Developed Countries

Underweight We moved to a large over small cap preference last month, based on the exploding balance sheets of small cap equities. Our thesis was that the rapid increase in leverage would find its way into higher risk premia for small cap equities, necessitating a valuation derating. Small caps have since been outperforming owing to their inherent trade war insulation (top panel), implying the opposite has happened and risk premia have, in fact, decreased. The middle panel of the chart shows the cyclically adjusted relative price to earnings (CAPE) ratio. While on a forward earnings basis, small caps are trading at an elevated (but still within the realm of normal) 13% premium to large caps, on a cyclically adjusted basis, the premium has exploded near all-time highs, approaching 50%, well above the historical mean. This lofty relative CAPE multiple leaves small caps increasingly vulnerable to profit and debt related shocks and we reiterate our large cap bias.

Please note that we are also publishing a Special Report on Mexico. Highlights The selloff in EM financial markets has been induced by slowing global trade amid lingering poor EM fundamentals. The Federal Reserve's resolve to tighten is aggravating the situation but is not the main cause of the EM turmoil. Consequently, the necessary conditions for a reversal in ongoing EM turbulence are not the Fed turning dovish but rather a bottom in the global trade cycle and China's growth. The latter two are not on the horizon, and we therefore believe there is much more downside in EM risk assets and currencies. Feature In our trip to Asia last week, the majority of investors we met attributed the current emerging market (EM) selloff to Federal Reserve tightening and trade wars. While we are not suggesting that the Fed tightening or trade war rhetoric have not impacted EM risk assets, we do contend that these reasons are inadequate to explain the selloff. In our opinion, the EM selloff has as much been driven by a slowdown in global trade as by expectations of higher U.S. interest rates and other factors. Diagnosing the underlying bases of a market move correctly is instrumental in gauging its sustainability and an eventual reversal. If one believes that the EM selloff has been due to the Fed, it would require the Fed turning dovish for the selloff to halt and reverse. If, however, the EM carnage has been driven by slowing global trade, the necessary condition for a reversal would be a bottom in the global trade cycle. In such a case, a dovish turn by the Fed or a drop in U.S. bond yields in and of themselves are unlikely to be sufficient. While EM risk assets could rebound for a couple of weeks on lower interest rate expectations in the U.S., any rebound will prove to be short-lived, and EM will resume their downtrend. Assessing the dynamics of both financial markets and the business cycle has led us to conclude that the EM selloff has been not only due to Fed tightening and the U.S.-China trade confrontation, but even more so due to a slowdown in global trade. The latter has transpired even though U.S. economic growth remains very robust. Chart I-1 illustrates that EM currencies and sovereign spreads correlate well with global trade growth. Since the beginning of this year, global trade and EM manufacturing have been decelerating, despite ongoing strength in U.S. demand. This, in our opinion, has been the main reason for the selloff in EM risk assets. In fact, EM manufacturing PMI and EM non-financials' corporate profit growth have rolled over since early this year, explaining widening in EM credit spreads (Chart I-2). Chart I-1EM Cracks Have Opened As Global Trade##br## Has Begun Slowing Down Chart I-2Slowdown In EM Corporate Profits ##br##Explains Widening Of EM Credit Spreads In turn, Chart I-3 demonstrates that the correlation between EM corporate spreads and share prices on one hand and U.S. bond yields on the other is rather loose. Notably, U.S. bond yields are at the same level they were in early April when the EM-centred selloff began. Meanwhile, EM equity and credit markets have diverged from their U.S. peers since early April (Chart I-4). Chart I-3EM Risk Assets And U.S. Bond Yields: ##br##Loose Correlation Chart I-4The Recent Divergence##br## Between EM And U.S. In this context, an important question is as follows: Why are EM economies and financial markets more vulnerable to rising U.S. borrowing costs than the U.S. itself? In reality, the American economy, stock market and corporate credit should be more exposed to Fed tightening than EM economies and financial markets. Yet the U.S. economy, stocks and corporate credit market have so far weathered rising borrowing costs quite well. Most interest rate-sensitive segments such as mortgages for home purchases and the junk corporate credit market have remained resilient. Historically, the correlation between EM risk assets and the Fed funds rate has been mixed - albeit more positive than negative (Chart I-5). On this chart, we shaded the periods when EM stocks rallied despite rising Fed funds rate. Chart I-5EM Stocks And Fed Tightening Cycles The episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals - elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Chart I-6The 1997/98 EM Crises Pushed U.S. Bond Yields Lower Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-'98. These late 1990 EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields (Chart I-6). In contrast, EM stocks, credit markets and currencies did well during a period of rising Fed funds rate in 1988-89, 1999-2000, and 2017 as illustrated in Chart I-5. Altogether, we conclude that rising U.S. interest rates in and of themselves are not a sufficient condition for EM to sell off. Only in combination with poor EM fundamentals and a weakening global business cycle are rising U.S. borrowing costs negative for EM financial markets. EM fundamentals have been and remain indigent since early this decade. The 2016-'17 rally in EM was due to improving global growth. Yet the global business cycle has rolled over since early this year. This, in combination with lingering weak fundamentals throughout EM and the Fed's tightening, has produced the current EM selloff. All in all, the ongoing selloff in EM risk assets has been mainly due to the slowdown in global trade/business cycle. When global trade expands, weak parts of the chain do well. Conversely, when global trade growth dwindles, these same weak links are the first to break. As we have argued repeatedly, EM fundamentals have remained destitute in spite of 2016-17 rally. Indeed as soon as global trade began decelerating, the weakest parts of the global chain cracked. Specifically, China's import volumes for many raw materials and commodities have decelerated significantly (Chart I-7A and Chart I-7B). Imports of consumer goods, machinery, and transport equipment remain strong (Chart 7A, bottom panel). We believe it is a matter of time before the ongoing slowdown in credit and capital spending brings about weaker imports of industrial goods and machinery. Chart I-7AChina: Imports Volumes Have Been Slowing Down Chart I-7BChina: Imports Volumes Have Been Slowing Down Even though consumer spending in China remains robust, it has had a limited impact on the global economy in general and the rest of EM in particular. Most consumer goods and services that Chinese households buy are produced and sold domestically by mainland companies. In short, China's impact on EM and the rest of the world are primarily via its imports of commodities/raw materials and industrial goods, which are very vulnerable. On-shore listed Chinese stocks are also signaling that a pronounced growth deceleration is underway. Even though the MSCI China investable equity indexes remain elevated, their onshore peers have plunged. Chart I-8A and 8B demonstrate that China's onshore listed stock prices - large cap, small cap and many sectors - have plunged to or below their early 2016 lows. Chart I-8AChinese Share Prices: Onshore And Offshore Markets Chart I-8BChinese Share Prices: Onshore And Offshore Markets Chart I-9New Cyclical Lows For EM Relative Performance This downbeat message from Chinese onshore equity prices along with the recent sharp depreciation of the RMB corroborate that the mainland growth slowdown is gaining speed, which in turn argues for a bearish outlook for EM financial markets. Bottom Line: Our diagnosis is that the selloff in EM financial markets has been induced by slowing global trade and China's growth deceleration amid lingering poor EM fundamentals. The Fed's resolve in tightening is aggravating the situation, but it is not the main cause behind the EM turmoil. Consequently, the necessary conditions for a reversal of the ongoing EM turbulence are not the Fed turning dovish but a bottom in the global trade cycle and Chinese growth. The latter two are not on the horizon, and we therefore posit there is much more downside in EM risk assets and currencies. EM relative equity performance versus DM has broken to new cycle lows for the small-cap and equal-weighted indexes (Chart I-9, top and middle panels). The market cap-weighted overall index will likely be heading to new lows for this cycle too (Chart I-9, bottom panel). Investors should stay short/underweight EM risk assets. Our recommended country allocation is presented below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Wage inflation in the EU28 is running at exactly the same rate as in the U.S. In the euro area, it is only modestly lower. As the current business cycle completes, the euro area versus U.S. bond yield spread will narrow, one way or the other. European equities are structurally handicapped by their substantial underexposure to technology, their substantial overexposure to financials, and the structurally undervalued currency. Still, there will be phases in which financials outperform technology and therefore in which European equities outperform. We anticipate that the next such phase to overweight European equities will occur later this year. In the near term, one European stock market that could outperform is Switzerland's SMI. Feature Largely unnoticed and without great fanfare, Europe has just overtaken the U.S. on a very important labour market measure. For the first time in living memory, the percentage of the working age (15-64) population that is in the labour force is higher in Europe than it is in the U.S., for both men and women (Chart of the Week). Chart of the WeekMale Labour Force Participation Is Now Higher In Europe Than In The U.S. One putative explanation is that as U.S. baby boomers have aged, people older than 64 have chosen to remain in the labour force, which has indirectly weighed on the U.S. 15-64 participation rate. But the phenomenon of baby boomers staying in the workforce is common to both Europe and the U.S. and cannot explain the extent of outperformance in European labour participation - a ten percentage point catch-up since the start of this millennium (Chart I-2). Chart I-2Labour Force Participation Is Now Higher ##br##In Europe Than In The U.S. The true explanation is that the European female participation rate has been in a major structural uptrend (Chart I-3) while the U.S. male participation rate has been in a major structural downtrend (Chart I-4). Chart I-3European Female Labour Force Participation##br## Is In A Structural Uptrend Chart I-4U.S. Male Labour Force Participation##br## Is In A Structural Downtrend Misleading Comparison 1: The Unemployment Rate In Europe Vs The U.S. This week, our purpose is not to discuss the reasons behind these labour participation trends - as we covered these in our recent report How Women Are Powering The European Economy.1 Rather, we want to point out one important repercussion: when the participation rate is changing, the unemployment rate is a misleading measure of labour market slack. When labour participation is rising, a seemingly high unemployment rate overstates true slack; conversely, when labour participation is falling, a seemingly low unemployment rate understates true slack. To understand why, consider a population in which the numbers employed, unemployed, and officially inactive stand at 95:5:25. The unemployment rate is 5%. But let's assume that ten officially inactive people could, with some mild encouragement, participate in the formal labour market. This means the true slack is fifteen people, or 14%.2 Now imagine that five of the officially inactive people join the formal labour force, albeit with a slightly higher unemployment rate given their inexperience in the formal labour force. Under these circumstances, the numbers employed, unemployed, and officially inactive might reasonably change to 99:6:20. The unemployment rate has increased to 5.7%, suggesting slack has increased. But the truth is that slack has actually decreased to eleven people, or 10%.3 Clearly, the process also works the other way. If somebody leaves the formal labour force, it might depress the unemployment rate, giving the impression of a tight labour market. But the impression would be misleading. As a recent paper from the Federal Reserve Bank of Boston pointed out:4 "Informal work arrangements, such as gig economy jobs... embodies an economically significant amount of labour market slack that is not captured in the U-3 unemployment rate and other standard estimates of slack... Informal work can be viewed as slack because most informal work participants would drop informal work for formal work, (thereby) adding potential labour supply to the formal market that could reduce pressure on measured wages" Is there any direct evidence for this thesis? Yes, the evidence is compelling. Standard measures of slack, such as the unemployment rate, suggest that the labour market has substantially more slack in Europe than in the U.S. (Chart I-5). Yet wage inflation is running at exactly the same rate in the EU28 as in the U.S. (Chart I-6). And in the euro area, it is only modestly lower (Chart I-7). Chart I-5The Unemployment Rate Suggests Much More ##br##Slack In Europe Than In The U.S. ... Chart I-6...But Wage Inflation ##br##Is Identical! Chart I-7Euro Area Wage Inflation##br## Is Not Far Behind This brings us to a glaring structural anomaly which must eventually correct. The gulf in monetary policy between the ECB and the Fed - reflected in the bond yield spread - has become unsustainably stretched relative to the economic fundamentals, specifically the difference in wage inflation which in reality is very modest (Chart I-8). As the current business cycle completes, we expect this bond yield spread to narrow, one way or the other. Chart I-8The U.S.-Euro Area Bond Yield Spread Is Stretched ##br##Relative To The Wage Inflation Differential Misleading Comparison 2: Equity Valuations In Europe Vs The U.S. Staying on the theme of Europe versus U.S. comparisons which are highly misleading, let's share one of the most common questions we get: are European equities relatively cheap, as their headline valuation suggests? The answer is an emphatic no. Compared with currencies and bonds, mainstream stock markets have little connection with the economies of their countries or regions of domicile. Mainstream stock markets are just collections of multinational companies, with each stock market defined by its own unique sector fingerprint. Sectors with vastly different structural growth prospects - say, financials and technology - must necessarily trade on vastly different valuations. So the sector with the lower headline valuation is not necessarily the cheaper sector. By extension, the stock market with the lower headline valuation because of its sector fingerprint is not necessarily the cheaper stock market. This means that a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is highly misleading. To which, a frequent follow-up question is: within the same sector, are European companies cheaper than their counterparts elsewhere in the world? The answer is, not necessarily. To understand why, consider the international cruise company Carnival which has a dual listing, one in London, one in New York. The London listing has recently traded at a substantial discount to the New York listing (Chart I-9 and Chart I-10). Does this mean that the London listing is cheap? Of course not. If it were, the markets would arbitrage away this valuation anomaly instantaneously! Chart I-9Carnival Can Trade On A Different Valuation##br## In London And New York... Chart I-10...Because Of The Currency##br## Translation Effect On the face of it, the valuations of Carnival's two listings should be the same because the underlying company is the same. However, the London and New York valuations can deviate substantially because of the so-called 'currency translation effect'. An international company like Carnival will intentionally receive its sales and profits across multiple global currencies - say, dollars and pounds, but a stock market listing is denominated in just one currency. If investors anticipate the dollar ultimately to weaken versus the pound - because they see that the pound is structurally cheap today - they might downgrade Carnival's multi-currency profit growth expectations in pound terms. Thereby, the London listing will trade at a discount to the New York listing. But the discount is a false impression. Allowing for the anticipated decline in the dollar versus the pound, the London listing is not cheap. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. European Equity Relative Performance Has Little Connection With European Economic Relative Performance Given the large distortions to stock market valuations from sector effects and currency translation effects, picking markets on the basis of relative valuation is a very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express. This creates a paradox. The overall economic fundamentals in Europe, correctly measured, are not inferior to those in the United States. Yet European stock market relative performance has very little to do with Europe's relative economic performance. European equities are structurally handicapped by their substantial underexposure to technology, their substantial overexposure to financials, and the structurally undervalued currency. Unfortunately, this will necessarily weigh on their long-term relative performance prospects. Still, there will be phases in which financials outperform technology and therefore in which European equities outperform other major markets. We anticipate that the next such phase to overweight European equities will occur later this year. In the near term, one European stock market that could outperform is Switzerland's SMI. Given its overweighting to healthcare - Novartis and Roche - and healthcare's outperformance this year, the SMI should have fared well in the first half. However, this tailwind was countered by a stronger headwind - the SMI has a huge underweight to oil and gas, which is the one cyclical sector that has outperformed. But as we pointed out last week, the performance of oil and gas equities is technically stretched, and will require strong momentum in the crude price to extend further. Therefore, we like the combination of overweight healthcare, underweight oil and gas - which is precisely what Switzerland's SMI offers (Chart I-11). Chart I-11Switzerland = Long Healthcare, Short Energy Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report, 'How Women Are Powering The European Economy' dated June 7, 2018 available at eis.bcaresearch.com 2 5/(95+5) = 5%, (5+10)/(95+5+10) = 14% 3 6/(99+6) =5.7%, (6+5)/(99+6+5) = 10% 4 The Federal Reserve Bank of Boston Current Policy Perspectives No. 18-2 'Wage Inflation and Informal Work' by Anat Bracha and Mary A. Burke, October 2017. Fractal Trading Model This week we note that the outperformance of consumer services versus consumer goods is technically stretched. The 65-day fractal dimension is at a limit that has reliably signalled reversals. The recommended trade is short global consumer services versus consumer goods. Set a profit target of 2.5% with a symmetrical stop-loss. 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-12 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Underweight Carnival Corp, the largest cruise line operator, saw its share price plunge Monday after it dropped its earnings guidance range to absorb the impact of rapidly rising fuel costs. This share price drubbing dragged the other cruise line operators and the overall index down with it; relative performance of the S&P hotels, resorts and cruise lines index is now at a year low (top panel). Rising fuel costs can be transitory and, accordingly, are not the reason we initiated and maintain our underweight rating on the index. Rather, we believed the outperformance of cruise lines in 2017 had reached a peak (second panel) as margin gains from rising occupancy rates had crested (third panel) and eventually a capacity growth cycle would have to begin anew with all the associated negative margin implications. A grim outlook in the hotels side of the index does not temper our negativity; pricing has recently pulled out of deflation but huge capacity additions should make any gains temporary (bottom panel). Overall, we reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN, NCLH.

Neutral The specter of Netflix, as well as other tech giants circling the space, has accelerated an inter- and intra-industry consolidation (second panel). We were well positioned for this shake up in the space as we went underweight the media complex in early March. But now, we deem that the easy money has been made and most of the negative narrative is reflected in bombed out relative valuations (bottom panel). While our sense is that pipelines (S&P cable & satellite index) are the likely losers and content providers (S&P movies & entertainment) are the likely winners from the ongoing broad media deck reshuffling, the way we are executing the S&P media upgrade to neutral is by lifting both the S&P cable & satellite and S&P movies & entertainment sub-indexes to neutral. Bottom Line: We booked relative profits of 13.5% in the S&P cable & satellite index and a relative loss of 8.3% on the S&P movies & entertainment index when we moved both to a benchmark allocation on Monday. Please see our Weekly Report for more details. The ticker symbols for the stocks in the S&P cable & satellite and S&P movies & entertainment indexes are: BLBG: S5CBST - CMCSA, CHTR, DISH and BLBG: S5MOVI - DIS, FOXA, FOX, VIAB, respectively.

NOTE: We will not be publishing a report next week. The next Global Fixed Income Strategy Weekly Report will be published on Tuesday, July 10th. Highlights Global Corporates: The clash between monetary policy and the markets that we have been expecting to unfold in 2018 is upon us. Downgrade global spread product exposure to neutral (3 of 5) from overweight, and raise government bond exposure to neutral. Maintain a below-benchmark portfolio duration, however, as global bond yields have not yet peaked for this cycle. Country Allocation: Move to neutral on U.S. investment grade and high-yield corporates, while staying underweight (2 of 5) on euro area corporates. Downgrade emerging market hard currency sovereign and corporate debt to maximum underweight (1 of 5) - the combination of a rising dollar, Fed tightening and slower Chinese growth will remain a huge problem for emerging market assets. Feature Chart Of The Week3 Big Reasons To Downgrade Spread Product Last week, BCA as a firm moved to a less positive stance on global equities and credit, downgrading both to neutral from overweight on a cyclical (6-12 month) horizon.1 Dating back to our 2018 Outlook published at the end of last December, we had anticipated that we would be shifting to a less aggressive asset allocation sometime around mid-year.2 The expected trigger would be a move by central banks to a more restrictive policy stance that would start to impact future growth expectations. That time has come, and we are now recommending moving to a less bullish stance on global credit. Many of the tailwinds that supported the stellar performance of risk assets in 2017 - most importantly, coordinated global growth, accommodative monetary policies and a weakening U.S. dollar - have transformed into headwinds over the course of 2018 and are unlikely to reverse before risk assets suffer a setback (Chart of the week). At a minimum, there is now enough uncertainty, at a time when many asset classes are richly priced, to make the risk/reward balance for being long growth-sensitive assets like equities and corporate debt less attractive. This week, we are downgrading our recommended stance on global spread product to neutral (3 out of 5) from overweight, while upgrading our recommended allocation for government bonds to neutral from underweight. This represents an unwind of a long-standing recommendation that dates back to January 31st, 2017 when we strategically downgraded U.S. Treasury exposure and upgraded U.S. corporate debt.3 We are closing that recommendation at a relative total return gain of 2.3% for U.S. investment grade and 6.7% for U.S. high-yield over Treasuries (Chart 2). Chart 2Closing A Successful Overweight Stance ##br##On U.S. Corporates We still believe that global bond yields will remain under upward pressure from both higher inflation and a less favorable supply/demand balance for fixed income (more issuance, less central bank buying). The fact that bond yields will NOT be able to fall much to reinvigorate softening global growth - because of rising inflation at a time of diminished economic slack - is a critical reason why we are turning more cautious on global credit. Thus, we are maintaining our recommended below-benchmark overall portfolio duration stance, even as we upgrade our government bond allocation to neutral. We recommend placing the proceeds of a reduction of global corporate debt exposure into shorter-maturity government bonds, which we are doing in our model bond portfolio (see page 15). At the country level, we are downgrading U.S. corporate bonds, both investment grade and high-yield, to neutral from overweight. We still are of the view that U.S. corporates are better positioned to outperform non-U.S. credit, however, even in a more challenging environment for credit returns. Thus we are keeping our recommended underweight allocations to euro area corporate debt (2 out of 5 for both investment grade and high-yield). We see a much nastier backdrop brewing for emerging markets (EM), however - a stronger dollar, higher U.S. interest rates, slowing Chinese growth, diminished global capital flows - so we are downgrading both EM hard currency sovereign and corporate debt to maximum underweight (1 out of 5). In terms of other spread product categories, we are maintaining our neutral allocation to U.S. mortgage-backed securities, while downgrading U.K. and Canadian corporate debt to underweight. For those that can invest in U.S. muni debt, we are upgrading that sector to overweight (4 out of 5). The Reasons To Cut Corporate Credit Exposure Now Global credit has not performed well in the first half of 2018, with only U.S. high-yield corporates providing a positive return year-to-date among the major markets: U.S. investment grade: -3.6% total return, -1.7% excess return over duration-matched Treasuries U.S. high-yield: +0.7% total return, +1.5% excess return Euro area investment grade: -0.3% total return, -1.1% excess return Euro area high-yield: -0.5% total return, -1.0% excess return EM USD-denominated sovereign debt: -5.5% total return, -3.6% excess return EM USD-denominated corporate debt: -2.9% total return, -1.7% excess return Chart 3The Start Of Something Big? While there have been plenty of geopolitical tensions for markets to fret over this year (U.S. trade policy, North Korea), the biggest reason for the underperformance of credit is due to the most typical of reasons - tightening global monetary policy. One way to measure the stance of monetary policy is to look at the slope of government bond yield curves. According to the Bloomberg Barclays government bond index data, the "global yield curve" - the spread between the Global Treasury index yield for the 7-10 year and 1-3 year maturity buckets - is now a mere 6bps (Chart 3). That is the flattest the global curve has been since the first quarter of 2007. That is a potentially ominous sign given that the Global Financial Crisis began brewing around the same time. The global yield curve became deeply inverted in the late 1990s, as well, which preceeded the 1998 EM crisis and, later, the global telecom bust. Fundamentally, we see four main reasons to downgrade global credit now: 1. Global growth is slowing and becoming less synchronized The first half of 2018 has seen a deceleration of global economic activity from the robust pace of 2017. This has been a broad-based cooling of activity so far, with cyclical indicators like manufacturing PMIs still well above the 50 level that suggests expanding growth in all major economies. Yet there are signs that the pullback in growth may persist throughout 2018 and into 2019. The OECD's global leading economic indicator (LEI) is rolling over and our LEI diffusion index - a leading indicator of the LEI - suggests additional weakness should be expected. This is significant for credit markets, as returns on corporate bonds are highly correlated to the swings in the global LEI (Chart 4). This is true even in the U.S., which is bucking the slowing global growth trend and where confidence is booming and domestic leading indicators are accelerating (Chart 5). Chart 4Corporate Bonds Follow The Global LEI Chart 5Upside Risks For U.S. Growth That easing of non-U.S. growth is likely rooted in the slowdown underway in China. Policymakers there have been tightening monetary conditions and acting to reign in excessive debt growth. This has resulted in a slowing of overall economic growth after the stimulus-fueled boom in 2016 that helped kick-start global growth last year through robust Chinese imports and consumption of industrial commodities. Given the sheer size of Chinese demand, the global economy will look very different when Chinese imports are growing at a 30% pace rather than the current pace below 10%. Our most reliable forward-looking indicators for Chinese growth, like our Li Keqiang leading indicator, are calling for additional cooling of Chinese economic activity in the latter half of 2018 (Chart 6). This reinforces the signal given by our global LEI diffusion index, with both indicating that additional struggles in the performance of global credit markets should be expected (based off the relationship shown in Chart 4). One additional point: the ongoing trade tensions between the Trump administration and all of the major U.S. trading partners represents an additional potential downside risk to global growth. The story is still quite fluid, as it always is with this president, but the uncertainty created by the trade frictions is definitely a negative for risk assets, at a minimum. 2. Global inflation pressures are rising, most notably in the U.S. Even with the latest dip in non-U.S. growth, the global economy is still operating with the least amount of spare capacity since the mid-2000s boom. The U.S. unemployment rate is down to 3.8%, the lowest level in eighteen years. 75% of OECD countries now have unemployment rates below the OECD's estimate of the full-employment NAIRU, with capacity utilization rates also rising. The pricing backdrop is as healthy as it has been since 2011, according to the measure of world export prices from the Netherlands-based Bureau for Economic Policy Analysis which is now growing at a 10% annual rate (Chart 7). Chart 6Downside Risks For Chinese Growth Chart 7A More Inflationary Global Backdrop, Especially In The U.S. The previous two times export prices grew that rapidly in 2008 and 2011 - two very challenging years for financial markets - global CPI inflation rates expanded rapidly, especially in the U.S. Headline CPI inflation ended up reaching peaks of 6% and 4%, respectively, during those prior two episodes. Non-U.S. inflation rates also accelerated, but not to the same degree as in the U.S. A similar dynamic is playing out in 2018, with U.S. inflation rates accelerating (both headline and core), at a faster pace than in the other major developed economies. With the U.S. labor market growing tighter each month, and with U.S. growth likely to continue expanding at an above-potential pace for the next few quarters, it is unlikely that the current upturn in U.S. inflation will slow on its own. This will ensure that the Fed will continue on its planned monetary tightening path that will soon take U.S. monetary conditions into restrictive territory - eventually weighing on U.S. growth expectations and raising concerns over future downgrade and default risks, and returns, in U.S. corporate bond markets. 3. Growth and monetary policy divergences will continue to boost the value of the U.S. dollar The divergences between growth, inflation and monetary policy in the U.S. and the rest of the world are now helping raise the value of the U.S. dollar, which had declined nearly 10% on peak-to-trough basis in 2017. The dollar has been rising in 2018, which has been weighing on EM currencies and financial markets as is typically the case during periods of dollar strength. EM economies have been rapidly accumulating dollar-denominated debt in recent years, leaving EM borrowers as highly exposed to the swings in the dollar and interest rates as they have been since the late 1990s. The current backdrop is setting itself up for a repeat of the 2015/16 period when pro-U.S. growth divergences caused the dollar to soar and triggered major selloffs in EM financial assets that spilled over into U.S. and developed market equities and credit (Chart 8). Right now, the moves have been far more modest than seen in the 2015/16 period. Since the start of 2018, the U.S. trade-weighted dollar is up 4% and EM equities are down -6% (in U.S. dollar terms), while U.S. investment grade credit spreads have risen 37bps from the February lows. This is far less than the moves seen in 2015/16, where the dollar rose 16%, EM equities sold off -34% and U.S. credit spreads widened nearly 100bps. Those moves were enough to cause the Fed to delay its rate hike plans after the initial post-QE rate hike in December 2015, triggering a significant decline in U.S. bond yields (bottom panel) and the dollar that eventually stabilized global financial markets. With the U.S. economy in a much healthier position today than two years ago, and with U.S. core inflation running close to the Fed's 2% target, it will take much larger market moves than have been seen of late before the Fed would consider taking a pause on its current 25bps-per-quarter pace of rate hikes. The mechanism for that to happen will be a stronger dollar and any associated impact on U.S. financial markets. However, it must be a very large move (as it was in 2015/16) to have enough of a negative impact on the U.S. economy, U.S. corporate profits or U.S. inflation for financial markets, and the Fed, to take notice. In Chart 9, we show the U.S. trade-weighted dollar with three different scenarios for the change in the currency to the end of 2018: flat, up 5% and up 10%. We show the dollar in level terms in the top panel, while showing the year-over-year growth rate of the dollar (on an inverted scale) in the bottom three panels. In those last three panels, we also show the potential areas where a strong dollar would impact the U.S. economy the most: net exports, corporate profit growth from earnings earned outside the U.S. (using top-down profit data) and headline inflation. Chart 82015/16 Revisited? Not Yet Chart 9A Much Stronger USD Is Needed To Impact U.S. Growth & Inflation The charts show that a 10% rise in the dollar by year-end would likely take enough of a bite out of U.S. growth and inflation for U.S. equity and credit markets to sell off and for the Fed to take a pause on its rate hike plans. A more modest 5% rise in the dollar will have a more muted impact, especially with stronger underlying U.S. growth and inflation pressures than was the case in 2015/16. That latter scenario of a more moderate rise in the dollar would be our most likely scenario - one that would prove to be challenging for U.S. credit market performance. The dollar increase would be enough to keep EM financial markets on the defensive, but would not be large enough to get Fed rate hikes out of the way and allow for a big decline in Treasury yields that would help support risk assets. A slowly rising dollar is another reason to reduce credit exposure in fixed income portfolios. 4. Central bank liquidity provision through asset purchases is slowing rapidly One of our major themes for 2018 has been that the removal of the extraordinary liquidity expansion by central banks would weigh on asset returns. This would occur through the Fed allowing maturing bonds accumulated during its QE program to begin running off its balance sheet, and through a slower pace of bond buying in the case of the European Central Bank (ECB) and the Bank of Japan (BoJ). Already, the increase in developed market bond yields, and the lowering of returns in global equities and credit, have largely followed the path laid out by our indicator of central bank liquidity provision - the annual growth in the balance sheets of the Fed, ECB, BoJ and Bank of England (Chart 10). Our central bank liquidity indicator suggests that there is still more upside for global government bond yields as central banks become less directly active in bond markets. At the same time, the diminished liquidity growth means there is less investor money to be forced out of risk-free government bonds into risky assets like corporate credit, which should help erode credit market returns on the margin. This will occur through reduced inflows into credit that are just chasing yield, and a return to more fundamental drivers of credit market valuation like growth, inflation, leverage and downgrade/default risks - all of which are now on the rise in the U.S. Bottom Line: The clash between monetary policy and the markets that we have been expecting to unfold in 2018 is upon us. Tightening monetary policies, rising bond yields, slowing global growth, widening growth divergences, increasing U.S. inflation pressures, a strengthening U.S. dollar, emerging market instability, diminished central bank liquidity, reduced global capital flows, global trade tensions - all are now creating a backdrop that is more challenging for risk assets. Downgrade global spread product exposure to neutral (3 of 5) from overweight, and raise government bond exposure to neutral. Maintain a below-benchmark portfolio duration, however, as global bond yields have not yet peaked for this cycle. Asset Allocation Decisions To Be Made So in terms of our fixed income asset allocation recommendations, but in our strategic tables on page 16 and our model bond portfolio on page 15, we are making the following changes: Downgrade U.S. Investment Grade & High-Yield Corporates To Neutral (3 out of 5) The bulk of our primary indicators for U.S. credit are at levels that are consistent with a neutral allocation (Chart 11). Our top-down Corporate Health Monitor is right at the line dividing the deteriorating health and improving health regimes (although this is only because of a cyclical improvement in some of the underlying indicators). U.S. monetary policy is close to neutral, as measured by the real fed funds rate versus the Fed's r-star estimate. The U.S. Treasury curve is very flat, although it is not yet inverted as typically precedes the end of a credit cycle. Finally, bank lending standards are only modestly in "net easing" territory according to the Fed's senior loan officer survey. Chart 10Fading Impact Of Global QE On Bond Markets Chart 11Downgrade U.S. IG & HY Corporates To Neutral With all these indicators hovering around neutral levels, a neutral allocation to U.S. corporates seems justified. Additionally, we recommend cutting across all credit tiers for both investment grade and high-yield, rather than focusing on cutting a specific tier more than another. Our preferred valuation metric - the 12-month breakeven spread relative to its history - is near the bottom quartile for all credit tiers (Charts 12 & 13) without one looking particularly more expensive than the others. Chart 12Not Much Of A Spread Cushion In U.S. Investment Grade ... Chart 13... Or U.S. High-Yield Keep Euro Area Investment Grade & High-Yield At Underweight (2 out of 5) We have maintained this strategic view based on the convergence between our top-down Corporate Health Monitors for both the U.S. and euro area. Right now, the cyclical improvement in U.S. financial metrics has come at the same time as a cyclical deterioration of euro area metrics from very healthy levels (Chart 14). The spread between the two Monitors has proven to be a good directional indicator for the relative performance between U.S. and euro area credit. That spread continues to point to additional expected outperformance by U.S. corporates, even in an overall more challenging environment for global credit markets. Throw in increased Italian political turmoil, softer euro area growth and the upcoming ECB tapering of its asset purchases - which will include corporate debt that the ECB has been buying steadily for the past three years - and the case for underweighting euro area corporates, especially versus U.S. equivalents, is a strong one. Downgrade EM Hard Currency Sovereign & Corporate Debt To Maximum Underweight (1 out of 5) We have been favoring U.S. investment grade credit over EM credit the past several months. The growth divergence between the U.S. and EM has been widening, while EM market valuations had gotten very rich. Now, EM spread widening is starting to correct that mis-valuation, although is still early in the process. The spread differential between U.S and EM credit is a good leading indicator of the relative returns between the two asset classes (Chart 15), thus last year's EM outperformance is leading to this year's underperformance. Chart 14Stay Underweight Euro Area Corporates Chart 15Move To Maximum Underweight EM Credit We wish to maintain the same "two notch" gap between our recommended level of U.S. and EM credit exposure, so by downgrading U.S. corporates to neutral (3 of 5), we must downgrade EM corporates to maximum underweight (1 of 5). All of the above changes will be reflected in our model bond portfolio on page 15. One final point - we should lay out the case for out next move from here. If the Fed tightening cycle goes as we envision it will, with U.S. growth staying strong and inflation expectations rising back to levels consistent with the Fed's inflation target, then we expect the next move will be to downgrade U.S. corporates to underweight. However, if there is enough of a market setback to cause the Fed to delay its rate hike cycle, as was the case in 2016, then we may consider moving back to overweight U.S. corporates on a tactical basis. We suspect, however, that the moves today are the beginning of the end game for the current credit cycle - the negatives for corporates are now outweighing the positives, and that gap is likely to get wider in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19th 2018, available at gis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure", dated January 31st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Global Growth: The risk to U.S. financial markets from global growth divergences and increasingly hawkish trade policy is rising, and it is unlikely to be resolved without a market riot. Credit Cycle: Valuation is expensive and indicators of monetary conditions suggest we are very late in the cycle. Both factors suggest that excess returns to corporate bonds will be meager, even if recession is avoided. Given concerns about global growth, the risk/reward trade-off favors a more defensive allocation to spread product. Corporate Leverage: Profit growth has just barely kept pace with debt growth during the past few quarters and will likely moderate as wage costs accelerate in the second half of the year. The resultant increase in leverage will pressure corporate bond spreads wider. Feature Table 1Recommended Portfolio##br## Specification Last week we sent a Special Report to all BCA clients advising them to cyclically reduce exposure to risk assets (equities and corporate bonds), moving from an overweight allocation to neutral.1 For U.S. bond portfolios, we recommend that investors adopt a neutral allocation to spread product versus Treasuries, while also upgrading the more defensive municipal bond sector at the expense of corporate credit. We also advise investors to maintain below-benchmark portfolio duration (Table 1). In this week's report we explain the rationale for these portfolio changes. Specifically, we run through our favorite credit cycle indicators, which we split into three categories: valuation, monetary conditions and credit quality. The message from the indicators is that it is still somewhat too soon to expect rising corporate defaults and sustained spread widening. However, the indicators also suggest that we are very late in the cycle and return expectations should be quite low. Put differently, the expected excess return from overweight corporate bond positions no longer justifies the risk of staying overweight for too long. This is particularly true given the ongoing slowdown in global growth and escalating tit-for-tat trade war. Neither of which is likely to be resolved without some market pain. Credit Cycle Indicators Valuation While value in the investment grade corporate bond space has improved somewhat since January, the sector remains expensive relative to history. Chart 1 shows the 12-month breakeven spread for each investment grade credit tier as a percentile rank for the period between 1996 and today.2 According to this measure, investment grade corporate bonds are about as expensive as they were in 2006/07, just prior to the 2008 recession and default cycle. Chart 2 shows the same valuation measure for the high-yield credit tiers. High-Yield spreads are somewhat wider than 2006/07 levels, though they are still quite low relative to the post-1996 timeframe as a whole. One critical difference between the late stages of the last credit cycle (2006/07) and the current environment is that corporate balance sheets are now in significantly worse shape. If we adjust for this by dividing the 12-month breakeven spread by our preferred measure of gross leverage we see that high-yield valuation now looks similar to 2006/07 levels, while investment grade credit looks significantly more expensive (Chart 3). Chart 1Investment Grade Valuation Chart 2High-Yield Valuation Chart 3Leverage-Adjusted Value These valuation measures do not suggest that spreads are about to widen. It is clear from the charts that valuation can remain expensive for long periods of time, particularly in the late stages of the credit cycle. However, the indicators do tell us that return expectations should be low relative to history and that relatively little spread widening is required before corporate bonds see losses relative to duration-matched Treasuries. All else equal, our threshold for moving out of corporate credit should be low. Monetary Conditions Chart 4Inflation Indicators We place a great deal of importance on monetary indicators for timing allocation shifts into and out of corporate bonds. The reason relates to our understanding of the Fed Policy Loop.3 When inflation is far below target, the central bank has a strong incentive to nurture economic growth. This means it will be quick to respond to any relapse in financial markets that might eventually lead to an economic slow-down. Credit spreads are unlikely to widen meaningfully in these environments of low inflation and a responsive Fed. However, as inflation approaches target the central bank's reaction function starts to change. It becomes marginally more concerned with preventing an overshoot of the inflation target and marginally less concerned with supporting economic growth. It will therefore be more willing to tolerate some widening in credit spreads before responding with a dovish policy action. With that in mind, we monitor three inflation indicators to help us determine when inflation is strong enough to significantly impair the "Fed put" on credit spreads. They are (Chart 4): Re-anchored long-dated TIPS breakeven inflation rates, within a range between 2.3% and 2.5%. The St. Louis Fed's Price Pressures Measure above 15%. Year-over-year core PCE inflation above 2%. Long-maturity TIPS breakeven inflation rates have increased significantly during the past year, but have not quite hit our target range. The 10-year TIPS breakeven inflation rate currently sits at 2.11% and the 5-year/5-year forward TIPS breakeven inflation rate currently sits at 2.17%. Similarly, the St. Louis Fed's Price Pressures Measure, an aggregate economic indicator designed to measure the percent chance that inflation exceeds 2.5% during the next 12 months, currently sits at 13%. This is only just below the 15% threshold that we have previously found to be correlated with significantly lower corporate bond excess returns (Table 2).4 Table 2Investment Corporate Bond Excess Returns* Under Different Ranges ##br##Of Price Pressures Measure** (January 1990 To Present) Finally, year-over-year core PCE inflation has not yet returned to the Fed's 2% target but appears to be on its way. The annualized 3-month rate of change has exceeded 2% in three of the past four months and the extreme tightness in labor markets and resultant wage pressures are likely to keep core inflation in a gradual uptrend going forward. Year-over-year core PCE inflation is very likely to reach the Fed's 2% target before the end of the year. All in all, inflation pressures suggest that investors' inflation expectations are not yet completely re-anchored around the Fed's 2% target, and probably have a bit more upside. However, we expect that all three of our inflation indicators will hit their key thresholds within the next few months. When we combine the fact that our inflation indicators are very close to sending a bearish signal for corporate bonds with our growing concerns about global growth and trade (see section titled "Global Growth Divergences: A Repeat Of 2015" below), we think it is prudent to start scaling back the credit risk in U.S. bond portfolios today. Another important indicator of monetary conditions is the slope of the yield curve. As Fed Chairman Jerome Powell explained at the last FOMC press conference, the yield curve is really about appropriate monetary policy. When it is very steep it signals that policy is currently accommodative and will tighten in the future. When it is inverted it signals that policy is restrictive and is likely to ease. Logically, when monetary conditions are close to neutral the yield curve will be very flat. The market will be uncertain about whether rates will rise or fall in the future. With that in mind we can split historical cycles into three phases based on the 3-year/10-year slope of the Treasury curve: (i) early in the recovery when the 3/10 slope is above 50 bps, (ii) the middle of the cycle when the 3/10 slope is between 0 bps and 50 bps, and (iii) late in the cycle when the 3/10 slope is inverted (Chart 5). Chart 5Corporate Bond Performance And The Yield Curve We find that corporate bond excess returns are highest early in the cycle when the yield curve is steep. Excess returns drop significantly once the 3/10 slope flattens to below 50 bps, and then turn negative once the yield curve inverts (Table 3). Table 3Risk Asset Performance In Different Yield Curve Regimes The 3/10 slope is currently 25 bps. We are firmly entrenched in the middle phase of the credit cycle where excess returns tend to be very low, though often still positive. Given the uncertainty surrounding when the yield curve will invert, sacrificing some small potential excess return by scaling back spread product exposure to neutral seems prudent. Credit Quality The final class of credit cycle indicators we track relates to the fundamental balance sheet health of the nonfinancial corporate sector. Chief among those indicators is our measure of gross leverage that we calculate as pre-tax profits divided by total debt. Typically, periods of rising gross leverage tend to coincide with corporate spread widening, and vice-versa. Alternatively, we can say that periods when profit growth is sustainably below the rate of debt growth tend to coincide with widening credit spreads (Chart 6). Using our most recent data, which extend only to the end of Q1 2018, profit growth has roughly kept pace with debt growth since the middle of 2016, resulting in relatively flat leverage. But this dynamic will probably not be sustained for much longer. While corporate revenue growth is strong, it cannot accelerate indefinitely. The ISM index is already peaking, and the recent bout of dollar strength will act as a headwind (Chart 7, panels 1 & 2). Chart 6Leverage Won't Stay Flat For Long Chart 7Watch Out For Rising Wages But more important is that tight labor markets are already putting upward pressure on wage costs and this wage acceleration is very likely to persist. Our Profit Margin Proxy, calculated as corporate selling prices less unit labor costs, already points to a moderation in profit growth in the second half of the year (Chart 7, panels 3 & 4). With profit growth very likely to moderate in the second half of the year, and given that it would be highly unusual for the rate of debt growth to decline meaningfully outside of recession, we expect corporate leverage to start rising again in the third and fourth quarters of this year. Bottom Line: The overall message from our credit cycle indicators is that we are very late in the cycle and expected excess returns to corporate bonds should be low. Given the risks to global growth on the horizon, it makes sense to turn more cautious on spread product. Global Growth Divergences: A Repeat Of 2015 Chart 8Global Growth Divergence Won't End Well From mid-2016 until a few months ago the global economy had benefited from a period of synchronized global growth, but that dynamic has now broken down. Leading indicators show that the large divergence between strong U.S. growth and weak growth in the rest of the world that was one of our key investment themes in 2014/15 has re-emerged (Chart 8). As in the 2014/15 period, the end result of divergent growth between the U.S. and the rest of the world is upward pressure on the U.S. dollar. This serves to tighten U.S. financial conditions at the margin, and exacerbates economic pain in emerging markets who have to contend with large balances of USD-denominated debt. Further, unlike in 2014/15, the global economy now has to deal with the imposition of tariffs and an escalating trade war that is unlikely to die down any time soon.5 Since the United States is a relatively large and closed economy, any moderation in global trade will be felt more acutely outside the U.S. But this only serves to increase global growth divergences and add to the upward pressure on the dollar. Eventually, as in 2015, we expect this divergence in growth and the resultant upward pressure on the dollar to culminate in a risk-off event in U.S. financial markets. At that point, the Fed will be forced to take notice and will likely pause rate hikes for a period of time. The Fed kept rate hikes on hold for an entire year following a similar market event in late 2015, but any future pause will probably not be as long. With inflation much closer to target than in 2015, the Fed will be reluctant to pause the rate hike cycle for more than a quarter or two. It is for this reason that we maintain below-benchmark portfolio duration even as we shift to a more defensive posture on spread product. The impact of divergent global growth will likely first be felt in credit spreads, and any knock-on impact to the pace of Fed rate hikes and Treasury yields could prove fleeting. Bottom Line: The risk to U.S. financial markets from global growth divergences and increasingly hawkish trade policies is rising, and is unlikely to be resolved without a market riot. Given meager expected returns in corporate bonds, it makes sense to get more defensive on spread product. Upgrade Municipal Bonds In addition to Treasuries, we also recommend allocating some of the proceeds from the corporate bond downgrade to tax-exempt municipals. As is shown in our Total Return Bond Map, municipal bonds are less risky than corporates and, depending on each investor's marginal tax rate, could offer reasonably high expected returns (Chart 9). Meanwhile, our Municipal Health Monitor remains entrenched below zero, suggesting that municipal ratings upgrades will continue to outpace downgrades, and net state & local government borrowing appears to be hooking down (Chart 10). Chart 9Total Return Bond Map (As Of June 21, 2018) Chart 10Municipal Health Still Improving In short, the current macro environment is much more negative for corporate credit quality than it is for municipal credit quality. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at www.bcaresearch.com/reports/view_report/25520/bca 2 We focus on the breakeven spread to adjust for changes in the average duration of the index over time. We calculate the 12-month breakeven spread as simply the index option-adjusted spread divided by index duration, ignoring the modest impact of convexity. 3 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2018, available at usbs.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, "Are You 'Sick Of Winning' Yet?", dated June 20, 2018, available at gps.bcaresearch.com

Highlights We have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range; when the economy is at full employment, stocks are more likely to sell off after these sideways periods than if there is still some slack in the labor market. Feature The outlook for global risk assets will likely be more challenging in the coming months. With that in mind, we have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. BCA still expects that the U.S. stock-to-bond ratio will grind higher in the next 12 months, as U.S. stocks move sideways and Treasury yields climb (Chart 1A and 1B). We recommend that investors put the proceeds from the sale of equity positions into cash. Chart 1AScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.80% Chart 1BScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.29% Within a fixed-income only portfolio, we are selling credit and putting the proceeds into Treasuries. We maintain our underweight duration stance given our view of the Fed and the 10-year Treasury. At 2.91%, the 10-year is still below BCA's view of fair value (3.29%). Moreover, BCA's position is that the Fed's gradual path of rate hikes is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels.1 On the credit side, we note that late in the cycle the yield curve is moderately flat, between 0 and 50 bps. Work by our U.S. Bond Strategy team2 shows that periods when the curve is flat are consistent with much lower excess returns than when the slope is above 50 bps (Chart 2). Given the low potential reward, a neutral posture on credit makes the most sense. Investors will not give up too much by starting to downgrade early. Tomorrow's U.S. Bond Strategy report will provide more details on the corporates versus Treasuries allocation. Chart 2Corporate Bond Performance And The Yield Curve BCA has recommended overweight positions in U.S. risk assets since spring 2009 when equities became attractive from a risk/reward perspective. At that time, the U.S. economy was weak, the Fed was easing, equity valuations were depressed and forward earnings estimates were dismal (Chart 3). In contrast, the risk/reward for risk assets today is much less attractive. The economy is in the late stages of an expansion and is running beyond full employment. The central bank is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (Chart 3 again). This means that good news is already priced into the equity market. When the Shiller PE, a measure of the market's valuation, is between 30 and 40, 1-year returns are tepid at best (Chart 4). Chart 3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Chart 4Expected Returns Given Starting Point Shiller P/E We are not trimming exposure to risk assets because we are more concerned about the economic outlook. BCA's view is that odds of a U.S. recession in the next 12 months remain low. Furthermore, the traditional recession signals that we track do not suggest a recession is nigh (Chart 5). For example, the 2/10 yield curve is still positive at 34 basis points (panel 2). Upward movement in long-dated breakevens will offset some of the upward pressure at the front-end from further Fed rate hikes, limiting the amount of curve flattening during the next few months. Once long-dated breakevens get back to a range between 2.3% and 2.5% then flattening could proceed more rapidly.3 Panel 3 shows that the LEI crosses below zero when a recession is imminent. The May LEI rose by 6% year-over-year. Initial claims for unemployment insurance in the week ending June 16 were 24K below their mid-December 2017 reading. Panel 4 shows that a 6-month increase in unemployment claims of between 75,000 and 100,000 is associated with a recession. The bottom line is that we are not concerned about a recession. Nonetheless, BCA's Equity Scorecard has dropped to 2, below the critical value of three that has been consistent in the past with positive equity returns (not shown). Table 1 updates our Exit Checklist of items that are important for the equity allocation call. Three of the nine are now giving a 'sell' signal and they suggest that prudence is necessary, despite the constructive economic outlook. Chart 5No Recession Signal Here Table 1Exit Checklist For Risk Assets Furthermore, several technical indicators that we monitor signal caution. The National Association of Active Investment Managers (NAAIM) says that active managers have increased equity risk since the start of the year (Chart 6). At 89%, the average equity exposure of institutional investors is close to the cycle high reached in March 2017, which was the highest since 2007, just before the S&P 500 peak in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated. At slightly under 2, it is at a position where bear markets began in 2000 and 2007, and it is well above the level seen just before the 2015 bear market (Chart 7, panel 1). That said, not all technical indicators are flashing red. Chart 8 shows that BCA's Technical Indicator is not at an extreme (panel 1). Moreover, BCA's Equity Sentiment Composite Index is neutral (panel 2); panel 3 shows that the U.S. large cap equities remain in the middle of their 2009-2018 recovery channel, albeit in the top half of the channel. Note that the S&P 500 tested the top end of the channel (near 2850) in January 2018. Chart 6Active Managers Have Increased ##br##Equity Exposure This Year Chart 7Equity Speculation Is Elevated Chart 8Not All Technical Indicators Are Bearish The risk to our neutral stance on equities is that credit and equities will rally to fresh highs before the cycle is done. However, given our bias for capital preservation and views on the late stage of the business cycle, it is not advisable to reach for the last few drops of return. With equity valuations stretched, we would rather be early and judicious and miss out on the last few basis points of outperformance rather than be late and underperform as risk assets sell off. BCA's view is that the next recession will be sparked by the Fed overtightening in 2019 and 2020 when it finds itself behind the curve on inflation. Moreover, because inflation is at the Fed's 2% target and the economy is beyond full employment, the price at which the Fed's "policy put" gets exercised is much lower than earlier in the cycle. The implication is that the Fed will be reluctant to deviate from its tightening path even in the face of more turmoil in the EM space or in Europe. This supports our guarded view on equities and our decision to move into cash instead of Treasuries. Geopolitical risk is another reason to be cautious. Chart 9 shows that globalization, a tailwind for risk assets, is stalling. Moreover, there is an increased threat of a breakup in the Eurozone, led by political uncertainty in Italy (Chart 10). In addition, tensions with Iran are mounting. Nonetheless, our Geopolitical Strategy service notes that the U.S.'s relationship with China is the primary source of geopolitical peril (Chart 11).4 Although we are not adjusting our view on the dollar,5 a stronger greenback would bolster our case for caution on risk assets. A higher dollar would hurt the profits of U.S. multinationals and could lead to instability in the emerging markets, raising the odds of a policy misstep. Chart 9Globalization Has Reached Its Zenith Chart 10Risk Of Eurozone Breakup Is Rising Chart 11BCA's Geopolitical Power Index Illustrates A Multipolar World Equity volatility will accelerate through year end, as is often the case late in equity bull markets. Bottom Line: If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months, especially if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Treading Water BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range (See Appendix Charts 1 and 2).6 We excluded bear markets and recessions from our analysis because our view is that neither condition will occur in the next 12 months. Table 2 shows that these sideways episodes lasted an average of eight months. At the end of six of the ten intervals, U.S. large cap equities rallied (1986, 1988, 1992, 1997-1998, 2004, and 2015); after two phases, stocks recovered briefly and then sold off (1951-52 and 1972). At the conclusion of the 1991 episode, stocks rallied and then resumed moving sideways. Stocks sold off after the eight-month sideways phase in 1976. Table 2What Happens After Stocks Move Sideways? Four (1951-52, 1972, 1988, 1997-98) of the ten sideways periods occurred after the U.S. economy reached full employment. The 10 year Treasury yield increased as stocks moved sideways in 1972 and in 1988, but fell in the 1997-98 episode. The S&P 500 PE ratio increased in two sideways phases (1972 and 1997-98) and contracted in 1988. S&P 500 EPS growth accelerated in 1972, 1988 and 1997-98 phases. The S&P 500 rallied after the sideways episodes in 1988 and 1997-98, but sold off after the 1951-52 and 1972 sideways phases that occurred after the economy hit full employment (Chart 12). Chart 12S&P 500 Valuations, EPS Growth, Margins And The 10-Year Treasury Yield When Stocks Move Sideways As the S&P 500 moved sideways when the economy was not yet at full employment (1976, 1986, 1991, 1992, 2004 and 2015), 10-year Treasury yields fell four times (1976, 1986, 1991 and 1992) and rose in two (2004 and 2015). The forward PE ratio for the S&P 500 expanded in 1986 and 1992, but contracted in 1991, 2004 and 2015. EPS growth during sideways episodes for stocks when the economy was not yet at full employment is mixed. EPS growth accelerated in 1976, 1992 and 2004, but slowed in 1986, 1991 and 2015 as oil prices fell. U.S. large cap equities rallied after four of the sideways periods when the economy was not yet at full employment (1986, 1992, 2004 and 2015) but sold off after the 1976 sideways move (Chart 12 again). We intend to further examine the macro backdrop during sideways periods for U.S. equities in future Weekly Reports. Bottom Line: BCA expects bond yields to rise in the next 12 months and S&P 500 profit growth will peak. Stocks are more likely to move higher after a period of sideways price action if the economy is not at full employment. Rising PE ratios as stocks move sideways most often lead to equity rallies after the sideways phases end. With valuations already elevated, PEs are unlikely to expand much further in this cycle. Moreover, the U.S. economy reached full employment in early 2017, making it less likely that the Fed will hit the pause button on its rate hike regime. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA's U.S. Bond Strategy Weekly Report, "As Good as It Gets For Corporate Debt," published April 24, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," published June 19, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA's Geopolitical Strategy "Are You Sick of Winning Yet," published June 20, 2018. Available at gps.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," published June 20, 2018. Available at gis.bcaresearch.com. 6 There are well-established periods for bull and bear markets for U.S. equities, however not for "sideways" episodes for stocks. We have defined "sideways" as a period of range-bound equity price movements that have lasted for at least five months outside of recessions and bear markets. Readers may have other definitions of "sideways". APPENDIX CHARTS Chart 1Sideways Epsisodes For Stocks 1950-1980... Chart 2..And 1980-2018

Highlights Portfolio Strategy Selling in the S&P cable & satellite index is overdone. Recession type valuations fully reflect the acquirer discount heavyweight CMCSA is still commanding. Lift exposure to neutral. Content providers' assets are highly coveted, and these firms remain in play as media is undergoing a tectonic shift. The industry's demand backdrop is also on the rise, signaling that it no longer pays to underweight the S&P movies & entertainment index. Increasing construction expenditures, ballooning balance sheets, soft relative selling prices and a rising U.S. dollar all suggest that restaurant profits will underwhelm. Downgrade to underweight. Recent Changes Raise the S&P cable & satellite index to neutral today. Lift the S&P movies & entertainment index to a benchmark allocation today. Act on the downgrade alert and trim the S&P restaurants index to underweight today. Table 1 Feature Geopolitical risks held equities hostage last week as President Trump toughened his tariff rhetoric toward China. While the risk of a global trade spat remains acute, the market is becoming desensitized to daily trade-related headlines and remains resilient. Given the plethora of political risks and upcoming midterm elections, I look forward to hearing Greg Valliere's keynote speech in BCA's Toronto Investment Conference on September 24-25. Importantly, last week rising protectionism along with "Three Policy Puts Going Kaput" compelled BCA's Global Investment Strategy service to turn more cautious toward global risk assets over its 6 to 12 month cyclical horizon, prompting them to downgrade global equities from overweight to a neutral stance.1 We have sympathy for this view and acknowledge that the risks to our still sanguine U.S. equity market view, which we have been flagging in recent publications, have increased a notch. We are especially worried about the greenback's appreciation and increasing potential to infiltrate SPX EPS in calendar 2019 (please see Chart 2 and Chart 4 from the June 4th Weekly Report). Given that technology has the highest foreign sales exposure (58% of total sales) among GICS1 sectors, and a 26% market cap weight, we are closely monitoring leading indicators for tech profits. Indeed, for calendar 2019 the S&P tech sector's contribution to S&P 500 profit growth is the highest at 21%, with financials right on its tail at 20% (Chart 1). Energy sector EPS base effects are filtered out in 2019, but industrials, that have a 37% foreign sales exposure and are at the epicenter of President Trump's tariff rhetoric, also explain 13% of SPX EPS growth in calendar 2019 (Chart 1). Chart 1Contribution To S&P 500 2019 EPS Growth In fact, over a structural (2-3 year) time horizon we are aligned with BCA's more bearish equity outlook. We have been advocating this longer term thesis in our travels visiting BCA clients (please download our latest marketing slide deck here that highlights our bearish secular equity market view). Importantly, the three signposts we are monitoring to help us time the end of the business cycle, and thus equity bull market, are: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). There are currently no ticks in any of these three boxes, and we conclude that the S&P 500 has yet to peak for the cycle (Chart 2). Crucially, the Fed is inflating a massive bubble by staying too easy for too long. It is rather obvious to us that the U.S. economy is firing on all cylinders with real non-residential investment growing near 10% in Q1, but the real fed funds rate is still near the zero line (Chart 3). In addition, recent Fed minutes signaled that the Fed is willing to take some inflation risk, which will further push equity markets into steeper disequilibrium. It would be unprecedented for the cycle to end with the real fed funds rate glued to zero (Chart 3). Chart 2Recession Indicators Chart 3Real Fed Funds Rate Is Still Zero! Moreover, the U.S. economy just received a two year fiscal stimulus injection which is rare in both duration and magnitude during the late stages of the expansion and thus inherently inflationary. Worrisomely, the last time this happened was in the mid-to-late 1960s that led to the inflationary 1970s (please see Chart 1 and Table 2 from our October 9th "Can Easy Fiscal Offset Tighter Monetary Policy?" Weekly Report). Tack on the starting point of a World War-like debt-to-GDP ratio and the only regulatory mechanism for government profligacy is the bond market (Chart 4). Chart 4Interest Rates Have Nowhere To Go But Up Another way to make the debt arithmetic work is if one believes the White House's real GDP projections of 3%+ as far as the eye can see, which stand in marked contrast to the IMF's, the CBO's and the Fed's own projections (Chart 5). Therefore, the path of least resistance for interest rates is higher as a way to slow down the economy and also rein in debt excesses. Typically, this overheating late in the cycle is synonymous with a blow off phase in equities (Chart 6), before the bottom falls out. Chart 5Don't Believe The White House Chart 6Blow Off Phase In sum, while BCA downgraded global equities to neutral last week on a cyclical time horizon, we are deviating from the BCA House View and still believe that the S&P 500 will make new all-time highs in absolute terms before the next recession hits. This week we are making a few subsurface changes to the S&P consumer discretionary sector, but we maintain an underweight allocation to this interest rate-sensitive sector. New Media Landscape: (Pipelines Vs. Content Providers) Vs. Netflix At last count Netflix broke into the top 25 largest companies (market cap based) in the S&P 500, and if it keeps up its frenetic pace it is on track to surpass Boeing. While legacy media giants had a chance to scoop up Netflix in the past few years, its current stratospheric valuation makes it uneconomical and nonsensical. Instead, the specter of Netflix, as well as other tech giants circling the space, has accelerated an inter- and intra-industry consolidation (bottom panel, Chart 7). Why? Because Netflix not only went straight to the consumer on a new medium, the internet, and sped up cord cutting, but also blurred industry lines by becoming a content provider producing its own original content in addition to offering third party content. The media landscape is thus still trying to adjust to the Netflix induced "creative destruction" and media executives are scrambling to compete with/protect legacy franchises from Netflix. The recently cleared AT&T/Time Warner merger has intensified the bidding war of remaining crown jewel assets in the legacy content media world. We were well positioned for this shake up in the space as we went underweight the media complex in early March.2 But now, we deem that the easy money has been made and most of the negative narrative is reflected in bombed out relative valuations despite depressed relative profit and sales growth estimates (second & third panels, Chart 7). As a result we recommend lifting exposure back to benchmark in the broad S&P media index. Beyond these industry related intricacies, the macro backdrop is starting to turn in favor of media outfits, warning that it no longer pays to be bearish. Chart 8 shows that relative consumer outlays on media have spiked recently. The implication is that industry revenue growth has more upside. BCA's ad spending indicator also corroborates this firming top line growth message, as does the latest ISM services survey that remains squarely above the 50 boom/bust line on a broad array of measures. Unsurprisingly, this budding demand recovery has translated into a pick up in industry pricing power with our media selling price gauge even surpassing overall inflation. The implication is that media profits could surprise to the upside. Chart 7M&A Frenzy Continues Chart 8Overlooked Demand Recovery While our sense is that pipelines (S&P cable & satellite index) are the likely losers and content providers (S&P movies & entertainment) are the likely winners from the ongoing broad media deck reshuffling, the way we are executing the S&P media upgrade to neutral is by lifting both the S&P cable & satellite and S&P movies & entertainment sub-indexes to neutral. On the cable front, M&A activity is weighing heavily on relative share prices as index heavyweight Comcast is a possible acquirer of the Murdoch empire assets. However, this bellwether company is not a pure pipeline play and were it to win the FOX-related assets bidding war, it would further diversify its cash flow. Monetizing those assets involves execution risk, especially as the legacy cable business is wrestling with decelerating selling prices and still has to contend with cord cutting (top & middle panels, Chart 9). Encouragingly, the bottom panel of Chart 9 shows that likely all the negative news flow is already baked into compelling relative valuations. With regard to the content providers, not only are some of these assets currently caught up in a bidding war, but every remaining independent content provider is now in play, and deal hungry investment bankers are aggressively pitching M&A to media (and likely other industry) CEOs. Macro headwinds are also morphing into tailwinds for the S&P movies & entertainment group. Consumer confidence is pushing multi decade highs and given the fact that the economy is at full employment any increase in discretionary consumer incomes will likely further boost recreation outlays (Chart 10). Industry pricing power is also expanding at a healthy clip at a time when industry executives are showing labor restraint (Chart 11). If selling prices stay firm on the back of improving demand as we expect, then movies & entertainment profit margins will enter an expansion phase (middle panel, Chart 10). Chart 9Cable's Blues Are ##br##Well Discounted Chart 10Firming ##br##Recreation Outlays... Chart 11And Recovering Operating Metrics##br## Remain Underappreciated None of this rosy outlook is reflected in cyclically low S&P movies & entertainment relative valuations (bottom panel, Chart 10). Bottom Line: Book relative profits of 13.5% in the S&P cable & satellite index since inception and lift to neutral. Boost the S&P movies & entertainment index to a benchmark allocation for a relative loss of 8.3% since the early March inception. As a result the broad S&P media index also commands a neutral weighting. The ticker symbols for the stocks in the S&P cable & satellite and S&P movies & entertainment indexes are: BLBG: S5CBST - CMCSA, CHTR, DISH and BLBG: S5MOVI - DIS, FOXA, FOX, VIAB, respectively. Portion Control In Restaurants Restauranteurs are eternal optimists; at least that is the lesson we take from the National Restaurant Association's Restaurant Performance Index (RPI) which only rarely dips below the expansion line (Chart 12, second panel). However, changes in this overly optimistic sentiment survey are useful as they closely lead the S&P restaurants index's relative performance. This indicator has recently rolled over and we think the timing is right to turn negative on restaurants (Chart 12, bottom panel). The recent evaporation of industry pricing power echoes the RPI's early indications of a downturn (Chart 13, second panel). In view of how tightly it moves with relative industry sales, the growth outlook for restaurants has darkened considerably. The underlying driver of weakening pricing power is the industry's collapsing share of the consumer's wallet over the past two years, which has been at least as destructive to industry growth as the Great Recession (Chart 13, bottom panel). While both relative consumption and sales, which move in lockstep, have been staging a recovery in 2018, they both remain firmly in deflationary territory. Meanwhile, industry wages - the largest input cost - have been expanding above trend for the better part of the past four years (Chart 14, second panel). Though restaurant wage growth has recently slowed considerably it has not been enough to bring our margin proxy out of negative territory, implying sliding relative earnings growth is set to continue (Chart 14, bottom panel). Chart 12Optimism Reigns In Restaurants Chart 13Falling Pricing Should Weigh On Sales Chart 14Labor Costs Are A Profit Headwind A rising U.S. dollar is an additional profit headwind for this heavily internationally-geared consumer discretionary sub-index. Despite dollar strength offering an input cost tailwind via lower food commodity costs, declining translation of foreign profits will likely swamp those gains. McDonald's and Starbucks, which together represent 80% of the weight of the S&P restaurants index, had 62% and 49%, respectively, of their locations outside the U.S. at the end of last year. To compensate for a tough profit outlook, restaurants have embarked on a construction spending spree that shows no signs of abating (Chart 15, second panel). The predictable result has been a near-doubling of leverage ratios over the past three years (Chart 15, bottom panel). A weak profit backdrop signals that relief from these levels will be hard to find. Chart 15Restaurants Are Binging On Debt Chart 16Valuations Do Not Reflect Risks Valuations have been treading water at above-normal levels for several years (Chart 16, second and third panels). Perky valuations seem poised for a fall given the cloudy profit outlook and the higher risk premium that recently geared up balance sheets typically command. Bottom Line: Still-high valuations are not supported by falling returns in an increasingly capital intensive industry. Accordingly, we are pulling the trigger on last month's downgrade alert on the S&P restaurants index and moving to an underweight allocation. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG. What Does All This Mean For The S&P Consumer Discretionary Index? Chart 17Stay Underweight Consumer Discretionary Despite the S&P media's heavy weighting in the broad consumer discretionary sector, our S&P restaurants downgrade sustains the below benchmark allocation in the S&P consumer discretionary sector. Importantly, the three key factors weighing on this early-cyclical sector we identified in early March remain intact: rising fed funds rate, quantitative tightening and higher prices at the pump (Chart 17). Meanwhile, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (middle panel, Chart 17). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 17). Bottom Line: Earnings underperformance will eventually result in relative share price underperformance. Stay underweight the S&P consumer discretionary index. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 19, 2018, available at gis.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Feature Valuations, whether for currencies, equities or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced so far this year, it is always useful to pause and reflect on where currency valuations stand. In this optic, this week we update our set of long-term valuation models for currencies that we introduced In February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 These models cover 22 currencies, incorporating both G-10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning or middle of a long-term currency cycle. Second, by providing strong directional signals, they help us judge whether any given move is more likely to be a countertrend development or not, offering insight on its potential longevity. Finally, they assist us and our clients in cutting through the fog, and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Dollar: Back At Fair Value 2017 was a terrible year for the dollar, but the selloff had one important positive impact: it erased the dollar's massive overvaluation that was so evident in the direct wake of U.S. President Donald Trump's election. In fact, today, based on its long-term drivers, the dollar is modestly cheap (Chart 1). Fair value for the dollar is currently flattered by the fact that real long-term yields are higher in the U.S. than in the rest of the G-10. Investors are thus betting that U.S. neutral interest rates are much higher than in other advanced economies. This also means that the uptrend currently evident in the dollar's fair value could end once we get closer to the point where Europe can join the U.S. toward lifting rates - a point at which investors could begin upgrading their estimates of the neutral rate in the rest of the world. This would be dollar bearish. For the time being, we recommend investors keep a bullish posturing on the USD for the remainder of 2018. Not only is global growth still slowing, a traditionally dollar-bullish development, but also the fed funds rate is likely to be moving closer to r-star. As we have previously showed, when the fed funds rate rises above r-star, the dollar tends to respond positively.2 Finally, cyclical valuations are not a handicap for the dollar anymore. The Euro Chart 2The Euro Is Still Cheap As most currencies managed to rise against the dollar last year, the trade-weighted euro's appreciation was not as dramatic as that of EUR/USD. Practically, this also means that despite a furious rally in this pair, the broad euro remains cheap on a cyclical basis, a cheapness that has only been accentuated by weakness in the euro since the first quarter of 2018 (Chart 2). The large current account of the euro area, which stands at 3.5% of GDP, is starting to have a positive impact on the euro's fair value, as it is lifting the currency bloc's net international investment position. Moreover, euro area interest rates may remain low relative to the U.S. for the next 12 to 18 months, but the 5-year forward 1-month EONIA rate is still near rock-bottom levels, and has scope to rise on a multi-year basis. This points toward a continuation of the uptrend in the euro's fair value. For the time being, despite a rosy long-term outlook for the euro, we prefer to remain short EUR/USD. Shorter-term fair value estimates are around 1.12, and the euro tends to depreciate against the dollar when global growth is weakening, as is currently the case. Moreover, the euro area domestic economy is not enjoying the same strength as the U.S. right now. This creates an additional handicap for the euro, especially as the Federal Reserve is set to keep increasing rates at a pace of four hikes a year, while the European Central Bank remains as least a year away from lifting rates. The Yen Chart 3Attractive Long-Term Valuation, But... The yen remains one of the cheapest major currencies in the world (Chart 3), as the large positive net international investment position of Japan, which stands at 64% of GDP, still constitutes an important support for it. Moreover, the low rate of Japanese inflation is helping Japan's competitiveness. However, while valuations represent a tailwind for the yen, the Bank of Japan faces an equally potent headwind. At current levels, the yen may not be much of a problem for Japan's competitiveness, but it remains the key driver of the country's financial conditions. Meanwhile, Japanese FCI are the best explanatory variable for Japanese inflation.3 It therefore follows that any strengthening in the yen will hinder the ability of the BoJ to hit its inflation target, forcing this central bank to maintain a dovish tilt for the foreseeable future. As a result, while we see how the current soft patch in global growth may help the yen, we worry that any positive impact on the JPY may prove transitory. Instead, we would rather play the yen-bullish impact of slowing global growth and rising trade tensions by selling the euro versus the yen than by selling the USD, as the ECB does not have the same hawkish bias as the Fed, and as the European economy is not the same juggernaut as the U.S. right now. The British Pound Chart 4Smaller Discount In The GBP The real-trade weighted pound has been appreciating for 13 months. This reflects two factors: the nominal exchange rate of the pound has regained composure from its nadir of January 2017, and higher inflation has created additional upward pressures on the real GBP. As a result of these dynamics, the deep discount of the real trade-weighted pound to its long-term fair value has eroded (Chart 4). The risk that the May government could fall and be replaced either by a hard-Brexit PM or a Corbyn-led coalition means that a risk premia still needs to be embedded in the price of the pound. As a result, the current small discount in the pound may not be enough to compensate investors for taking on this risk. This suggests that the large discount of the pound to its purchasing-power-parity fair value might overstate its cheapness. While the risks surrounding British politics means that the pound is not an attractive buy on a long-term basis anymore, we do like it versus the euro on a short-term basis: EUR/GBP tends to depreciate when EUR/USD has downside, and the U.K. economy may soon begin to stabilize as slowing inflation helps British real wages grow again after contracting from October 2016 to October 2017, which implies that the growth driver may move a bit in favor of the pound. The Canadian Dollar Chart 5CAD Near Fair Value The stabilization of the fair value for the real trade-weighted Canadian dollar is linked to the rebound in commodity prices, oil in particular. However, despite this improvement, the CAD has depreciated and is now trading again in line with its long-term fair value (Chart 5). This lack of clear valuation opportunity implies that the CAD will remain chained to economic developments. On the negative side, the CAD still faces some potentially acrimonious NAFTA negotiations, especially as U.S. President Donald Trump could continue with his bellicose trade rhetoric until the mid-term elections. Additionally, global growth is slowing and emerging markets are experiencing growing stresses, which may hurt commodity prices and therefore pull the CAD's long-term fair value lower. On the positive side, the Canadian economy is strong and is exhibiting a sever lack of slack in its labor market, which is generating both rapidly growing wages and core inflation of 1.8%. The Bank of Canada is therefore set to increase rates further this year, potentially matching the pace of rate increase of the Fed over the coming 24 months. As a result of this confluence of forces, we are reluctant to buy the CAD against the USD, especially as the former is strong. Instead, we prefer buying the CAD against the EUR and the AUD, two currencies set to suffer if global growth decelerates but that do not have the same support from monetary policy as the loonie. The Australian Dollar Chart 6The AUD Is Not Yet Cheap The real trade-weighted Australian dollar has depreciated by 5%, which has caused a decrease in the AUD's premium to its long-term fair value. The decline in the premium also reflects a small upgrade in the equilibrium rate itself, a side effect of rising commodity prices last year. However, despite these improvements, the AUD still remains expensive (Chart 6). Moreover, the rise in the fair value may prove elusive, as the slowdown in global growth and rising global trade tensions could also push down the AUD's fair value. These dynamics make the AUD our least-favored currency in the G-10. Additionally, the domestic economy lacks vigor. Despite low unemployment, the underemployment rate tracked by the Reserve Bank of Australia remains nears a three-decade high, which is weighing on both wages and inflation. This means that unlike in Canada, the RBA is not set to increase rates this year, and may in fact be forced to wait well into 2019 or even 2020 before doing so. The AUD therefore is not in a position to benefit from the same policy support as the CAD. We are currently short the AUD against the CAD and the NZD. We have also recommended investors short the Aussie against the yen as this cross is among the most sensitive to global growth. The New Zealand Dollar Chart 7NZD Vs Fair Value After having traded at a small discount to its fair value in the wake of the formation of a Labour / NZ first coalition government, the NZD is now back at equilibrium (Chart 7). The resilience of the kiwi versus the Aussie has been a key factor driving the trade-weighted kiwi higher this year. Going forward, a lack of clearly defined over- or undervaluation in the kiwi suggests that the NZD will be like the Canadian dollar: very responsive to international and domestic economic developments. This gives rise to a very muddled picture. Based on the output and unemployment gaps, the New Zealand economy seems at full employment, yet it has not seen much in terms of wage or inflationary pressures. As a result, the Reserve Bank of New Zealand has refrained from adopting a hawkish tone. Moreover, the populist policy prescriptions of the Ardern government are also creating downside risk for the kiwi. High immigration has been a pillar behind New Zealand's high-trend growth rate, and therefore a buttress behind the nation's high interest rates. Yet, the government wants to curtail this source of dynamism. On the international front, the kiwi economy has historically been very sensitive to global growth. While this could be a long-term advantage, in the short-term the current global growth soft patch represents a potent handicap for the kiwi. In the end, we judge Australia's problems as deeper than New Zealand's. Since valuations are also in the NZD's favor, the only exposure we like to the kiwi is to buy it against the AUD. The Swiss Franc Chart 8The SNB's Problem On purchasing power parity metrics, the Swiss franc is expensive, and the meteoric rise of Swiss unit labor costs expressed in euros only confirms this picture. The problem is that this expensiveness is justified once other factors are taken into account, namely Switzerland's gargantuan net international investment position of 128% of GDP, which exerts an inexorable upward drift on the franc's fair value. Once this factor is incorporated, the Swiss franc currently looks cheap (Chart 8). The implication of this dichotomy is that the Swiss franc could experience upward pressure, especially when global growth slows, which is the case right now. However, the Swiss National Bank remains highly worried that an indebted economy like Switzerland, which also suffers from a housing bubble, cannot afford the deflationary pressures created by a strong franc. As a result, we anticipate that the SNB will continue to fight tooth and nail against any strength in the franc. Practically, we are currently short EUR/CHF on a tactical basis. Nonetheless, once we see signs that global growth is bottoming, we will once again look to buy the euro against the CHF as the SNB will remain in the driver's seat. The Swedish Krona Chart 9What The Riksbank Wants The Swedish krona is quite cheap (Chart 9), but in all likelihood the Riksbank wants it this way. Sweden is a small, open economy, with total trade representing 86% of GDP. This means that a cheap krona is a key ingredient to generating easy monetary conditions. However, this begs the question: Does Sweden actually need easy monetary conditions? We would argue that the answer to this question is no. Sweden has an elevated rate of capacity utilization as well as closed unemployment and output gaps. In fact, trend Swedish inflation has moved up, albeit in a choppy fashion, and the Swedish economy remains strong. Moreover, the country currently faces one of the most rabid housing bubbles in the world, which has caused household debt to surge to 182% of disposable income. This is creating serious vulnerabilities in the Swedish economy - dangers that will only grow larger as the Riksbank keep monetary policy at extremely easy levels. A case can be made that with large exposure to both global trade and industrial production cycles, the current slowdown in global growth is creating a risk for Sweden. These risks are compounded by the rising threat of a trade war. This could justify easier monetary policy, and thus a weaker SEK. When all is said and done, while the short-term outlook for the SEK will remained stymied by the global growth outlook, we do expect the Riksbank to increase rates this year as inflation could accelerate significantly. As a result, we recommend investors use this period of weakness to buy the SEK against both the dollar and the euro. The Norwegian Krone Chart 10The NOK Is The Cheapest Commodity Currency In The G-10 The Norwegian krone has experienced a meaningful rally against the euro and the krona this year - the currencies of its largest trading partners - and as such, the large discount of the real trade-weighted krone to its equilibrium rate has declined. On a long-term basis, the krone remains the most attractive commodity currency in the G-10 based on valuations alone (Chart 10). While we have been long NOK/SEK, currently we have a tactical negative bias towards this cross. Investors have aggressively bought inflation protection, a development that tends to favor the NOK over the SEK. However, slowing global growth could disappoint these expectations, resulting in a period of weakness in the NOK/SEK pair. Nonetheless, we believe this is only a short-term development, and BCA's bullish cyclical view on oil will ultimately dominate. As a result, we recommend long-term buyers use any weakness in the NOK right now to buy more of it against the euro, the SEK, and especially against the AUD. The Yuan Chart 11The CNY Is At Equilibrium The fair value of the Chinese yuan has been in a well-defined secular bull market because China's productivity - even if it has slowed - remains notably higher than productivity growth among its trading partners. However, while the yuan traded at a generous discount to its fair value in early 2017, this is no longer the case (Chart 11). Despite this, on a long-term basis we foresee further appreciation in the yuan as we expect the Chinese economy to continue to generate higher productivity growth than its trading partners. Moreover, for investors with multi-decade investment horizons, a slow shift toward the RMB as a reserve currency will ultimately help the yuan. However, do not expect this force to be felt in the RMB any time soon. On a shorter-term horizon, the picture is more complex. Chinese economic activity is slowing as monetary conditions as well as various regulatory and administrative rules have been tightened - all of them neatly fitting under the rubric of structural reforms. Now that the trade relationship between the U.S. and China is becoming more acrimonious, Chinese authorities are likely to try using various relief valves to limit downside to Chinese growth. The RMB could be one of these tools. As such, the recent strength in the trade-weighted dollar is likely to continue to weigh on the CNY versus the USD. Paradoxically, the USD's strength is also likely to mean that the trade-weighted yuan could experience some upside. The Brazilian Real Chart 12More Downside In The BRL Despite the real's recent pronounced weakness, it has more room to fall before trading at a discount to its long-term fair value (Chart 12). More worrisome, the equilibrium rate for the BRL has been stable, even though commodity prices have rebounded. This raises the risk that the BRL could experience a greater decline than what is currently implied by its small premium to fair value if commodity prices were to fall. Moreover, bear markets in the real have historically ended at significant discounts to fair value. The current economic environment suggests this additional decline could materialize through the remainder of 2018. Weak global growth has historically been a poison for commodity prices as well as for carry trades, two factors that have a strong explanatory power for the real. Moreover, China's deceleration and regulatory tightening should translate into further weakness in Chinese imports of raw materials, which would have an immediate deleterious impact on the BRL. Additionally, as we have previously argued, when the fed funds rate rise above r-star, this increases the probability of an accident in global capital markets. Since elevated debt loads are to be found in EM and not in the U.S., this implies that vulnerability to a financial accident is greatest in the EM space. The BRL, with its great liquidity and high representation in investors' portfolios, could bear the brunt of such an adjustment. The Mexican Peso Chart 13The MXN Is A Bargain Once Again When we updated our long-term models last September, the peso was one of the most expensive currencies covered, and we flagged downside risk. With President Trump re-asserting his protectionist rhetoric, and with EM bonds and currencies experiencing a wave of pain, the MXN has eradicated all of its overvaluation and is once again trading at a significant discount to its long-term fair value (Chart 13). Is it time to buy the peso? On a pure valuation basis, the downside now seems limited. However, risks are still plentiful. For one, NAFTA negotiations are likely to remain rocky, at least until the U.S. mid-term elections. Trump's hawkish trade rhetoric is a surefire way to rally the GOP base at the polls in November. Second, the leading candidate in the polls for the Mexican presidential elections this summer is Andres Manuel Lopez Obrador, the former mayor of Mexico City. Not only could AMLO's leftist status frighten investors, he is looking to drive a hard bargain with the U.S. on NAFTA, a clear recipe for plentiful headline risk in the coming months. Third, the MXN is the EM currency with the most abundant liquidity, and slowing global growth along with rising EM volatility could easily take its toll on the Mexican currency. As a result, to take advantage of the MXN's discount to fair value, a discount that is especially pronounced when contrasted with other EM currencies, we recommend investors buy the MXN versus the BRL or the ZAR instead of buying it outright against the USD. These trades are made even more attractive by the fact that Mexican rates are now comparable to those offered on South African or Brazilian paper. The Chilean Peso Chart 14The CLP Is At Risk We were correct to flag last September that the CLP had less downside than the BRL. But now, while the BRL's premium to fair value has declined significantly, the Chilean peso continues to trade near its highest premium of the past 10 years (Chart 14). This suggests the peso could have significant downside if EM weakness grows deeper. This risk is compounded by the fact that the peso's fair value is most sensitive to copper prices. Prices of the red metal had been stable until recent trading sessions. However, with the world largest consumer of copper - China - having accumulated large stockpiles and now slowing, copper prices could experience significant downside, dragging down the CLP in the process. An additional risk lurking for the CLP is the fact that Chile displays some of the largest USD debt as a percent of GDP in the EM space. This means that a strong dollar could inflict a dangerous tightening in Chilean financial conditions. This risk is even more potent as the strength in the dollar is itself a consequence of slowing global growth - a development that is normally negative for the Chilean peso. This confluence thus suggests that the expensive CLP is at great risk in the coming months. The Colombian Peso Chart 15The COP Is Latam's Cheapest Currency The Colombian peso is currently the cheapest currency covered by our models. The COP has not been able to rise along with oil prices, creating a large discount in the process (Chart 15). Three factors have weighed on the Colombian currency. First, Colombia just had elections. While a market-friendly outcome ultimately prevailed, investors were already expressing worry ahead of the first round of voting four weeks ago. Second, Colombia has a large current account deficit of 3.7% of GDP, creating a funding risk in an environment where liquidity for EM carry trades has decreased. Finally, Colombia has a heavy USD-debt load. However, this factor is mitigated by the fact that private debt stands at 65% of Colombia's GDP, reflecting the banking sector's conservative lending practices. At this juncture, the COP is an attractive long-term buy, especially as president-elect Ivan Duque is likely to pursue market-friendly policies. However, the country's large current account deficit as well as the general risk to commodity prices emanating from weaker global growth suggests that short-term downside risk is still present in the COP versus the USD. As a result, while we recommend long-term investors gain exposure to this cheap Latin American currency, short-term players should stay on the sidelines. Instead, we recommend tactical investors capitalize on the COP's cheapness by buying it against the expensive CLP. Not only are valuations and carry considerations favorable, Chile has even more dollar debt than Colombia, suggesting that the former is more exposed to dollar risk than the latter. Moreover, Chile is levered to metals prices while Colombia is levered to oil prices. Our commodity strategists are more positive on crude than on copper, and our negative outlook on China reinforces this message. The South African Rand Chart 16The Rand Will Cheapen Further Despite its more than 20% depreciation versus the dollar since February, the rand continues to trade above its estimate of long-term fair value (Chart 16). The equilibrium rate for the ZAR is in a structural decline, even after adjusting for inflation, as the productivity of the South African economy remains in a downtrend relative to that of its trading partners. This means the long-term trend in the ZAR will continue to point south. On a cyclical basis, it is not just valuations that concern us when thinking about the rand. South Africa runs a deficit in terms of FDI; however, portfolio inflows into the country have been rather large, resulting in foreign ownership of South African bonds of 44%. Additionally, net speculative positions in the rand are still at elevated levels. This implies that investors could easily sell their South African assets if natural resource prices were to sag. Since BCA's view on Chinese activity as well as the soft patch currently experienced by the global economy augur poorly for commodities, this could create potent downside risks for the ZAR. We will be willing buyers only once the rand's overvaluation is corrected. The Russian Ruble Chart 17The Ruble Is At Fair Value There is no evidence of mispricing in the rubble (Chart 17). Moreover the Russian central bank runs a very orthodox monetary policy, which gives us comfort that the RUB, with its elevated carry, remains an attractive long-term hold within the EM FX complex. On a shorter-term basis, the picture is more complex. The RUB is both an oil play as well as a carry currency. This means that the RUB is very exposed to global growth and liquidity conditions. This creates major risks for the ruble. EM FX volatility has been rising, and slowing global growth could result in an unwinding of inflation-protection trades, which may pull oil prices down. This combination is negative for both EM currencies and oil plays for the remainder of 2018. Our favorite way to take advantage of the RUB's sound macroeconomic policy, high interest rates and lack of valuation extremes is to buy it against other EM currencies. It is especially attractive against the BRL, the ZAR and the CLP. The only EM commodity currency against which it doesn't stack up favorably is the COP, as the COP possesses a much deeper discount to fair value than the RUB, limiting its downside if the global economy were to slow more sharply than we anticipate. The Korean Won Chart 18Despite Its Modest Cheapness, The KRW Is At Risk The Korean won currently trades at a modest discount to its long-term fair value (Chart 18). This suggests the KRW will possess more defensive attributes than the more expensive Latin American currencies. However, BCA is worried over the Korean currency's cyclical outlook. The Korean economy is highly levered to both global trade and the Chinese investment cycle. This means the Korean won is greatly exposed to the two largest risks in the global economy. Moreover, the Korean economy is saddled with a large debt load for the nonfinancial private sector of 193% of GDP, which means the Bank of Korea could be forced to take a dovish turn if the economy is fully hit by a global and Chinese slowdown. Moreover, the won has historically been very sensitive to EM sovereign spreads. EM spreads have moved above their 200-day moving average, which suggests technical vulnerability. This may well spread to the won, especially in light of the global economic environment. The Philippine Peso Chart 19Big Discount In The PHP The PHP is one of the rare EM currencies to trade at a significant discount to its long-term fair value (Chart 19). There are two main reasons behind this. First, the Philippines runs a current account deficit of 0.5% of GDP. This makes the PHP vulnerable in an environment where global liquidity has gotten scarcer and where carry trades have underperformed. The second reason behind the PHP's large discount is politics. Global investors remain uncomfortable with President Duterte's policies, and as such are imputing a large risk premium on the currency. Is the PHP attractive? On valuation alone, it is. However, the current account dynamics are expected to become increasingly troubling. The economy is in fine shape and the trade deficit could continue to widen as imports get a lift from strong domestic demand - something that could infringe on the PHP's attractiveness. However, on the positive side, the PHP has historically displayed a robust negative correlation with commodity prices, energy in particular. This suggests that if commodity prices experience a period of relapse, the PHP could benefit. The best way to take advantage of these dynamics is to not buy the PHP outright against the USD but instead to buy it against EM currencies levered to commodity prices like the MYR or the CLP. The Singapore Dollar Chart 20The SGD's Decline Is Not Over The Singapore dollar remains pricey (Chart 20). However, this is no guarantee of upcoming weakness. After all, the SGD is the main tool used by the Monetary Authority of Singapore to control monetary policy. Moreover, the MAS targets a basket of currencies versus the SGD. Based on these dynamics, historically the SGD has displayed a low beta versus the USD. Essentially, it is a defensive currency within the EM space. The SGD has historically moved in tandem with commodity prices. This makes sense. Commodity prices are a key input in Singapore inflation, and commodity prices perform well when global industrial activity and global trade are strong. This means that not only do rising commodity prices require a higher SGD to combat inflation, higher commodity prices materialize in an environment where this small trading nation is supported by potent tailwinds. Additionally, Singapore loan growth correlates quite closely with commodity prices, suggesting that strong commodity prices result in important amounts of savings from commodity producers being recycled in the Singaporean financial system. To prevent Singapore's economy from overheating in response to these liquidity inflows, MAS is being forced to tighten policy through a higher SGD. Today, with global growth softening and global trade likely to deteriorate, the Singaporean economy is likely to face important headwinds. Tightening monetary policy in the U.S. and in China will create additional headwinds. As a result, so long as the USD has upside, the SGD is likely to have downside versus the greenback. On a longer-term basis, we would expect the correction of the SGD's overvaluation to not happen versus the dollar but versus other EM currencies. The Hong Kong Dollar Chart 21The HKD Is Fairly Valued The troughs and peaks in the HKD follow the gyrations of the U.S. dollar. This is to be expected as the HKD has been pegged to the USD since 1983. Like the USD, it was expensive in early 2017, but now it is trading closer to fair value (Chart 21). Additionally, due to the large weight of the yuan in the trade-weighted HKD, the strength in the CNY versus the USD has had a greater impact on taming the HKD's overvaluation than it has on the USD's own mispricing. Moreover, the HKD is trading very close to the lower bound of its peg versus the USD, which has also contributed to the correction of its overvaluation. Even when the HKD was expensive last year, we were never worried that the peg would be undone. Historically, the Hong Kong Monetary Authority has shown its willingness to tolerate deflation when the HKD has been expensive. The most recent period was no different. Moreover, the HKMA has ample fire power in terms of reserves to support the HKD if the need ever existed. Ultimately, the stability created by the HKD peg is still essential to Hong Kong's relevance as a financial center for China, especially in the face of the growing preeminence of Shanghai and Beijing as domestic financial centers. As a result, while we could see the HKD become a bit more expensive over the remainder of 2018 as the USD rallies a bit further, our long-term negative view on the USD suggests that on a multiyear basis the HKD will only cheapen. The Saudi Riyal Chart 22The SAR Remains Expensive Like the HKD, the riyal is pegged to the USD. However, unlike the HKD, the softness in the USD last year was not enough to purge the SAR's overvaluation (Chart 22). Ultimately, the kingdom's poor productivity means that the SAR needs more than a 15% fall in the dollar index to make the Saudi economy competitive. However, this matters little. Historically, when the SAR has been expensive, the Saudi Arabia Monetary Authority has picked the HKMA solution: deflation over devaluation. Ultimately, Saudi Arabia is a country that imports all goods other than energy products. With a young population, a surge in inflation caused by a falling currency is a risk to the durability of the regime that Riyadh is not willing to test. Moreover, SAMA has the firepower to support the SAR, especially when the aggregate wealth of the extended royal family is taken into account. Additionally, the rally in oil prices since February 2016 has put to rest worries about the country's fiscal standing. On a long-term basis, the current regime wants to reform the economy, moving away from oil and increasing productivity growth. This will be essential to supporting the SAR and decreasing its overvaluation without having to resort to deflation. However, it remains to be seen if Crown Prince Mohamed Bin Salman's ambitious reforms can in fact be implemented and be fruitful. Much will depend on this for the future stability of the riyal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary