in their input costs in the next 12 months; in early 2016, those same firms saw only a 1.3% rise (panel 1). Nearly 80% of managements expect their unit costs to climb by at least 1.1% in the next year. More than 20% of firms expect their input costs to jump at least 3.1% in the same period. Chart 6AStrength In The Labor Market... Chart 6B... Is Broad-Based Chart 7Businesses Worried About Input Costs Small businesses are increasingly able to pass on prices to consumers (Chart 5, panels 3 and 4). At 14%, having rolled over slightly, the percentage of small businesses reporting price changes remains near a 10-year high in June (panel 2). Moreover, 24% of small businesses planned price hikes in June, also a 7-year high. In late 2016, only about 4% of these entities expected to boost prices in the next 12 months (panel 3). Moreover, the New York Fed's Underlying Inflation Gauge5 hit a 13-year high in June (not shown). Bottom Line: The U.S. labor market continues to tighten and businesses face escalating labor and input costs. The implication is that margins may soon reach a top. In last week's report,6 we showed that the performance of a broad range of U.S. and global risk assets falters after margins peak late in the business cycle. Moreover, shortages of labor and some raw materials will push up inflation and keep the Fed on track to tighten two more times this year. BCA's view is that by mid-2019, the central bank will find itself behind the curve on inflation and begin to tighten more aggressively. Shortages and capacity constraints in the important trucking industry support our view. Keep On Trucking The trucking industry exemplifies the robust labor market, with strong demand for trucking services and shortages of drivers. Wage inflation remains muted in the trucking industry, despite strong demand for trucking services and shortages of drivers. Nonetheless, anecdotal data suggest that wages are understated in the trucking industry. Freight costs, which are key components in firms' input costs, affect the economy as a whole. Table 1 shows that trucking is one of many industries with labor shortages according to the 2018 Beige Books. However, the JOLTS data show that trucking has labor constraints, but very little wage inflation. The PPI for truck transportation services7 (a good proxy for what trucking firms charge customers) is up 7.7% year-over year (Chart 8). Some of that increase is linked to higher gasoline prices. However, it is difficult to split out the impact of wage costs from the gasoline costs in the PPI. Table 1Labor 'Shortages' Identified##BR##In The Beige Book Chart 8Margin Pressure In##BR##The Trucking Industry A Cass Freight Index that tracks full-truckload prices, but excludes fuel and fuel surcharges, rose 9% year-over-year in May (not shown).8 The broad Cass Freight Index climbed 17.3% year-over year in May, and suggests further gains are ahead for U.S. capital spending (Chart 9). Moreover, the latest survey by the FTR Transport Intelligence for June surged for orders of heavy trucks, with June being the highest on record at 140% year-over-year (not shown).9 Chart 9Supply Constraints In The Freight Business Will Erode U.S. Profit Margins The implication is that demand for trucking services remains vigorous and will ultimately push up wages. Higher wages in trucking mean higher shipping costs, and portends a peak in U.S. corporate margins later this year. A Divided FOMC The labor market, wages and inflation were key topics at the June 12-13 Federal Open Market Committee (FOMC) meeting. Trade and fiscal policy were also discussed. Policymakers noted that some firms have responded to a lack of qualified workers by offering training, introducing automation and boosting wages. This is typical late-cycle behavior. Fed economists recently updated their quantitative assessments of the FOMC's meeting minutes.10 The note provides a guide (Table 1 in the Fed paper and Table 2) to the number of quantitative descriptors (one, a couple, a few, etc.). We use this rubric to assess the FOMC's latest views. Table 3 evaluates the Fed's latest thinking on the labor market and wages, while Table 4 assesses the FOMC's discussion of inflation and inflation expectations. Table 2FOMC Minutes Rubric Table 3FOMC Assessment Of The Labor Market And Wages At June 2018 Meeting FOMC participants generally expected the unemployment rate to either remain below or decline further below their estimates of the longer run normal rate. Only several FOMC members thought that the unemployment rate overstated the labor market's strength. Furthermore, a number of members anticipated wage inflation to pick up (Table 3) given that the unemployment rate is expected to stay below the committee's view of NAIRU. Table 4 shows that FOMC members generally agreed that inflation was on track to meet the Fed's 2% target. However, many participants saw downside risks to inflation linked to political and economic turmoil in Europe and the emerging markets. A number noted that it was premature to conclude that the Fed had achieved its 2% inflation target. Nonetheless, some members worried that a prolonged stretch of economic activity above the economy's long-term potential could "give rise to inflationary pressures or financial imbalances." Only a few noted that inflation expectations were not consistent with the Fed's 2% objective. Only one member argued that the postponing rate hikes would help push up inflation expectations. Table 4FOMC Assessment Of Inflation And Inflation Expectations At June 2018 Meeting On trade, most FOMC participants noted that the uncertainty and risks associated with trade policy had intensified and expressed concern over the potential negative effects on business sentiment and investment spending. The committee continued to see fiscal policy as a plus for economic growth in the next few years. Nonetheless, a few participants worried that fiscal policy is not on a sustainable path (See next section, "An Unprecedented Macro Experiment"). Financial stability was not on the agenda at the latest FOMC meeting, although Fed Chair Powell discussed the topic at his mid-June news conference.11 Moreover, in a radio interview12 last week, Powell also mentioned financial stability. Our view is that the Fed will continue to focus on vulnerabilities in the U.S. and overseas financial markets in upcoming meetings.13 Bottom Line: So far, Fed policymakers have maintained their gradual approach to tightening policy (i.e. 25 basis points per quarter) as they try to balance the risk of a major inflation overshoot against the hazards of prematurely ending the economic expansion. Several policymakers reiterated that long-term inflation expectations are still not high enough to be consistent with meeting the 2% inflation target over the medium term. That is why we expect the Fed to become more aggressive in targeting an economic slowdown when the 10-year TIPS breakeven rate moves back into its 2.3-2.5% range.14 Stay tuned. An Unprecedented Macro Experiment15 Congress is conducting an extra-ordinary economic experiment: substantial fiscal stimulus when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind. However, the celebration could be followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely spill far more red ink than during any other economic expansion since the 1940s (Chart 10). Moreover, the debt ratio, which swelled to 106% in 1946 after WWII, could rocket past that level before 2030, even in the absence of a recession (Chart 11). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart 10U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Chart 11U.S. Debt In Historical Context Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Politicians are following the voters shift to the left. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as in the past. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.16 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle-class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block in the 2020s. President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning (i.e. jobs rather than cultural factors). Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to have high approval ratings among his supporters. Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Unlike the Reagan years, we do not expect that there will be a strong political force capable of leading a fight against budget deficits. The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake up voters and the political establishment into making tough decisions. Given demographic trends, it appears more likely that taxes will be on the rise than entitlements will be cut. We do not foresee a crisis in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas (Chart 12). U.S. government debt has already been downgraded by the S&P to AA+ in 2013, and the other two main rating agencies will probably follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium to entice them to continually raise their exposure to U.S. government bonds. Chart 12An Unsustainable Debt Accumulation Chart 13Structural Drivers Of The U.S. Dollar Taxes will eventually rise to service the government debt and some capital spending will be crowded out, both of which will undermine the economy's growth potential (Chart 13). Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because imports will be more expensive. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Escalating Trade Disputes Pressuring Base Metals", published July 12, 2018. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis", published July 11, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again", published July 6, 2018. Available at gis.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf", published July 5, 2018. Available at ces.bcaresearch.com. 5 https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Revisiting The Late Cycle View", published July 9, 2018. Available at usis.bcaresearch.com. 7 See Table 10 https://www.bls.gov/ppi/ppidr201806.pdf 8 https://www.cassinfo.com/transportation-expense-management/supply-chain-analysis/cass-freight-index.aspx 9 https://ftrintel.com/news/ftr-reports-north-american-class-8-orders-for-june-at-historic-highs 10 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 11 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 12 https://www.marketplace.org/2018/07/12/economy/powell-transcript 13 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 14 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "The Deflationary Mindset", published July 10, 2018. Available at usbs.bcaresearch.com. 15 Please see BCA Research's The Bank Credit Analyst Monthly Publication, "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 16 Please see BCA Research's Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016. Available at gps.bcaresearch.com.

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Robert P. Ryan, Chief Commodity & Energy Strategist The London Metal Exchange Index (LMEX) will remain under significant downward pressure, unless and until fears of escalating Sino - U.S. trade disputes are allayed. Should this dispute devolve into full-blown trade war - something our geopolitical strategists expect - EM economies deeply embedded in global supply chains could be especially hard hit.1 This would have ramifications for commodity prices in general, base metals in particular. Alternatively, if this trade dispute evolves into a more open and free global trading system, EM income growth will drive commodity demand - particularly for metals - significantly higher. Highlights Energy: Overweight. China's $5 billion loan and $250mm direct investment in Venezuela's oil industry will alleviate the country's oil-production and -export collapse for a brief interval. However, unless China brings its own industry experts in to run Venezuela's state-owned oil company, which has suffered a near-total loss of highly trained personnel, and manages to reverse government mismanagement and corruption, it is difficult to see the collapse in that country's oil industry being reversed. Separately, China's investment in and commitment to Venezuela could be a harbinger of future deals between it and Iran, if China decides to flex its economic muscle and widen the playing field in its trade dispute with the U.S. beyond ags. Base Metals: Neutral. Fears of a global trade war overly punishing EM economies, many of which are deeply entwined in global supply chains, are weighing on base metals prices (see below). Right-tail - i.e., upside risks - are, for the most part, being ignored. Our assessment of balances and upside risk, particularly in copper, makes getting long attractive. We are, therefore, going long the Dec/18 $3.00 COMEX calls vs. short $3.20/lb calls at tonight's close. This is a tactical position. Precious Metals: Neutral. Gold recovered somewhat - trading above $1,260/oz earlier in the week - as global trade tensions increased. It since settled to the $1,250/oz level as trade anxieties re-emerged. Ags/Softs: Underweight. Prompt soybeans futures are probing five-year lows, after the U.S. announced an additional $34 billion in tariffs against China, which were immediately followed by Chinese reprisals, highlighted by 25% tariffs against soybeans. Feature Prices of the six base metals futures comprising the LMEX are highly sensitive to EM growth, which has benefited from the expansion of global supply chains. As a result, metals' prices are highly sensitive to EM incomes, EM trade volumes, and FX levels. Our modeling indicates these global macro variables will continue to play an outsized role in determining the trajectory of the metals' prices, particularly as relates to EM - China trade (Chart of the Week).2 Chart Of The WeekEM Macro Variables Drive LMEX EM incomes and trade volumes have, for the most part, held up well this year. Our base case outlook is for the resilience underpinning the global economy to continue for the remainder of the year, in line with the IMF and World Bank expectations.3 However, escalating trade disputes are threatening to weigh on the global flow of goods, which, if they persist and deepen, will dampen demand for raw materials in general, and metals in particular. An acceleration in trade restrictions would dent not only trade flows, but also would harm EM incomes in the process. Our base case longer term gets cloudier. In the left tail of returns distributions, rising interest rates on the back of the Fed's interest-rate normalization process will remain on track, particularly as inflation and inflation expectations pick up. This will support a stronger dollar, which, all else equal, will increase EM debt servicing costs. Our colleagues in BCA Research's Global Investment Strategy note, "Emerging markets are particularly sensitive to changes in U.S. financial conditions. About 80% of EM foreign-currency debt is denominated in dollars. A stronger dollar and higher U.S. interest rates make it more difficult for EM borrowers to service their debts. While EM foreign-currency debt has declined as a share of total debt outstanding, this is only because the past decade has seen a boom in local debt issuance. As a share of GDP, exports, and international reserves, U.S. dollar debt is at levels not seen in over 15 years."4 We expect the Sino - U.S. trade dispute will get nastier, but we are mindful of the right tail risks in this process, as well. If leaders in the U.S., China, and EU can agree to revamp and modernize the rules of the road for global trade - i.e., protect intellectual property, remove forced technology transfers, and make markets more open and transparent - the upside risks to base metals returns, and commodities in general, would be significant. In such an evolution, EM income growth would accelerate, super-charging global trade volumes, and commodity demand. Trade Volumes Resilient For Now, But Protectionism Looms Overhead At present, global trade in goods amounts to more than $17 trillion of merchandise exports, while commercial services exports are more than $5 trillion.5 Accounting for tariffs imposed by the U.S. under Sections 232, and 301, as well as retaliatory action by China, Mexico, the EU, and Canada, barriers have so far been implemented on ~$150 billion worth of traded goods. This represents less than 1% of merchandise trade. Thus, current restrictions -- while intensifying -- will not significantly curb global flows (Chart 2). And, so far, EM trade volumes have held up well, with resilience in the flow of goods: Our forward-looking models are pointing toward continued trade-related support for base metals in coming months (Chart 3). Chart 2U.S.-China Trade Hit By Tariffs Chart 3EM Trade Will Hold Up, Absent A Trade War This should - ceteris paribus - translate into greater demand for metals, and a strong LMEX. Our modelling finds that the LMEX and EM trade volumes are cointegrated, and that a 1% increase in EM import volumes maps to a 1.3% increase in the LMEX, in line with the overall income elasticity of trade reported by the World Bank last month.6 However, risks surrounding the flow of goods globally - especially between the U.S. and China and the U.S. and EU - are mounting. This is jeopardizing our base case for resilient EM trade and income in the near term. Most notable is the recent U.S. trade restriction imposed on $34 billion worth of Chinese imports effective July 6, and China's subsequent retaliation in kind, which hit U.S. ag exports - particularly soybeans - hard. Additional barriers similar to the tit-for-tat of late between the U.S. and China, raise the odds of a global trade war and further depress metal prices.7 If this U.S.-Sino trade spat devolves into a full-blown trade war, in which the U.S., China and the EU erect trade barriers, or raise tariffs or restrictions on foreign investment, global trade momentum could slow significantly, which would be devastating for EM income growth. The World Bank finds that if tariffs were to reach legal maximum rates under WTO commitments, global trade flows would decline by 9% - in line with the decline experienced during the global financial crisis (GFC) (Chart 4).8 In addition to mounting trade restrictions, the sustainability of Chinese demand is also relevant to our metals demand-side outlook. China's imports account for the bulk of EM import volumes, and a significant domestic slowdown that dents import demand would weigh on the metals complex. To date, China's import volume growth appears to be holding up, reflecting a controlled domestic demand environment (Chart 5). Chart 4Trade War Would Hurt EM Trade Chart 5China Trade Indicates Slowdown Is Controlled Trade Barriers Would Hit EM Incomes Hard As noted above, in line with our base case outlook of supportive trade volumes so far this year, the IMF and World Bank expect the global economy to remain strong this year and next, highlighting trade as one of the two main growth catalysts (Table 1). DM growth, while showing signs of moderating, remains perched above potential. We expect this to persist, especially given fiscal stimulus measures in the U.S. announced earlier this year. According to our modelling, a 1% increase in EM GDP translates to a 1.1% rise in the LMEX. Global PMIs remain above the 50 mark, indicating global manufacturing continues to expand, which will remain supportive of commodity demand generally (Chart 6). Table 1Global Growth Expected To Remain Supportive Chart 6U.S. Will Outperform, Supporting DM Growth China's ~ $14 trillion GDP accounts for some ~ 16% of global GDP and is the highest among the EM economies.9 China accounts for ~ 50% of global demand for metals represented in the LMEX (Chart 7). China's base-metals demand has been resilient, despite tighter credit and monetary conditions and little in the way of fiscal stimulus in China. We continue to expect Chinese domestic demand will experience a managed slowdown as the government tackles its reform agenda in 2H18. Chart 7China's Outsized Role In Metal Markets Since 2000, the impact of income growth in China has only a slightly larger effect on the LME's price index versus that of DM regions such as the Euro Area.10 Our analysis indicates that, unlike the rest of the world, China's metal consumption is trend-stationary - i.e., mean reverting - and behaves almost as it if were a policy variable, which is to say a time series that is more a function of government policy than the laws of supply and demand. Bottom Line: EM income and trade volumes are expected to remain strong, which will be supportive of metals prices. Even so, markets are now dealing with a trade spat that could metastasize into a full-blown trade war. We are not there yet. However, the tail risks are increasing and markets now have to account for a higher likelihood of a slowdown in EM trade volumes, which could be followed by a redistribution of base-metals demand and re-ordering of trade flows. On the flip side, a resolution of the trade frictions would resolve many of these tail risks, and likely would lend support to metal prices via higher EM income growth. In any case, the FX outlook is not supportive for metal prices. A stronger dollar - our base case expectation - will weigh on metal demand and the LMEX. Fundamentals Will Play A Secondary Role Individual market fundamentals, such as aluminum supply cuts, copper mine strikes, and zinc's physical deficit contributed to the LMEX's outperformance last year (Chart 8). Metal-specific supply, demand and inventory conditions will continue influencing the individual metals in the index. Aluminum and copper constitute three-quarters of the LMEX, and fundamental developments in these two markets are especially relevant (Chart 9). Chart 8Individual Fundamentals Supported LMEX Last Year Chart 9Copper, Aluminum Markets Are Key U.S. sanctions on leading Russian aluminum producer Rusal and its top shareholder, the oligarch Oleg Deripaska, led to a 9% surge in the LMEX in the first few weeks of April, followed by a 6% retracement by the end of the month (Chart 10). While risks from this politically motivated tailwind have mostly faded - the U.S. announced that a change in ownership will exempt Rusal from these sanctions - geopolitical tensions remain relevant. Chart 10Individual Markets Remain Relevant In the very near term, ongoing contract renegotiations at Chile's Escondida mine are an upside risk to the LMEX in the coming weeks. BHP's final offer to the labor union is due on July 24. Reuters reports that little progress has been made to settle the disputes between BHP and the union: agreement has been reached on only one-fifth of the points of contention.11 While June upside from these renegotiations have since faded and taken a back seat to downside pressures from the fear of a global trade war, a labor strike at the mine which dents supply, would support copper prices, and offset at least part of the index's downside macro risks. At 14.8% of the index, zinc accounts for a much smaller weight in the LMEX. After strong gains last year, the metal has been a headwind to the LMEX since March. Following two consecutive years of physical deficits, the market is moving toward a surplus, causing prices to slide. However, recent news of a possible production cut by Chinese smelters is preventing major declines. If this were to materialize - details remain vague at best - we would expect to see some support in the zinc market. Bottom Line: Demand-side macro variables - EM trade, incomes, and currencies - explain almost all of the movements in the LMEX. To date, these variables exhibit resilience pointing to support for metal prices. Left-side tail risks arising from possible trade wars have the market's attention and have been weighing on the complex of late. We expect these downside risks to be most relevant in the remainder of this year, and to take a front seat to individual market fundamentals. Nevertheless, individual metals' fundamentals will be important to follow. Right-side tail risks also bear watching, particularly if the current trade spats involving the U.S., China and the EU are resolved in favor of freer, more open global trade. This would super-charge EM growth, which would be bullish for commodities generally, base metals and oil in particular. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy titled "The U.S. And China: Sizing Up The Crisis," published July 11, 2018, available at gps.bcaresearch.com. 2 The adjusted R-squared for each of our two cointegrating regressions is greater than 0.95. These models cover the 2000 to present period. Our modelling also indicates that the LMEX is cointegrated with these three explanatory variables, i.e., they share a long-term trend, wherein the LMEX rises as these variables rise. 3 Please see the IMF's World Economic Outlook of April 2018 (https://www.imf.org/en/Publications/WEO/Issues/2018/03/20/world-economic-outlook-april-2018), and the World Bank's June 2018 Global Economic Prospects (http://www.worldbank.org/en/publication/global-economic-prospects). 4 Please see BCA Research Global Investment Strategy Weekly Report titled "Who Suffers When The Fed Hikes Rates?" dated June 1, 2018, available at gis.bcaresearch.com. 5 Please see "Strong trade growth in 2018 rests on policy choices," published by the World Trade Organization April 12, 2018. 6 The period for our estimate is 2000 to now. We discuss the World Bank's trade elasticities in "Trade Wars, China Credit Policy Will Roil Global Copper Markets" published by BCA Research's Commodity & Energy Strategy June 21, 2018. It is available at ces.bcaresearch.com. 7 The U.S. is threatening to impose tariffs on an additional $200 billion worth of Chinese imports. 8 This is based on a simulation where WTO members increase tariffs to bound rates under WTO commitments as well as a 3% increase in the cost of traded services. This would mean average global tariff rates would legally more than triple from the current 2.7% to 10.2%. This exercise does not take into account the impact of other non-tariff restrictions, such as those on investments. Please see World Bank Policy Research Working Paper 8277 titled "The Global Costs of Protectionism," dated December 2017. 9 Please see "The world's biggest economies in 2018," published by The World Economic Forum at https://www.weforum.org/agenda/2018/04/the-worlds-biggest-economies-in-2018/. 10 A 1 percentage-point (p.p.) increase in China's year-on-year (y/y) GDP rate translates to a 1.8% increase in the LMEX, while a 1 p.p. increase in y/y changes in the Euro Area's y/y GDP rate is associated with a 1.6% increase in the LMEX. These results are based on a dynamic OLS model which also includes the JPM EM currency index and EM export volumes as explanatory variables. The adjusted R2 for the model is 0.97. 11 "Conversations can continue until July 24, at which point BHP must present its final offer, according to a negotiation schedule provided by the company. Between July 27 and July 31, the union will vote to either accept the company's offer or go on strike. After the vote, either party has as many as four days to request a period of government mediation that can last 10 days." Please see "Labour talks at BHP's Escondida mine in Chile enter 'home stretch," dated July 6, 2018, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Mathieu Savary, Foreign Exchange Strategist Highlights On a short-term basis, the dollar is massively overextended and is likely to experience a correction over the coming weeks. EM assets and currencies are the anti-dollar, and will benefit from these dynamics. As a result, oversold commodity currencies like the AUD, CAD, and NZD should be the main beneficiaries of a dollar correction within the G-10 FX space. However, this bout of dollar weakness is unlikely to mark the end of the greenback's 2018 rally. Global liquidity conditions remain very dollar bullish as the U.S. economy is absorbing liquidity from the rest of the world. This creates a scarcity of greenbacks in international markets. It is also dollar bullish because it weighs on the outlook for global growth, flattering the countercyclical nature of the USD. Gold should be the key gauge to judge whether these dynamics will be playing out as we foresee. Feature The last quarter was dominated by the dollar's strength and weakness in EM bonds; weakness that has now spread to EM equities. After such violent moves, it is now time to reflect and to try to understand what the second half of the year may have in store for the dollar. In our view, the dollar move has become overextended. As a result, we anticipate the dollar to experience a correction over the course of the coming months - a move that should benefit risk assets, and EM plays in particular. However, while this correction is likely to be playable for tactical traders, this does not spell the end of the dollar rally and EM selloff. The global liquidity backdrop supports a continuation of the trends seen over the past few months. Short-Term Momentum Extremes The vigor of the dollar rally this year along with the violence of EM bond, currency and equity selling has been eye-catching. However, we are seeing many signs that these moves may have become overdone on a short-term basis. Let's begin with EM assets. EM assets are very important due to their high sensitivity to global liquidity, global growth and the dollar. The market breadth of EM stocks is near its most oversold levels since the financial crisis. This suggests that commodity currencies are likely to experience a relief rally in the coming weeks (Chart I-1). In fact, both the MACD and 14-day RSI oscillators of EM stocks are corroborating this message, having hit some of their lowest levels since 2016 (Chart I-2). Such a rebound could be especially beneficial for the AUD, NZD, and CAD, as speculators have accumulated large short positions in these currencies (Chart I-3). Chart I-1EM Are ##br##Oversold Chart I-2EM Oscillators Point##br## To A Rebound Chart I-3More Reasons For The AUD ##br##And His Friends To Rebound The key for this rally to unfold will be U.S. dollar weakness - a correction that we feel is likely to materialize. From a technical perspective, our dollar capitulation index is currently flagging massively overbought conditions, a picture that our intermediate-term indicator also highlights (Chart I-4). Looking at the euro - the largest constituent of the DXY dollar index - provides a mirror image. The EUR/USD's intermediate-term momentum measure is flagging deeply oversold levels, and the paucity of up days in this pair over the recent month is also congruent with a temporary bottom (Chart I-5). In fact, shorter-term indicators like the MACD and 14-day RSI oscillators have not only reached deeply oversold readings, but have also recently begun to form positive divergences with the price of EUR/USD itself (Chart I-6). Chart I-4The Dollar Should Correct Chart I-5Euro Is The Anti-Dollar Chart I-6Positive Divergences In The Euro What could be a catalyst for a dollar correction that would also help EM assets and thus provide a welcome boost to the euro, and even more so commodity currencies? China obviously plays a key role. One of the crucial ingredients behind the recent generalized USD strength and selloff in EM-related plays has been the rapid fall in the yuan against the dollar. As we argued last week, this remains a key risk for the remainder of the year. However, we also prophesized that Beijing is concerned by the speed of the recent decline, and could try to manage the pace of CNY's fall for now.1 Early this week, the People's Bank of China began "open-mouth" operations in an effort to support the RMB, which seems to be putting a temporary floor under the renminbi. As long as the dam resists, the DXY's rally will pause. Additionally, the speed of the divergence between U.S. growth and the rest of the world has probably reached a short-term peak that will temporarily get reversed. As Chart I-7 illustrates, European, Japanese and Australian economic surprises are attempting to form a bottom, while U.S. ones have just moved below the zero line. Finally, the dollar is likely to lose one of its key supports from last quarter: the U.S. Treasury. As Chart I-8 illustrates, when the Treasury rebuilds its cash balances, the dollar does well. Essentially, through 2017, the Treasury was draining its cash balance ahead of the debt-ceiling standoff. By spending its stash of cash, the U.S. federal government was injecting reserves - in effect liquidity - into the banking system. After the debt-ceiling extension last September, the Treasury proceeded to rebuild its pile of funds, draining reserves and liquidity out of the banking system. This process is now over, and therefore this support for the dollar will continue to fade. Chart I-7Economic Surprises And The Dollar: ##br##From Friends To Foes Chart I-8The U.S. Treasury Is Done Rebalancing##br## Its Cash Balance Altogether, these dynamics are likely to cause the dollar to soften in the near term, especially since, as Dhaval Joshi highlighted in BCA's European Investment Strategy, currency market players are displaying a high degree of groupthink - as measured by the trade-weighted dollar's fractal dimension - and could easily be panicked by a defusing of the growth divergence theme (Chart I-9). Chart I-9Group Think In The Dollar = Hightended Risk Of Countertrend Bottom Line: The dominant trends of the second quarter - a strong dollar, weak commodity currencies and EM plays - are now crowded trades. With the Chinese monetary authorities trying to limit the speed of the CNY's decline, with economic surprises outside the U.S. finding a floor, and with the U.S. Treasury backing away from reducing liquidity in the banking system, a countertrend move across the dollar, EM assets, and commodity currencies is a growing possibility. Why A Countertrend Move And Not A New Trend? Our view remains that global growth has further room to decelerate, that investors have fully anticipated an increase in global inflation, and that the renminbi has greater downside. All these support our expectation that if a period of weakness in the dollar were to materialize this summer, it would be temporary.2 However, another factor plays a big role: The evolution of liquidity flows in the global economy. Essentially, at the core of this argument lies the fact that we worry that the continued growth outperformance of the U.S. along with the revival of animal spirits in this enormous economy will suck in dollar liquidity from the rest of the world. Not only will this create a scarcity of dollars, thus bidding up the price of the greenback in the process, but it will also hurt highly indebted EM economies - nations that have high dollar debts and thus need dollar liquidity to stay afloat (Chart I-10). To begin with, U.S. banks have been slowly increasing their lending to the U.S. private sector. The upsurge in business confidence, with the NFIB small business survey and the Duke CFO survey near record highs, along with the increase in U.S. capex, confirms the durability of this rebound. Additionally, U.S. households also have the wherewithal to increase their borrowings. Not only is household debt as a percentage of disposable income near a 15-year low but, most importantly, debt servicing costs as a percentage of disposable income remain at levels last seen in the early 1980s (Chart I-11). Moreover, banks are still easing their lending standards on mortgages - which represent nearly 70% of household credit - and mortgage quality as measured by FICO scores are still well above levels that prevailed prior to the financial crisis. Chart I-10EM Dollar Debt Is High EM##br## Have A Lot Of Dollar Debt Chart I-11U.S. Households Have The ##br##Wherewithal To Take On Debt This is important, because when banks increase their loan books, they run down their liquidity (Chart I-12). To be more specific, rising loan issuance results in banks selling securities on their balance sheets and running down their cash balances. As Chart I-13 illustrates, when the cash and security inventories of U.S. commercial banks decrease, the U.S. dollar rallies. This relationship was very strong from 1980 to 2008 but loosened for two years during the financial crisis. Since 2010, it has re-established itself. The probability is therefore high that it will remain in place, and be a dollar-bullish factor over the medium term. Chart I-12Rapid Loan Growth Means Less Liquid Chart I-13The Dollar Abhors Liquid Bank Balance Sheets Moreover, by looking at the holdings of securities on banks' balance sheets, we can see that since 2012, they have even provided a leading signal on the dollar. This relationship currently points toward additional dollar strength (Chart I-14). The tighter relationship between securities holdings and the dollar than between total liquidity on banks' balance sheets and the dollar is due to the fact that securities can be re-hypothecated, and therefore can create a much greater supply of dollars in offshore markets than cash alone. The dollar-bullish liquidity backdrop is not limited to banks' balance sheets alone. Long-term portfolio flows into the U.S. have increased substantially in recent months, but still remain well below previous peaks (Chart I-15, top panel). Moreover, as the U.S.'s growing energy independence has prevented the trade deficit from expanding, the American basic balance of payments is now back in positive territory (Chart I-15, bottom panel). This too suggests that the U.S. is absorbing more dollars than it is supplying to the global economy. Chart I-14Declining Security Holdings Of Banks##br## Point To A Surge In The Dollar Chart I-15Money Is Flowing##br## Out Of The U.S. This reality is mirrored by the link between the bond issuance of U.S. firms and the dollar. When U.S. businesses increase their issuance of bonds, this tends to result in a strong dollar and weak majors (Chart I-16). The vigor of the U.S. economy and the deregulatory tendencies of the Trump administration suggest that U.S. companies could continue to issue more bonds, which will drag more liquidity out of the rest of the world and support the dollar in the process. The profit repatriation initiated by President Trump's tax reform is also supportive of the dollar. As Chart I-17 illustrates, when U.S. entities repatriate funds from abroad, the dollar tends to strengthen. Today, they are doing so with more gusto than ever. It is important to remember that this is not a reflection of American firms necessarily buying dollars directly. After all, a lot of their foreign earnings are already held in USD. Instead, it reflects the fact that when U.S. firms bring back their dollars into the U.S., the supply of high-quality collateral available in offshore markets declines, which means that acquiring dollars becomes more expensive.3 Chart I-16Rising Bond Issuance Helps The Dollar Chart I-17Trump's Tax Repatriation Is Dollar Bullish Finally, this decline in dollar liquidity is starting to be felt abroad, a phenomenon magnified by the slowdown in global trade. Global reserves are not increasing as fast as they were in 2017. As a result, a key component of global dollar-based liquidity, the Federal Reserve's accumulation of custodial holdings of securities, is also declining fast - a decrease exacerbated by the fact that the Fed is curtailing the size of its own balance sheet (Chart I-18). Historically, a decline in dollar-based liquidity is not only associated with lower global growth and a stronger greenback, but also with falling EM asset prices, EM currencies, and commodity currencies. Gold prices will provide insight on whether global liquidity remains favorable to the dollar and negative for EM assets. As Chart I-19 illustrates, gold has already broken down an intermediate upward sloping trend line, but is rebounding against the primary trend in place since the early days of 2016. If this rebound peters off and gold breaks below this primary trend line, it will be a clear indication that the decline in liquidity outside the U.S. is having a nefarious impact on global growth. This headwind to global economic activity will support additional dollar strength and asset price weakness. Chart I-18Declinning Dollar Bond Liquidity Chart I-19Litmus Test For Liquidity Bottom Line: The dollar faces near-term downside risk, but this move is likely to prove to be countertrend in nature as the global liquidity backdrop remains dollar bullish. The U.S. economy is currently sucking in global liquidity from the rest of the world, which is creating a scarcity of dollars in offshore markets. Not only is this scarcity inherently dollar bullish, but it also weighs on global growth, further flattering the dollar - a currency that performs well when global growth softens. As a result, while short-term investors should hedge some of their long-dollar exposure over the coming weeks, longer-term investors should use this correction to accumulate more dollars in order to benefit from another leg of the dollar's rally this fall. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Reports, titled "What Is Good For China Doesn't Always Help The World", dated June 19, 2018, "Inflation Is In The Price", dated June 15, 2018, and "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: ISM manufacturing increased to 60.2 from 58.7; ISM prices paid declined to 76.8 from 79.5; Continuing and initial jobless claims both increased, disappointing expectations; Factory orders grew by 0.4% in monthly terms. After hitting deeply overbought levels, the dollar is losing momentum and risks correcting as economic surprises in the U.S. continue to decline while global ones are finding a floor, for now. Even if the dollar were to correct, budding inflationary pressures and higher growth in the U.S. are likely to prompt the Fed to hike at a faster rate than the rest of the developed world, providing the greenback with substantial upside. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 This Time Is NOT Different - May 25, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: Manufacturing PMI improved for Italy, declined for France and remained unchanged for Germany, while decreasing for the euro area as a whole; Euro area retail sales increased by 1.4%, less than the expected 1.5%; Speculations about the ECB's actions are causing substantial movements in markets. The French 5/30 yield curve flattened by about 30 bps at rumors of an "Operation Twist" by the ECB, following the end of the APP in December. However, the euro has remained stable for around a month now, suggesting that markets have already discounted a substantially easier monetary policy. Despite this, the current slowdown in global growth is likely to have a further detrimental effect on the euro. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth surprised to the upside, coming in at 1.3%. However, the Markit Services PMI came in at 51.4, underperforming expectations. Moreover, consumer confidence surprised to the downside, coming in at 43.7. USD/JPY has rallied by roughly 0.5% this past week. Overall we continue to be positive on the yen tactically, given that trade tensions as well as tightening in China should continue to create a risk-off environment where the yen thrives. However, on a longer term basis we maintain our bearish stance, as the BoJ will keep its ultra-dovish monetary policy in order to kick start Japan's moribund inflation. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: Mortgage approvals outperformed expectations, coming in at 64.526 thousand. Moreover, Construction PMI surprised to the upside, coming in at 53.1. Finally, Markit Services PMI also outperformed expectations, coming in at 55.1. GBP/USD has risen by roughly 1% since last week. Overall, we expect that cable will continue to depreciate, as any pullback in the dollar will likely be temporary. Nevertheless, the pound should outperform the euro, given that Europe will likely suffer more from emerging market weakness than the U.K. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was disappointing: The AiG Performance of Manufacturing Index declined slightly from 57.5 to 57.4; RBA Commodity Index in SDR terms grew by 6.6% only, less than the expected 7.5%; Building permits contracted by 3.2% on a monthly basis; The trade balance came out less than expected at AUD 827 million. In its latest monetary policy statement, the RBA highlighted that Australian monetary conditions have tightened, noting lower housing credit growth and tighter lending standards. As 85% of home loans are variable-rate mortgages, the highly indebted Australian households are extremely susceptible to a direct tightening in interest rates. Furthermore, wage growth at 2.1% and inflation at 1.9% implies a paltry 0.2% real wage growth, adding additional risk to household financial conditions. Alongside a clouded global growth outlook, the RBA is therefore unlikely to hike in this environment anytime soon. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has been relatively flat this week. Overall, even if a short-term bounce is likely over the coming weeks, we continue to be bearish on this cross, as commodity currencies like the NZD or the AUD should suffer in the current risk-off environment where liquidity is scarce. However, the New Zealand dollar will probably outperform the Australian dollar. After all, Australia is more exposed to the Chinese Industrial Cycle than New Zealand, being a large base metals exporter. Meanwhile, we remain bearish on the NZD on a longer term basis, as the new government will restrict immigration and implement a dual mandate for the RBNZ, both measures which will lower the neutral rate in New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Despite the rapid increase in oil prices, the Canadian dollar has not been able to keep up. NAFTA tensions are placing downward pressure on the loonie, despite the Canadian economy's rosy conditions. The most recent Business Outlook Survey by the BoC shows increasing economic activity with a robust sales outlook. In addition, capacity utilization is becoming ever tighter, with the amount of firms finding it difficult to meet unexpected demand at the highest level since the history of the data. Furthermore, the labor market continues to tighten, as hiring plans continue to trend upward. This is likely to keep the BoC somewhat hawkish, despite trade worries. The strength of the Canadian economy is therefore likely to lift the CAD above other G10 currencies this year, except against the greenback. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator outperformed expectations, coming in at 101.7. Moreover, the SVME PMI index also surprised to the upside, coming in at 61.6. However, retail sales yearly growth underperformed expectations, coming in at -0.1%. Finally, headline inflation came in line with expectations, coming in at 1.1%. EUR/CHF has risen by roughly 0.5% this week. Overall, we continue to be bullish on a tactical basis on the franc, given that trade tensions and the policy tightening in China should ultimately keep the current risk-off in place. That being said we are cyclically bearish on the CHF, as the SNB will continue to maintain an extraordinarily easy monetary policy stance in order to prevent an appreciating franc to prevent the Swiss central bank from reaching its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 1.8%. Moreover, registered unemployment continued to be very low at 2.2%, in line with expectations. USD/NOK has fallen by nearly 1% since last week, partly due to the rise in oil price, caused by a large draw in inventories. Overall we continue to be bullish on this cross, given that we maintain that the U.S. dollar will continue rising. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 A shift in stance at the Riksbank has been the major force behind the SEK's appreciation of around 2% against both USD and EUR in the past couple of days. The upward revision of CPIF inflation from 1.9% to 2.1% in both 2018 and 2019, and the downward revision of the unemployment rate were particularly important. In addition, three policymakers expressed hawkish views: Deputy Governors Flodén and Skingsley suggested a hike in October or December, while Ohlsson advocated for a higher repo rate of 25 bps now in response to stronger economic growth in both Sweden and abroad. Consistently, these members expressed similar opinions on the termination of foreign exchange interventions, as inflation is near its target. However, the underlying dovish intonations of Stegan Ingves still lurk within the Riksbank, presenting possible downside risk in the short-term. Nevertheless, these views support our longer-term bullish view of the SEK vis-à-vis the euro, based on diverging rate differentials. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The not-so-veiled threat to Gulf Arab oil shipments through the critically important Strait of Hormuz by Iran's President Rouhani earlier this week was a response to the ramping up of maximum pressure by the Trump administration, which is demanding importers of Iranian crude reduce volumes to zero. This was a predictable first step toward what could become a chaotic oil pricing environment (Map 1).1 Map 1Iran Threatens Gulf Shipments Again Oil prices surged on reports of the Iranian threat Tuesday morning, sold off, and recovered later in the day. Pledges from the Kingdom of Saudi Arabia (KSA) to lift production to as much as 11mm b/d this month - a record high - were all but ignored by the market. The threat to safe passage through the Strait of Hormuz - where ~ 20% of global supply transits daily - raises the spectre of military confrontation between the U.S. and Iran, and their respective allies. The growing risks from tighter supply - markets could lose as much as 2mm b/d of Iranian and Venezuelan exports as things stand now - now must be augmented by the likelihood of a Gulf conflict. Energy: Overweight. We remain long call spreads along the Brent forward curve and the S&P GSCI, as we expect volatility, prices and backwardation to move higher. These recommendations are up 34.6% since they were recommended five months ago. Base Metals: Neutral. Treatment and refining charges are higher following smelter closings. Metal Bulletin's TC/RC index was ~ $80/MT at end-June, up ~ $3 vs end-May. Precious Metals: Neutral. Gold traded below $1,240/oz over the past week, but recovered above $1,250/oz as geopolitical tensions rise. Ags/Softs: Underweight. The USDA expects U.S. farm exports in 2018 will come in at $142.5 billion, the second-highest level on record, according to agriculture.com. Feature Oil pricing could become chaotic, as U.S. policy measures aimed at Iran are countered by responses that are not altogether unexpected. In addition to limited spare capacity, and increased unplanned production outages, markets now must discount the likelihood of renewed armed conflict (short of all-out war) in the Gulf between the U.S. and Iran, and their respective allies. To appreciate the significance of President Rouhani's not-so-veiled threat to deny safe passage through the Strait of Hormuz to oil tankers carrying Gulf Arab states' exports, one need only consider that some 20% of the world's oil supply flows through this narrow passage on any given day.2 The response of the president of Iran to U.S. policy - nominally directed at denying Iran the capacity to develop nuclear weapons, but arguably meant to force the existing regime from power - is a predictable next step in the brinkmanship now being played out between these long-standing rivals.3 Following the lifting of nuclear-related sanctions in 2015, Iran's production rose ~ 1mm b/d from 2.8mm b/d to 3.8mm b/d. We expect 500k b/d of Iran's exports will be lost to the market by the end of 1H19, as a result of sanctions being re-imposed November 4. Other estimates run as high as 1mm b/d being lost if the U.S. succeeds in getting importers to drastically reduce purchases. The ire of the U.S. also is directed at Venezuela, where the loss of that country's ~ 1mm b/d of exports would become all but certain, if, as U.S. Secretary of State Mike Pompeo pressed for last month, U.S. trade sanctions against the failing state are imposed.4 We estimate Venezuela's production is down close to 1mm b/d since end-2016, and will average ~ 1.07mm b/d in 2H18 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) BCA's Ensemble Forecast Includes Extreme Events In our updated balances modeling, our base case front-loaded the OPEC 2.0 production increase announced by the coalition at its end-June meeting in Vienna. Core OPEC 2.0's 1.1mm b/d increase (1H19 vs 1H18) is offset by losses in the rest of OPEC 2.0 amounting to ~ 530k b/d in 2H18, and ~ 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels. We assume Iran's exports fall 200k b/d by the end of this year, and another 300k b/d by the end of 1H19, resulting in a total loss of 500k b/d by 2H19. Global supply rises ~ 2mm b/d this year and next, averaging 99.9mm b/d and 101.7mm b/d, respectively, in our estimates. The bulk of this growth is provided by U.S. shale-oil output, which we estimate will rise by 1.28mm b/d this year, and 1.33mm b/d next year. On the demand side, we expect global growth to remain strong, powered as always by stout EM consumption. That said, rising trade frictions, signs the synchronized global growth that powered EM oil demand could move out of synch, and divergent monetary policies at systematically important central banks could take some of the wind out of our consumption-forecast sails (Chart of the Week). That said, if a supply-side event results in a sharp upward price move, we would expect demand growth to adjust lower in fairly short order. This is because many EM states removed or reduced oil-price subsidies in the wake of the prices collapse following OPEC's declaration of a market-share war in late 2014, which leaves consumers in these state more directly exposed to higher prices than in previous cycles. Our base case is augmented with three scenarios. In our simulations, the Venezuela collapse is met by OPEC 2.0's core producers lifting production another 200k b/d, which takes its total output hike to 1.2mm b/d in 2019. OPEC 2.0 does not respond to the lower-than-expected U.S. shale growth contingency we're modeling, which is brought on by pipeline bottlenecks in the Permian Basin. Our scenarios are: A reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks (Scenario 2, Chart 2); Venezuela production collapses to 250k b/d from current levels of ~ 1.07mm b/d, which allows it to support domestic refined product demand and nothing more (Scenario 3, Chart 2); Both of these occurring simultaneously in the Oct/18 - Sep/19 interval (Scenario 4, Chart 2). Chart of the WeekTight Supply, Strong Demand##BR##Remain Supportive of Prices Chart 2BCA's Scenarios Include##BR##Production Losses In Venezuela, Iran The Stark Reality Of Low Spare Capacity Chart 3Global Spare Capacity Stretched Thin Our scenario analyses - particularly Scenarios 3 and 4 - illustrate the stark reality confronting oil markets: Spare capacity will not be sufficient to keep prices below $80/bbl in the event Venezuela collapses, or if Iranian export losses are greater than the 500k b/d we currently are modeling. The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year. This will fall to just over 1mm b/d next year (Chart 3).5 As things stand now, idle and spare capacity of KSA, Russia and core OPEC 2.0 states that actually can increase production would be taxed to the extreme to cover losses of Iranian exports, if some of the higher levels projected by analysts - i.e., up to 1mm b/d - are realized (Chart 4). KSA's maximum sustainable capacity is believed to be ~ 12mm b/d; officials have indicated production will be raised to close to 11mm b/d in July, then likely held there. This record level of production will test KSA's production infrastructure, and would leave the Kingdom with 1mm b/d of spare capacity. Russia is believed to have ~ 400k b/d of spare capacity; it likely will restore ~ 200k b/d of production to the market over the near future, leaving 200k b/d as spare capacity. If just the two high-loss events described above are realized - i.e., Iran export losses come in at 1mm b/d instead of the 500k b/d we expect, and Venezuela's 1mm b/d of exports are lost because the state collapses - global inventory draws will accelerate until enough demand is destroyed via higher prices to clear the market at whatever level of supply can be maintained (Chart 5). Approaching that point, we would expect OECD strategic petroleum reserves (SPRs) to be released.6 Chart 4OPEC 2.0's Core Producers Would Be##BR##Taxed to Replace Lost Exports Chart 5A Supply Shock Would Draw##BR##Crude Inventories Sharply Chart 6Falling Net Imports Implies##BR##Current SPR Could Be Too Large It is difficult to forecast the price at which markets would clear if we get to the state described above. However, it is worthwhile noting that OPEC spare capacity in 2008 stood at 1.4mm b/d, or 2.4% of global consumption. The 1.8mm b/d of OPEC spare capacity EIA estimates is now available to the market represents 1.8% of daily consumption globally. By next year, the EIA's estimated 1mm b/d of OPEC spare capacity will represent a little over 1% of global daily consumption. It was in this economic setting that WTI and Brent breached $150/bbl in mid-2008, just before the Global Financial Crisis tanked the world economy.7 Bottom Line: Into the mix of tightening global supply and limited spare capacity, oil markets now confront higher odds of armed conflict in the Gulf once again. Oil pricing will remain volatile, and could become chaotic as brinkmanship raises the level of uncertainty in markets. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Rouhani says U.S. pressure to stop Iranian oil may affect regional exports," published by uk.reuters.com July 3, 2018. We explore the Trump administration's maximum pressure in a Commodity & Energy Strategy Special Report published June 7, 2018, entitled "Iraq is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. We are using the term chaotic in the sense of "... sensitive dependence on initial conditions or 'the butterfly effect'" described in "Weak Emergence" by Mark A. Bedau (1997), which appears in Philosophical Perspectives: Mind, Causation, And World, Vol. 11, J. Tomberlin, ed., Blackwell, Malden MA. 2 The U.S. EIA calls the Strait of Hormuz "the world's most important oil chokepoint" in its "World Oil Transit Chokepoints," published by the U.S. EIA July 25, 2017. By the EIA's estimates, 80% of the crude oil transiting the strait is bound for Asian markets, with China, Japan, India, South Korea and Singapore being the largest markets. 3 Please see "Mattis's Last Stand Is Iran," published by Foreign Policy June 28, 2018, on foreignpolicy.com. The essay describes the state of play within the Trump administration vis-à-vis Iran. President Trump's third national security advisor, John Bolton, has stated the goal of the administration's policy is not regime change, but denial of the capacity to develop nuclear weapons. However, Bolton repeatedly called for regime change in Iran prior to being tapped as the national security advisor, and has advocated going to war with Iran to prevent it from developing a nuclear weapons capability, in a New York Times op-ed published March 26, 2015, entitled "To Stop Iran's Bomb, Bomb Iran." 4 Please see "Pompeo calls on OAS to oust Venezuela," published by CNN Politics June 4, 2018. 5 OPEC 2.0 is the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. On June 22, 2018, the coalition agreed to raise production 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman, and Qatar. The other core members of OPEC 2.0 are believed to have close to 300k b/d of spare capacity. Other estimates put the spare capacity as high as 3.4mm b/d. The ex-KSA estimates are pieced together by using the International Energy Agency's estimates for core OPEC and Citicorp's estimates for Russia. Please see "Russia's OPEC Deal Dilemma Worsens as Idled Crude Capacity Grows," published by bloomberg.com May 16, 2018. 6 In just-completed research, our colleague Matt Conlan writes the U.S. SPR, at ~ 660mm barrels, can cover more than 100 days of net U.S. crude imports (Chart 6). This coverage will rise to 140 days of net crude imports by the end of 2019. Please see "American Energy Independence And SPR Ramifications," published by BCA Research's Energy Sector Strategy July 4, 2018. 7 Please see the discussion of demand beginning on p. 228 of Hamilton, James D. (2009), "Causes And Consequences Of The Oil Shock Of 2007 - 08," published by the Brookings Institute. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Recommended Allocation Risks to equities and credit are now evenly balanced. We downgrade both to neutral. We are worried that desynchronized growth will further push up the dollar, damaging emerging markets, especially since U.S. inflation will remove the Fed "put". The trade war is nowhere near over, and China shows signs of slowing growth. To de-risk, we raise U.S. equities to overweight, cut the euro zone to neutral, and increase our underweight in EM. We move overweight in cash, rather than fixed income because, with inflation still rising, we see U.S. 10-year rates at 3.3% by year-end. We turn more cautious on equity sectors (reducing the pro-cyclicality of our recommendations by raising consumer staples and cutting materials) and suggest less pro-risk tilts for alternative assets, shifting to hedge funds and away from private equity. Overview Lowering Risk Assets To Neutral Since last December we have been advising risk-averse clients, who prioritize capital preservation, to turn cautious, but suggested that professional fund managers who need to maximize quarterly performance stay invested in risk assets. With U.S. equities returning 3% in the first half of the year and junk bonds 0% (versus -1% for U.S. Treasury bonds), that was probably a correct assessment. Now, however, our analysis indicates that the risk/reward trade-off has deteriorated. Although we still do not expect a global recession until 2020, risks to the global equity bull market have increased. The return outlook is asymmetrical: a last-year bull market "melt-up" could give 15-20% upside, but in bear markets over the past 50 years global equities have seen peak-to-trough declines of 25-60% (Table 1). We think it better to turn cautious too early. A key to successful asset allocation is missing the big drawdowns - but getting the timing of these right is a near impossibility. Table 1How Much Stocks Fall In Bear Markets Chart 1Growth Is Becoming More Desynchronized What are the risks we are talking about? Global growth is slowing and becoming less synchronized (Chart 1). Fiscal stimulus and a high level of confidence among businesses are keeping U.S. growth strong, with GDP set to grow by close to 3% this year and S&P 500 earnings by 20%. But the euro zone and Japan have weakened, and these growing divergences are likely to push the dollar up further, which will cause more trouble in emerging markets. EM central banks are reacting either by raising rates to defend their currencies (which will hurt growth) or by staying on hold (which risks significant inflation). With the U.S. on the verge of overheating, the Fed will need to prioritize the fight against inflation. Lead indicators of core inflation suggest it is likely to continue to rise (Chart 2). The FOMC's key projections seem incompatible with each other: it sees GDP growth at 2.7% this year (well above trend), but unemployment barely falling further, bottoming at 3.6% by end-2018 (from 3.8% now) and core PCE inflation peaking at 2.1% (now: 2.0%). A further rise in inflation means that the Fed "put option" will expire: even if there were a global risk-off event, the Fed might not be able to put tightening on hold. It will take only one or two more hikes for Fed policy to be restrictive - something we have previously flagged as a key warning signal (Chart 3). Chart 2U.S. Inflation Could Pick Up Further Chart 3Fed Policy Is Close To Being Restrictive There is no end in sight for the trade war. President Trump is unlikely to back down on imposing further tariffs on China, since the tough stance is proving popular with his support base. On the other hand, President Xi Jinping would lose face by giving in to U.S. demands. BCA's geopolitical strategists warn that we are not at peak pessimism, and do not rule out even a military dimension.1 China is unlikely to roll out stimulus, as it did in 2015. With the authorities focused on structural reform, for example debt deleveraging, the pain threshold for stimulus is higher than in the past. Recent moves such as reductions in banks' reserve requirement have had little impact on effective interest rates (Chart 4). More likely, China might engineer a weakening of the RMB, as it did in 2015. There are signs that it is already doing so (Chart 5). This would exacerbate political tensions. Chart 4China Has Not Eased Monetary Conditions... Chart 5...But It Might Be Depreciating The RMB As we explain in detail in the pages that follow, with risk now two-way, we cut our weighting in global equities to neutral. We are not going underweight since global economic growth remains above trend, and corporate earnings will continue to grow robustly (though no faster than analysts are already forecasting). We see upside risk if the Fed were to allow an overshoot of inflation amid strong growth. If the concerns highlighted above cause a 15% correction in equity markets - triggering the Fed to go on hold - we would be inclined to move back overweight (having in mind a scenario like 1987 or 1998, where a sell-off led to a last-year bull-market rally). More likely, however, we will move underweight at the end of the year, when recession signals, such as an inverted yield curve, appear. We have shifted our detailed recommendations to line up with this de-risking. We move overweight U.S. equities (which are lower beta, and where unhedged returns should benefit from a stronger dollar). We keep our overweight on Japan, since the Bank of Japan remains the last major central bank in fully accommodative mode. We increase our underweight in EM equities. Among sectors, we reduce pro-cyclicality by cutting materials to underweight and raising consumer staples to overweight. We remain underweight fixed income, since inflationary pressures point to the 10-year U.S. Treasury bond yield moving up to 3.3% before the end of this cycle. We remain short duration and continue to prefer inflation-linked securities over nominal bonds. Within fixed income, we cut corporate credit to neutral, in line with our de-risking. Finally, we recommend that investors move into cash rather than bonds, though we understand that, especially for European investors, this may mean accepting a small negative return.2 Still puzzled how markets may pan out over the next 12 months? Then join BCA's annual Conference in Toronto this September, where I will be chairing a panel on asset allocation, featuring two experienced Chief Investment Officers, Erin Browne of UBS Asset Management, and Norman Villamin of Union Bancaire Privée. Garry Evans, Senior Vice President garry@bcaresearch.com What Our Clients Are Asking How To Overweight Cash? Chart 6Sometimes Cas Is The Only Answer BCA's call to start to derisk portfolios includes a new overweight in cash. This is logical since, historically, cash often outperformed both equities and bonds early in a downturn, when growth was starting to falter (bad for equities) but inflation was still rising (bad for bonds) - though this last happened in 1994 (Chart 6, panel 1). Currently, a move to cash is easy for U.S. investors, who can invest in three-month Treasury bills yielding 1.9%, or USD money market funds, some of which offer just over 2%. But it is much harder for investors in the euro area, where three-month German government bills yield -0.55%. Also, in Japan cash yields -0.17% and in Switzerland -0.73%. Some European investors will be tempted to go into U.S. cash. Given our view of dollar appreciation over the next six months, this should pay off. But it clearly is risky, should we be wrong and the dollar decline. As theory predicts, the cost of hedging the U.S. dollar exposure wipes out any advantage (since three-month euro-dollar forwards are 2.7% lower on an annualized basis than EURUSD spot). Some investors will have to put up with a small negative return in nominal terms in order to (largely) protect their capital. More imaginative European fund managers might be able to come up with schemes to get cash-like returns but with a positive return. For example, Danish mortgage bonds yield 1.8% (in Danish krone, which is largely pegged to the euro) with little risk. U.S. mortgage-backed securities offer yields well over 3%, which should give a positive return after hedging costs (and relatively low risk, given the robust state of the U.S. housing market) - panel 3. Carefully-selected global macro hedge funds can give attractive Libor-plus returns.3 We still see attractiveness of catastrophe bonds,4 which have a high yield and no correlation to the economic cycle. How Seriously Should We Take The Risk Of A Trade War? Is this a full-blown trade war? The answer is not yet. However, the risk is rising that the current spat will turn into one. President Trump has escalated tensions further by indicating that a 10% tariff would be placed on $200 billion of Chinese imports, in addition to the 25% tariff on $50 billion of imports announced in March and to be implemented on July 6. Trump's incentive to escalate the conflict is that a tough trade policy plays well with his support base (Chart 7). Ever since the trade issue hit the headlines early this year, his approval ratings have been on the rise. This means that he is unlikely to back down at least until the mid-term elections in November. Xi Jinping is also unlikely, for his own political reasons, to give in to U.S. demands. But China's retaliation will most likely come through non-tariff actions, since its imports from the U.S. total only about $130 billion (compared to $500 billion of Chinese exports to the U.S.). It could look to restrict imports, for example via quotas, or cause extra bottlenecks for U.S. businesses operating in China. Additionally, it could threaten to sell some of its holdings of U.S. Treasuries, or devalue the RMB. As Chart 8 shows, the RMB has already weakened against the dollar this year (though this was mainly due to the dollar's overall strength). There are suggestions that China might adjust the currency basket that it targets for the RMB, for example by adding more Asian currencies, to allow further depreciation against the dollar. Chart 7 Chart 8Sharp Rise In RMB This Year It is hard, then, to see a smooth outcome to this standoff. A further escalation could even have a military dimension, with the U.S. having recently opened a new "embassy" in Taiwan, and sailing navy vessels close to Chinese "islands" in the South China Sea. It is also a complication that President Trump has recently raised tensions with other G7 trading partners, rather than engaging their help in combatting China's perceived unfair trading practices. Is It Time To Buy Chinese A-Shares? In Q2 2018, MSCI China A-shares lost 19% in absolute terms, compared to a 3.5% gain for MSCI U.S. Some investors attribute this performance divergence to trade tension between the U.S. and China, and take the view that the Chinese government may step in to stimulate the economy and support the equity market, similar to what happened in 2015. We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. Given elevated debt levels and excess capacity in some parts of the economy and worries about pollution, however, the bar for a fresh round of stimulus is a lot higher than in the past. With the incremental inclusion of MSCI on-shore A-Shares into the MSCI China investible universe, A-shares are gaining more attention from international investors. However, the A-Share Index is very different from the MSCI China Index. First, the sector compositions are very different, as shown in Chart 9. The MSCI China index is not only dominated by the tech sector (40%), it's also very concentrated, with the top 10 names accounting for 56% of the index, while the top 10 names in the A-shares account for only about 20%. Second, even in the same sectors, the performance of the two indexes has diverged as shown in Chart 10. We see the reason for these divergences being that domestic investors are more concerned about growth in China than foreign investors are. Instead of buying A-Shares, investors should be more cautious on the MSCI China Index, for which we have a neutral view within MSCI EM universe. Chart 9 Chart 10ONE CHINA, TWO DIFFERENT EQUITY INDEXES What Are The Characteristics Of The Private Debt Market? Chart 11Private Debt Market Private debt (Chart 11) raised a record $115 billion through 158 funds in 2017, pushing aggregate AUM from $244 billion in 2007 to $664 billion in 2017. This explosive growth was driven by bank consolidation in the U.S., increased financial sector regulation, and the global search for yield. Private debt has historically enjoyed a higher yield and return, along with fewer defaults, than traditional public-market corporate bonds. Below are some of the key points from our recent Special Report:5 Private debt has returned an average net IRR of 13% from 1989 to 2015. This compares to an annualized total return of 7% and 7.2% for equities and corporate bonds respectively. Investors can diversify their sources of risk and return by giving access to more esoteric exposures such as illiquidity and manager skill. The core risk exposure in private debt comes from idiosyncratic firm-specific sources, which is not the case with publicly traded corporate credit. Investors can gain more tailored exposure to different industries and customized duration horizons. Additionally, private debt was the only group in the private space that did not experience a contraction in AUM during the financial crisis. Direct lending and mezzanine debt are capital preservation strategies that offer more stable returns while minimizing downside. Distressed debt and venture debt are more return-maximizing strategies that offer larger gains, but with a higher probability of losses. In the late stages of an economic cycle, investors should deploy capital defensively through first-lien and other senior secured debt positions. In contrast, a recession would create opportunities for distressed strategies and within deeper parts of the capital structure. Global Economy Overview: Growing divergences are emerging in global growth, with the U.S. producing strong data, but a cyclical slowdown in the euro area and Japan, and the risk of significantly slower growth in China and other emerging markets. This means that monetary policy divergences are also likely to increase, exacerbating the rise in the U.S. dollar and putting further pressure on emerging markets. Eventually, however, tighter financial conditions could start to dampen growth in the U.S. too. U.S.: Data has been very strong for the past few months, with the Fed's two NowCasts pointing to 2.9% and 4.5% QoQ annualized GDP growth in Q2. Small businesses are confident (with the NFIB survey at a near record high), which suggests that the capex recovery is likely to continue. With unemployment at the lowest level since 1969, wages should pick up soon, boosting consumption. But it is possible the data might now start to weaken. The Surprise Index (Chart 12, panel 1) has turned down. And a combination of trade war and a stronger dollar (up 8% in trade-weighted terms since April) might start to dent business and consumer confidence. Chart 12U.S. Growth Remains Strong... Chart 13...While Europe, Japan And EMs Start To Slow Euro Area: Euro area data, by contrast to the U.S., have turned down since the start of the year, with both the PMI and IFO slipping significantly (Chart 13, panel 1). This is most likely because the 6% appreciation of the euro last year has affected export growth, which has slowed to 3.1% YoY, from 8.3% at the start of the year. However, the PMI remains strong (around the same level as the U.S.) and, with a weaker euro since April, growth might pick up late in the year, as long as problems with trade and Italy do not deteriorate. Japan: Japan's growth has also slipped noticeably in recent months (Chart 13, panel 2), perhaps also because of currency strength, though question-marks over Prime Minister Abe's longevity and the slowdown in China may also be having an effect. The rise in inflation towards the Bank of Japan's 2% target has also faltered, with core CPI in April back to 0.3% YoY, though wages have seen a modest pickup to 1.2%. Emerging Markets: China is now showing clear signs of slowing, as the tightened monetary conditions and slower credit growth of the past 12 months have an effect. Fixed-asset investment, retail sales and industrial production all surprised to the downside in May. The authorities have responded to this (and to threat of trade disruptions) by slightly easing monetary policy, though this has not yet fed through to market rates, which have risen as a result of rising defaults. Elsewhere in EM, many central banks have responded to sharp declines in their currencies by raising rates, which is likely to dampen growth. Those, such as Brazil, which refrained from defensive rate hikes, are likely to see an acceleration in inflation Interest rates: The Fed has signaled that it plans to continue to hike once a quarter at least for the next 12 months. It may eventually have to accelerate that pace if core PCE inflation moves decisively above 2%. The ECB, by contrast, announced a "dovish tightening" last month, when it signaled the end of asset purchases in December, but no rate hike "through the summer" of next year. It can do this because euro zone core inflation remains around 1%, with fewer underlying inflationary pressures than in the U.S. The Bank of Japan is set to remain the last major central bank with accommodative policy, since it is unlikely to alter its yield-curve control any time soon. Global Equities Chart 14Neutral Global Equities A Bird In The Hand Is Worth Two In The Bush: After the initial strong recovery from the low in March 2009, global equity earnings have risen by only 20% from Q3 2011, and that rise mostly came after February 2016. In the same period, global equity prices, however, have gained over 80%, largely due to multiple expansion (Chart 14), supported by accommodative monetary and stimulative fiscal policies. Year-to-date, our pro-cyclical equity positioning has played out well with developed markets (DM) outperforming emerging markets (EM) by 8.8%, and cyclical equities outperforming defensives by 2.9%. As the year progresses, however, we are becoming more and more concerned about future prospects given the stage of the cycle, stretched valuations and the elevated profit margin.6 The three macro "policy puts", namely the Fed Put, the China Put and the Draghi Put, are all in jeopardy of disappearing or, at the very least, of weakening, in addition to the risk of rising protectionism. BCA's House View has downgraded global risk assets to neutral.7 Reflecting this change, within global equities we recommend investors to take a more defensive stance by reducing portfolio risk. We remain overweight DM and underweight EM; We upgrade U.S. equities to overweight at the expense of the euro area (see next page); Sector-wise, we suggest to take profits in the pro-cyclical tilts and become more defensive (see page 14). Please see page 21 for the complete portfolio allocation details. U.S. Vs. The Euro Area: Trading Places Chart 15Favor U.S. Vs. Euro Area In line with the BCA House View to reduce exposure in global risk assets, we are downgrading the euro area to neutral in order to fund an upgrade of the U.S. to overweight from neutral, for the following reasons: First, GAA's recommended equity portfolio has always been expressed in USD terms on an unhedged basis. Historically, the relative total return performance of euro area equities vs. the U.S. has been highly correlated with the euro/USD exchange rate. With BCA's House View calling for further strength of the USD versus the euro, we expect euro area total return in USD terms to underperform the U.S. (Chart 15, panel 1). Second, the euro area economy has been weakening vs. the U.S. as seen by the relative performance of PMIs in the two regions; this bodes ill for the euro area's relative profitability (Chart 15, Panel 2). Third, because euro area equities have a much higher beta to global equities than U.S. equities do, shifting towards the U.S. reduces the overall portfolio beta (Chart 15, Panel 3). Last, even though euro area equities are cheaper than the U.S. in absolute term, they have always traded at a discount to the U.S. On a relative basis, this discount is currently fair compared to the historical average. Sector Allocation: Become More Defensive Chart 16Sectors: Turn Defensive Year to date, our pro-cyclical sector positioning has worked very well, especially the underweights in telecoms, consumer staples and utilities, and the overweight of energy. The overweight in healthcare also has worked well, but the overweights in financials and industrials, as well as the underweight of consumer discretionary, have not panned out. Global economic growth has peaked, albeit at a high level. This does not bode well for the profitability of the economically sensitive sectors (industrials, consumer discretionary and materials) relative to the defensive sectors (healthcare, consumer staples and telecoms), as shown in Chart 16, top two panels. In addition, slowing Chinese growth will weigh on the materials sector, and rising tension in global trade will pressure the industrials sector. As such, we are upgrading consumer staples to overweight (from underweight) and telecoms to neutral, and downgrading materials to underweight (from neutral). Oil has gained 16% so far this year, driving energy equities to outperform the global benchmark by 6.2%. Going forward, however, the oil outlook is less certain as OPEC and Russia work to ease production controls, and demand is cloudy. This prompts us to close the overweight in the energy sector to stay on the sideline for now (Chart 16, bottom panel). We also suggest investors to reduce exposure in financials to a benchmark weighting due to our concerns on Europe and also the flattening of yield curves. After all these changes, we are now overweight healthcare and consumer staples while underweight consumer discretionary, utilities and materials. All other sectors are in line with benchmark weightings. Government Bonds Maintain Slight Underweight On Duration. BCA's house view has downgraded global risk assets to neutral and raised cash to overweight, while maintaining an underweight in fixed income.8 This prompts us to downgrade credit to neutral vs. government bonds (see next page). However, we still see rates rising over the next 9-12 months and so our short duration recommendation for the government bonds is unchanged. The U.S. Fed is on track to deliver a 25bps rate hike each quarter given robust business confidence and tight labor markets, and the ECB has announced it will stop new bond buying in its Asset Purchase Program after December this year. As such, bond yields are likely to move higher in both the U.S. and the euro area given the close relationship between 10-year term premium and net issuance (Chart 17). Chart 17Yields Will Rise Further Chart 18Favor Inflation-Linked Bonds Favor Linkers Vs. Nominal Bonds. The latest NFIB survey shows that wage pressure is on the rise, with reports of compensation increases hitting a record high (Chart 18, top panel). BCA's U.S. Bond Strategy still believes that the U.S. TIPS breakeven will rise to 2.4-2.5% around the time that U.S. core PCE inflation exceeds the Fed's 2% target rate (the Fed forecasts 2.1% by end-2018). Compared to the current breakeven level of 2.1%, this means 10-year TIPS has upside of 30-40bps, an important source of return in the low-return fixed income space (Chart 18, panel 2). Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds (Chart 18, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 19Spreads Not Attractive We have favored both investment-grade and high-yield corporates (Chart 19) over government bonds for over two years. But, while monetary and credit conditions remain favorable, we think rising uncertainty and weakening corporate balance sheets in the coming quarters warrant a more cautious stance. We are moving to neutral on corporate credit. In Q1, outstanding U.S. corporate debt grew at an annualized rate of 4.4%, while pre-tax profits (on a national accounts basis) contracted by 5.7%, raising gross leverage from 6.9x to 7.1x. The benign default rates and tight credit spreads associated with robust economic growth are at risk now that leverage growth is soon poised to overtake cash flow growth, challenging companies' debt service capability. Finally, if labor costs accelerate, leverage will continue to rise in 2H18. Since February, our financial conditions index has tightened considerably driven by a combination of falling equity prices and a stronger dollar. As monetary policy shifts to an outright restrictive stance once inflation reaches the Fed's target later in 2018, corporates will suffer. The risk-adjusted returns to high yield (Chart 20) are no longer attractive relative to government bonds. Chart 20Junk Only Attractive If Defaults Stay Low Chart 21Rising Leverage Finally, valuations are expensive. Investment grade spreads have widened by 50bps from the start of the year, but junk spreads are still close to their post-crisis lows. As we are late in the credit cycle, we do not expect further contraction in spreads. For now monetary and credit quality indicators remain stable, but we are booking profits and moving both investment-grade and high-yield corporates to neutral. In the second half of the year, as corporate leverage (Chart 21) starts to deteriorate and monetary policy gets more restrictive, we will look to further review our allocations. Commodities Chart 22Strong Demand But Uncertain Supply In Oil Energy (Overweight): Underlying demand/supply fundamentals (Chart 22, panel 2) will continue to drive prices, as the correlation with the U.S. dollar breaks down. We expect the key OPEC countries to increase production by 800k b/d and over 210k b/d in 2H18 and 1H19 respectively. This will be offset by losses in the rest of OPEC of 530k b/d and 640k b/d in 2H18 and 1H19 respectively. Venezuelan production has dropped from a peak of 2.1m b/d to 1.4m b/d, and we expect it to reach 1.2m b/d by year end and 1.0m b/d by the end of 2019. Additionally, we expect Iranian exports to fall by 200k b/d to the end of 2018, and by another 300k b/d by the end of 1H19 as a result of sanctions. Demand seems to be holding up for now, but is conditional on developments in global trade. BCA's energy team forecasts Brent crude to average $70 in 2H18 and $77 in 2019. Industrial Metals (Neutral): China remains the largest consumer of metals, and so price action will react to underlying economic growth there and to the dynamics of its local metals markets. Additionally, a strengthening dollar will add downward pressure to prices and increase volatility. We expect a physical surplus in copper markets to emerge by year end, given slower demand growth and supply concerns due to restrictions on China's imports of scrap copper. Precious Metals (Neutral): Rising global uncertainties and geopolitical tensions driven by trade wars and divergent monetary policy will continue to keep market volatility high. During periods of equity market downturns, gold will continue to be an attractive hedge. Additionally, as inflationary pressures continue to rise, investors will continue to look for inflation protection in gold. However, rising interest rates and a strengthening dollar could limit price upside. We recommend gold as a safe-haven asset against unexpected volatility and inflation surprises. Currencies Chart 23Dollar Appreciation To Continue King Dollar U.S. Dollar: Following the recent strong economic data out of the U.S., the Fed is likely to maintain its moderately hawkish stance and follow its current dot plan of gradual rate hikes over the course of this year and next. For now the Fed is unlikely to accelerate the pace of hikes: it hinted that it could allow inflation to overshoot its target of 2% on core PCE. We expect the U.S. dollar to appreciate further over the coming months (Chart 23, panel 1). Euro: Disappointments in European economic data, in addition to political uncertainties in Italy, have led to a correction in the EUR/USD (Chart 23, panel 2). The ECB's indication that it will not raise rates through the summer of 2019 added further downward pressure on the currency. In addition, rising tension related to trade war and its impact on European growth is likely to dampen the euro's performance further. We look for EUR/USD to weaken to at least 1.12. JPY: The outlook for the yen is more mixed than for the euro. Japanese data over the past couple of months have been anemic, and interest rate differentials with the U.S. point to a weakening yen (Chart 23, panel 3). Moreover, the BoJ is still concerned with achieving its inflation target and so remains the last major central bank in full accommodative mode. However, escalating global tension is likely to be a positive factor for the JPY as a safe haven currency. It also looks far cheaper relative to PPP than does the euro. We see the yen trading fairly flat to the USD, but appreciating against the euro. EM Currencies: Tighter U.S. financial conditions, rising bond yields, and a strengthening dollar are all disastrous for EM currencies (Chart 23, panel 4). Additionally, the ongoing growth slowdown in China, and in EM as a whole, will add further downside pressures on most EM currencies. Alternatives Chart 24Turn Defensive On Alts Allocations to alternatives continue to rise as investors look for new avenues to preserve capital and generate attractive returns. We are turning more cautious on risk assets across all asset classes on the back of a possible growth slowdown and restrictive monetary policy. With intra-correlations between alternative assets reaching new lows (Chart 24), investors need to be especially careful picking the right category of alt investments. Return Enhancers: We have favored private equity over hedge funds since 1Q16, and this has generated an excess return of 20%. But, given our decision to scale back on risk assets on the back of a possible growth slowdown, we are turning cautious on private equity. Higher private-market multiples, stiff competition for buyouts from large corporates, and an uncertain macro outlook will make deal flow difficult. On the other hand, as volatility makes a comeback and markets move sideways, discretionary and systematic macro funds should fare better. We recommend investors pair back on their private equity allocations and increase hedge funds as we prepare for the next recession. Inflation Hedges: We have favored direct real estate over commodity futures since 1Q16; this position has generated a small loss of 1.4%. Total global commercial real-estate (CRE) loans outstanding have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. CRE prices peaked in late 2016, and are now flat-lining, partly due to the downturn of shopping malls and traditional retail. On the other hand, commodity futures have had a good run on the back of rising energy prices. We recommend investors reduce their real estate allocations, and put on modest positions in commodity futures as an inflation hedge. Volatility Dampeners: We have favored farmland and timberland over structured products since 1Q16, and this has generated an excess return of 6%. As noted in our Special Report,9 of the two, timberland assets tend to have a stronger correlation with growth, whereas farmland demand is relatively inelastic during times of a slowdown. Additionally, farmland returns tend to have lower volatility compared to timberland. Structured products will continue to suffer with rising rates. We recommend investors allocate more to farmland over timberland, and stay underweight structured products. Risks To Our View Chart 25What If China's Imports Weaken Sharply Our neutral view on risk assets implies that we see the upside and downside risks as evenly balanced. Could the macro environment turn out to be worse than we envisage? Clearly, there would be more downside for equities if the risks we highlighted in the Overview (slowing growth, U.S. inflation, trade war, Chinese policy) all come through. China and emerging markets are the key. China's import growth has been trending down for 12 months; could it turn significantly negative, as it did in 2015 (Chart 25)? Emerging markets look sensitive to further rises in U.S. interest rates and the dollar. The most vulnerable currencies have already fallen by up to 20% since the start of the year, but could fall further (Chart 26). We would not over-emphasize these risks, however. If growth were to slow drastically, China would roll out stimulus. Emerging markets are more resilient than they were in the 1990s, thanks to currencies that mostly are floating and generally healthier current account positions (though, note, their foreign-currency debt is bigger). Chart 26EM Currencies Could Fall Further Chart 27Is This An Excuse For The Fed To Be Dovish? On the positive side, the biggest upside risk comes from the Fed slowing the pace of rate hikes even though growth is robust. This might be because U.S. inflation remains subdued (perhaps for structural reasons) - or because the Fed allows an overshoot of inflation, either under political pressure, or because of arguments that its inflation target is "symmetrical" and that it has missed it on the downside ever since the target was introduced in 2012 (Chart 27). This would be likely to weaken the dollar, giving emerging markets a reprieve. It might lead to a 1999-like stock market rally, perhaps led again by tech - specifically, internet - stocks. 1 Please see What Our Clients Are Asking: How Seriously Should We Take The Risk Of A Trade War, on page 7 of this Quarterly for more analysis of this subject. 2 Please see What Our Clients Are Asking: How To Overweight Cash, on page 6 of this Quarterly for some suggestions on how to minimize this. 3 Please see Global Asset Allocation Special Report, "Hedge Funds: Still Worth Investing In?", dated June 16, 2017, available at gaa.bcaresearch.com 4 Please see Global Asset Allocation Special Report, "A Primer On Catastrophe Bonds", dated December 12, 2017, available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Private Debt: An Investment Primer", dated June 6, 2018, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation - Quarterly Portfolio Outlook, dated April 3, 2018, available at gaa.bcaresearch.com 7 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 8 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 9 Please see Global Asset Allocation - Special Report "U.S. Farmland & Timberland: An Investment Primer", dated October 24, 2017, available at gaa.bcaresearch.com GAA Asset Allocation

Highlights May's soft durable goods orders report is probably not a precursor of weaker capex. Despite shortages of inventory and rising rates, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions. Oil price volatility is set to rise. Feature Despite a late-week rally, U.S. equities finished the week lower as investors worried about global trade, higher oil prices, and an economic slowdown in China. 10-Year Treasury yields fell even as inflation returned to the Fed's target. The trade-weighted dollar moved higher last week, and rose 5% in the second quarter. Last week's economic data skewed to the softer side of expectations, but despite the recent run of disappointing data, Q2 GDP growth is still tracking well above 3.0%. Chart 1Core Inflation Is At The Fed's Target Supply bottlenecks are a hallmark of late-cycle economic expansions. In recent months, the Fed's Beige Book identified supply shortages in the labor and product markets in the U.S.1 Many of these economic pinch points are in the energy sector, where businesses are running out of labor, rail and trucking capacity, and in some cases, roads.2 Capacity constraints are also an issue in the overseas oil markets and will lead to increased volatility. Moreover, there are signs that a growing scarcity of some raw materials may be affecting overall business capital spending in the U.S. Low inventories of new and existing homes for sale are factors in the soft activity in the housing sector. The tighter labor and product markets are pushing up U.S. inflation. At 1.96% year-over-year, the May reading on core PCE, the Fed's preferred measure of inflation, is near a cycle high and has returned to the central bank's target (Chart 1). Moreover, there were a record number of inflation words in the Fed's latest Beige Book. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb.3 Fed policymakers have signaled that they will not mind an overshoot of the 2% inflation target. However, with core PCE inflation at 2% and the unemployment rate well below the Fed's estimate of full employment, the FOMC will be slower to defend the stock market in the event of a swoon. Bottom Line: Product and labor markets continue to tighten and push inflation higher, raising the odds that the central bank will take a more aggressive stance in the next 12 months. Last week,4 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Capital Spending Update Business capital spending remains upbeat, but may be near a peak. Core durable goods orders dipped by 0.2% m/m in May. The monthly data can be unreliable and it is more useful to look at the year-over-year rates of change. But even here, there is a softening trend. From a recent high of 12.9% y/y, the annual growth rate in core durable goods orders has slowed to 6.6% y/y. Nonetheless, we do not believe that a major down-cycle in U.S. capex has started. The regional Fed surveys of investment intentions remain at lofty levels (Chart 2, panel 2). In addition, managements' attitudes toward capital spending are still upbeat, according to the latest surveys from Duke University, the Conference Board and the Business Roundtable. However, there was a slight downtick in the Business Roundtable metric in Q2 because of the uncertainty surrounding tariffs (Chart 2, panel 1). Moreover, in his post FOMC meeting press conference last month, Fed Chair Powell noted that companies may be delaying decisions on investment spending due to uncertainty around trade policy.5 A tight labor market and accelerating wages mean that firms should look for ways to boost output through productivity-enhancing capex. Furthermore, the 2017 Tax Cuts and Jobs Act allowed for accelerated depreciation, which increased the immediate tax incentive for investment spending. Chart 3 illustrates that through Q1 2018, corporate outlays for dividends ran slightly ahead of previous cycles, while capex and buybacks were about average. BCA will continue to monitor this mix. The lack of business spending on share repurchases is surprising given the spike in buyback announcements in the wake of the tax legislation. (Chart 4, panel 1). However, the bottom panel of Chart 4 indicates that net equity withdrawal is muted and in a downtrend despite the elevated buyback announcements. Chart 2Capex Indicators Still Solid... Chart 3Comparison Of Corporate Outlays Across Four Economic Expansion Phases The positive reading on BCA's Capital Structure Preference Indicator supports our stance that buybacks will add to EPS growth this year (Chart 5, second panel). This indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is a financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The indicator is currently positive, although not as high as it was in 2015. Chart 4Still Some Room To Run For Buybacks Chart 5Buybacks Adding To EPS Growth Bottom Line: May's soft durable goods orders report is probably not a precursor of weaker capex. Corporate managers will look to escalate productivity via capital spending in the next few years as an offset to tight labor markets and scarce resources. The upswing in capital spending is another sign that the U.S. economy is in the late stages of the business cycle.6 Housing Slack Still On Decline The latest soundings on home construction and sales show that inventories of new and existing homes are close to record lows (Chart 6, panel 1 and 2) and that homeownership rates are in a clear uptrend albeit at near historical lows (panel 3), boosted by the tight labor market and rising incomes (panel 4). Most indicators show that the housing market continues to grow along the typical path of the classic boom/bust residential real estate cycle (Chart 7). As such, we expect residential investment will add to GDP growth this year and support housing-related investments. Chart 6Housing Fundamentals##BR##Are Stout Chart 7Still Plenty Of Gas Left##BR##In The Tank For Housing Even so, our past work7 indicated that housing reached a zenith several quarters before other sectors of the economy. BCA's view is that the 10-year treasury rate will peak at 3.80%.8 Nonetheless, housing affordability remains well above average and will be supportive of housing investment even if rates climb by 100 bps (Chart 8). Furthermore, mortgage payments as a share of median income will stay below average if rates escalate by 100 or even 200 bps (panel 2). However, a 200 bp increase in mortgage rates, admittedly an extreme scenario, would crimp housing affordability and nudge the mortgage payment as a share of median income above its long-term average (panels 1 and 2). Homebuilders' costs are rising. The Beige Books released this year pointed out that homebuilders face fierce competition for labor and input costs are rising. In addition, the Beige Book notes slow sales are due to a lack of inventory in some regions of the U.S.9 The implication is that home prices may rise if homebuilders pass on the higher labor and material costs to buyers. There is a shortage of demand for mortgage loans, despite the favorable lending conditions (Chart 9). In addition, first-time homebuyers, a key source of demand for existing homes, has turned from a tailwind to a modest headwind in recent years (Chart 10). Chart 8Housing Affordability Under##BR##Various Rate Assumptions Chart 9Easy To Get A Mortgage,##BR##But Mortgage Demand Is Softening Chart 10Is First Time Homebuyers##BR##Support For Housing Waning? Bottom Line: The housing market remains in an uptrend. A shortage of inventory may be hurting sales, but rising rates are not a threat to affordability. Rising costs for labor and raw materials may cut into homebuilder profits and a recent downshift in first-time homebuyers is a concern. Nonetheless, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. In late May, BCA's U.S. Equity Strategy team upgraded the S&P 500 homebuilders industry group to neutral from underweight, citing lower bond yields, solid homebuilder fundamentals and compelling valuations.10 From a macro perspective, we will continue to closely monitor residential investment as we assess the onset of the next recession. Protect Or Defend? BCA's Protector Portfolio does not protect in sideways equity markets. In last week's report,11 we identified 10 periods since 1950 when the S&P 500 equity markets moved sideways for at least 5 months in a narrow range. Table 1 shows the performance of our Defensive and Protector Portfolios12 when U.S. equities are range bound. Our analysis is constrained by data limitations. Table 1S&P Defensives And BCA Protector Portfolios In Sideways Equity Markets On average, investors have been better off in the S&P 500 than in our Protector Portfolio during sideways phases that have occurred since 1986. Our portfolio outperformed the S&P 500 in only one (2004) of the seven sideways periods. On average, the S&P 500 returned 22% while the Protector Portfolio posted a 2.8% decline. Moreover, the portfolio lost value in the 1988 and 2015 sideways episodes (Chart 11A). Chart 11AS&P Defensives In##BR##Sideways Equity Markets Chart 11BBCA's Protector Portfolio In##BR##Sideways Equity Markets On the other hand, our Defensive Portfolio outperformed both the S&P 500 and the Protector Portfolio during the three sideways periods since its inception in 1995 (Chart 11B). Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins.13 Bottom Line: BCA's Protector Portfolio has underperformed the S&P 500 and defensive equities in sideways periods for U.S. equities. We recommend that investors put the proceeds from the sale of equity positions into cash. Nonetheless, investors seeking protection against a potential equity market sell-off should look to our Protector Portfolio over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. Conversely, we would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell-off by more than 15% in the next few months. This would be the case if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Signs Of Stress In Oil West Texas Intermediate (WTI) oil futures hit a fresh 4-year high last week, despite OPEC 2.0's decision to pump more oil. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions.14 BCA's view is that the Kingdom of Saudi Arabia (KSA) and the core members of OPEC 2.0 - i.e. the seven states in the 24-state coalition that actually can increase production - are attempting to get ahead of an almost certain tightening of the global oil market. Our base case is that OPEC 2.0's core states will front-load their production increase with approx. 800k b/d added to the market in 2H18 and just over 210k b/d in 1H19.15 This will lift the core's total output by about 1.1mm b/d by the end of 1H19 versus 1H18. The increased output from core OPEC 2.0 is, however, offset by losses in the rest of OPEC 2.0 of approx. 530k b/d in 2H18 and just under 640k b/d in 1H19. This leaves OPEC 2.0's net output up by about 275k b/d in 2H18 and down by about 430k b/d in 1H19 compared with 1H18 levels (Chart 12). We keep demand growth at 1.7mm b/d in 2018 and 2019. Our oil strategists' base case is augmented with three possible scenarios: Venezuela's production collapses to 250k b/d from its current 1.3mm b/d, which would allow it to support the demand for domestically refined product and nothing more; A reduction in our forecasted increase in U.S. shale production arising from pipeline bottlenecks; and Both of these two scenarios occur simultaneously between October 2018 and September 2019. Chart 13 illustrates that our revised "ensemble" forecast, an average of the scenarios noted above, for 2H18 Brent stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded increase in OPEC 2.0 production The global benchmark will likely return to $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months. Chart 12OPEC 2.0's Core's Production Increase##BR##Offset By Non-Core Losses Chart 13Updated Ensemble Forecast Reflects##BR##Venezuela Deterioration, Shale Bottlenecks Elevated oil price volatility is a headwind for risk assets. The instability in crude oil markets will continue for the next 18 months, particularly if unplanned outages continue to occur. We identified seven prior periods of increasing oil price volatility. Chart 14 shows that three of these episodes of higher realized oil uncertainty occurred after the economy reached full employment (1998, 2001 and 2008). Two overlapped with recessions (2001 and 2008). Another three coincided with the Russian default crisis of 1998, the accounting scandals and Iraq war in 2002/2003, the U.S. debt downgrade, Arab Spring, the European debt crisis in 2011, and the China-led manufacturing slowdown in 2015. All of these events, at the margin directly or indirectly, affected oil supply demand or both. Because these were shocks of one sort or another-financial, geopolitical or economic-they raised markets' perceptions of risk on the upside and downside for oil prices. Chart 14Risk Assets During Oil Market Volatility Risk assets underperformed, other than in the 2002-2003 period of heightened oil market fluctuations associated with the General Strike in Venezuela, which took that country's production to zero for a brief period. The dollar fell in the first three phases of oil price volatility in Chart 14, but increased in the past four. Higher oil volatility tends to coincide with falling oil prices, but a price shock that lifts prices also can accompany higher volatility. Bottom Line: BCA's Commodity & Energy Strategy team notes that oil supply outages are mounting and will lead to more turbulence. Moreover, risk assets tend to underperform as oil volatility escalates. We are neutral on the energy sector. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's Energy Sector Strategy Weekly Report "Permian Pipeline Constraints Pose Risks To 2019 Shale Production Growth", published June 13, 2018. Available at nrg.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 9 https://www.federalreserve.gov/monetarypolicy/beigebook201805.htm 10 Please see BCA Research's U.S. Equity Strategy Weekly Report "Seeing The Light", published May 29, 2018. Available at uses.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report "A Golden Opportunity", published March 5, 2018. Available at usis.bcaresearch.com. 13 Please see BCA Research's Bank Credit Analyst Monthly Report "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 14 Please see BCA Research's Commodity & Energy Strategy Weekly Report " OPEC 2.0 Scrambles To Reassure Markets", published June 28, 2018. Available at ces.bcaresearch.com. 15 OPEC 2.0 is the coalition led by Saudi Arabia (KSA) and Russia. This past week it agreed to boost production by 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman and Qatar.