Currencies

Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? A Breakdown In The Making? A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator bca.ems_wr_2018_05_17_s1_c4 bca.ems_wr_2018_05_17_s1_c4 Chart I-5China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits bca.ems_wr_2018_05_17_s1_c8 bca.ems_wr_2018_05_17_s1_c8 Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels ...At Low Levels ...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Brazil: Exports Are Slowing Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Stay tactically long the SEK. Our preferred expression is long SEK/GBP. Stay tactically short the NOK. Our preferred expression is long AUD/NOK. Take profits in the underweight to Poland... ...and open a tactical countertrend position: long Poland's Warsaw General Index, short Italy's MIB. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both The League and 5 Star Movement have dropped calls for a referendum on Italy's membership of the monetary union. Feature Italy And The U.K. Compete For Political Risk The European political lens is once again focussed on Italy as the two anti-establishment parties - The League and 5 Star Movement - negotiate to form a government. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both parties have dropped calls for a referendum on Italy's membership of the monetary union, and have instead turned their fire on the EU's fiscal rules, specifically the 3 per cent limit on budget deficits. Chart of the WeekThe SEK Is Due A Tactical Rebound The SEK Is Due A Tactical Rebound The SEK Is Due A Tactical Rebound The populist demand for some fiscal relaxation is actually smart economics. When the private sector is paying down debt - as it is in Italy - private sector demand shrinks. To prevent a recession, the government must step in to borrow and spend the paid-down debt. And what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. This means that as long as Italian populists correctly push back on the EU's draconian fiscal rules rather than the monetary union per se, the market is right to regard Italian politics as a drama, rather than an existential risk to the euro (Chart I-2). Chart I-2The Market Remains Unconcerned ##br##About Euro Break-Up Risk The Market Remains Unconcerned About Euro Break-Up Risk The Market Remains Unconcerned About Euro Break-Up Risk Maybe the European political lens should be focussed instead on Britain. The Conservative party remains as bitterly divided as ever on its vision for the U.K.'s future trading and customs relationships with the EU and the rest of the world. Paralysed and frightened by this division, Theresa May is delaying the legislative passage of three crucial bills - the EU Withdrawal Bill, the Trade Bill, and the Customs Bill. When these bills eventually reach a vote in the House of Commons later this year, any one of them could result in a humiliating defeat for May - and, quite likely, resignations from the government. Meanwhile, as the government kicks the issue into the long grass, firms are holding fire on long-term spending commitments in the U.K. and rechannelling the investment to elsewhere in Europe. Buy SEKs, Avoid NOKs For all the recent swings in the euro versus the dollar and pound, the trade-weighted euro has remained a paragon of relative stability (Chart I-3). This is because the moves versus the dollar and pound have largely cancelled out (Chart I-4). Earlier this year, euro weakness versus the pound coincided with strength versus the dollar; more recently, euro weakness versus the dollar has coincided with strength versus the pound. Chart I-3The Trade-Weighted Euro Has ##br##Remained Relatively Stable... The Trade-Weighted Euro Has Remained Relatively Stable... The Trade-Weighted Euro Has Remained Relatively Stable... Chart I-4...Because Moves Versus The Dollar And The ##br##Pound Have Largely Cancelled Out ...Because Moves Versus The Dollar And The Pound Have Largely Cancelled Out ...Because Moves Versus The Dollar And The Pound Have Largely Cancelled Out Interestingly, the driver of the trade-weighted euro remains the same as it has been for the past fifteen years - it is simply the euro area's long bond yield shortfall versus the U.K. and U.S. (Chart I-5). With the ECB already at the realistic limit of ultra-loose policy, the path for policy rate expectations cannot go meaningfully lower. This means that the trade-weighted euro has some long-term support given that the BoE and/or the Fed have tightening expectations that could be priced out, while the ECB effectively doesn't. Chart I-5The Trade Weighted Euro Is A Function Of The Euro Area's ##br##Long Bond Yield Shortfall Versus The U.K. And U.S. The Trade Weighted Euro Is A Function Of The Euro Area's Long Bond Yield Shortfall Versus The U.K. And U.S. The Trade Weighted Euro Is A Function Of The Euro Area's Long Bond Yield Shortfall Versus The U.K. And U.S. Put another way, for the trade-weighted euro to drift significantly lower, relative surprises in the economic, financial and political news have to be significantly worse in the euro area than in both the U.K. and the U.S. We think this configuration is unlikely. Nevertheless, the more interesting tactical opportunities lie elsewhere: the Swedish krona and the Norwegian krone. Recent tweaks to monetary policy frameworks in Sweden and Norway are responsible, at least partly, for technically exaggerated moves in their currencies which are likely to reverse. In the case of Sweden, the inflation target is unchanged at 2 per cent but the Riksbank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." Given that Sweden's inflation rate is now close to 2 per cent, the market interpreted this tweak as very dovish - because it permits the continuation of ultra-accommodative policy. The upshot was that the SEK sold off. But our tried and tested indicator of excessive groupthink suggests that the currency may have overreacted (Chart of the Week). Hence, the tactical opportunity is to stay long the SEK, and our preferred expression is long SEK/GBP. In the case of Norway, a Royal Decree on Monetary Policy lowered the Norges Bank inflation target from 2.5 to 2.0 per cent. This followed years of failure to achieve the higher target. The market interpreted this change as hawkish, as it created the scope for tighter - or at least, less loose - policy than was previously expected. The upshot was that the NOK rallied. But again, the market reaction shows evidence of a technical overreaction (Chart I-6). Hence, the tactical opportunity is to stay short the NOK, and our preferred expression is long AUD/NOK. Chart I-6Our Preferred Expression Of Short NOK Is Versus The AUD Our Preferred Expression Of Short NOK Is Versus The AUD Our Preferred Expression Of Short NOK Is Versus The AUD Financial Markets Are Not Complicated, But They Are Complex The words 'complicated' and 'complex' appear to be interchangeable, but their meanings are quite distinct. The distinction is important because financial markets are not complicated, but they are complex. Something that is complicated is the sum of a large number of separate parts or processes. For example, making a car is complicated. But predicting the performance of financial markets over the medium term - say, a year or longer - is uncomplicated. The philosophy of Investment Reductionism teaches us that investment strategy is not made up of many separate parts or processes. It reduces to just three things: Predicting the evolution of the global economy. Predicting central bank reaction functions. Predicting tail-events: political, economic and financial. For example, this week's lesson in Investment Reductionism is to illustrate that the medium term decision to allocate between emerging market equities and the Eurostoxx600 largely reduces to the prospects for global metal prices (Chart I-7). Chart I-7EM Versus Eurostoxx600 = Metal Prices EM Versus Eurostoxx600 = Metal Prices EM Versus Eurostoxx600 = Metal Prices By contrast, something that is complex is not the sum of its parts, because the parts interact in unpredictable ways. Complexity characterizes the behaviour of financial markets over the short term - say, up to around six months. Therefore, the best way to model the behaviour of any investment over the very short term is to think of it as a complex adaptive system. A complex adaptive system is a system with a large number of mutually interacting agents, which can learn from their interactions and thereby adapt their subsequent behaviour. Examples include traffic flows, crowds in stadiums, and of course financial markets. A crucial property of all such systems is they possess an endogenous tipping point of instability, at which the behaviour undergoes a 'phase-shift'. This is the essence of how we identify likely short-term trend reversals in any investment such as the SEK and the NOK. This week's final trade recommendation uses this idea once again. Poland's equity market has underperformed recently in line with the general underperformance of the emerging market basket - and our underweight in the Warsaw General Index versus the Eurostoxx600 is handsomely in profit. However, looking at the market as a complex adaptive system, the extent of Poland's underperformance is overdone (Chart I-8). Chart I-8The Extent Of Poland's Underperformance Is Overdone The Extent Of Poland's Underperformance Is Overdone The Extent Of Poland's Underperformance Is Overdone Hence we are taking profit on our underweight in Poland and putting on a short-term countertrend position: long Poland's Warsaw General Index, short Italy's MIB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's new trade recommendation is a pair-trade: long Poland's Warsaw General Index, short Italy's MIB. The profit target is 5% with a symmetrical stop loss. Our preferred expression of long SEK is versus the GBP which is already in profit since initiation. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long SEK Long SEK The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? EM Breakdown? EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Global Growth On A Knife Edge Global Growth On A Knife Edge Chart 4German Data... German Data... German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Is Erdogan In Trouble? Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Chart 24Voters Want Governance Improvements Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.

Dear Client, This week, we are sending you a Special Report written by my colleague Juan Correa. This piece discusses value investing in the FX space, using purchasing power parity metrics in order to device profitable trading rules for investors. Contrarily to naive uses of PPP, the methods described by Juan provide profitable signals on long-term as well as short-term investment horizons. I trust you will find this report interesting and informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature "In our own day, many people have greatly increased their fortunes by carrying to Flanders and France ducats of two, four and ten....on each of which they make a big profit; and they bring merchandise from abroad which is worth little there and much here." - Martin Azpilicueta, Comentorio Resolutario de Usuras, 1556 Purchase Power Parity, or PPP, is perhaps the most basic concept for establishing the fair value of a currency. The theory dates back to 16th century Spain, where a group of theologians witnessed firsthand how a large influx of gold from the New World created a tremendous price imbalance between Spain and neighboring countries, providing traders with an opportunity to make a profit. From their observations, the main axiom of PPP was born: Once converted to a common currency, national price levels should be equal to one another. The theory is an offshoot of the Law of One Price, and simply states that if the above condition does not hold, there exists an arbitrage opportunity. Since its discovery, PPP has become a pillar of international economics, and has been the preferred measure to determine exchange rates for newly established countries. However, the usefulness of PPP to make investment decisions in currency markets remains doubtful. Specifically, academic literature has shown that the speed of convergence of currencies to their implied fair value is extremely slow1 (between 3 and 5 years2), making PPP a poor timing indicator. Moreover, academics have also struggled to find compelling evidence of long-run PPP convergence when including non-U.S. dollar crosses.3 This last point is crucial, as the data shows that many crosses do not revert back to their fair value, even If we consider multi-decade time horizons, and even if we take the average of the crosses for a particular currency to smooth out outliers (Chart I-1A and Chart I-1B). Chart I-1APPP: An Unreliable Fair Value Measure (I) PPP: An Unreliable Fair Value Measure (I) PPP: An Unreliable Fair Value Measure (I) Chart I-1BPPP: An Unreliable Fair Value Measure (I) PPP: An Unreliable Fair Value Measure (I) PPP: An Unreliable Fair Value Measure (I) A good example is EUR/CHF. This cross has been undervalued relative to its PPP value by at least 7% for more than three decades, suggesting there should have been immense upward pressure on this exchange rate. However over this same time frame, EUR/CHF has steadily depreciated by more than 36% (Chart I-2). Any investor using this absolute PPP undervaluation as a signal to buy this cross would have made a mistake, even with a very long time horizon. Chart I-2EUR/CHF: A Deceptive Bargain EUR/CHF: A Deceptive Bargain EUR/CHF: A Deceptive Bargain The PPP Puzzle: Theoretical Considerations Chart I-3The Penn Effect In Action Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Cases like the one above, where there is a consistent violation of the supposed non-arbitrage axiom, show how PPP can be a misleading indicator, even for long-term investors. While this valuation metric can be useful for some currencies, it cannot be applied in systematic fashion to make buying and selling decisions on the whole universe of investable G10 crosses. The unreliability of PPP is not a novel observation. Economists and investors alike have made numerous attempts to explain why PPP is not binding. Below we discuss the theoretical reasons as to why this is the case, and we review the performance of some of the common solutions used to solve these issues. The Balassa-Samuelson Hypothesis The Balassa-Samuelson Hypothesis originated from the empirical observation that countries with higher GDP per capita tend to have structurally higher prices (also known as "The Penn Effect") (Chart I-3). This hypothesis argues that this phenomenon occurs because richer countries, which are more productive, tend to have most of their competitive advantage concentrated in the tradable goods sector. In order for wages to equalize across sectors of the economy, non-tradable goods prices rise, making consumer price baskets, which are composed of both tradable and non-tradable goods, structurally higher in more productive countries.4 This theory would suggest that tradable prices should be uniform across countries. Therefore, an obvious solution to account for the Balassa-Samuelson effect would be to use tradable goods to estimate fair value. After all, a non-arbitrage condition can only hold in goods that can be traded. We use Bloomberg PPI-based PPP fair-value estimates to analyze whether assessing equilibria based on producer prices indices (which tend to be composed of highly tradable goods) provides a better fair-value estimate. Disappointingly, PPI-based PPP shows no material improvement in terms of acting as a reliable fair value measure over the PPP of the OECD that encompasses broader price baskets (Chart I-4A and Chart I-4B).5 Indeed, multiple currencies still display structural over- or under-valuations over multiple decades.6 Chart I-4ANo Significant Improvement ##br##In Valuation Using PPI (I) No Significant Improvement In Valuation Using PPI (I) No Significant Improvement In Valuation Using PPI (I) Chart I-4BNo Significant Improvement ##br##In Valuation Using PPI (II) No Significant Improvement In Valuation Using PPI (II) No Significant Improvement In Valuation Using PPI (II) The Border Effect Chart I-5The Border Effect In Action Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Why is it that highly tradable goods like those included in producer price indices can have such different prices in two countries over such a long period of time? A likely answer is transaction costs. Non-arbitrage conditions hold only if transaction costs are absent or minimal. In practice, this is rarely the case. Consider the results from the paper "The Border Effect: Some New Evidence."7 In this paper, Gopinath et al measure wholesale (pre-gross margin, pre-tax) costs of tradable goods from the same retail chain in both the U.S. and Canada. Overall, they find that while the difference between intra-country store costs is negligible, the median difference between Canadian and U.S. stores is nearly 18% (Chart I-5). This effect holds even when adjusting for distance as well as average income around the store. The results are particularly striking considering the U.S. and Canada share a common land border, speak the same language and have an extensive free-trade agreement. Accounting For Distortions: Stable Distribution Strategies Chart I-6Winners And Losers Of PPP Strategies Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Practitioners tend to have limited data on the degree of distortion affecting the PPP fair value of a currency. A strategy that sidesteps this issue is to buy (or sell) crosses that are undervalued (overvalued) relative to their historical distributions. Such a strategy recognizes that some currencies tend to be structurally overvalued and others tend to be structurally undervalued, for whatever the reason. However, these strategies assume that this overvaluation / undervaluation should be stationary through time.8 Therefore, if a currency is much more overvalued or undervalued than implied by its historical distribution, a selling or buying opportunity exists. We tested these kinds of "Stable Distribution" PPP strategies from the perspective of all G10 countries. Our methodology was the following: We estimated the average deviation of every currency cross from their OECD PPP measures over the first half of our sample (historical mean). We also estimated the standard deviation around this mean (sigma bands). We back tested the following strategy in the second half of our sample: Buy a currency when its disequilibrium to its OECD PPP estimate stands one standard deviation below its average PPP deviation. Hold this position until the currency's deviation from PPP returns to its historical mean. Sell a currency when its disequilibrium to its OECD PPP estimate stands one standard deviation above its average PPP deviation. Hold this position until the currency's deviation from PPP returns to its historical mean. Remain neutral otherwise. The Stable Distribution strategy provided positive returns in our sample of 37 out of the 45 crosses in the G10. However not all currencies performed equally. Crosses containing the British pound or the Swiss Franc did the best, while crosses containing the Japanese yen or Canadian dollar fared the worst (Chart I-6). Currencies where this strategy performed well exhibited a relatively stationary mean deviation from PPP, even if they were chronically overvalued like the Swiss franc (Chart I-7). This allowed the strategy to account for the distortion and provide an attractive return profile. Conversely, the strategy did rather poorly for yen-based investors (Chart I-8). This currency clearly experienced a paradigm shift in its structural valuation. Thus, the assumption that the past is a good predictor of the future failed to materialize, making for an unattractive return profile. Chart I-7CHF: Stable Valuation CHF: Stable Valuation CHF: Stable Valuation Chart I-8JPY: Paradigm Shift JPY: Paradigm Shift JPY: Paradigm Shift Please see Appendix C where the performance of the Stable Distribution strategy is presented for other currencies. A Few Words On Relative PPP A great number of PPP models are made using OLS regression on relative inflation rates (relative PPP). Although these kinds of models can be useful and tailored to account for other factors such as productivity or trade dynamics, they make the same assumption of stationarity in the distribution of the deviations of currencies from the Law of One Price as the strategy discussed above. Moreover, different composition in price baskets represent yet another drawback for OLS-based models. For a more detailed discussion on PPP measures, please see Appendix A. To see the performance of relative PPP models, please see Appendix D. Bottom Line: To account for distortions in valuations, investors can buy/sell currencies that are under/overvalued according to historical precedence by assuming the distribution will remain constant. While this strategy has performed well for currencies like the pound and the franc, the assumption of stationarity in valuation has failed to hold for the yen. Rethinking Theory: PPP Rank Is there any way where PPP valuations provide a reliable signal to investors, irrespective of the currency they are based on? We believe so. However, a slight rethink of PPP is required. While it is true there are many idiosyncratic reasons why the non-arbitrage condition of PPP cannot hold, this force should exert some pressure on currencies on average. In other words, when the sample of currencies under investigation is large, the sum of the distortions should tend to even out. We can express this by relaxing the axiom of PPP as follows: Once converted to a common currency, national price levels should, on average, converge. While this may seem like an insignificant change, this relaxed version of the PPP does one thing that absolute PPP does not: it focuses on buying overvalued currencies provided that at the same time more-overvalued currencies are also being sold, and selling undervalued currencies provided that concurrently more undervalued ones are being bought. We tested our relaxed-PPP axiom using the following strategy: Ranking all nine G10 currencies from cheapest to most expensive against our home currency, based on their percentage deviation from the OECD PPP estimate. Of these nine, buying the three most undervalued (or least overvalued) currencies against our home currency. Of these nine, selling the three most overvalued (or least undervalued) currencies against our home currency. Remaining neutral the middle three currencies. Rebalancing the portfolio every month (For clarity Table I-1 shows the steps taken by the strategy from the perspective of a EUR-based investor) Table 1 Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test We call this strategy "PPP Rank." Chart I-9A and Chart I-9B show that the PPP Rank strategy manages to have an attractive return profile regardless of the home currency of the investor. Moreover, the performance of this strategy does not exhibit large drawdowns over our sample.9 Chart I-9APPP Rank: A Robust Value Strategy (I) PPP Rank: A Robust Value Strategy (I) PPP Rank: A Robust Value Strategy (I) Chart I-9BPPP Rank: A Robust Value Strategy (II) PPP Rank: A Robust Value Strategy (II) PPP Rank: A Robust Value Strategy (II) Another advantage of this strategy is that it does not make assumptions regarding the underlying distribution of a currency's mis-valuation. This makes the strategy's results robust throughout our sample. Nevertheless, its main disadvantage is that its success rests on a well-diversified exposure to all G10 currencies. Therefore, this strategy, like most factor-based methods, goes against investing in a few currency pairs, or having highly concentrated currency exposure. To be sure, the strategy does not claim to solve the PPP puzzle. Instead, we recognize that in practice finding the absolute fair value of a currency may not even be possible. However, this does not prevent investors from reliably generating positive returns by using diversification to implement value strategies in the FX market. Bottom Line: By investing in various currencies at once and ranking them according to their valuation, our PPP Rank strategy provides a way to profit from PPP valuations at an aggregate level in a way that is robust across currencies. Investment Implications What are PPP Rank and the Stable distribution strategies telling us now? Matrix 1 shows the recommendations from the PPP Rank strategy at the current juncture, for investors based in all the G10 countries. Currently, this value-based strategy tends to favor the GBP, the EUR and the JPY while being bearish on the NOK, the CHF and the AUD. These insights confirm our long-term bearish stance on the Swiss Franc10 and long-term bullish stance on the euro.11 As a reminder, this strategy works best with equal currency exposure. Please see Appendix B to see the performance of the strategy as a hedging tool. Matrix 1PPP Rank Recommendation Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Conversely, out of the top five crosses where the Stable Distribution PPP strategy worked best, no cross currently displays a one standard deviation over- or under-valuation that would signal a buying or selling opportunity (Please see Appendix C to see a ranking of the performance of the stable distribution strategy on all G10 crosses). As a concluding remark, investors must remember that PPP valuations make several assumptions than do not hold in practice, and existing methods to measure PPP equilibrium have numerous limitations. Therefore, caution should be taken when using PPP to make currency decisions. Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Appendix A: Comparison Of Different PPP Measures Table II-1 Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Appendix B: PPP Rank And International Portfolio Hedging The majority of long-term players in the currency market are asset managers, who must decide whether or not and to what degree they should hedge their currency exposure arising from their positions in foreign markets. Given the long-term nature of PPP, we believe it best to analyze the performance of PPP Rank in the context of international portfolio hedging. Thus, we test whether our PPP Rank strategy adds value to the hedging process of international equity portfolio managers based in five different countries (the U.S, the euro area, Japan, the U.K. and Australia). Our methodology is the following: We hedge the totality of our currency exposure in the markets with the three most overvalued currencies according to PPP. We do not hedge our currency exposure in the markers with the three most undervalued currencies according to PPP. We hedge half of our currency exposure (least-regret hedging) for the middle three currencies. We apply the above strategy to an equally weighted G10 portfolio. Overall, we find that our ranking hedging strategy, applying our relaxed PPP axiom, tends to provide superior returns to all other hedging frameworks for portfolio managers in the U.S., Europe and the U.K. Meanwhile, returns for this strategy place second in Japan and Australia versus the alternatives over our sample (Chart II-1) Chart II-1PPP Rank Vs. Alternatives (I) PPP Rank Vs. Alternatives (I) PPP Rank Vs. Alternatives (I) More importantly, however, our hedging strategy outperforms traditional strategies from a risk-adjusted perspective, regardless of the home currency of the portfolio manager (Chart II-2).12 Another important consideration is the reliability and robustness of the strategy. To measure this, we compare the risk-adjusted returns of the PPP Rank strategy against the alternatives across four windows: 1999-2003, 2004-2008, 2009-2013 and 2014 to present. Chart II-3 shows that our PPP Rank strategy ranks best or second best throughout all windows, no matter where the investor is based. This stands in contrast to the alternatives, whose returns can vary wildly depending on the time frame analyzed. Chart II-2PPP Rank Vs. Alternatives (II) Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Chart II-3PPP Rank Vs. Alternatives (III) Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test While the PPP Rank strategy is both effective and robust for equity hedging in our sample, it is worth noting that in practice it is not likely that equity investors have equal exposure to all G10 currencies. Therefore we also conducted a sensitivity analysis by using market weights (rebalanced monthly) for each G10 equity market, eliminating some of the currency exposure diversification which stands as the pillar of our strategy. Chart II-4A shows that when the portfolio currency exposure becomes more concentrated, the performance in terms of risk-adjusted returns suffers slightly for Australian and Japanese investors in our sample. However, as Chart II-4B shows, the robustness of the strategy is significantly reduced, with the performance of PPP Rank relative to the alternatives fluctuating more widely, depending on the time period analyzed. It is thus worth noting that the ranking strategy is most appropriate for investors who have diversified currency exposure to many currencies. Chart II-4ASensitivity Analysis Of PPP Rank ##br##Using Market Weights Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Chart II-4BSensitivity Analysis Of PPP Rank ##br##Using Market Weights Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Appendix C: Stable Distribution Strategies Chart III-1 - Chart III-8 and Table III-1 Chart III-1U.S. Dollar U.S. Dollar U.S. Dollar Chart III-2Euro Euro Euro Chart III-3British Pound British Pound British Pound Chart III-4Australian Dollar Australian Dollar Australian Dollar Chart III-5New Zealand Dollar New Zealand Dollar New Zealand Dollar Chart III-6Canadian Dollar Canadian Dollar Canadian Dollar Chart III-7Swedish Krona Swedish Krona Swedish Krona Chart III-8Norwegian Krone Norwegian Krone Norwegian Krone Table III-1G10 Crosses Ranked By Risk-Adjusted Returns In Stable Distribution Strategy Value Strategies In FX Markets: Putting PPP To The Test Value Strategies In FX Markets: Putting PPP To The Test Appendix D: Relative PPP We test Relative PPP strategies from the perspective of all G10 countries. Our methodology is the following: We regress the currency against relative PPI inflation. We estimate the regression coefficients for the first half of our sample. We also estimate the standard deviation around the fair value. We back test the following strategy in the second half of our sample: Buying a currency when it is undervalued by one standard deviation according to the regression model, and holding this position until the currency PPP deviation returns to its model implied fair value. Selling a currency when it is overvalued by one standard deviation according to the regression model, and holding this position until the currency PPP deviation returns to its model implied fair value. Remain neutral otherwise. Chart IV-1ARegression Based Relative PPP (I) Regression Based Relative PPP (I) Regression Based Relative PPP (I) Chart IV-1BRegression Based Relative PPP (I) Regression Based Relative PPP (I) Regression Based Relative PPP (I) 1 These results are also contentious. Most evidence of PPP holding in the long run is based on rejecting the null hypothesis of a unit root in the real exchange rate (in other words, the real exchange rate is stationary throughout time). However this is a necessary but not sufficient condition, as one would have to know that the level at which the real exchange rate is reverting to is in fact the PPP equilibrium. For more details please see Taylor, Alan M., and Mark P. Taylor. "The Purchase Power Parity Debate". Journal of Economic Perspectives, vol. 18, no.4, fall 2014, pp. 135-158. 2 Rogoff, Kenneth. "The Purchase Power Parity Puzzle". Journal of Economic Literature, vol. 34, no.2, June 1996, pp.647-668. 3 O'Connell, Paul G.J., The Overvaluation of PPP (April 1, 1996). Available at SSRN: https://ssrn.com/abstract=4125 4 While the Penn Effect is an empirical fact, the validity of the Balassa-Samuelson hypothesis as an explanation for it continues to be disputed. Please see Gubler, Mathias and Cristoph Sax (2016). The Balassa-Samuelson Effect Reversed: New Evidence from OECD Countries. SNB Working Papers and Choudhri, Ehsan U. and Lawrence L. Schembri (2009). Productivity, the Terms of Trade, and the Real Exchange Rate: The Balassa-Samuelson Hypothesis Revisited. Bank of Canada Working Papers 5 Although there is data from 1986 for this measure, Bloomberg uses a long-run averaging method of data from 1986 to 2000 to estimate equilibrium. Therefore we only look at the out-of-sample performance of this measure since 2000. 6 While PPI-based PPP fair value estimates are theoretically more appropriate in establishing fair value, the existing measures of PPI-based fair value have several drawbacks. For a comparison between different fair value measures please see Appendix A. 7 Gopinath, G., Gourinchas, P., Hsieh, C., & Li, N.L. (2009). Estimating the Border Effect: Some New Evidence. 8 This methodology fits most academic research supporting the existence of PPP (i.e. the real exchange rate is stationary.) 9 The success of this strategy suggest that PPP might hold loosely at a global level. 10 Please see Foreign Exchange Strategy Special Report, titled "The SNB Doesn't Want Switzerland To Become Japan," dated March 23, 2018, available at fes.bcaresearch.com 11 Please see Foreign Exchange Strategy Weekly Report, titled "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com 12 It is important to remember that investors based in two different currencies can have different hedged returns even when investing in the same portfolio. This is because it is impossible to perfectly hedge variable income assets such as equities. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Tinbergen's rule says that the successful implementation of economic policy requires there to be at least as many "instruments" as "objectives." Policymakers today are increasingly discovering that they have too many of the latter but not enough of the former. By turning fiscal policy into a political tool rather than one for macroeconomic stabilization, the U.S. has found itself in a position where it can either meet President Trump's goal of having a smaller trade deficit or the Fed's goal of keeping the economy from overheating, but not both. In the near term, we expect the Fed's priorities to prevail. This will keep the dollar rally intact, which could spell bad news for some emerging markets. Longer term, the Fed, like most other central banks, must confront the vexing problem that the interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Getting inflation up a bit may be one way to mitigate this problem, as it would allow nominal interest rates to rise without pushing real rates into punitive territory. This suggests that the structural path for bond yields is up, consistent with our thesis that the 35-year bond bull market is over. Feature Constraints And Preferences The late Jan Tinbergen was one of the great economists of the twentieth century. Often referred to as the father of econometrics, Tinbergen and Ragnar Frisch were the first people to be awarded the Nobel Prize in Economics in 1969. One of Tinbergen's most enduring contributions was his demonstration that the successful implementation of economic policy requires there to be at least as many "instruments" (i.e., policy tools) as "objectives" (i.e., policy goals). Just like any system of equations can be "overdetermined" or "underdetermined," any set of "policy functions" may have a unique solution, many solutions, or no solution at all. The first outcome corresponds to a situation where there are as many instruments as objectives, the second where there are more instruments than objectives, and the third where there are fewer instruments than objectives. In essence, the Tinbergen rule is a mathematical formulation of the idea that it is hard to hit two birds with one stone. The Tinbergen rule often comes up in macroeconomics. Consider a country that wants to have a low and stable unemployment rate (what economists call "internal balance") and a current account position that is neither too big nor too small ("external balance"). This amounts to two objectives, which can be realized with the right mix of two instruments: Monetary and fiscal policy. As discussed in greater detail in Appendix A, the classic Swan Diagram, named after Australian economist Trevor Swan, shows how this is done. Chart 1Spain: The Cost Of The Crisis Spain: The Cost Of The Crisis Spain: The Cost Of The Crisis If the country wants to add a third objective to its list of policy goals, it has to either give up one of its existing objectives or find an additional policy instrument. Suppose, for example, that a country wants to move to a pegged exchange rate. It can either forego monetary independence, or introduce capital controls in order to allow domestic interest rates to deviate from the interest rates of the economy to which it is pegging its currency. This is the logic behind Robert Mundell's "Impossible Trinity," which states that an economy cannot simultaneously have all three of the following: A fixed exchange rate, free capital mobility, and an independent central bank. It can only choose two items from the list. Peripheral Europe learned this lesson the hard way in 2011. Not only did euro membership deny Greece, Italy, Spain, Portugal, and Ireland access to an independent monetary policy and a flexible currency, but the ECB's failure under the bumbling leadership of Jean-Claude Trichet to backstop sovereign debt markets necessitated fiscal austerity at a time when these economies needed stimulus. These countries were left with no effective macro policy instruments whatsoever, thus putting them at the complete mercy of the bond vigilantes, German politicians, and the multilateral lending agencies. The only thing they could do was incur a brutal internal devaluation to make themselves more competitive. Even for "success stories" such as Spain, the cost in terms of lost output was over one-third of GDP (Chart 1) - and probably much more if one includes the deleterious effect on potential GDP growth from the crisis. Trump Versus Tinbergen One might think that the U.S. is largely immune from Tinbergen's rule. It is not. President Trump and the Republicans in Congress have rammed through massive tax cuts and spending increases (Chart 2). By doing so, they have turned fiscal policy into a political tool rather than one for macroeconomic stabilization. In and of itself, that is not an insuperable constraint since monetary policy can still be used to achieve internal balance. The problem is that Trump has also declared that he wants external balance, meaning a much smaller trade deficit. Now we have two policy objectives (full employment and more net exports) and only one available instrument: Monetary policy. Chart 2The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline This puts the Fed in a bind. If the Fed hikes rates aggressively, this will keep the economy from overheating, thus achieving internal balance. But higher rates are likely to bid up the value of the dollar, leading to a larger trade deficit. On the flipside, if the Fed drags its feet in raising rates, the dollar could weaken, resulting in a smaller trade deficit and moving the economy closer to external balance. However, the combination of low real interest rates, a weaker dollar, and dollops of fiscal stimulus will cause the unemployment rate to fall further, leading to higher inflation. Investor uncertainty about which path the Fed will choose may be partly responsible for the gyrations in the dollar of late. At least for the next year or so, our guess is that the Fed's independence will keep it on course to raise rates more than the market is currently pricing in, which will result in a stronger dollar. Beyond then, the picture is less clear. This is partly because the increasing politicization of society may begin to affect the Fed's behavior. History suggests that inflation tends to be higher in countries with less independent central banks (Chart 3). But it is also because Tinbergen's ghost is likely to make another appearance, this time in a wholly different way. Chart 3Inflation Tends To Be Higher In Countries Lacking Independent Central Banks Tinbergen's Ghost Tinbergen's Ghost The Fed's "Other" Mandate Officially, the Fed has two mandates: ensuring maximum employment and stable prices. In practice, this "dual mandate" can be boiled down to a single policy objective: Keeping the unemployment rate near NAIRU, the so-called Non-Accelerating Inflation Rate of Unemployment. The Fed has sought to meet this objective through the use of countercyclical monetary policy: Easing monetary policy when output falls below potential and tightening it when the economy is at risk of overheating. So far, so good. The problem is that the Fed, like most other central banks, is being asked to take on another policy objective: ensuring financial stability. Here's the rub though: The interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Excessively low rates are a threat to financial stability. A decline in interest rates pushes up the present value of expected cash flows; the lower the discount rate, the more of an asset's value will depend on cash flows that may not be realized for many years. This tends to increase asset market volatility. In addition, borrowers need to devote a smaller share of their incomes towards servicing their debt obligations when interest rates are low. This tends to increase debt levels. From The Great Moderation To The Great Intemperance Starting in the 1990s, far from entering an era which policymakers once naively referred to as the "Great Moderation," it is possible that the world entered a precarious period where the only way to generate enough spending was to push down interest rates so much that asset bubbles became commonplace. In a world where central bankers have to choose between insufficient demand and recurrent asset bubbles, the idea of a "neutral rate" loses much of its meaning. By definition, the neutral rate is a steady-state concept. However, if the interest rate that produces full employment and stable inflation is so low that it also generates financial instability, how can one possibly describe this interest rate as "neutral"? Faced with the increasingly irreconcilable twin objectives of keeping the unemployment rate near NAIRU and putting the financial system on the straight and narrow, central bankers have reached out for a second policy instrument: macroprudential regulations. So far, however, the jury is still out on whether this tool is sufficiently powerful to prevent future financial crises. Politics has a bad habit of getting in the way of effective regulation. President Trump and the Republicans have been looking for ways to water down the Dodd-Frank Act. The Democrats are complaining that banks and other financial institutions are not doing enough to channel credit to various allegedly "underserved" groups. Faced with such political pressure, it is not clear that regulators can do their jobs. If You Can't Raise r-Star, Raise i-Star What is the Fed to do? One possibility may be to aim for somewhat more inflation. A higher inflation target would allow the Fed to raise nominal policy rates while still keeping real rates low enough to maintain full employment. Higher nominal rates would impose more discipline on borrowers and discourage excessive debt accumulation. Higher inflation would also reduce the likelihood of reaching the zero bound again, while also limiting the economic fallout of asset busts. The Case-Shiller 20-City Composite Index declined by 34% in nominal terms and 41% in real terms between April 2006 and March 2012. Had inflation averaged 4% over this period rather than 2.2%, a 41% decline in real home prices would have corresponded to a less severe 26% decrease in nominal prices, resulting in fewer underwater mortgages. Finally, higher inflation would allow countries to increase nominal income growth. In fact, higher inflation may be the only viable way to reduce debt-to-GDP ratios in a high-debt, low-productivity growth world. Investment Conclusions We advised clients on July 5, 2016 that we had reached "The End Of The 35-Year Bond Bull Market." As fate would have it, this was the exact same day that the 10-year yield reached an all-time closing low of 1.37%. Bond positioning is very short now (Chart 4), so a partial retracement in yields is probable. Cyclically and structurally, however, the path for yields is up. Much like what transpired between the mid-1960s and the early 1980s, investors should expect global bond yields to reach a series of "higher highs" and "higher lows" with each passing business cycle (Chart 5). Chart 4Traders Are Short Treasurys Traders Are Short Treasurys Traders Are Short Treasurys Chart 5A Template For The Next Decade? A Template For The Next Decade? A Template For The Next Decade? Just as was the case back then, the Fed is now behind the curve in raising rates. The three-month and six-month annualized change in core PCE has reached 2.6% and 2.3%, respectively. Yesterday's CPI report was softer than expected, but the miss was almost entirely due to a deceleration in used car prices and airfares, both of which are likely to be temporary. Meanwhile, the labor market remains strong. The unemployment rate is down to 3.9%, just slightly above the 2000 low of 3.8%. According to the latest JOLTS survey released earlier this week, there are now more job openings than unemployed workers, the first time this has happened in the 17-year history of the survey (Chart 6). Faced with this reality, the Fed will keep begrudgingly raising rates until the economy slows. Right now, the real economy is not showing much strain from higher rates. The cyclical component of our MacroQuant model, which draws on a variety of forward-looking economic indicators, moved back into positive territory this week. Both the housing market and capital spending are in reasonably good shape (Chart 7). Chart 6There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 7Higher Rates Have Not (Yet) Slowed The Economy Higher Rates Have Not (Yet) Slowed The Economy Higher Rates Have Not (Yet) Slowed The Economy The U.S. financial sector should also be able to weather further monetary tightening. Corporate debt has risen, but overall U.S. private-sector debt as a percent of GDP is still 18 percentage points lower than in 2008 (Chart 8). Lenders are also more circumspect than they were before the Great Recession. For example, banks have been tightening lending standards on credit and automobile loans, which should reverse the increase in delinquency rates seen in those categories (Chart 9). Chart 8U.S. Private Debt Still Below Pre-Recession Levels U.S. Private Debt Still Below Pre-Recession Levels U.S. Private Debt Still Below Pre-Recession Levels Chart 9Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Resilience to Fed tightening may not extend to the rest of the world, however. Following the script of the late 1990s, it is likely that the combination of higher U.S. rates and a stronger dollar will cause some emerging markets to fall out of bed before U.S. financial conditions have tightened by enough to slow U.S. growth (Chart 10). This week's turbulence in Turkey and Argentina may be a sign of things to come. For now, investors should underweight EM assets relative to their developed market peers. Chart 10Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com APPENDIX A The Swan Diagram The Swan Diagram depicts four "zones of economic unhappiness," each one representing the different ways in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). A rightward movement along the horizontal axis represents an easing of fiscal policy, whereas an upward movement along the vertical axis represents an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order keep the unemployment rate stable. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. To bring imports back down, the currency must weaken. Any point to right of the internal balance schedule represents overheating; any point to the left represents rising unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Appendix Chart 1Four Zones Of Unhappiness Tinbergen's Ghost Tinbergen's Ghost Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The U.S. dollar still has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. Fixed-income investors should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Argentine financial markets are rioting. We elaborate on our investment strategy below. Downgrade Indonesian stocks from neutral to underweight within an EM equity portfolio. Feature The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. Rüdiger Dornbusch Emerging markets (EM) currencies have come under substantial selling pressure. Various indexes of EM currencies versus the U.S. dollar have broken below their 200-day moving averages (Chart I-1). EM sovereign spreads are widening, and local bonds yields are moving higher from very low levels. Chart I-1EM Currencies: A Breakdown? EM Currencies: A Breakdown? EM Currencies: A Breakdown? Our view is that we are witnessing the beginning of a major down leg in EM currencies and a major up leg in the U.S. dollar. This constitutes a negative environment for all EM risk assets. As the above quote from professor Rüdiger Dornbusch eloquently states, a meltdown in financial markets could take much longer to develop, but once it commences it is likely to play out much faster than investors expect. This does not mean we are certain that a full-blown EM crisis is bound to happen. Neither can we predict the speed of financial market moves. Nevertheless, based on our macro themes, we maintain that this down leg in EM currencies and EM risk assets will likely be large enough to qualify as a bear market rather than a correction. Consistently, we continue to recommend that investors adopt defensive strategies or play EM risk assets on the short side. This bear market in EM could be comparable to the EM selloff episodes of 2013 (Taper Tantrum) or 2015 (China's slowdown). In this report, we first discuss the outlook for the broad U.S. dollar, then examine the factors that typically drive EM currencies, and those that do not. The Dollar: A Major Bottom In Place The U.S. dollar has recently rebounded sharply, and we believe this marks the beginning of a major rally. The following factors will support the greenback in the months ahead: The U.S. dollar does well in periods of a slowdown in global trade (Chart I-2). The average manufacturing PMI index of export-oriented Asia economies such as Korea, Taiwan and Singapore points to a peak in global export volumes (Chart I-3). Further, China's Container Freight index signifies an impending deceleration in Asian export shipments (Chart I-4, top panel). Chart I-2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Chart I-3A Peak In Global Export Growth A Peak In Global Export Growth A Peak In Global Export Growth Chart I-4A Leading Indicator For Asian Exports ##br##And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies Notably, this freight index - the price to ship containers - also correlates with emerging Asia currencies, and suggests that the latter stands to depreciate (Chart I-4, bottom panel). Chart I-5U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate The dollar should do particularly well if the epicenter of the global growth slowdown is centred in China - and if U.S. domestic demand remains robust due to fiscal stimulus, as we expect. Within advanced economies, the U.S. is the least vulnerable to a China and EM slowdown. Delta of relative growth will be shifting in favor of the U.S. versus the rest of the world. This will propel the dollar higher. Amid weakness in the world trade, growth will be priced at a premium. This will favor financial markets with stronger growth. The greenback will be the winner in the coming months. The U.S. twin deficits - the current account and budget deficits - would have acted as a drag on the dollar if global growth was robust/recovering. However, amid weakening global growth, the U.S. twin deficits are not a malignant phenomenon for the dollar; they will in fact support it as they instigate and reflect strong U.S. growth. As the Federal Reserve continues to reduce its balance sheet, the banking system's excess reserves will decline. Our U.S. dollar liquidity measure has petered out, which has historically been consistent with a bottom in the dollar; the latter is shown inverted on Chart I-5. As we have argued for some time, and to the contrary of widespread investor consensus, the U.S. dollar is not expensive. According to the real effective exchange rate based on unit labor costs, the greenback is fairly valued, as is the euro (Chart I-6). The yen is cheap but the Korean won is expensive (Chart I-6, bottom two panels). In our opinion, a real effective exchange rate based on unit labor costs is the most pertinent measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component in many companies and unit labor costs are critical to competitiveness. Chart I-7 demonstrates that commodities-related currencies including those of Australia, New Zealand and Norway are on the expensive side, while the Canadian dollar is fairly valued. Chart I-6The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive Chart I-7Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap There are no measures of real effective exchange rate based on unit labor costs for many EM currencies. If DM commodities currencies are not cheap, then it is fair to assume that EM commodities currencies are not cheap either. We are not suggesting that exchange rates of commodity producing EM nations are expensive, but we do believe their valuations are probably closer to neutral. When valuations are neutral, they are not a constraint for the underlying asset price. The latter can go either up or down. In short, the dollar is not expensive, and valuations will not deter its appreciation in the coming months. Finally, from the perspective of market technicals, the dollar's exchange rates versus many currencies appear to have encountered resistance at their long-term moving averages, as illustrated in Chart I-8A and Chart I-8B. Usually, when a market finds support (or resistance) at its long-term moving average, it often makes new highs (or lows). Chart I-8ATechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Chart I-8BTechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies We are not certain if the broad trade-weighted U.S. dollar will make a new high. However, some EM currencies will drop close to or retest their early 2016 lows. Such potential downside is substantial enough to short the most vulnerable EM currencies. Bottom Line: The U.S. dollar has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. What Really Drives EM Currencies A common narrative is that EM balance of payments and fiscal balances have already improved, making many EMs less vulnerable than they were during the 2013 Taper Tantrum. What's more, the interest rate differential between EM and the U.S. is still positive, heralding upward pressure on EM currencies. We do not subscribe to this analysis. First, current account balances do not always drive EM exchange rates. Chart I-9A and Chart I-9B illustrates that there is no meaningful positive correlation between EM currencies and both the level and changes in their current account balances. The same holds for the correlation between fiscal balances and exchange rates. Chart I-9ACurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Chart I-9BCurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Second, neither nominal nor real interest rate differentials over U.S. rates explain the trend in EM currencies, as shown in Chart I-10. Further, neither the level nor changes in interest rate differentials explain trends in EM exchange rates. On the contrary, it is the trend in EM currencies that drives local interest rates in EM. That is why getting the currencies right is of paramount importance to investors in various EM asset classes. So which factors do drive EM exchange rates? The key variables that define trends in EM currencies are U.S. bond yields, global trade cycles and commodities prices. The changes in U.S. bond yields and TIPS (inflation-adjusted) yields - not their difference with EM yields - have explained EM currency moves in recent years (Chart I-11). Chart I-10Interest Rate Differential Does Not ##br##Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Chart I-11EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields Chart I-4 on page 3 demonstrates that China's Container Freight index leads regional exports and strongly correlates with emerging Asian currencies. Non-Asian EM currencies are mostly leveraged to commodities prices, as these countries (all nations in Latin America, Russia and South Africa) produce commodities. Not surprisingly, the EM exchange rate composed primarily of EM non-Asian currencies correlates well with commodities prices (Chart I-12). Finally, EM currencies are substantially more exposed to China than to DM economies. Chart I-13 shows that when Chinese imports are underperforming DM imports, EM currencies tend to depreciate. Chart I-12EM Currencies And Commodities Prices EM Currencies And Commodities Prices EM Currencies And Commodities Prices Chart I-13EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM As such, what has caused EM currencies to riot in recent weeks? In short, it is the combination of the rise in U.S. bond yields and budding signs of slowdown in global trade. Chart I-14EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low Commodities prices have so far been firm with oil prices skyrocketing. We expect the combination of China's slowdown and a stronger U.S. dollar to eventually suppress commodities prices in the months ahead. That will produce another down leg in EM currencies. Finally, the volatility measure for EM currencies is still very low, albeit rising (Chart I-14). This suggests that investors remain somewhat complacent on EM exchange rates. Bottom Line: Our negative view on EM currencies has been anchored on two pillars: the U.S. dollar rally driven by higher U.S. interest rate expectations and weaker Chinese growth/lower commodities prices. We are now witnessing the first down leg in EM currency bear market propelled by the first pillar. It is not over yet. The second down leg will come when China's growth slows and commodities prices relapse in the coming months. All in all, there is still material downside in EM exchange rates. EM Local Bond And Credit Markets EM local bond yields typically rise when EM currencies drop meaningfully (Chart I-15). Foreign investors hold a large share of EM local currency bonds (Table I-1). Chart I-15EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies Table I-1Foreign Ownership Of EM Local Bonds EM: A Correction Or Bear Market? EM: A Correction Or Bear Market? As EM currency depreciation erodes foreign investors' returns on EM local currency bonds, there could be a rush to exit their positions. Chart I-16 portrays that the total return on J.P. Morgan GBI EM local currency bonds in U.S. dollar terms has broken below its 200-day moving average. Fluctuations in total return on local bonds is primary driven by currency moves. If our negative EM currency view is correct, there will be more downside in this EM domestic bonds total return index. EM sovereign and corporate credit spreads often widen when EM currencies depreciate (Chart I-17). As EM currencies lose value, U.S. dollar debt becomes more expensive to service, and credit spreads should widen to reflect higher credit risks. Chart I-16EM Local Bonds Total ##br##Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars Chart I-17EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies Finally, the ratios of U.S. dollar debt-to-exports and U.S. dollar debt-to-international reserves for EM ex-China are very elevated (Chart I-18). If these nations' exports stumble in the months ahead, the inflows of foreign currency will diminish, and credit spreads could widen to price this in. Chart I-18EM Ex-China: U.S. Dollar Debt ##br##Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective To be sure, this does not mean there will be widespread defaults. Simply, credit spreads are too low and investor sentiment is too upbeat. As EM growth deteriorates, asset prices will have to re-price. Bottom Line: Asset allocators should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Argentina Is Under Fire 10 May 2018 Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Chart II-1Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Chart II-2Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Chart II-3Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Chart II-4Argentina: Are Interest ##br##Rates High Enough? Argentina: Are Interest Rates High Enough? Argentina: Are Interest Rates High Enough? Chart II-5Argentina: Highest Real Interest ##br##Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Chart II-6Argentina: High Borrowing Costs ##br##Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Chart II-7Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Indonesia: Facing Major Headwinds 10 May 2018 Indonesian stocks appear to be in freefall in absolute terms and relative to the EM benchmark (Chart III-1). Meanwhile, the currency has been selling off and local currency as well as sovereign (U.S. dollar) bonds spreads are widening versus U.S. Treasurys from low levels (Chart III-2). Chart III-1Indonesian Equities: Absolute ##br##And Relative Performance Indonesian Equities: Absolute And Relative Performance Indonesian Equities: Absolute And Relative Performance Chart III-2Indonesian Local Bonds ##br##And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads These developments have been occurring due to vulnerabilities relating to Indonesia's balance of payments (BoP) dynamics. We believe Indonesia's BoP dynamics will deteriorate further and as such there is more downside for both the rupiah and its financial markets from here: Stronger U.S. growth and higher inflation prints will likely lead to higher interest rate expectations in the U.S. and lift the U.S. dollar further. This will likely lead to Indonesia's underperformance. Chart III-3 shows that Indonesia's relative equity performance versus the EM benchmark has been extremely sensitive to moves in U.S. Treasury yields. Hence, the cost of funding has been a critical variable for Indonesia. Indonesia is also a large commodities exporting nation and the latter account for around 30% of its exports. Specifically, coal, palm oil and copper make up about 9%, 8% and 2% of its exports, respectively. Coal exports are facing major headwinds. The Chinese government has moved to restrict coal imports in several Chinese ports in order to protect its domestic coal producers as we argued in our Special Report titled Revisiting China's De-Capacity Reforms.1 This development will be devastating for Indonesia's coal industry. Chart III-4 shows that the Adaro Energy's stock price - a large Indonesian coal mining company - is falling sharply. This stock price has already fallen by 40% in U.S. dollar terms since its peak on January 30. Chart III-3Indonesia Is Very Sensitive ##br##To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Chart III-4Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Further, palm oil prices have been weak while copper prices might be on edge of breaking down. Meanwhile, there are others negatives related to shipments of these commodities. Palm oil exports are at risk because India has imposed import duties on palm oil, while the European Parliament voted in favor of a ban on the use of palm oil in bio fuel by 2021. Offsetting these, however, China has just agreed to purchase more palm oil from Indonesia. In regard to copper, the ongoing dispute on environmental regulation between Freeport-McMoRan - a U.S. mining company that operates a large copper mine in Indonesia - and the Indonesian government, risks disrupting Freeport's copper production in Indonesia, hurting the country's export revenues. On the whole, export revenues are at risk of plummeting at a time when Indonesian imports are already too strong. This will worsen BoP dynamics further. Chart III-5 shows that a deteriorating trade balance in Indonesia is usually bearish for its equity market. It seems that the current account deficit will be widening when foreign funding is drying up. This requires either a major depreciation in the currency or much higher interest rates. As such, Bank Indonesia (BI) - Indonesia's central bank - might be forced to raise interest rates to cool down domestic demand and attract foreign funding to stabilize the rupiah. Even if the BI does not raise rates, it might opt to defend the rupiah by selling its international reserves. This would still bid up local interbank rates as defending the currency entails drawing down banking system liquidity, i.e., banks' reserves at the central bank. Chart III-6 shows that Indonesian interbank rates are starting to rise in response to falling international reserves. Chart III-5Indonesia: Swings In Trade ##br##Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Chart III-6Indonesia: Currency Defense By Selling ##br##FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Higher rates will weaken domestic demand and are bearish for share prices. Importantly, foreign ownership of local bonds is still high at 39% and a weaker rupiah could cause selling by foreign investors, pushing yields even higher. Chart III-7Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk Finally, a word on Indonesian banks is warranted. Financials account for 42% of Indonesia's MSCI market cap and 47% of its total earnings. Thus their performance is also very crucial for the outlook of the overall stock market. In our March 1st Weekly Report,2 we argued that Indonesian banks have been lowering their provisions to artificially boost earnings. This is not sustainable as these provisions are insufficient and will have to rise. As they ultimately rise, bank profits and share prices will hurt (Chart III-7). Bottom Line: We recommend investors to downgrade Indonesia's stocks from neutral to underweight within an EM equity portfolio. We also reiterate our short IDR / long USD trade and the short position in local bonds. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Revisiting China's De-Capacity Reforms," dated April 26, 2018, the link available on page 23. 2 Please see Emerging Markets Strategy Weekly Report "EM Equity Valuations (Part II)," dated March 1, 2018, the link available on page 23. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The U.S. labor market is now at full employment and the plethora of fiscal stimulus coming down the pike could cause the economy to overheat. If the recent rebound in the U.S. dollar reverses, this will only add to aggregate demand by boosting net exports. There are two main scenarios in which the U.S. can avoid overheating while the value of the greenback resumes its decline: 1) The Fed tightens monetary policy by enough to slow growth but other central banks tighten monetary policy even more; 2) the U.S. is hit by an adverse demand shock that forces the Fed to back away from further rate hikes. Neither scenario can be easily discounted, but both seem unlikely. The first scenario assumes that the neutral real rate of interest is fairly high outside the U.S., when most of the evidence says otherwise. The second scenario ignores the fact that adverse demand shocks, even if they originate from the U.S., tend to become global fairly quickly. Weaker global growth is usually bullish for the dollar. This suggests that the dollar rally has legs. EUR/USD is on track to hit 1.15 over the coming months, but a plunge below that level is possible given that the dollar is one of the most momentum-driven currencies out there. For now, investors should favor DM over EM equities and oil over metals. Feature Running Hot More than a decade after the Great Recession began, the U.S. labor market is back to full employment (Chart 1). The headline unemployment rate stands at 4.1%, below the Fed's estimate of NAIRU. Broader measures of labor slack, such as the U-6 rate, the number of workers outside the labor force wanting a job, and the share of the unemployed who have quit their jobs, are also back to pre-recession levels. Most business surveys show that companies are struggling to fill vacant positions (Chart 2). Wage growth is picking up, especially among low-skilled workers, whose compensation tends to be more closely tied to labor slack than their better-skilled counterparts (Table 1). Chart 1U.S. Is Back To Full Employment U.S. Is Back To Full Employment U.S. Is Back To Full Employment Chart 2Survey Data Point To Higher Wage Growth Ahead Survey Data Point To Higher Wage Growth Ahead Survey Data Point To Higher Wage Growth Ahead Table 1Wage Growth Is Accelerating The U.S. Needs A Stronger Dollar The U.S. Needs A Stronger Dollar Despite its recent rebound, the broad trade-weighted dollar is still down nearly 7% since its December 2016 high. According to the New York Fed's macro model, a sustained decline in the dollar of that magnitude would be expected to boost the level of GDP by about 0.5%. This would be equivalent to a permanent 50 basis-point cut in interest rates in terms of its effect on aggregate demand.1 Not that long ago, market participants and numerous pundits expected the dollar to continue its slide. Net short dollar positions reached their highest level in nearly six years in mid-April, before moving lower over the past two weeks (Chart 3). "Short dollar" registered as the second-most crowded trade in the monthly BofA Merrill Lynch survey of fund managers that was conducted between April 6 and 12, behind only "long FAANG-BAT stocks."2 Chart 3Short Dollar Is A Crowded Trade The U.S. Needs A Stronger Dollar The U.S. Needs A Stronger Dollar The Fed's Dilemma This raises an obvious question. If the consensus view that so many market investors subscribed to only a few weeks ago turns out to be correct and the dollar does give up its recent gains, how is the Fed supposed to tighten financial conditions by enough to keep the economy from overheating? One response is the Fed could raise rates by enough to slow growth. If the dollar falls while this is happening, so be it. The Fed can always hike rates more quickly in order to ensure that the contractionary effect of higher interest rates more than offsets the stimulative effect of a weaker dollar. The problem with this answer is that the dollar is only likely to weaken if other central banks are tightening monetary policy as much or more than the Fed. Chart 4 shows that the dollar has generally moved in line with interest rate differentials between the U.S. and its trading partners. Chart 4Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials There is little scope for rate expectations to narrow at the short end of the yield curve if U.S. growth remains above trend for the remainder of the year, as we expect will be the case. This is simply because most other major central banks are in no hurry to raise rates. The ECB has effectively pledged not to raise rates until at least the middle of next year. The U.K. remains mired in a post-Brexit slump. The BoJ is nowhere close to meeting its 2% inflation target (20-year CPI swaps are still trading at 0.6%). There is some room for rate expectations to converge further along the yield curve. However, for that to happen, investors must come to believe that the gap in the neutral rate of interest between the U.S. and its trading partners will shrink. It is far from obvious that they will do so. The Neutral Rate Is Higher In The U.S. Than The Euro Area Consider a comparison between the U.S. and the euro area. A reasonable proxy for the market's view of the neutral rate is the expected overnight rate ten years ahead, which can be calculated using eurodollar and euribor futures. The spread currently stands at about 100 basis points in favor of the U.S., down from 150 basis points at the start of 2017. Taking into account the fact that market-based inflation expectations are somewhat lower in the euro area, the spread in real terms is close to 50 basis points. That is not a lot, considering all the reasons to suppose that the neutral rate is higher in the U.S.: U.S. fiscal policy is a lot more stimulative. The IMF expects the U.S. fiscal impulse, which measures the change in the structural budget deficit, to reach 0.8% of GDP in 2018 and 0.9% in 2019. The fiscal impulse in the euro area and most other economies is likely to be much smaller (Chart 5). While the U.S. fiscal impulse will fall back to zero in 2020-21 barring a fresh wave of tax cuts or spending increases, the difference in the structural fiscal balance between the U.S. and the euro area will still widen to a record high of 6% of GDP by then (Chart 6). It is this difference that determines the gap in neutral rates.3 The U.S. will feel decreasing private-sector deleveraging headwinds in the years ahead. Euro area private-sector debt, measured as a share of GDP, is above U.S. levels and still close to all-time highs. In contrast, U.S. private-sector debt is down by 18% of GDP from its 2008 peak (Chart 7). The demographic divide between the U.S. and the euro area will widen. A rising labor participation rate allowed the euro area's labor force to grow at virtually the same pace as the U.S. between 2000 and 2015 (Chart 8). However, now that the euro area participation rate is above the U.S., the scope for further structural gains in participation in the euro area are limited. Over the past two years, labor force growth in the euro area has fallen behind the United States. If this trend continues and labor force growth in the two regions converges to the underlying rate of growth in the working-age population, it could reduce euro area GDP growth by over 0.5 percentage points relative to U.S. growth. Slower GDP growth typically implies a lower neutral rate. Chart 5U.S. Fiscal Policy##br## Is More Stimulative U.S. Fiscal Policy Is More Stimulative U.S. Fiscal Policy Is More Stimulative Chart 6U.S. And Euro Area: Gap In Fiscal##br## Balances Will Hit Record Highs U.S. And Euro Area: Gap In Fiscal Balances Will Hit Record Highs U.S. And Euro Area: Gap In Fiscal Balances Will Hit Record Highs Chart 7Deleveraging Headwinds Will Be##br## Stronger In The Euro Area Than The U.S. Deleveraging Headwinds Will Be Stronger In The Euro Area Than The U.S. Deleveraging Headwinds Will Be Stronger In The Euro Area Than The U.S. Chart 8Slowing Euro Area Labor Force ##br##Participation Will Weigh On Growth Slowing Euro Area Labor Force Participation Will Weigh On Growth Slowing Euro Area Labor Force Participation Will Weigh On Growth When Things Go Sour If other major central banks find themselves hard-pressed to raise rates anywhere close to U.S. levels, how about the opposite case: The one where an adverse shock forces the Fed to cut rates towards overseas levels? Since interest rates in many other economies remain at rock-bottom levels, there is little scope for their central banks to cut rates even if they wanted to. In contrast, the Fed is no longer constrained by the zero bound, which gives it greater leeway to ease monetary policy. While such a scenario cannot be easily ruled out, it is mitigated by the fact that frothy asset markets in the U.S. have not produced large imbalances in the real economy. This stands in sharp contrast to the last two recessions. The Great Recession was exacerbated by a massive overhang of empty homes. The 2001 recession was aggravated by a huge overhang of capital equipment left in the wake of the dotcom bust. The surging dollar and increased Chinese competition also laid waste to a large part of the U.S. manufacturing base, necessitating a period of painful adjustment. Today, both the housing and manufacturing sectors are in reasonably good shape. This suggests that rates can rise further before growth stalls out. And even if the U.S. economy begins to flounder, it is not clear that this would lead to a weaker dollar. Remember that the U.S. mortgage market was the focal point of the Global Financial Crisis, and yet the dollar still strengthened by over 20% between July 2008 and March 2009. A recent IMF study concluded that changes in U.S. financial conditions have an outsized effect on growth outside the United States.4 Weaker global growth is generally good for the dollar (Chart 9). The old adage "When America sneezes, the rest of the world catches a cold" still rings true. If higher U.S. rates lead to a stronger dollar, this could put pressure on emerging markets. Similar to what transpired in the mid-to-late 1990s, a feedback loop could arise where rising EM stress causes the dollar to strengthen, leading to even more EM stress: A vicious circle for emerging markets, but a virtuous one for the greenback. Chart 10 shows that EM equities are almost perfectly inversely correlated with U.S. financial conditions. Chart 9Decelerating Global Growth Tends ##br## To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Chart 10Tightening U.S. Financial Conditions Will Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Will Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Will Not Bode Well For EM Stocks Investment Conclusions The dollar is bouncing back. This week's FOMC statement caused the greenback to briefly sell off before it rallied back. We do not think the Fed's decision to include the word "symmetric" in describing its inflation target was as important as some observers believe. The Fed has stressed that it has a symmetric target for many years. If anything, the inclusion of the word could mean that the Fed now realizes that it is behind the curve in normalizing monetary policy and thus wants to prepare the market for the inevitable inflation overshoot. That could mean more rate hikes down the road, not fewer. As such, we expect the dollar to continue strengthening. Our Foreign Exchange Strategy team's intermediate-term timing model sees EUR/USD hitting 1.15 in the next three-to-six months (Chart 11). A plunge below this level is possible given that the dollar is one of the most momentum-driven currencies out there (Chart 12). Chart 11Euro Is Poised To Weaken Euro Is Poised To Weaken Euro Is Poised To Weaken Chart 12The Dollar Is A Momentum-Driven Currency The U.S. Needs A Stronger Dollar The U.S. Needs A Stronger Dollar Sterling should also edge lower against the dollar over the next few quarters. Our global fixed-income strategists remain bullish on gilts, reflecting their view that the market has been too hawkish about how many hikes the BoE can deliver over the next year. Over a longer-term horizon, the pound has upside against both the U.S. dollar and most other currencies. If a new Brexit referendum were held today, the "remain" side would probably win (Chart 13). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The Japanese yen faces cyclical downside risks as global bond yields move higher, leaving JGBs in the dust. However, similar to sterling, the longer-term prospects for the yen are brighter. The currency is cheap and should benefit from Japan's large current account surplus and its status as a massive holder of overseas assets (Chart 14). Chart 13Bremorse Sets In Bremorse Sets In Bremorse Sets In Chart 14The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish Emerging market currencies rallied between early 2016 and the beginning of this year, but have faltered lately (Chart 15). BCA's EM and geopolitical strategists expect the Chinese government to expedite structural reforms and take steps to slow credit growth and cool the bubbly housing market. We do not anticipate that this will lead to a proverbial hard landing, but it could put renewed pressure on commodity prices over the next few months. Metals are much more exposed to a China slowdown than oil (Chart 16). Correspondingly, we favor "oily" currencies such as the Canadian dollar over "metallic" currencies such as the Australian dollar. Chart 15EM Currencies Have Been ##br##Wobbling Of Late EM Currencies Have Been Wobbling Of Late EM Currencies Have Been Wobbling Of Late Chart 16Base Metals Are More Sensitive ##br##To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth As for risk assets in general, our model still points to near-term downside risks to global equities (Chart 17). However, we expect these risks to fade as global growth stabilizes at an above-trend pace. That should set the stage for a rally in developed market stocks into year-end. Chart 17MacroQuant* Model: Still Pointing To Moderate Downside Risks For Stocks The U.S. Needs A Stronger Dollar The U.S. Needs A Stronger Dollar Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Specifically, the New York Fed model says that a 10% depreciation in the dollar would be expected to raise the level of real GDP by 0.5% in the first year and by a further 0.2% in the second year, for a cumulative increase of 0.7%. A 7% decline in the dollar would thus translate into a 0.7*7 = 0.49% increase in GDP. Using former Fed chair Janet Yellen’s preferred specification of the Taylor rule equation, which assigns a coefficient of one on the output gap, a permanent 0.49% of GDP increase in net exports would have the same effect on aggregate demand as a permanent 49 basis-point decline in the fed funds rate. Assuming a constant term premium, this would also be equivalent to a 49 basis-point decline in long-term Treasury yields. 2 FAANG stands for Facebook, Apple, Amazon, Netflix, and Google. BAT stands for Baidu, Alibaba, and Tencent. 3 Conceptually, changes in the budget deficit drive changes in aggregate demand, whereas the level of the budget deficit drives the level of aggregate demand. One can see this simply by noting that aggregate demand is equal to C+I+G+X-M. A one-off increase in G temporarily lifts the growth rate in demand, but permanently increases the level of demand. The neutral rate is determined by the level of demand and not the change in demand because the neutral rate, by definition, is the interest rate that equalizes the level of aggregate demand with aggregate supply. 4 Please see “Getting The Policy Mix Right,” IMF Global Financial Stability Report, (Chapter 3), (April 2017). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The greenback normally weakens when the U.S. business cycle matures; 2018 may prove an exception to this rule. Rising U.S. inflation could clash with deteriorating global growth, bringing the monetary divergence narrative back in vogue. This would help the dollar. EM assets are especially at risk from a rising dollar. Tightening EM financial conditions would ensue, creating additional support for the dollar. The yen is caught between bearish and bullish crosscurrents. Continue to favor short EUR/JPY and short AUD/JPY over bets on USD/JPY. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Feature Late in the business cycle, U.S. growth begins to slow relative to the rest of the world, and normally the U.S. dollar weakens in the process. The general trajectory of the dollar this business cycle is likely to end up following this historical pattern, and last year's decline for the greenback was fully in line with past experience. However, 2018 could be an odd year, where the dollar manages to rally thanks to a combination of softening global growth and rising inflationary pressures in the U.S., which forces the Federal Reserve to be less sensitive to the trajectory of global economic conditions than it has been since the recession ended in 2009. Normally, The USD Sags Late Cycle We have already showed that EUR/USD tends to rally once the U.S. business cycle matures enough that the Fed pushes interest rates closer to their neutral level. Essentially, because the eurozone business cycle tends to lag that of the U.S., the European Central Bank also lags the Fed, which also implies that European policy rates remain accommodative longer than those in the U.S. Paradoxically, this means that late in the cycle, European growth can outperform that of the U.S., and markets can price in more upcoming interest rate increases in Europe than in the U.S., lifting the euro in the process (Chart I-1). Chart I-1The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle Not too surprisingly, these dynamics can be recreated for the entire dollar index. As Chart I-2 illustrates, when we move into the later innings of the business cycle, global growth begins to outperform U.S. growth, and in the process, the DXY weakens. There has been an exception to these dynamics - the late 1990s - when the dollar managed to rally despite the lateness of the U.S. business cycle. Back then, the dollar was in a bubble, and the strong sensitivity of the dollar to momentum (Chart I-3) helped foment self-fulfilling dollar strength.1 Moreover, EM growth was generally weak. This begs the question, could 2018 evoke the late 1990s? Chart I-2What Works For The Euro Mirrors What Works For The Dollar What Works For The Euro Mirrors What Works For The Dollar What Works For The Euro Mirrors What Works For The Dollar Chart I-3Momentum Winners: USD And JPY Crosses A Long, Strange Cycle A Long, Strange Cycle Bottom Line: Normally, the U.S. dollar tends to weaken in the later innings of the U.S. business cycle, as non-U.S. growth overtakes U.S. growth. However, in 1999 and in 2000, the dollar managed to rally despite the U.S. business cycle moving toward its last hurrah. Not A Normal Cycle This cycle has been anything but normal. Growth in the entire G-10 has been rather tepid. While it is true that potential growth, or the supply side of the economy, is lower than it once was, courtesy of anemic productivity growth and an ageing population, demand growth has also suffered thanks to a protracted period of deleveraging. But the U.S. has been quicker than most other major economies in dealing with the ills that ailed her, executing a quicker private sector deleveraging than the rest of the G-10 (Chart I-4). As a result, today the U.S. output and unemployment gaps are more closed than is the case in the rest of the G-10. As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Chart I-4The U.S. Delevered, It Is Now Reaping The Benefits The U.S. Delevered, It Is Now Reaping The Benefits The U.S. Delevered, It Is Now Reaping The Benefits Chart I-5The Fed Is Now Less Sensitive To Foreign Shocks The Fed Is Now Less Sensitive To Foreign Shocks The Fed Is Now Less Sensitive To Foreign Shocks As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Core PCE is now at 1.9%, and thus the 2% target is finally within reach. Just as importantly, 10-year and 5-year/5-year forward inflation breakevens have rebounded to 2.17% and 2.24% respectively, close to the 2.3% to 2.5% range - consistent with the Fed achieving its inflation target (Chart I-6). This implies that inflation expectations are getting re-anchored at comfortable levels for the Fed. As the threat of deflation and deflationary expectation passes, the Fed is escaping the fate of the Bank of Japan in the late 1990s. It also means that the Fed is now less likely to respond as vigorously to a deflationary shock emanating from outside the U.S. than was the case in 2016, when the U.S. economy still had plentiful slack, and realized and expected inflation was wobblier. The rest of the DM economies have not deleveraged, have more slack, and are more opened to global trade than the U.S. This exposure to the global economic cycle was a blessing in 2017, when global trade and global industrial activity were accelerating. But this is not the case anymore. As Chart I-7 illustrates, the Global Zew Economic Expectations survey is exhibiting negative momentum, which historically has preceded periods of deceleration in the momentum of global PMIs as well. Chart I-6Stage 1 Almost Complete The Fed Finally Enjoys ##br##Compliant Inflationary Conditions Stage 1 Almost Complete The Fed Finally Enjoys Compliant Inflationary Conditions Stage 1 Almost Complete The Fed Finally Enjoys Compliant Inflationary Conditions Chart I-7Downdraft In##br## Global Growth Downdraft In Global Growth Downdraft In Global Growth While this phenomenon is a global one, Asia stands at its epicenter. China's industrial activity is slowing sharply, as both the Li-Keqiang index2 and its leading index, developed by Jonathan LaBerge who runs BCA's China Investment Strategy service, are falling (Chart I-8, top panel). China is not alone: Korean exports and manufacturing production are now contracting on an annual basis; Singapore too is suffering from a clearly visible malaise (Chart I-8, middle and bottom panels). Advanced economies are also catching the Asian cold. Australia and Sweden, two small open economies, have seen key leading economic gauges slow (Chart I-9, top panel). Even Canadian export volumes have rolled over (Chart I-9, middle panel). Finally, the more closed European economy is showing worrying signs, with exports slowing sharply and PMIs rolling over. As we highlighted two weeks ago, even the European locomotive - Germany - is being affected, with domestic manufacturing orders now contracting on an annual basis.3 Chart I-8Asia Is The Source Of The Malaise Asia Is The Source Of The Malaise Asia Is The Source Of The Malaise Chart I-9The Cold Might Be Spreading The Cold Might Be Spreading The Cold Might Be Spreading This dichotomy between U.S. inflation and weakening global activity is resurrecting a theme that was all the rage in 2015 and 2016: monetary divergences. Fed officials sound as hawkish as ever and will likely push up the fed funds rate five times over the next 18 months even if global growth softens a bit. However, the ECB, the Riksbank, the Bank of England, the Reserve Bank of Australia, the Bank of Canada and even the BoJ are all backpedaling on their removal of monetary accommodation. They worry that growth is not yet robust enough, or that capacity utilization is not as high as may seem. The theme of monetary divergence will therefore likely be the result of non-U.S. central banks softening their rhetoric, not the Fed tightening hers. The end result is likely to cause a period of strength in the U.S. dollar, one that may have already begun. In fact, that strength is likely to have further to go for the following five reasons: First, as we showed in Chart I-3, the dollar is a momentum currency, and as Chart I-10 illustrates, the dollar's momentum is improving after having formed a positive divergence with prices. Chart I-10USD Momentum Is Picking Up USD Momentum Is Picking Up USD Momentum Is Picking Up Second, speculators and levered investors currently hold near-record amounts of long bets on various currencies, implying they are massively short the dollar (Chart I-11). This raises the probability of a short squeeze if the dollar's autocorrelation of returns stays in place. Chart I-11 A Long, Strange Cycle A Long, Strange Cycle Third, the dollar is prodigiously cheap relative to interest rate differentials (Chart I-12). While divergences from interest rate parity are common in the FX market, they never last forever. Thus, if monetary divergences become once again a dominant narrative among FX market participants, a move toward UIP equilibria will grow more likely. Fourth, rising Libor-OIS spreads have been pointing to a growing shortage of dollars in the offshore market. The decline in excess reserves in the U.S. banking system corroborates the view that liquidity is slowing drying up. Historically, these occurrences point to a strong dollar (Chart I-13). Chart I-12A Return To Interest-Rate##br## Parity? A Return To Interest-Rate Parity? A Return To Interest-Rate Parity? Chart I-13Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Fifth, a strong dollar tightens EM financial conditions (Chart I-14). This could deepen the malaise already visible in Asia that seems to be slowly spreading to the global economy. This last point is essential, as it lies at the crux of the reason why the USD is the epitome of "momentum currencies." Essentially, this reflects the importance of the dollar as a source of funding for emerging market governments and businesses. The amount of EM dollar debt has been rising. In fact, excluding China, dollar-denominated debt today represents 16% of EM GDP, 65% of EM exports and 75% of EM reserves - the highest levels since the turn of the millennium (Chart I-15). Practically, this means that the price of EM currencies versus the USD is a key component to the cost of capital in EM. Chart I-14The Dollar Is The Enemy ##br##Of EM Financial Conditions The Dollar Is The Enemy Of EM Financial Conditions The Dollar Is The Enemy Of EM Financial Conditions Chart I-15EM Have A Lot ##br##Of Dollar Debt EM Have A Lot Of Dollar Debt EM Have A Lot Of Dollar Debt Additionally, EM local currency debt instruments are exhibiting their highest duration since we have data, making them more vulnerable to higher global interest rates (Chart I-16). Hence, the capital losses resulting from a given move higher in interest rates have grown, sharpening the risk that EM bond markets could experience a violent liquidation event. Moreover according to the IIF, the average sovereign rating of EM debt is at its lowest level since 2009. Normally, the allocation of global institutional investors into EM debt is positively correlated with the quality of EM issuers, but today this allocation has risen to more than 12%, the highest share in over five years. This suggests that DM investors are overly exposed to EM risk, creating another source of potential selling of EM assets. Ultimately, these risk factors can create a powerful feedback loop that support the sensitivity of the dollar to momentum. A strong U.S. dollar hurts EM assets, which prompts overexposed global investors to sell EM currencies further. This can be seen in the negative correlation of the broad trade-weighted dollar and high-yield EM bond prices (Chart I-17, top panel). Additionally, because rising EM bond yields as well as falling EM equities and currencies tighten EM financial conditions, this hurts EM growth. However, the U.S. economy is not as sensitive to EM growth as the rest of the world is.4 As a result, weakness in EM assets also translates into dollar strength against the majors (Chart I-17, middle panel). Additionally, commodity currencies tend to suffer more in this environment than European ones, as shown by the rallies in EUR/AUD concurrent with EM bond price weakness (Chart I-17, bottom panel). These risky dynamics in EM markets therefore are a key reason why we expect the U.S. dollar to be able to rally, bucking the normal weakness associated with the late stages of a U.S. business cycle expansion. Specifically, EUR/USD is set to suffer this year as the euro's technical picture has deteriorated significantly (Chart I-18), and, as we argued two weeks ago, the euro area still has plenty of slack. Chart I-16Heightened EM Duration Risk Heightened EM Duration Risk Heightened EM Duration Risk Chart I-17EM Risks Help The Greenback EM Risks Help The Greenback EM Risks Help The Greenback Chart I-18EUR/USD Technicals Are Flimsy EUR/USD Technicals Are Flimsy EUR/USD Technicals Are Flimsy Bottom Line: For the remainder of 2018, the dollar is likely to buck the weakness it normally experiences in the late innings of a .S. business cycle expansion. The U.S. is significantly ahead of the rest of the world when it comes to inflation, giving more room for the Fed to hike rates. This difference is now put in sharper focus than last year as the global economy is weakening, which could prompt a period of dovish rhetoric in the rest of the world that will not be matched by an equivalent backtracking in the U.S. Moreover, while positioning and technical considerations also favor a dollar rebound, the vulnerability of EM assets increases this risk by creating an additional drag on foreign growth. What To Do With The Yen? The yen currently sits at a tricky spot. Historically, the yen tends to depreciate against the USD when we are at the tail end of a U.S. business cycle expansion (Chart I-19). Toward the end of the business cycle, U.S. bond yields experience some upside - upside that is not mimicked by Japanese interest rates. The resultant widening in interest rate differentials favors the dollar. Chart I-19The Yen Doesn't Enjoy Late Cycle Dynamics The Yen Doesn't Enjoy Late Cycle Dynamics The Yen Doesn't Enjoy Late Cycle Dynamics On the other hand, a period of weakness in EM assets, even if prompted by a dollar rebound, could help the yen. The yen is a crucial funding currency in global carry trades, and a reversal of these carry trades will spur some large yen buying. Moreover, Japan has a net international investment position of US$3.1 trillion. This means that Japanese investors, who are heavily exposed to EM assets, are likely to repatriate some funds back home. So what to do? We have to listen to economic conditions in Japan. So far, despite an unemployment rate at 25-year lows and a job-opening-to-applicant ratio at a 44-year highs, Japan has not been able to generate much inflationary pressures. In fact, while the national CPI data has remained robust, the Tokyo CPI, which provides one additional month of data, has begun to roll over (Chart I-20). The Japanese current account is deteriorating sharply. This mostly reflects the downshift in EM economic activity as 44% of Japanese exports are destined to those markets. Interestingly, in response to the deterioration in export growth, import growth is also decelerating sharply, pointing toward a domestic impact from the foreign weakness (Chart I-21). It is looking increasingly clear that overall economic momentum in Japan is slowing. Both the shipment-to-inventory ratio as well as the Cabinet Office leading diffusion index are exhibiting sharp drops - signs that normally foretell a slowdown in industrial production and therefore a deterioration in capacity utilization, which still stands well below pre-2008 levels (Chart I-22). Chart I-20Weakening Japanese Inflation Weakening Japanese Inflation Weakening Japanese Inflation Chart I-21The Asian Malaise Is Hitting Japan The Asian Malaise Is Hitting Japan The Asian Malaise Is Hitting Japan Chart I-22Japanese Outlook Deteriorating Japanese Outlook Deteriorating Japanese Outlook Deteriorating In response to these developments, BoJ Governor Haruhiko Kuroda has been sounding more dovish. Moreover, after its latest policy meeting, the BoJ is acknowledging that it will take more time than anticipated for inflation to move toward its 2% target. In this environment, the yen has begun to weaken against the USD, especially as the greenback has been strong across the board. Moreover, USD/JPY was already trading at a discount to interest rate differentials. The downshift in Japanese economic data as well as the shift in tone by the BoJ are catalyzing the closure of this gap. Practically talking, USD/JPY is currently a very dangerous cross to play, as it is caught between various cross currents: a broad-based dollar rebound and a BoJ responding to a slowing economy can help USD/JPY; however, rising EM risks could boost it. On balance, we now expect the bullish USD forces to prevail on the yen, but we are not strongly committed to this view. Instead, have long maintained that the higher probability vehicle to play the yen is to short EUR/JPY.5 We remain committed to this strategy for the yen. Based on interest rate differentials, the price of commodities and global risk aversion, the euro can decline further against the yen, as previous overshoots are followed with significant undershoots (Chart 23, left panels). Moreover, speculators remains too long the euro versus the yen (Chart I-23, right panels). Additionally, EUR/JPY remains expensive on a long-term basis, trading 13% above its PPP-implied fair value. Finally, in contrast to Japan's large positive net international investment position, Europe's stands at -4.5% of GDP. Japanese investors have proportionally more funds held abroad than European investors do, and therefore more scope to repatriate funds in the event of rising EM asset volatility. We have also highlighted that selling AUD/JPY, while a more volatile bet than being short EUR/JPY, is another attractive way to play the risk to EM markets. Not only is AUD/JPY still very overvalued (Chart I-24), but Australia remains highly exposed to EM growth. This remains an attractive bet, despite a good selloff so far this year. Chart I-23AShort EUR/JPY Is A Cleaner Story (I) Short EUR/JPY Is A Cleaner Story (I) Short EUR/JPY Is A Cleaner Story (I) Chart I-23BShort EUR/JPY Is A Cleaner Story (II) Short EUR/JPY Is A Cleaner Story (II) Short EUR/JPY Is A Cleaner Story (II) Chart I-24AUD/JPY Is At Risk AUD/JPY Is At Risk AUD/JPY Is At Risk Bottom Line: The yen tends to depreciate against the USD in the later innings of a U.S. business cycle expansion, a response to rising U.S. bond yields. However, the yen also benefits when EM asset prices fall, a growing risk at the current economic juncture. Moreover, Japanese economic data are deteriorating and the BoJ is shifting toward a more dovish slant. The balance of these forces suggests that the yen rally against the dollar is done for now. However, the yen has further scope to rise against the EUR and the AUD. Two Charts On EUR/GBP Since we are anticipating EUR/USD to fall further toward 1.15, this also begs questions for the pound. Historically, a weak EUR/USD is accompanied by a depreciating EUR/GBP (Chart I-25). Essentially, the pound acts as a low-beta euro against the USD, and therefore when EUR/USD weakens, GBP/USD weakens less, resulting in a falling EUR/GBP. This time around, British economic developments further confirm this assessment. The spread between the British CBI retail sales survey actual and expected component has collapsed, pointing to a depreciating EUR/GBP (Chart I-26). Essentially, the brunt of the negative impact of Brexit on the British economy is currently being felt, which is affecting investor sentiment on the pound relative to the euro. Why could consumption, which represents nearly 70% of the U.K. economy, rebound from current poor readings? Once inflation weakens - a direct consequence of the previous rebound in cable - real incomes of British households will recover from their currently depressed levels, boosting consumption in the process. Chart I-25Where EUR/USD Goes,##br## EUR/GBP Follows Where EUR/USD Goes, EUR/GBP Follows Where EUR/USD Goes, EUR/GBP Follows Chart I-26Economic Conditions Also Point ##br##To A Weakening EUR/GBP Economic Conditions Also Point To A Weakening EUR/GBP Economic Conditions Also Point To A Weakening EUR/GBP Finally, today only 42% of the British electorate is pleased with having voted for Brexit, the lowest share of the population since that fateful June 2016 night. Moreover, this week, the House of Lords voted that Westminster can adjust the final deal with the EU before turning it into law. This implies that the probability of a soft Brexit, or even no Brexit at all, is increasing. However, the challenge to Theresa May's post-Brexit customs plan by MP Rees-Mogg, is creating yet another short-term hurdle that makes the path toward this outcome rather torturous. Additionally, it also raises the probability of a Corbyn-led government if the current one collapses. As a result, while the economic developments continue to favor being short EUR/GBP, the political environment is still filled with landmines, creating ample volatility in the pound crosses. We will use any rebound to EUR/GBP 0.895 to sell this pair. Bottom Line: If the euro weakens further, GBP/USD is likely to follow and depreciate as well. However, the pound will likely rally against the euro. Historically, GBP/USD behaves as a low-beta version of EUR/USD. Moreover, the maximum post-Brexit economic pain is potentially being felt right now, implying a less cloudy economic outlook for the U.K. Additionally, the probability of a soft Brexit or no Brexit at all is growing even if partial volatility remains. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 The Li-Keqiang index is based on railway cargo volume, electricity consumption, and loan growth. 3 Please see Foreign Exchange Strategy Weekly Report, titled "The ECB's Dilemma", dated April 20, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YYC!", dated January 12, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was marginally positive this week. As headline PCE climbed to the targeted 2% level, the underlying core PCE also edged up to 1.9%, highlighting growing inflationary forces. However, countering these positive releases were disappointing PMIs and a slowing ISM, as well as pending home sales, which contracted on a 4.4% annual basis. Regardless, the Fed acknowledged the strength of the U.S. economy. The FOMC referred to the inflation target as "symmetric", signaling that for now, inflation above target will not be used as an excuse to lift rates faster than currently forecasted in the dots. Nevertheless, the much-awaited breakout in the dollar materialized two weeks ago. As global growth wains, key central banks such as the ECB, BoJ, and BoE are likely to retreat to a more dovish tilt, as growth forecasts are revised down. This should give the greenback a substantial boost this year. Report Links: Is King Dollar Facing Regicide? - April 27, 2018 U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was weak: M3 and M1 money supply growth both weakened to 3.7% and 7.6%; Annual GDP growth slowed down to 2.5%, as expected; Both the headline and core measures of inflation disappointed, coming in at 1.2% and 0.7%, respectively. The euro broke down below a crucial upward-slopping trendline, which was defining the euro's rally last year. Additionally, EUR/USD has also broken the 200-day moving average technical barrier, highlighting the impact on the euro of weakening global growth and faltering European data. This decline in activity, along with the presence of hidden-labor market slack have been picked up by President Mario Draghi and other key ECB officials. Therefore, weakness in the euro is likely to continue for now. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Nikkei manufacturing PMI surprised to the upside, coming in at 53.8. However, Tokyo inflation ex-fresh food underperformed expectations, coming in at 0.6%. Moreover, consumer confidence also surprised negatively, coming in at 43.6. Finally, housing starts yearly growth underperformed expectations, coming in at -8.3%. The Bank of Japan decided to keep its key policy rate at -0.1% last Friday. Overall, the BoJ sounded slightly more dovish, acknowledging that it might take more time for inflation to move to their 2% target. Taking this into account, it might be dangerous to short USD/JPY as the BoJ could adjust policy to depreciate the currency. However investors could short EUR/JPY to take advantage of increased risk aversion. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 1.2%. Moreover, manufacturing PMI also surprised to the downside, coming in at 53.9. Additionally, both consumer credit and mortgage approvals underperformed expectations, coming in at 0.254 billion pounds, and 62.014 thousand approvals respectively. The pound has depreciated by nearly 5.5% in the past 2 weeks. Poor inflation and economic data as well as generalized dollar strength. Overall, we continue to be bearish on the pound, as the uncertainty surrounding Brexit will continue to scare away international capital. Moreover, the strength of the pound last year should weigh significantly on inflation, limiting the ability of the BoE to raise rates significantly. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was generally good: Building permits picked up, growing at a 14.5% annual rate, and a 2.6% monthly rate, beating expectations; The trade balance outperformed expectations comfortably, coming in at AUD 1.527 million; However, the AIG Performance of Manufacturing Index went down to 58.3 from 63.1; The AUD capitulated as a result of the growing global growth weakness, trading at just above 0.75. The RBA is reluctant to hike rates as Governor Lowe sited both stress in the money market and stretched household-debt levels as key reasons for his reluctance to hike. In other news, growing tension between Australia and its largest investor, China, are emerging in response to rumors that Chinese agents have been lobbying Australian officials in order to influence Australian politics. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: The unemployment rate surprised positively, coming in at 4.4%. Moreover, employment quarter-on-quarter growth outperformed expectations, coming in at 0.6%. However, the Labour cost index yearly growth surprised to the downside, coming in at 1.9%. Finally, the participation rate also surprised negatively, coming in at 70.8%. NZD/USD has depreciated by nearly 5%. Overall we continue to be negative on the kiwi, given that an environment of risk aversion will hurt high carry currencies like the New Zealand dollar. Moreover, a slowdown in global growth should also start to hurt the kiwi economy, given that this economy is very levered to China and emerging markets. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was mixed: Raw material price index increased by 2.1% in March, more than the expected 0.6%; GDP grew at a 0.4% monthly rate, beating expectations of 0.3%; However, the Markit manufacturing PMI disappointed slightly at 55.5. The CAD only suffered lightly despite the greenback's rally. Governor Poloz argued that the expensive Canadian housing market and the elevated household debt load have made the economy more sensitive to higher interest rates than in the past. He also pointed out that interest rates "will naturally move higher" to the neutral rate level, ultimately giving mixed signals. Despite these mixed comments by Poloz, the CAD managed to rise against most currencies expect the USD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales yearly growth underperformed expectations, coming in at -1.8%. Moreover, the KOF leading indicator also surprised negatively, coming in at 105.3 However, the SVME Purchasing Manager's Index came in at 63.9. EUR/CHF has been flat these last 2 weeks. Overall, we continue to bullish on this cross on a cyclical basis, given that the SNB will keep intervening in currency markets, as the economy is still too weak, and inflationary pressures are still to tepid for Switzerland to sustain a strong franc. However, EUR/CHF could see some downside tactically in an environment of rising risk aversion. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Registered unemployment surprised positively, coming in at 2.4%. Moreover, the Norges Bank credit indicator also outperformed expectations, coming in at 6.3%. USD/NOK has risen by more than 4% these past 2 weeks. This has occurred even though oil has been flat during this same time period. Overall we are positive on USD/NOK, as this cross is more influenced by relative rate differentials between the U.S. and Norway than it is by oil prices. However, the krone could outperform other commodity currencies, as oil should outperform base metals, as the latter is more sensitive to the Chinese industrial cycle than the latter. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The krona's collapse seem never ending. While the krona never responds well to an environment where global growth is weakening and where asset prices are becoming more volatile, Riksbank governor Stefan Ingves is not backing away from his dovish bias. In fact, the Swedish central bank is perfectly pleased with the krona's dismal performance. Thus, the Riksbank is creating a stealth devaluation of its currency, one that is falling under President Donald Trump's radar. Swedish core inflation currently stands at 1.5%, but it is set to increase. The Riksbank's resource utilization gauge is trending up and the Swedish housing bubble is supporting domestic consumption. As a result, the Swedish output gap is well above zero, and wage and inflationary pressures are growing. The Riksbank will ultimately be forced to hike rates much faster than it currently forecasts. Thus, we would anticipate than when the global soft patch passes, the SEK could begin to rally with great alacrity. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature A Conversation With Ms. Mea I met with some of our European clients over the past few weeks, and used the opportunity to connect with Ms. Mea, a long-standing client of BCA who visited us last fall.1 As always, Ms. Mea was keen to scrutinize our viewpoints, delve into intricacies of our analysis and understand the differences between our interpretations of the global macro landscape and the prevailing market consensus. I hope clients find our latest dialogue insightful. Ms. Mea: It seems your negative call on emerging markets (EM) is finally beginning to work out: EM share prices in both absolute terms and relative to developed markets (DM) have dropped to their 200-day moving averages (Chart I-1). It seems we are at a critical juncture: If share prices bottom at these levels, a major upleg is likely and, conversely, if they break below this technical support, considerable downside may be in the cards. What makes you think this is not a buying opportunity? Indeed, EM stocks are testing a critical technical level. I doubt this is a buying opportunity. It looks like EM corporate profit and revenue growth have peaked (Chart I-2, top and middle panels). The question is not if but how much downside there is. I believe the downside will be substantial because the forces that drove this recovery are in the process of reversing. Chart I-1EM Equities Are At Critical Juncture EM Equities Are At Critical Juncture EM Equities Are At Critical Juncture Chart I-2EM Profits Have Topped Out EM Profits Have Topped Out EM Profits Have Topped Out First, the Chinese credit and fiscal stimulus of early 2016 has been reversed, and our China credit and fiscal spending impulse projects considerable downside in EM non-financial corporate earnings growth (Chart I-2, bottom panel). Second, Asia's manufacturing cycle is downshifting (Chart I-3). Korea's export growth is flirting with contraction (Chart I-3, bottom panel). Even if U.S. final demand remains robust, U.S. imports could slow, hurting the rest of the world. Chart I-4 illustrates that America's imports have been growing faster than its final demand, implying re-stocking of imported goods. Typically, periods of re-stocking are followed by waves of de-stocking. During the latter periods, import growth decelerates. Chart I-3Asia: Trade Is Decelerating Asia: Trade Is Decelerating Asia: Trade Is Decelerating Chart I-4U.S.: Final Demand And Imports U.S.: Final Demand And Imports U.S.: Final Demand And Imports Third, investor sentiment remains quite bullish on EM and EM equity valuations are not cheap in both absolute and relative terms (Chart I-5). Meanwhile, credit spreads as well as local bond yield spreads over U.S. Treasurys are very narrow. Chart I-5EM Equities Are Not Cheap EM Equities Are Not Cheap EM Equities Are Not Cheap Last but not least, U.S. wage growth and core inflation are rising. This warrants rising U.S. interest rate expectations and a rally in the dollar. As EM currencies depreciate against the greenback, EM stocks and bonds will sell off too. In a nutshell, it appears that the December and January spike in EM share prices was the final blow-off phase of this cyclical bull market. It is typical for a major market move to culminate with a bang. It seems this was the case with EM share prices, currencies and local bonds in December and January. Interestingly, the fact that EM share prices have failed to break above their previous highs is a bad omen (Chart I-1 on page 1). If our negative outlook on China's industrial cycle, commodities prices and the bullish view on the U.S. dollar play out, the current selloff in EM risk assets will progress into another bear market similar to the 2014-'15 episode. Ms. Mea: There is a widely held belief in the investment community that we are in the late expansion phase of the global business cycle. Late cyclical equity sectors, especially commodities and industrials, typically outperform at this stage. If so, this warrants overweighting EM as high commodities prices are going to help EM equities outperform DM ones. This is contrary to your recommended strategy of underweighting EM versus DM. Where and why do you differ from the consensus view? When discussing cycles, it is important to specify which economy we are referencing. With respect to the U.S. economy, I agree that we may be in a late-cycle expansion phase, when growth is strong, and wages and inflation are rising. In fact, in my opinion, U.S. wages and core CPI are likely to surprise to the upside (Chart I-6). Based on America's current economic dynamics, it makes sense to be overweighting late cyclicals. That said, just because the U.S. is in the late phase of its own expansion cycle doesn't mean China is at the same stage too. China's business cycle varies greatly from that of the U.S. and Europe. In my opinion, China's industrial sector in general, and capital spending in particular, are re-commencing the downtrend that took place between 2012-'16, but was interrupted by the injection of massive credit and fiscal stimulus in early 2016. Chart I-7 portrays China's manufacturing cycle along with the performance of EM stocks relative to their DM peers, as well as commodities prices. A few observations are in order: Chart I-6U.S. Wages And Inflation To Rise Further U.S. Wages And Inflation To Rise Further U.S. Wages And Inflation To Rise Further Chart I-7Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? China's capital spending and most of its industrial sectors were in their late cycle expansion phase in 2009-2011. The post-Lehman monetary and fiscal stimulus produced an unprecedented boom in investment spending. Yet, it was unsustainable because it created a misallocation of capital, enormous amounts of debt and asset bubbles. During this period, EM outperformed DM by a large margin, and global late cyclicals - such as materials, energy and industrials - outperformed the global equity benchmark. From 2012 to early 2016, there was a major downtrend in China's capital spending. Demand for capital goods/machinery and commodities downshifted and in some cases contracted (Chart I-8). After the new round of stimulus in early 2016, the Chinese economy recovered. However, the impact of this stimulus has now waned, and policymakers have been tightening policy since early 2017. Consequently, the downtrend in the mainland's industrial sector appears to be re-commencing and will likely deepen. In short, I view the rally in EM and commodities over the past two years as a mid-cycle hiatus in the bear market that began in 2011. Odds are that EM and commodities will sell off even if DM demand holds up. Chart I-9 denotes that global machinery and chemical stocks have already been underperforming the global equity benchmark. Energy stocks are still being supported by the rally in oil prices, but in my opinion it is a matter of time before oil prices roll over (we discuss our oil outlook below). However, given energy stocks have done so poorly relative to other sectors amid rising crude prices, they may not underperform, even if oil prices relapse. Chart I-8China: Construction Industry Profile China: Construction Industry Profile China: Construction Industry Profile Chart I-9Global Late Cyclicals Have Underperformed Global Late Cyclicals Have Underperformed Global Late Cyclicals Have Underperformed In 2010, I made the call that EM share prices, currencies and commodities had peaked for the decade. At the same time, I argued that technology, health care, and the equity markets with large weights in these sectors, namely the U.S., would deliver strong returns. This roadmap by and large remains pertinent. Chart I-10China Accounts For 50% Of ##br##Global Metals Demand Where Are EMs In The Cycle? Where Are EMs In The Cycle? Typically, winners of the previous decade perform poorly during the entire following decade. EM and commodities were the superstars of the last decade. There are still two more years to go in this decade. Consistent with this roadmap, we expect EM risk assets and commodities to relapse anew in the next 12-18 months. While the last two years were very painful not to chase the EM and commodities rallies, odds are that this has been a mid-cycle hiatus in a decade-long downtrend. Ms. Mea: Don't you think strong growth in DM will drive commodities prices higher, despite weakness in China? Are you bearish on oil because of China's demand too? I am optimistic about domestic demand in the U.S. and Europe. Yet, commodities prices, especially industrial commodities, are driven by China, not the U.S., EU or India. China consumes at least 50% of industrial and base metals (Chart I-10). Consistent with our view of a downtrend in China's capital spending in general, and construction in particular, we remain downbeat on industrial metals prices. Regarding oil prices, China's share in global oil demand is much smaller than it is for metals - the country consumes 14% of the world's petroleum products. Further, we are not negative on Chinese household demand for gasoline, but we are negative on mainland diesel demand. The latter fluctuates with industrial activity, as Chart I-11 illustrates. Importantly, oil prices will likely go down even if China's oil consumption growth remains robust. The basis is as follows: Investors' net long positions in oil are at record high levels (Chart I-12). Chart I-11China's Diesel Demand China's Diesel Demand China's Diesel Demand Chart I-12Investors Are Record Long Oil Investors Are Record Long Oil Investors Are Record Long Oil Traders have been buying oil because of rollover yield. Since the oil market is in backwardation, investors have been capturing rollover yield when they roll over contracts. Oil has been a carry trade over the past year as expectations of tight supply and a weaker U.S. dollar have spurred record numbers of investors to go long oil. As the U.S. dollar strengthens and China's growth slows, these traders will likely head for the exits with respect to their long oil positions. China has been importing more oil than it consumes since 2014. Our hunch is it has been accumulating strategic oil reserves. With oil prices spiking to $70, the pace of accumulation of strategic oil reserves may slow, and prices could retreat. China traditionally purchases commodities on dips. Finally, oil typically shoots up in the late stages of the business cycle. Chart I-13 illustrates that oil prices lag or at best are coincident with the global industrial cycle. In fact, often these spikes in oil prices - like the current one - occur due to supply constraints in the late stages of the business cycle. Nevertheless, they often mark the top. Chart I-13Oil Is Often Late To Peak Oil Is Often Late To Peak Oil Is Often Late To Peak In brief, while the case for oil is different than for industrial metals, risks to crude prices are tilted to the downside over the next six-to-nine months or so.2 Ms. Mea: One of the key drivers of your view on global markets has been a strong U.S. dollar. Why do you think the recent rebound in the dollar has staying power, and how far will it rally? Odds are that the U.S. dollar has made a major bottom and has entered a cyclical bull market. While we are not sure whether the greenback will surpass its early 2016 highs, it will at least re-test those levels on many crosses, especially versus EM and commodities currencies. The euro and other European currencies will likely not drop to their early 2016 lows, and as a result, EM currencies stand to depreciate considerably versus both the U.S. dollar and the euro. This will undermine the dollar- and euro-based investors' returns in EM equities and local currency bonds, and lead to an exodus of foreign funds. Contrary to market consensus thinking, the EM local interest rate differential over DM does not drive EM exchange rates. In fact, there is an inverse relationship between local interest rate spreads over U.S. rates and their currencies (Chart I-14). It is the exchange rate that drives local rates in EM. Currency depreciation pushes interest rates up, and exchange rate appreciation leads to lower interest rates. Many EM currencies correlate with commodities prices and global trade. The latter two will likely weigh on EM exchange rates in the next six to nine months. What's more, EM are much more leveraged to China than to DM. Both EM currencies as well as EM's relative equity performance versus DM mirror marginal shifts between Chinese and DM imports - the latter is a proxy for their domestic demand (Chart I-15). Chart I-14EM Currencies And Yields Differential Over U.S. EM Currencies And Yields Differential Over U.S. EM Currencies And Yields Differential Over U.S. Chart I-15EM Is Much More Sensitive To China Than DM EM Is Much More Sensitive To China Than DM EM Is Much More Sensitive To China Than DM As China's growth slumps, EM will likely catch pneumonia, while DM gets away with just a cold. This entails that EM currencies will come under downward pressure against both the U.S. dollar and the euro. Finally, provided EM ex-China has accumulated a lot of U.S. dollar debt, their currency depreciation will elevate debt stress. While we do not expect this to result in massive defaults, the ability of debtor companies with foreign currency liabilities to invest and expand will be curtailed. This is a negative for growth. EM debtors with dollar debt are much more vulnerable to an appreciating dollar than rising U.S. interest rates. From the perspective of their debt servicing costs alone, 10% dollar appreciation is much more painful than a 100 basis point rise in U.S. dollar rates. Hence, regardless of whether the greenback's rally occurs amid rising or falling U.S. bond yields, it will impose meaningful pain on EM debtors. In this context, EM sovereign and corporate spreads are too tight and will likely widen if and as EM currencies and commodities prices decline. Ms. Mea: In last week's statement, China's Politburo omitted the word "deleveraging" and the People's Bank of China cut the Reserve Requirement Ratio (RRR). Notably, onshore bond yields have dropped a lot. Does this not mean that stimulus is in the pipeline and the point of maximum stress for EM and commodities is now behind us? I doubt it. First, China's official media outlet, Caixin,3 explicitly stated that the Politburo statement does not mean either new stimulus or that the policy of battling financial excesses has been abandoned. Second, the RRR cut has led to only small net liquidity injections in the banking system. Its primary goal was to reduce interest rate costs for banks. Are falling bond yields in China a bullish or bearish signal for China-related risk assets? It is not clear. In 2017, interest rates rose considerably, yet China/EM risk assets completely ignored it. I was puzzled by this. Meanwhile, the recent drop in bond yields has coincided with falling EM share prices (Chart I-16). Third, the budget plan for 2018 does not entail major fiscal stimulus. Table I-1 denotes aggregate fiscal and quasi-fiscal spending will rise by 8% in 2018 compared to an actual rise of 8.6% in 2017 and 8.1% in 2016. All numbers are for nominal growth. Table I-1China: Fiscal And Quasi-Fiscal Spending (Annual Nominal Growth Rates) Where Are EMs In The Cycle? Where Are EMs In The Cycle? The government can always change its budgetary plans and boost fiscal spending beyond what is initially planned. This was the case in 2016. However, without material deterioration in growth, it is unlikely. The authorities undertook the 2015-2016 stimulus because of extremely weak growth and plunging global financial markets. Fourth, some commentators have noted that land sales have been strong, entailing more local government revenues and hence more infrastructure investment. Yet Chart I-17 portrays that the broad money impulse leads land sales. If their past relationship holds, land sales will decrease in the next 12 months. Chart I-16China's Bond Yields And EM Stocks China's Bond Yields And EM Stocks China's Bond Yields And EM Stocks Chart I-17China: Land Sales Are To Slump bca.ems_sr_2018_05_03_s1_c17 bca.ems_sr_2018_05_03_s1_c17 Finally, the regulatory clampdown on banks and shadow banking is ongoing. This along with the anti-corruption campaign in the financial industry could have a larger impact on credit origination than a marginal drop in interest rates or marginal liquidity provision. On the whole, if the authorities, again, open the credit and fiscal spigots wide, they will relinquish their pledge of structural reforms, a reduction of financial excesses and containing rising leverage. This would entail policymakers opting for a short-term gain in sacrifice of the country's long-term economic outlook. Growth financed by banks originating money out of thin air will ultimately (in the years ahead) lead to lower productivity and higher inflation - i.e., stagflation. I believe Beijing understands this and will not open the credit and fiscal taps too fast or too wide. In brief, China-related risk assets will likely sell off a lot before the next round of stimulus arrives. Ms. Mea: What about Chinese consumer spending and the outlook for technology companies that have become dominant in the EM equity index? Does your negative outlook for investment spending entail a downtrend in household spending? I have been bearish on China's industrial cycle and capex, but not on consumer spending. In fact, household expenditure growth is booming and is unlikely to slow a lot, even amid a downtrend in the construction sector. However, there are a number of reasons to expect a moderation of the current torrid pace of household spending: Capital spending accounts for 42% of GDP, and as it slumps, job creation and income gains will slow. If banks originate less credit, there will be less investment, and income growth will likely be affected. Contrary to widely held beliefs, Chinese households have become a bit leveraged - the ratio of household debt to disposable income is slightly higher in China than in the U.S. (Chart I-18). Further, borrowing costs in China are above those in the U.S. This entails that debt servicing costs as a share of disposable income are higher for households in China than in the U.S. Chart I-18Household Leverage: China And U.S. Household Leverage: China And U.S. Household Leverage: China And U.S. Not surprisingly, the authorities are clamping down on banks and shadow banking lending to households. It seems that policymakers in China worry much more about credit and leverage excesses than global investors. We published an in-depth Special Report on China's real estate market on April 6 where we argued that excesses remain large and a period of property price deflation cannot be ruled out.4 This means that property wealth effects could turn from a tailwind to a headwind for households for a period of time. All that said, I am not bearish on household spending, apart from real estate purchases. What does this entail for mega-cap companies' share prices, like Tencent and Alibaba? For sure, technology will continue to gain importance in China, like elsewhere. However, given these stocks have seen significant share price inflation and trade at high multiples, buying these stocks at current levels may not be a good investment. Valuations and business models as well as regulatory risks are key in the current circumstances. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. From a big-picture perspective, Chart I-19 demonstrates that Tencent's and Amazon's share prices have gone up 12- and10-fold, respectively, in real U.S. dollar terms since January 2010, as much as the run-up that occurred during previous bubbles. Chart I-19Each Decade Had A Mania Each Decade Had A Mania Each Decade Had A Mania With respect to performance of other heavyweights like TSMC and Samsung, the electronics cycle - like overall trade in Asia - has topped out, as evidenced by relapsing semiconductor prices (Chart I-20). Chart I-20Semiconductor Prices Have Rolled Over Semiconductor Prices Have Rolled Over Semiconductor Prices Have Rolled Over This is a very cyclical sector, and a further slowdown is to be expected following the growth outburst of the past 18 months. This may be enough to cause a meaningful correction in technology hardware and semi stocks. Ms. Mea: Finally, translating these themes into market strategy, what are your strongest conviction recommendations? Investment and asset allocation strategy should favor DM over EM in equity, currency and credit spaces. This strategy will likely pay off in both risk-on and risk-off environments. Our overweights within the EM equity universe are Mexico, Taiwan, Korea, India, Thailand and central Europe. In the meantime, Brazil, Turkey, South Africa and Malaysia are our strong-conviction underweights. In terms of sector trades, I would emphasize our long-standing short EM banks / long U.S. banks position. Finally, it seems EM currencies are breaking down versus the U.S. dollar. There is much more downside, and traders and investors should capitalize on this trend by being short a basket of EM currencies like the BRL, the ZAR, the CLP, the MYR and the IDR versus the dollar. For fixed-income investors, depreciating EM currencies are a major headwind for both local currency and U.S. dollar bonds, and we recommend defensive positioning. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Special Report "Ms. Mea Challenges The EMS View," dated October 19, 2017, available on emsbcaresearch.com 2 This differs from BCA's house view which is bullish on oil prices. 3 "Caixin View: Politburo Comments on Expanding Domestic Demand Don't Signal Stimulus," Caixin Global, April 2017. 4 Please see Emerging Markets Special Report "China Real Estate: A New-Bursting Bubble?," dated April 6, 2018, the link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since the start of the year, and it is too early to exit. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a tradeable reversal in yields. The trade-weighted euro has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. We have a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Feature Entering the fifth month of the year, one puzzle for investors is the conflicting messages coming from banks and bonds. While banks' relative performance is close to its 2018 low, bond yields are not far from their year-to-date high (Chart of the Week). Chart of the WeekBanks Or Bonds: Which One Is Right? Banks or Bonds: Which One Is Right? Banks or Bonds: Which One Is Right? This poses a puzzle because the performances of banks and bond yields are usually joined at the hip. The underperformance of the economically sensitive banks would suggest that global growth is decelerating, whereas the performance of bond yields would suggest that global activity is holding up well. Which one is right? The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Looking at the other classically cyclical sectors, the mystery seems to deepen. Industrials and basic materials are also in very clear downtrends this year, which corroborates the message from the banks. But the oil and gas sector is close to a year high, which corroborates the message from bond yields (Charts I-2-I-4). Chart I-2Industrials Have Underperformed... Industrials Have Underperformed... Industrials Have Underperformed... Chart I-3...And Basic Materials Have Underperformed ...And Basic Materials Have Underperformed ...And Basic Materials Have Underperformed Chart I-4...But Oil And Gas Has Outperformed... ...But Oil And Gas Has Outperformed... ...But Oil And Gas Has Outperformed... The conflicting messages from banks, basic materials and industrials on one side and bond yields and oil and gas equities on the other side reflect the disconnect between non-oil commodity prices which have drifted lower this year and oil prices which have moved sharply higher (Chart I-5). This disconnect, resulting from differing supply dynamics in the different commodity markets, points us to a likely solution to our puzzle. Chart I-5...Because Oil Has Disconnected ##br##From Other Commodities ...Because Oil Has Disconnected From Other Commodities ...Because Oil Has Disconnected From Other Commodities The classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. The global 6-month credit impulse is now indisputably in a mini-downswing phase. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation, inflation expectations, and thereby on central bank reaction functions. Based on previous mini-cycles, we can confidently say that mini-downswing phases last at least six to eight months and that the usual release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating activity and un-budging bond yields risks extending this mini-downswing phase. Therefore, for the next few months, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since we initiated it at the start of the year, and it is too early to exit. This sector strategy necessarily impacts regional allocation as explained in the next section. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a natural cap and a tradeable reversal in yields. Even More Investment Reductionism Imagine a world in which all the global commodity firms decided to get their stock market listings in London; all the global financials decided to list on euro area bourses; all the major tech companies listed in New York; and all the industrials listed in Tokyo. Clearly, each major stock market would just be a play on its underlying global sector and nothing more. Our imagined world is an exaggeration, but it does illustrate an important truth. A quarter of the market capitalisation of each major stock market is in one dominant sector, and this gives each equity index its defining fingerprint: for the FTSE100 it is commodity firms; for the Eurostoxx50 it is financials; for the S&P500 it is technology; and for the Nikkei225 it is industrials (Table I-1). Table I-1Each Major Stock Market Has A Defining Fingerprint Banks Or Bonds: Which One Is Right? Banks Or Bonds: Which One Is Right? There is another important factor to consider: the currency. A global oil company like BP receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining fingerprints for the major indexes turn out to be: FTSE100: global commodity shares expressed in pounds. Eurostoxx50: global banks expressed in euros. S&P500: global technology expressed in dollars. Nikkei225: global industrials expressed in yen. And that's pretty much all you need to know for regional equity allocation! The charts in this report should leave you in no doubt. True to our Investment Reductionism philosophy, the relative performance of the regional equity indexes just reduces to their defining fingerprints: FTSE100 versus S&P500 reduces to global commodity companies in pounds versus global tech companies in dollars, Eurostoxx50 versus Nikkei225 reduces to global banks in euros versus global industrials in yen. And so on (Charts I-6-I-11). Chart I-6FTSE 100 Vs. S&P 500 = Global Commodity##br## Equities In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Commodity Equities In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Commodity Equities In Pounds Vs. Global Tech In Dollars Chart I-7FTSE 100 Vs. Nikkei 225 = Global Commodity ##br##Equities In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Commodity Equities In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Commodity Equities In Pounds Vs. Global Industrials In Yen Chart I-8FTSE 100 Vs. Euro Stoxx 50 = Global Commodity##br## Equities In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Commodity Equities In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Commodity Equities In Pounds Vs. Global Banks In Euros Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In ##br##Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars Chart I-10Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In##br## Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Chart I-11S&P 500 Vs. Nikkei 225 = Global Tech In ##br##Dollars Vs. Global Industrials In Yen S&P 500 Vs. Nikkei 225 = Global Tech In Dollars Vs. Global Industrials In Yen S&P 500 Vs. Nikkei 225 = Global Tech In Dollars Vs. Global Industrials In Yen The Right Way To Invest In The 21st Century One important implication of Investment Reductionism is that the head-to-head comparison of stock market valuations is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, banks and technology - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Another implication is that simple 'value' indexes may not actually offer better value! In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem is that the whole concept of standard deviation assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations are 'non-stationary': they undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange. Pulling together these complexities of sector effects, currency effects, and step changes in sector valuations, we offer some strong advice on how to sequence the investment process: 1. Make your asset class decision at a global level. This is because asset classes tend to move as global entities, not regional entities. And also because at a global level, asset class valuation comparisons are less distorted by sector and currency effects. 2. Make your sector decisions. Given that the companies that dominate European (and all major) indexes are multinationals, the sector decision should be based on the direction of the global economy. 3. Make your currency decisions. 4. You do not need to make any more major decisions! The main regional equity allocation, country allocation and value/growth allocation just drop out from the sector and currency decision. With the global 6-month credit impulse now indisputably in a mini-downswing phase (Chart I-12), the classically cyclical sectors are likely to continue underperforming for the next few months; the rise in bond yields faces resistance; and the euro - at least on a trade-weighted basis - has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. Chart I-12The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Finally, in terms of regional equity allocation, Investment Reductionism implies a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* In addition to the fundamental arguments in the main body of this report, fractal analysis finds that the outperformance of Oil and Gas relative to other commodity equities is technically extended. Hence, this week's trade recommendation is to underweight euro area Oil and Gas versus global Basic Materials. Set a profit target of 5%, with a symmetrical stop-loss. In other trades, we are pleased to report that long USD/ZAR hit its 6% profit target, and is now closed. This leaves us with five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Short Euro Area Energy Vs. Global Basic Materials Short Euro Area Energy Vs. Global Basic Materials The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations