Developed Countries

Highlights The recent weakness in emerging markets (EM) has not yet altered the Fed's view of the U.S. economy. Capital spending in the U.S. remains upbeat despite a slowdown in economic momentum outside the country. May's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Feature Chart 1The Labor Market Continues To Tighten U.S. risk assets dipped along with Treasury yields last week as investor worry about Italy, emerging markets and global trade mounted. BCA's stance is that despite the increase in financial market and economic stress overseas, the Federal Reserve will stick to its gradual pace of rate hikes for now. Policymakers at the central bank would need to see a direct and prolonged impact on U.S. financial conditions before adjusting the path of rate hikes. Data released last week on housing, capital spending and the labor market confirmed that the U.S. economy is growing well above its long-term potential in 1H 2018 and that inflation remains at the Fed's 2% target (see section below). The U.S. added 223,000 jobs in May. The 3-month average, at almost 180,000, is well above the expansion in the labor force. Thus, the unemployment rate ticked down to 3.8%, matching the low seen during the height of the tech bubble in 2000 (Chart 1). For the FOMC, the unemployment rate has already reached the level policymakers had projected for the end of the year (3.8%). Indeed, by later this year unemployment is likely to drop below the FOMC's projection for the end of 2019 (3.6%). The Fed has signaled that it is comfortable with an overshoot of the 2% inflation target, but it will likely be forced by early 2019 to transition from simply normalizing monetary policy at a "gradual" pace to targeting slower growth. This would set the stage for a recession in 2020. Julia Coronado, a panelist at BCA's upcoming 2018 Investment Conference in Toronto, noted recently that inflation may fall short of the Fed's target and cause the Fed to scale back its planned hikes.1 Italy remains a key source of concern for markets. BCA's Geopolitical Strategy service notes that a new election is likely in Italy after August, prolonging the political uncertainty there. BCA's stance is that while Italian policymakers' fight with Brussels, Berlin, and the ECB will last throughout 2018, they are not looking to exit the euro area yet. Over the next ten years, however, BCA's Geopolitical Strategy service expects Italy to test the markets with a euro area exit attempt. We are sticking to our view that such an event is far more likely to occur following a recession than it is today.2 The Trump Administration re-ignited the trade war last week. We discuss below, in the context of the Fed's Beige Book, which noted an uptick in uncertainty surrounding trade. Is EM Weakness A Risk? The recent weakness in emerging markets has not altered the Fed's view of the U.S. economy. Chart 2, Chart 3 and Chart 4 show the performance of key U.S and EM financial market earnings and economic metrics indexed to the peak of MSCI's Emerging Market Index in mid-1997, late 2014 and early 2018. Chart 2 (panel 1) shows that the dollar's strength since the EM markets peaked last year is modest compared with prior cycles. Moreover, oil prices are rising today; in 1997-98 and 2014-15 prices collapsed. The implication is that rising oil prices suggest that global economic activity is in an uptrend. Last week, BCA's Commodity and Energy Service team revised their forecasts for oil prices in 2018 and 2019 warning investors to expect more volatility in oil markets.3 U.S. financial conditions (panel 3) have eased since the EM peak in early 2018. This contrasts with 1997-98 and in 2014-2016 when financial conditions tightened considerably. S&P 500 forward EPS estimates (panel 4) have climbed since the top in EM equities, but the rise is related to the 2017 tax bill. Analysts' estimates for U.S. large cap earnings also rose during the EM crisis in the late 1990s, but then fell in 2014 and 2015 as oil prices dropped. U.S. real final demand climbed after EM equities peaked in 1997 and 2014. BCA's view is that the U.S. economy will accelerate in the final three quarters of 2018 and run well above its long-term potential of 1.8%. Chart 2U.S. Financial Conditions, ##br##Oil And EPS During EM Stress Chart 3EM Assets 1997-98, ##br##2014-15 And Today Chart 4U.S. Stocks, Treasuries, ##br##Spread Product And EM Stress The rise in the dollar and Fed rate hike expectations have pressured some EM currencies, financial markets and economies. That said, the response is muted relative to previous cycles. A Boston Fed paper4 found that during recent bouts of international financial market turmoil, EM economies with fewer economic vulnerabilities performed better than economies that were more exposed. However, the paper also noted that during crises in the late 1990s and early 2000s, there was little differentiation in EM market performance. Chart 3 shows that in the late 1990s and between 2014 and 2016, EM currencies declined about 8.2% in the first few months after EM equity prices peaked. Today, EM currencies are down just 3.8% versus the dollar since the EM equity peak (panel 1). Panel 2 shows EM stocks relative to U.S. stocks since the EM summit and panel 3 shows the global LEI (ex the U.S.) is tracking the mid-1990s episode, but not the 2014-2016 experience. China's Li Keqiang Index (LKI) is also following the late 1990s episode. BCA's China Investment Strategy service states that China's economy will continue to weaken, but that the deceleration will not be as severe as the 2014-2016 slowdown (panel 4).5 U.S. Treasury yields are on the rise; in the late 1990s and 2014-2016 (Chart 4, panel 1) they headed downhill. That said, the yield on the 10-year Treasury note has dipped 3 bps in the past week as investor worry about EM, global trade and Italy more than offset a strong batch of U.S. economic data. Panels 2 and 3 show that the S&P 500 and the U.S. stock-to-bond ratio dipped after the peak in EM stocks this year and in the earlier episodes. We note that at this point in the previous two instances, both U.S. equity prices and the stock-to-bond ratio began to climb and soon surpassed their prior heights. BCA's view is that some caution is warranted on U.S. stocks in the next few months. However, in the next 12 months, the U.S. stock-to-bond ratio will move higher. Investment-grade (panel 4) and high-yield spreads (panel 5) climbed this year after the top in EM stock prices. Moreover, the escalation in high-yield spreads is muted relative to the increase in 2014 as oil prices peaked. We also note that current spread levels are well above those in the late 1990s. BCA's U.S. Bond Strategy service recommends investors overweight high-yield bonds relative to Treasuries.6 Previous periods of EM-related stress in the financial markets led to shifts in the relationship between the dollar and certain U.S. asset classes. The top panel of Chart 5 shows that the correlation between changes in U.S. stock prices and the dollar tends to increase during these episodes. The relationship is more consistent prior to 2000. Since that time, the dollar and U.S. equities have moved in opposite directions during intervals of EM stress. There is no clear pattern in the relationship between the stock-to-bond ratio and the dollar when EM stress intensifies (panel 2). There is a very choppy correlation between S&P operating earnings and the dollar (panel 3). Chart 5U.S. Financial Markets' Correlation With The Dollar During EM Stress Likewise, there is no consistent interconnection between bond yields and the dollar (Chart 5, panel 4) as EM stress increases. However, as the pressure mounts, we note that the correlation between the dollar and the 10-year begins to shift. Oil and gold prices and the dollar tend to move in opposite directions during times of EM stress (not shown). Moreover, since the early 2000s, there is a consistently negative relationship between the dollar, gold and oil. In recent years, an escalating dollar has been aligned with small cap stocks outperforming large caps. Larger companies have more exposure to overseas sales than small cap firms in the S&P 500.7 Bottom Line: Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. Stay short duration over a 12 month horizon. BCA's U.S. Bond Strategy service is looking for a trough in economic surprise and a capitulation in speculative positioning in the Treasury market to signal the end to the recent pullback in yields.8 Dollar Impact Capital spending in the U.S. remains upbeat despite a slowdown in economic momentum outside the country. BCA's view is that global growth will cool for the next few months and then reaccelerate. Chart 6 shows that global capital goods imports have rolled over (panel 1), but that new capital goods orders in the G3 remain in an upward trend (panel 2). Nonetheless, most of the strength in the G3 is from the U.S. BCA's model for nominal and real business investment (panel 3) suggests that capex is poised to rocket in the coming quarters. Moreover, CEO confidence measured by Duke and the Business Roundtable remain at cycle highs (Chart 7, panel 1) while business spending plans in the regional Fed surveys are still elevated (panels 2 and 3). Higher oil prices are not the only story behind the boom in U.S. business spending. Chart 8 shows that energy capex troughed (panel 3) a few months after oil prices (panel 1) in early 2016. Business spending outside the oil patch never turned negative on a year-over-year basis (panel 2) and it is still on the upswing. The 2017 tax bill and corporations' search for labor-saving machinery as wage and compensation metrics rise are behind the surge in spending. Robust corporate earnings also provide a tailwind for capex (panel 4). Chart 6Global Growth Is Rolling Over... Chart 7..But U.S. Growth Is Poised To Lift Off Chart 8Oil Is A Tailwind For Capes, ##br##But Not The Whole Story Last week's report on corporate profits allows us to compare the trajectory of the S&P 500's profits and margins to the NIPA measures (Chart 9). Both metrics indicate that earnings jumped in recent quarters (panel 1) to record heights (panel 2). Any disconnect between the two indicators has disappeared.9 Chart 10 shows that S&P 500 revenues dipped in Q1 (panel 1), but NIPA-based sales measures continued to climb (panel 2). However, panel 2 shows a divergence in margins. The BEA sounding leaped ahead in Q1 while the S&P 500 version levelled off. BCA's view is that S&P 500 earnings growth on a trailing four-quarter basis will peak later this year (Chart 11). Moreover, we anticipate the secular mean reversion of margins to re-assert itself in the S&P data, perhaps beginning later in 2018. Chart 9S&P And NIPA Profit Measures Are Aligned Chart 10NIPA And S&P Sales And Profit Margins The dollar's recent strength is not yet a threat to U.S. corporate profits nor the U.S. equity market. BCA's view is that the dollar will advance by 5% in the next 12 months. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur in 2019 due to lagged effects. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Nonetheless, the stronger greenback is not yet evident in forward EPS estimates for 2018 or 2019. (Chart 12). Chart 11Strong S&P 500 EPS Growth Ahead, ##br##Will Start To Slow Soon Chart 12Is the Stronger Dollar Starting To Impact 2019 EPS Estimates? Bottom Line: BCA's view is that the slowdown in growth outside the U.S. is not the start of a more significant downturn. Monetary policy is still accommodative worldwide, U.S. fiscal policy is loose and governments outside the U.S. are no longer tightening policy. The implication is that a big slide in global growth is not likely and that by the end of the summer, global growth will probably reaccelerate. Therefore, risks to the dollar are much more balanced and we do not foresee much more upside in the greenback. Stay long stocks versus bonds. However, investors with longer horizons should begin to prepare for lower real returns in the 2020s after a recession early in that decade. Beige Book Update The Beige Book released last week ahead of the FOMC's June 12-13 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in April and May. The Fed's business and banking contacts mentioned either tariffs or trade policy 34 times in the Beige Book. This was below 44 mentions in the April edition, but well above the 3 mentions in March. Moreover, uncertainty came up 13 times in May (Chart 13, panel 5); 10 were related to trade policy. There were nine mentions of trade in April and only two in March. Chart 13Rise Of Inflation Words ##br##And Uncertainty Stand Out BCA's view is that trade-related uncertainty will persist at least until the midterm elections in November.10 The Trump administration announced a new round of tariffs on Chinese products last week. Moreover, the U.S. plans to end the exemptions it provided to E.U. steelmakers on the tariffs that the U.S. imposed earlier this year. BCA's Geopolitical Strategy service notes that the U.S.-China trade war is back on. The significance of the administration's about-face on trade is that it invalidates the conventional view that President Xi and Trump would promptly make a deal to ease tensions. President Trump's election, however, has revealed the preference of the median voter in the U.S. on trade. That preference is far less committed to free trade than previously assumed. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 13, panel 1 shows that at 67% in May, BCA's Beige Book Monitor ticked up from April's 55% reading, which was the lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book remained near four-year lows. On the other hand, the number of strong words climbed in May, but remains below last fall's post-hurricane highs. The tax bill was noted 3 times in the latest Beige Book, down from 12 in April and 15 in March. The legislation was cast in a positive light in two of the three mentions. BCA's stance is that the dollar will move modestly higher in 2018. The trade-weighted dollar is up 4.1% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the minimal references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be an issue for corporate profits in Q2 2018. The handful of recent references sharply contrasts with the surge in comments during 2015 and early 2016 (Chart 13, panel 4). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. Table 1Labor 'Shortages' Identified In The Beige Book The disagreement on inflation between the Beige Book and the Fed's preferred price metric narrowed in May (Chart 13, panel 3). The number of inflation words rose to a fresh cycle zenith, surpassing the July 2017 peak. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator, failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb. May's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. The Beige Book noted that many firms responded to the lack of qualified workers by increasing wages and compensation packages. Moreover, the word "widespread", which is part of BCA's inflation words count, was used 11 times in May, to describe both labor shortages and rising input costs. Table 1 shows industries with labor shortages. In the year ended April 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.11 BCA's Beige Book Commercial Real Estate (CRE) Monitor12 remains in a downtrend (Chart 14). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.13 Chart 14Beige Book Commercial Real Estate Monitor Bottom Line: May's Beige Book supports our stance that inflation will lead to at least three more Fed rate hikes by the end of the year. Moreover, labor shortages may be spreading from highly skilled to moderately skilled workers, and rising input costs are widespread. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. The Fed may back off from this gradual path if stress in the emerging markets leads to tighter U.S. financial conditions. Still, it will take more than the recent spate of EM turmoil to deter the Fed. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 https://www.rutgersrealestate.com/blog-re/low-inflation-the-good-and-the-bad/ 2 Please see BCA Research's Geopolitical Strategy "Italy, Spain, Trade Wars... Oh My!", published May 30, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity And Energy Strategy "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again", published May 31,2018. Available at ces.bcaresearch.com. 4 https://www.bostonfed.org/-/media/Documents/Workingpapers/PDF/rpa1702.pdf 5 Please see BCA Research's China Investment Strategy Weekly Report, "11 Charts to Watch", published May 30, 2018. Available at cis.bcaresearch.com. 6 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", published May 8, 2018. Available at usbs.bcaresearch.com. 7 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Too Good To Be True", published January 22, 2018. Available at uses.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", published May 22, 2018. Available at usbs.bcaresearch.com. 9 Please see BCA's U.S. Investment Strategy Weekly Report, "Summer Stress Out", July 3, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 11 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 13 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com.

Recommended Allocation A Series Of Unfortunate Events Markets have taken a series of hits in recent months - sharp drops in emerging market currencies, a political crisis in Italy, and the ongoing trade war between the U.S. and China - not to mention a slowdown in cyclical growth. But risk assets have been remarkably resilient: the U.S. stock market is in the middle of its year-to-date range, and U.S. small cap stocks (more attuned to domestic conditions) are at record highs (Chart 1). The uncertainty is set to continue for a while. But, with global growth likely to settle at an above-trend pace, fiscal and monetary policy still accommodative, and earnings continuing to grow strongly, the recent resilience says to us that risk assets are likely to grind higher and to outperform bonds over the next 12 months. A major underlying cause of the recent volatility has been the growing disparity between growth in the U.S. and in the rest of the world (Chart 2). This is partly due to the strength of the euro and yen last year, which is now dampening activity in these regions, but the slowdown in Chinese industrial growth and a higher oil price may also be having a disproportionate effect on growth outside the U.S. This growth disparity has widened interest rate differentials, which have again become the major driver of currencies, pushing up the U.S. dollar (Chart 3). Chart 1Small Cap Stocks At A Record High Chart 2Disparity Between The U.S. And The Rest... Chart 3...Means Dollar Has Further To Rise In combination with rising U.S. interest rates (the 10-year Treasury yield rose above 3% last month, before correcting a little), dollar appreciation is a threat for emerging markets. EM assets have long shown a consistently strong inverse correlation with the dollar (Chart 4). We expect the EM sell-off to continue. Further Fed hikes and rising inflation expectations in the U.S. (relative to the euro area and Japan) will increase interest-rate differentials and push the dollar up further: we forecast 1.12 for euro/dollar. Investors are still far from capitulating on EM assets after several years of large purchases (Chart 5). Many EM central banks are being forced to raise rates to defend their currencies, which will dent growth. Some may even be forced into reintroducing capital controls. Several emerging economies besides Argentina and Turkey remain vulnerable, having worryingly high amounts of foreign currency debt (Chart 6). Chart 4Strong Dollar Is Bad For Em Assets Chart 5Em Is Still A Consensus Favorite Chart 6Worrying Levels Of FX Debt Chart 7Not Surprising That Italians Are Fed Up Geopolitics is likely to remain a drag on markets for a while, too. Italy remains the biggest threat. The discontent of the Italian population is unsurprising given the country's stagnation since it joined the euro (Chart 7). The probable coalition government of the Lega and Five Star Movement would introduce aggressive fiscal stimulus, putting it in confrontation with the EU's budgetary rules. But BCA's geopolitical strategists see little risk of Italy exiting the euro in the next two years (though 10 years might be a different story).1 Political gyrations may continue for some months, particularly if the new government persists with its plan to blow the fiscal deficit out to 7% of GDP, but the sell-off in short-term Italian bonds looks to be overdone. Developments in trade tariffs, Iran and North Korea could also weigh on markets in coming months. But ultimately economic fundamentals almost always outweigh geopolitical risk. Global growth is slowing, but to an above-trend pace. Fiscal policy is particularly stimulative this year, with 17 of the 33 OECD countries undertaking large fiscal easing, and a further 11 some easing. The overall cyclically-adjusted primary budget balance in OECD countries is forecast to ease by 0.5% of GDP this year and 0.4% next (Chart 8). Monetary policy remains accommodative almost everywhere. The FOMC, in its May statement, by adding the word "symmetric" to describe its 2% inflation objective, was clearly emphasizing that it sees no need to accelerate the pace of rate hikes, despite the recent pickup in core PCE inflation. We expect the Fed to continue to raise rates once a quarter, meaning that monetary policy will not become restrictive until around Q1 next year. With inflation expectations not yet fully normalized (Chart 9), the Fed could still exercise its "put option" by holding for a quarter or two if global risk were to rise significantly. Italy's problems also make it more likely that the ECB will stay easier for longer, and the probability is rising of its deciding to extend asset purchases into next year. Chart 8Fiscal Stimulus (Almost) Everywhere Chart 9Inflation Expectations Have Further To Rise With the consensus already forecasting global GDP to grow 3.4% this year, and U.S. earnings by 22%, there is no obvious catalyst for risk assets to rebound sharply (Chart 10). However, we find it inconceivable that equity markets will not be higher in 12 months' time - and will not have outperformed bonds over that time - if the macro environment plays out as we expect. We, therefore, continue to recommend an overweight on equities and underweight on fixed income, but might start to turn more defensive around the end of the year if the signs are in place that the recession we expect in 2020 is still on the cards. Equities: For the reasons described above, we remain cautious on EM equities. Within EM, our preference would be for markets such as China, Korea and India, which are likely to be less affected by investors' concerns about current account deficits and foreign-currency denominated debt. In DM, our preference remains for late-cyclical sectors, especially energy, financials and industrials. We mainly view regional and country selection as a derivative of the sector call: this supports our preference for euro zone and Japanese stocks over those in the U.S. and U.K. Fixed Income: A combination of quarterly Fed rate hikes, a further normalization of inflation expectations, and moderate rises in the real rate and term premium are likely to push the 10-year U.S. Treasury yield up to 3.5% by year-end (Chart 11). We, therefore, remain underweight duration and prefer TIPs to nominal bonds. We keep our overweights on spread product within the fixed-income bucket, since it should continue to outperform for another couple of quarters. U.S. high-yield spreads are likely to remain steady, giving an attractive carry even after accounting for defaults; investment grade spreads might start to recover, given that the sell-off of quality bonds by companies repatriating short-term investments held offshore ($35 Bn from the 20 largest U.S. companies in Q1) is now mostly over (Chart 12). Chart 10Can Growth Beat These Expectations? Chart 11Treasury Yield To Rise To 3.5% Chart 12Selective Spread Product Remains Attractive Currencies: Interest-rate differentials, as described above, are likely to push the dollar up further, especially against the euro. This should continue until the effect of a strong dollar/weak euro starts to rebalance growth surprises back to the euro area, perhaps around the end of the year. We see less chance of dollar appreciation against the yen (which is still undervalued against its PPP value of 98, and may benefit from its safe-haven status) and against the Canadian dollar (given the Bank of Canada's hawkish stance). Commodities: Industrial commodities are likely to continue to struggle against headwinds from the appreciating dollar, and the continuing moderate slowdown in China (Chart 13). The oil price has become a tougher call recently, with talk that OPEC may agree later this month to bring back as much as 1 million barrels/day in production, but Venezuelan and Iranian supply likely to exit the market. BCA's energy strategists now forecast WTI and Brent to average $70 and $78 in 2H18, and $67/$72 in 2019, but expect higher volatility in the price over coming months (Chart 14).2 Chart 13Continuing Signs Of China Slowdown Chart 14Forecasting Oil Is Getting Harder Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Client Note, "Italy, Spain, Trade Wars... Oh My!," dated 30 May 2018, available at gps.bcaresearch.com 2 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output: Volatility Set To Rise ... Again," dated 31 May 2018, available at ces.bcaresearch.com GAA Asset Allocation

Highlights Italy is a live drama. However, both Italy and Brussels have constraints that should lead to a compromise on fiscal stimulus. Italy will not leave the euro in the foreseeable future, and the European Central Bank has little incentive not to continue accepting Italian bonds. With the recent capitulation in the Italian bond market, the euro could experience a brief respite, potentially rallying toward 1.18 to 1.19. However, for the euro to endure a more durable bottom, global bond yields need to stop falling. Until then, EUR/USD could move toward 1.12. Falling bond yields imply more downside for EUR/JPY and EUR/CHF as well. NOK/SEK is not yet a buy. The trend in gold prices can be used to gauge where the fed funds rate stands vis-à-vis r-star. Feature In July 64AD, the Great Fire of Rome erupted, causing untold damage to the great imperial capital. Various Roman sources suggest that Emperor Nero started the fire to clear land in order to build himself a new palace, the Domus Aurea.1 This fire was a calamity, and was followed by a period of economic tumult and currency debasement. However, Rome recovered, the empire conquered more nations, and ultimately survived another 412 years. We have held a bearish view on the euro for 2018, expressed by recommending investors buy DXY and sell EUR/CAD, EUR/JPY and EUR/CHF. However, this view is underpinned by economic divergences and a softening in global growth. Our negative bias on the euro has greatly benefited from the fire that has engulfed Italian politics and bond markets. Taking stock of this week's political theatre, does it still make sense to be short the euro, and by extension long the dollar? As we foresee more downside in global bond yields, we think yes. However, while Italy is currently burning, it is not at risk of causing a collapse of the euro area. Pricing an end to the "empire" is thus an inappropriate reason to stay short the euro. The Italian Job Italy has once again become a trouble spot for investors. The M5S / Lega Nord coalition's manifesto proposes blowing out the fiscal deficit to above 7% of GDP by instituting a flat tax regime, increasing spending and undoing pension reforms instigated by the Monti government in 2012. In response to these developments, president Mattarella has removed the proposed finance minister, Paolo Savona, arguing he was too anti-euro and that abandoning the euro area was unconstitutional. He went on to nominate Carlo Cottarelli, nicknamed "Mr. Scissors," as a caretaker prime minister tasked with leading a technocratic government until new elections are implemented. However, the coalition rightfully argued that this move was executed under a false pretext, as its current policy proposal does not include leaving the euro area. Even before the drama had fully blossomed, Italy on Monday had been put on downgrade watch by Moody's. In light of the political developments, investors then worried that a new election would result in Italy potentially exiting the euro area. Italian 2-year yields spiked to a spread of 350 basis points against German Schatz. This implied a perceived probability of 11% that Italy will choose to exit the euro area over the course of the next two years. Another possible outcome discounted by investors was that the European Central Bank would stop accepting BTPs as repo collaterals, or stop buying them in its Asset Purchase Program. Chart I-1Italian Support For The Euro##br## Is Low But Well Above 50% Which of these two risks is more likely to materialize? We think the current implied probability of Italy electing to leave the euro over the coming two years is very low. Italians exhibit the lowest support toward the euro of any eurozone member state. However, a majority of Italians, 59% of them, still support the common currency (Chart I-1). In response to this constraint, the very nimble Five Star Movement, while still hell-bent on fiscal profligacy, has already greatly downplayed its Euroscepticism. While Lega Nord still has more Eurosceptic inclinations, it has not put leaving the euro area at the core of its coalition agreement with M5S. BCA has a great degree of confidence in this view, but it is important to not be dogmatic. BCA's Geopolitical Strategy service recommends investors closely follow the statements of these two parties over the course of the summer. The second risk is more real. The fiscal proposal of the coalition would blow the Italian budget deficit from 2.3% to more than 7% of GDP. Ratings agencies are already putting Italy on downgrade watch. Italy has a credit rating of Baa2, and only bonds with ratings of Baa3 or better are eligible at the ECB. It is possible that the central bank, in coordination with Brussels, exerts the same kind of pressure as it did in August 2011 when Jean Claude Trichet and Mario Draghi wrote a letter to Silvio Berlusconi demanding his resignation in exchange for financial market support for Italy. Despite this risk, we expect Italy to ultimately play ball and not blow up the deficit to 7% of GDP - simply because of economic constraints. These constraints are also likely to create an additional limit on the willingness and capacity of Italy to leave the euro area. The arguments we made in a joint Special Report with BCA's Geopolitical Strategy service titled "Europe's Divine Comedy Part II: Italy In Purgatorio," published in June 2017, remain valid: Italy will feel the pain from its transgressions before it can implement them.2 This is happening today as we write. Essentially, Italy's problem is rooted in the poor health of its banking system. Italian banks have capital in the order of EUR165 billion and NPLs of EUR130 billion, leaving EUR35 billion in excess capital. However, Italian commercial banks hold approximately EUR350 billion in BTPs. Thus, any decline in BTP value of 10% or more would render the Italian banking system insolvent (Chart I-2). Since suggesting abandoning the euro or conducting policy that exclude Italian debt from the ECB's window would cause a greater than 10% fall in BTP prices, this would kill off credit issuance in Italy as the banking sector would not have the wherewithal to extend new loans. This would prompt a large collapse in the credit impulse, and thus GDP growth (Chart I-3). The ensuing painful recession would cause Italians to backtrack on their intentions to leave the euro area. If Italy's credit rating and its access to the ECB is the reason for the collapse in BTP prices, the same dynamics will also force the Italian government to adopt a more realistic fiscal policy. This is why we do not believe the current M5S/Lega Nord government will be able to blow up the budget by as much as it currently wants. Chart I-2The Italian Constraints Lies##br## In The Banking Sector Chart I-3Credit Trends Explain##br## Italian Growth There are, however, incentives for Brussels to be more lenient on Italy. Italy is not Greece. The Troika had room to play hardball with Greece. Greek debt was EUR346 billion, or 10% of Germany's GDP (the perceived ultimate backer). The same cannot be said about Italy. Rome's debt stands at EUR2383 billion or 70% of Germany's GDP. In other words, as J. Paul Getty once said, "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Italy is the EU's problem. Chart I-4If You Owe The Bank 442 Billion, ##br##That's The Bank's Problem This problem is most evident in the Target 2 of the Bank of Italy. The Italian national central bank owes EUR442 billion to the Eurosystem, the most of any nation (Chart I-4). Claims on Italy can also be found on the balance sheets of commercial banks across Europe. French, Spanish, German, and Dutch commercial banks have Italian exposure of EUR426 billion, with EUR310 billion held by French banks alone. Italy's problems are definitely Europe's problem. A collapse of Italy could therefore impair the entire European banking sector. This means that the EU and the ECB have a strong built-in incentive to be lenient toward Italy. As a result, we expect that Brussels will be forced to accept a larger Italian deficit than 3% of GDP, as it did at the turn of the millennium when France and Germany were also in violation of the Stability and Growth Pact. The ECB could also make a conditional exception in terms of accepting Italian bonds. So What? The Italian situation remains fluid. While an election this summer, as early as July 29th, has been touted, efforts to form a government are still taking place. No matter what happens, the constraints on both Italy and the European institutions suggest that both sides of the table will have to come to a compromise regarding Italian public spending. The EU will have to tolerate a greater than 3% of GDP deficit, and the Five Star Movement, with whoever it coalesces, will not be able to blow up the budget deficit above 7% of GDP. Investors have made a mistake by pricing in an Italian exit. Hence, Italian 2-year yields could experience downside in the coming week. In fact, the daily move in Italian 2-year yields on Tuesday was the largest on record, despite what are still very low levels of interest rates by historical standards (Chart I-5). This suggests that May 29th represented a day of capitulation in the Italian bond market, at least on a short-term basis. As a result, the very oversold euro, which has declined more or less without a pause for the past 29 trading days, could stage a relief rally as investors re-evaluate the Italian risks (Chart I-6). Chart I-5Capitulation In The BTP Market Chart I-6The Euro Short-Term Rebound Can Continue This begs a crucial question: Is it time to bail on our various short bets on the euro as well as our long bet on the DXY? While a temporary resolution in Italy could easily prompt a euro rally toward 1.18-1.19, many issues that have prompted us to implement these views have yet to fully play out. For example, the euro's fair value, as implied by real short rate differentials, the slope of the euro area yield curve relative to the U.S. and growth differentials between the rest of the world and the U.S. - as captured by the price of copper relative to the price of lumber - still pegs an equilibrium for EUR/USD at 1.12 (Chart I-7). Chart I-7The Euro Has Yet To Purge Its Previous Excesses Additionally, while traders have capitulated on Italian bonds, investors have yet to capitulate on the euro. Speculators are still very long, and investor sentiment is still not consistent with a bottom (Chart I-8). Additionally, the trend in relative inflation still points toward a weaker euro, as it portends to an easing of European monetary policy relative to the U.S. (Chart I-9). The tension in Italy and the widening spreads in innocent Spain could play toward the ECB adjusting its forward guidance toward no hike for longer than is currently priced into the EONIA curve. Chart I-8No Capitulation Here Chart I-9Inflation Dynamics Point To A Lower EUR/USD However, the most important question right now for the euro is the direction of bond yields. Much will depend on the performance of bonds over the course of the coming months. Bottom Line: Italy is a political landmine, and the recent drama has weighed on the euro, causing EUR/USD to depreciate much faster than we anticipated. However, markets are currently embedding too-large a risk premium of an Italian exit. Both Italy and the EU will not stay as intransigent as they currently pretend, suggesting the market action will force a political compromise on the thorny question of deficits. As a result, while a rally in coming weeks of EUR/USD toward 1.18-1.19 is a very probable scenario, we anticipate the euro's weakness to end closer to 1.12 than currently recorded levels. All About Bond Yields BCA believes that bond yields are globally on a cyclical upswing, being lifted by the fact that global central banks are slowly but surely exiting the emergency stimulus measures put in place directly after the great financial crisis. Moreover, we also expect inflation to slowly come back, especially in the U.S. and Canada, also justifying higher yields. In response to these forces, BCA's three factor bond model, based on global manufacturing PMIs, the U.S. employment-to-population ratio and the dollar's bullish sentiment, suggests the fair value of 10-year Treasurys is at 3.3%, 46 basis points above current yields. However, markets do not move in a straight line. The bond market is especially prone to reversals as interest rates are a key determinant of the cost of capital. Thus, higher yields slow global economic activity, diminishing the reason why yields increased in the first place, creating a stop-and-go pattern. This time is no exception. In fact, Ryan Swift has been arguing in BCA's U.S. Bond Strategy service that after their sharp up-move from 2.04% to 3.11%, bond yields have downside on a short-term basis.3 A few factors explain why bond yields could experience a bit more downside in the coming months: Bond aggregates have been oversold (Chart I-10), with their 100-day rate of change hitting levels associated with a subsequent rebound in prices. This rebound is underway and doesn't look to have yet been fully played out. Chart I-10Bonds Were Too Oversold To Keep Falling In A Straight Line Positioning remains too skewed. Speculators are still very short Treasurys, and duration surveys conducted by J.P. Morgan Chase suggest there is still more room to surprise investors, prompting them to lighten their short-duration calls (Chart I-11). The changes in 10-year U.S. yields are very correlated with the U.S. surprise index. However, this economic indicator is highly mean-reverting. The increase in investors' expectations suggests there is room for disappointment on the economic front for market participants. Ryan's autoregressive model for economic surprises, which captures the mean-reverting behavior of this series, suggests that surprises will deteriorate further in the coming weeks (Chart I-12). Chart I-11Still No Capitulation In ##br##Bond Positioning Chart I-12Economic Surprise Index U.S. Surprise ##br##Index Can Mean-Revert Further Global growth continues to show signs of deterioration, as the diffusion index of our global leading economic indicators highlights that only 24% of the world's major economies are experiencing expanding LEIs (Chart I-13). Moreover, the deliquescence of EM carry trades funded in yen also points toward additional deceleration in global industrial activity, and export volumes growth out of Asia continues to slow (Chart I-13, bottom panels). Here, the recent performance of gold is most revealing. The yellow metal is a good gauge of global liquidity conditions, and it tends to perform well when bond yields, especially real rates, weaken. However, despite a fall in real yields in recent weeks, and despite the rising geopolitical risks associated with Italy and the re-emergence of trade wars, gold prices are softer than expected. This implies that bond yields have not yet fallen enough to put a floor under global growth. So why does the absolute trend in Treasury yields matter for EUR/USD? Simply because since 2008, EUR/USD has performed very poorly when bond yields have declined, displaying an average annualized rate of return of -6.3% as well as a median return of -9.7%, and weakening two-thirds of the time (Table I-1). This essentially confirms our previous analysis showing that generally, the euro is a rather pro-cyclical currency. This also suggests that even if the euro could experience a temporary rally in response to a re-pricing of Italian exit risk, it will be hard for the common currency to rally durably so long as bond yields have downside. Chart I-13Global Growth Is Slowing Signs##br## Of Soft Global Growth Table I-1Bond Rallies And The Currency Market Table I-1 also shows that the yen has experienced large upside in a falling yield environment, and most importantly has risen in all instances against the USD. As a result, we remain comfortable with our January 12, 2018 recommendation to sell EUR/JPY.4 Not only does EUR/JPY weaken 83% of the time when bond yields fall, but as Chart I-14 shows, relative positioning in EUR/JPY has more room to deteriorate, as previous excesses on the long side tend to be followed by periods of excessive short positioning. Moreover, as the bottom panel illustrates, a reversal in the performance of momentum stocks also comes hand in hand with a weak EUR/JPY. Chart I-15 also highlights that rising dollar funding costs tend to lead to a weaker EUR/JPY. Chart I-14EUR/JPY Is Still Vulnerable Chart I-15Funding Pressure Point To A Weaker EUR/JPY Table I-1 further shows that despite our positive long-term view on EUR/CHF, if we believe that yields could correct further, it is intellectually coherent to be short EUR/CHF on a tactical basis, as the pair has also fallen in 83% of the occurrences of bond market rallies. We are thus sticking with this short-term trade. Chart I-16CAD Benefits From A Valuation Cushion Table I-1 however, is more mixed for our short EUR/CAD bet. EUR/CAD rallies on half the instances where bond yields weaken, and generates an average annualized gain of 1%. Yields are therefore an unreliable gauge of this cross's trend. Instead, we continue to favor the CAD over the EUR on the basis of relative monetary policy dynamics and valuations. The Canadian economy has no slack, core inflation is at 1.9%, and the Bank of Canada just re-opened the door to hiking rates this year - essentially a mirror image to the euro area. Also, while EUR/USD is overvalued by 4.9% based on our preferred model, USD/CAD is overvalued by 14% based on our model using oil and relative rate expectations (Chart I-16). We are therefore sticking with this position, even though we are likely to experience volatility after a straight move down from 1.61 to 1.5. Yesterday's announcement that the White House is imposing tariffs on steel and aluminium on Canada and the EU is likely to be a crucial contributor to this episode of volatility. Finally Table I-1 shows that our negative view on commodity currencies is the correct one to hold in the current context, especially regarding the AUD, which within this group suffers by the greatest extent when yields fall. Additionally, this analysis confirms our assessment regarding NOK/SEK. We were long this pair, and continue to foresee upside for the Norwegian krone relative to the Swedish krona on a cyclical basis. However, we closed this trade as NOK/SEK was getting very overbought. Adding another justification for this tactical decision, a falling yield environment has been associated with this cross weakening in 83% of cases and depreciating on average by a 4.9% annualized rate - or 5.7% if we take the median fall. We will therefore wait to see a stabilization in bond yields before re-opening our NOK/SEK trade. Bottom Line: The rebound in bond prices expected by our U.S. bond strategist has further to run, as the global economy is experiencing a soft patch and U.S. economic surprises have additional downside. This suggests that EUR/USD is likely to depreciate more, prompting us to stick with our 1.12 target for now. EUR/JPY and EUR/CHF possess ample downside as well. While commodity currencies all weaken when bond yields decline, the AUD declines most often, and by the greatest extent. NOK/SEK can correct further before resuming its uptrend; only once bond yields stabilize will we buy this cross again. Gold, The Fed And R-star Following last week's report where we discussed the interaction of the dollar, the fed funds rate, and r-star,5 we received a few questions regarding the implication of this analysis for the gold market. While the message of this analysis was very clear for the dollar - the dollar weakens when the Fed increases rates and the fed funds rate is below the r-star, but strengthens significantly when the Fed lifts rates above r-star - the implications for gold of the interaction between rates and r-star is much murkier. Table I-2 shows the returns of gold, as well as the batting averages of the results, under the four states explored last week. We use medians instead of means, as average returns have been distorted by a few outliers. Table I-2Gold And The Interaction Between ##br##Rates And R* This table highlights that the best environment to hold gold has been the same environment that was harshest to the dollar: a rising fed funds rate, but one that stands below the neutral rate. Essentially, this suggests that in this environment, despite the efforts of the Fed to tighten monetary conditions, global liquidity remains plentiful, which fuels both global growth and gold prices. In this context, gold rallies 76% of the time by a median annualized rate of 14.4%. Chart I-17Gold As A Gauge For R* Perplexingly, there is no clear implications in the other states. When the fed funds rate rises and stands above the neutral rate, gold falls by a median annualized rate of 1.3%, but this only works 55% of the time. This probably reflects the fact that when the real fed funds rate rises in this environment, while in and of itself this should hurt gold, the growing incidence of accidents in global financial markets and the global economy helps gold, undoing the damage created by tighter monetary policy. When the fed funds rate is falling, gold's annualized returns are mixed, but most importantly the distribution of returns is no better than random. So while this analysis does not provide a clear signal for gold next year, it does help us generate a useful inference. If the Fed is indeed soon set to lift interest rates above the neutral rate, as the Laubach-Williams measure of r-star implies, the violent rally that gold experienced in 2017 should taper off. If gold were to continue to rally vigorously, maintaining its strong trend despite higher rates (Chart I-17), this would imply that the fed funds rate is still below r-star. As a corollary, the business cycle would have greater upside, the dollar greater downside, and EM assets should prove more resilient than we anticipate. Bottom Line: Where we stand in the interest rate cycle is less useful for calling the gold market than it is for calling the dollar. While a rising fed funds rate that stands below the neutral rate creates a very supportive environment for gold, other combinations are more opaque. However, this can help generate useful insights on the equilibrium rate. If faced with higher interest rates, gold remains on the strong upward trend it experienced in 2017, this would mean that U.S. policy is still accommodative as the fed funds rate would still be below r-star. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Tacitus, the main source describing the fire, was unsure of the veracity of these allegations. 2 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, titled "Europe's Divine Comedy Part II: Italy In Purgatorio", dated June 21, 2017, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, titled "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, and the Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, both available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was generally weak this week: Q1 GDP growth was revised down to an annualized pace of 2.2%, profit growth was weak; Core personal consumption expenditure grew at a 2.3% quarterly pace, underperforming expectations of 2.5%; Core PCE inflation came in line with expectations at 1.8%. The March number was revised down to 1.8% as well from 1.9% previously; However, the U.S. labor market continues to tighten, with both continuing and initial jobless claims falling more than expected. Washington is ramping up its hawkish stance on trade, implementing its steel and aluminum tariffs on the EU, Canada, as well as Mexico. The U.S. is nonetheless likely to fare better than the rest of the G-10 in the current soft patch for global growth as it is a less cyclical economy. Furthermore, with the dollar recoupling with rate differentials, Fed hikes will serve as an important tailwind for the greenback for the rest of this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Amidst the surfeit of political angst across Italy and Spain, some positive economic data have contributed to some relief to the euro's persistent decline this month. German headline and harmonized inflation surprised to the upside, both coming in at 2.2%; German unemployment declined to 5.2%; German retail sales increased by 2.3% on a monthly pace; Spanish harmonized inflation came in at 2.1%, beating expectations; Euro area headline and core inflation came in at 1.9% and 1.1%, respectively, an improvement over previous figures; Unemployment also declined to 8.5% from 8.6%, but came in higher than the expected 8.4%. In addition to abating political anxiety in Italy, ECB Executive Board Member Sabine Lautenschläger, noted that "all the conditions for inflation to kick in are in place". While these factors provided a relief for the euro, it is likely that interest rate differentials, waning global growth, and a labor market replete with slack will keep the upside in the euro capped for the remainder of this year. The longer-run outlook, however, is bullish, as the common currency remains cheap across several valuation metrics. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Retail trade yearly growth came in above expectations, coming in at 1.6%. It also increased from 1% last month. However, large retailer's sales growth surprised negatively, coming in at -0.8%. Moreover, the jobs/applicants ratio also underperformed expectations, coming in at 1.59. Finally, the consumer confidence index also surprised to the downside, coming in at 43.8. USD/JPY has fallen by roughly 1%, as political risks originating from Italy have helped safe heaven assets like the yen. Overall, we continue to be bullish on this cross on a tactical basis, given that we expect a slowdown in global growth to accentuate the current risk off environment. However the BoJ will likely intervene if the yen keeps going up, which makes a bearish stance on the yen appropriate on a cyc lical basis. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen's Mighty Rise Continues... For Now - February 16, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative Total Business Investment yearly growth underperformed expectations, coming it at 2%. Nationwide Housing Prices yearly growth also surprised negatively, coming in at 2.4%. Finally, mortgage approvals also surprised to the downside, coming in at 62.455 thousand. GBP/USD has fallen by roughly 0.6% this week. As of this week, we have reached the target of our tactical short GBP/USD trade with a tk% gain. While the rally in the dollar could certainly continue, pushing cable lower in the process, it is more prudent to adopt a more neutral stance toward this cross, given that it has depreciated by more than 7% since its highs on mid-April. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics- March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was on the weak side: Building permits contracted by 5% in monthly terms, and only increased by 1.9% in yearly terms, much less than the previous 15.6% and the expected 4.1%; Private sector credit grew by 0.4% in monthly terms, in line with expectations; Private capital expenditure also grew by only 0.4%, a weaker result than the expected 0.7%. After a meaningful fall, AUD/USD has been relatively flat for the last month. Markets seem to be fully aware of the slack currently hampering the Australian economy. The Australian interest rates futures curve continues to flatten, pricing in a lower probability of any hikes. Furthermore, U.S. trade protectionism is becoming more aggressive, which may pose a further threat to the AUD as Australian growth is highly levered to global trade. We remain bearish on this antipodean currency in both the short and the long term. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied by roughly 1% this week. Overall, we are negative on the NZD versus the U.S. dollar, given that pro-cyclical currencies like the kiwi tend to suffer in periods of heightened volatility and increasing risks. Continued trade tensions, as well as slowing global growth and political risks emanating from Italy will likely perpetuate the current environment going forward, hurting the kiwi in the process. That being said we are positive on this currency against the Australian dollar, as Australia's economy is much more sensitive to the Chinese industrial cycle than New Zealand's. Therefore a slowdown in emerging markets should weigh more heavily on the AUD than on the NZD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was disappointing this week: Industrial product price increased by 0.5% in monthly terms in April; The Raw Material Price Index increased 0.7%; The current account decreased to CAD-19.5 billion in Q1 of 2018; Quarterly GDP growth came in at 1.3%, disappointing expectations. On Wednesday, the CAD was buoyed by the BoC's hawkish monetary policy statement. According to the statement, the Governing Council will now take a "gradual" approach to policy adjustments, as opposed to the "cautious" one noted in previous statements. In addition, the reference to continued monetary accommodation and labor market slack was also removed. However, the White House announced on Thursday the imposition of tariffs on Canadian exports, which erased most of Wednesday's gain. While this adds substantial risk to the view, the outlook for trade negotiations is still murky, and could surprise on the upside. The CAD still remains cheap on key valuation metrics, with an economy exhibiting less slack than other G-10 counterparts. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance outperformed expectations, coming in at 2,289 million. This measure also came in above last month figure. However, the KOF leading indicator underperformed expectations, coming in at 100. It also decreased substantially from last month's reading. Finally, yearly GDP growth also surprised negatively, coming in at 2.2%. EUR/CHF has depreciated by roughly 1.5% this week. Overall, this cross should continue to depreciate given that we expect the current period of risk aversion to persist. Even if Italian political risks start to subside, investors will still have to worry about trade tensions, slowing global growth, and the deleterious impact of lower bond yields on this cross. This should help safe-haven assets like the franc outperform. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 0.5%. Moreover the Norges Bank credit indicator came in line with expectations, at 6.3%. USD/NOK has rallied by nearly 1.2% this week, as the rise in the dollar coupled with lower oil prices, have resulted in a toxic combination for the krone. Overall, we are positive on the krone relative to other commodity currencies. The krone has a large NIIP and current account surplus which makes it more resilient to terms of trade shocks. Moreover, oil should outperform other commodities given that it is more levered to DM growth than to the Chinese industrial cycle and given that the supply backdrop for crude is more favorable. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden has improved: Retail sales beat expectations, growing at a 0.6% monthly pace and a 3.6% annual pace; GDP growth accelerated to 3.3% in Q1 of 2018, higher than the 2.9% growth recorded last year; The trade balance declined by SEK6.5 billion in May; Consumer confidence also suffered slightly to 98.5 from 101. The SEK has strengthened substantially against the euro since its multi-year lows this month. Political woes subsided the euro, while rosy data from Sweden lifted the krona. Against the dollar, the SEK has weakened in recent weeks, due to the greenback's recent surge. We expect the SEK to remain strong against the euro for the remainder of this year, owing to cheap valuations and resurging inflationary pressures. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Overweight Defense stocks have been range-bound in the last week as geopolitical maneuvering has seen probabilities of conflict on the Korean peninsula swinging wildly back and forth. Using this conflict to value defense equities seems fraught with forecast risk and we would argue that focusing on domestic rearmament is a better use of investors' time. In last month's data release, Department of Defense outlays showed the longest streak of increases this decade, pointing to a continued acceleration in defense spending (second panel). This is mirrored by surging government investment in defense, now at its highest level in 5 years (third panel). The Trump administration's commitment to rearmament has now made it into the federal budget; the Congressional Budget Office (CBO) estimates defense outlays will approximate wartime levels in 2019 (bottom panel). Net, we expect earnings visibility will peak through the fog of war and be the ultimate driver of stock market returns; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL.

Dear Client, I will be visiting clients next week. Instead of our Weekly Report, we will be sending you a Special Report written by my colleagues Matt Gertken and Ray Park. The report addresses the North Korean situation and argues that a positive, if not perfect, diplomatic solution will result from U.S.-North Korean negotiations. Best regards, Peter Berezin, Chief Global Strategist Highlights The U.S. can withstand further rate hikes. Neither economic nor financial imbalances are especially elevated, while fiscal stimulus will offset much of the sting from tighter monetary policy. Unfortunately, America's resilience to higher rates does not extend to the rest of the world. A stronger dollar is undermining emerging markets, which are already under pressure from slower Chinese growth and the looming prospect of trade wars. The crisis in Italy will further restrain the ECB from withdrawing monetary support. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors could consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield has reached 4%. EUR/USD came within a whisker of our 1.15 target this week. We will book profits on our long DXY trade recommendation if the dollar index reaches 96. A defensive posture is appropriate for now, but risk assets should recover later this year as the global economy finds its footing. This could set the scene for a blow-off rally in stocks. Feature Gauging The Pain Threshold From Higher Rates Chart 1Market Expectations Slightly Below Fed Dots After the recent turbulence, the market is pricing in 100 basis points of Fed rate hikes between now and the end of 2020 (Chart 1). Such a pace of rate hikes would be quite slow by historic standards. In past tightening cycles, the Fed would typically raise rates by about 50 basis points per quarter. Investors expect the real fed funds rate to peak at around 1%, well below the historic average of 3%-to-5%. Underlying these expectations is the presumption that the neutral rate of interest - the rate consistent with full employment and stable inflation - is quite low, and that the Fed will not have to raise rates much above neutral to cool the economy. According to the April FOMC minutes, "a few" participants thought that the fed funds rate was already close to its equilibrium level. There are many reasons to think that R-star has fallen over time, but in practice, the margin of error around estimates of the neutral rate is huge. Thus, rather than getting bogged down over technical issues, investors would be well served by taking a more practical approach and asking what they should be on the lookout for to determine whether interest rates have moved into restrictive territory. The State Of The U.S. Housing Market Housing has historically been the most important interest rate-sensitive sector, so much so that Ed Leamer entitled his 2007 Jackson Hole symposium paper "Housing Is The Business Cycle."1 Given the recent runup in mortgage yields, it is not too surprising that the latest data on U.S. housing has been on the weak side (Chart 2). Mortgage applications for purchase have come off their highs. Housing starts, building permits, and new and existing home sales all declined in April. Homebuilder sentiment improved a tad, but this was due to an increase in the current sales component; future sales expectations were flat on the month. The share of respondents who indicated that now was a good time to buy a home in the latest University of Michigan Consumer Sentiment survey declined to 69% in May, continuing its slide from a peak of 83% in December 2014. Still, we would not fret too much about the state of the U.S. housing market (Chart 3). Construction activity has been slow to increase this cycle, which has pushed vacancies to ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2006 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Chart 2U.S. Housing: Higher Mortgage##br## Rates Are A Headwind... Chart 3...But Don't##br## Fret Yet Household Debt Is Not Yet At Worrying Levels Lenders also remain circumspect (Chart 4). Mortgage debt has barely grown as a share of disposable income throughout the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. A dwindling share of loan originations since the financial crisis has involved adjustable rate mortgages (Chart 5). This has made the housing market more resilient to Fed rate hikes. Other parts of the household credit arena look more menacing, but not so much that they threaten to short-circuit the economy. Banks have been tightening lending standards on auto loans since Q2 of 2016 and credit card loans since the second quarter of last year. This should help moderate the increase in default rates that has been observed in those categories (Chart 6). Chart 4Mortgage Debt Is Not ##br##A Cause For Concern Chart 5Housing Market: More Resilient To ##br##Rate Hikes Than It Used To Be Chart 6Lenders Are More ##br##Circumspect These Days Student debt has continued to trend higher, but the vast majority of these loans is backstopped by the government. While the Treasury's own finances are on an unsustainable trajectory, this is more of a long-term concern than a short-term problem. If anything, fiscal stimulus over the next two years will allow the Fed to raise rates more than it could otherwise without endangering the economy. Corporate Borrowing: High But Not Extreme Like a river, market liquidity tends to flow along the path of least resistance, rather than towards those who happen to be the most thirsty. While the household sector was piling on debt during the 2001-2007 boom, the U.S. corporate sector was still recovering from the hangover produced by the capex boom in the late 1990s. A decade later, corporate balance sheets were in good shape. Spurred on by ultra-low interest rates, corporate debt levels began to rise. Today, the ratio of corporate debt-to-GDP is near a record high. Valuations for corporate assets have reached lofty levels. In inflation-adjusted terms, commercial real estate prices are 4% above their pre-recession peak (Chart 7). U.S. equities also trade at a historically elevated multiple to earnings, sales, and book value (Chart 8). There are bright spots, however (Chart 9). Thanks to lofty corporate profits, the ratio of corporate debt-to-EBITDA is in the middle of its post-1990 range based on national accounts data. Interest payments-to-EBIT are near historic lows. Corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. Although the picture is not as benign if one performs a bottom-up analysis of publicly-listed companies, the overall message is that the U.S. corporate sector can handle higher rates. Corporate stresses will eventually rise, but it will likely take a recession for this to happen, which we don't expect until 2020. Chart 7Commercial Real Estate Prices: ##br##Above Pre-Recession Levels Chart 8U.S. Equities##br## Are Overvalued Chart 9Corporate Debt Is High,##br## But So Are Profits Cyclical Spending Still Subdued The discussion above suggests that U.S. interest rate-sensitive sectors can withstand further rate hikes. This conclusion is buttressed by the observation that the cyclical sectors of the economy - the ones that tend to weaken the most during recessions - have yet to reach levels that make them vulnerable to a sharp retrenchment. Chart 10 shows that the sum of business capital spending, residential and commercial construction, and consumer discretionary goods purchases is still well below levels that have preceded past recessions. Along the same lines, the private sector financial balance - the difference between what the private sector earns and what it spends - is currently in surplus to the tune of 2.2% of GDP. This compares to deficits of 5.4% of GDP in 2000 and 3.8% of GDP in 2006 (Chart 11). Further monetary tightening, to the extent that it prevents any brewing imbalances in the real economy and financial markets from worsening, may be just what the doctor ordered. Chart 10Cyclical Spending Still Below Levels##br## Preceding Past Recessions Chart 11U.S. Private Sector Financial##br## Balance Is Healthy The Sneeze Felt Around The World The U.S. is not an island unto itself. Even if a bit outdated, the old adage which says that when the U.S. sneezes the rest of the world catches a cold, still rings true. As such, focusing on the neutral rate only as it pertains to the U.S. is a bit too parochial. There may be a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain in the U.S. itself. Emerging markets are particularly sensitive to changes in U.S. financial conditions. About 80% of EM foreign-currency debt is denominated in dollars. A stronger dollar and higher U.S. interest rates make it more difficult for EM borrowers to service their debts. While EM foreign-currency debt has declined as a share of total debt outstanding, this is only because the past decade has seen a boom in local debt issuance (Chart 12). As a share of GDP, exports, and international reserves, U.S. dollar debt is at levels not seen in over 15 years (Chart 13). Most emerging markets entered 2018 with strong growth momentum. Recent tracking estimates point to some deceleration in GDP growth, but nothing too alarming (Chart 14). That could begin to change. EM financial conditions have started to tighten, which is likely to weigh on activity. BCA's Emerging Market and Geopolitical Strategy teams have flagged the prospect of policy-inducing tightening in China. Trade tensions also seem to be escalating again following President Trump's decision this week to curb Chinese investment in the U.S., impose a 25% tariff on $50 billion of Chinese imports, and slap tariffs on foreign steel. All this could put an additional dent in global growth. While this publication does not expect a full-blown EM crisis, a period of EM underperformance over the next few months is likely. Chart 12EM Borrowers Like Local Credit, ##br##But Don't Dislike Foreign-Currency Debt Chart 13EM Dollar##br## Debt Is High Chart 14EM Growth Decelerating,##br## But Not Dramatically... Yet Italy: If You Are Gonna Do The Time, You Might As Well Do The Crime Even if emerging markets avoid another major crisis, one can always count on Europe to try to fill the void. The Italian 10-year bond yield is up over 100 basis points since the middle of April. Assuming a fiscal multiplier of one, a standard Taylor Rule equation says that Italy would need 2% of GDP in fiscal stimulus per year to offset the tightening in financial conditions brought upon by the recent increase in borrowing costs.2 That is 20% of GDP in stimulus over the next decade to pay for a fiscal package that has yet to be implemented by a government that does not yet (and may never) exist. At this point, investors are basically punishing Italy for a crime – defaulting and possibly jettisoning the euro – it has yet to commit. If you are going to get reprimanded for something you have not done, you have more incentive to do it. The market realizes this, which is why it is locked in a vicious circle where rising yields make default more likely, leading to even higher yields (Chart 15). The fact that GDP per capita in Italy is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 16). Chart 15When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Chart 16Italy: Neither Divine Nor A Comedy As we go to press, rumours are swirling that the Five Star Movement and Lega may be able to form a government after agreeing to appoint a less euroskeptic finance minister than the one the Italian President previously rejected. Regardless of whether this happens, investors are likely to remain on edge. Support for Lega has risen by seven percent since voters went to the polls in March. Populism is here to stay. All this suggests that the brewing crisis in Italy will not blow over easily. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors should consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield reaches 4%. At that point, the risk-reward trade-off from owning Italian debt would be too good to ignore. Until the Italian bond market reaches a capitulation point, the euro will remain under pressure. The Italian sovereign debt market is the biggest in Europe and the fourth largest in the world after the U.S., Japan, and China. If foreign investors continue to shun Italian debt, that will reduce capital inflows into the euro area. This means less demand for the common currency. Investment Conclusions The softening of global growth this year, along with tensions in emerging markets and Italy, have lit a fire under the dollar. Our long DXY trade is up 10.7% inclusive of carry. We continue to think that the path of least resistance for the dollar is up, but we will be looking to book gains on our trade recommendation once the dollar index reaches 96. That's roughly 2% above current levels. Slower global growth is bad news for cyclical equities. European and Japanese equities have a greater tilt towards cyclical sectors, so it is likely that their stock markets will underperform the U.S. over the next few months. This is particularly the case for Europe, where banks have come under pressure due to slower domestic growth, rising bond yields in Italy and Spain, and heightened exposure to emerging markets. For now, our MacroQuant model, which is designed to capture short-term movements in the stock market, is recommending a somewhat below-benchmark allocation to equities. Looking further out, our 12-month cyclical view on stocks remains modestly constructive, reflecting our expectation that the next major recession in developed markets is still two years away. Keep in mind that even the EM crisis in the 1990s did not plunge the U.S. into recession. On the contrary, the crisis restrained the Fed from raising rates too quickly. The resulting dose of liquidity led to a massive blow-off rally in equities, which took the S&P 500 up 68% between October 1998 and March 2000. European stocks did even better during that period, outperforming their U.S. peers by 40% in local-currency terms. We may be heading for a similar sequence of events. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 The original Taylor Rule introduced by John Taylor in 1992 assigns a coefficient of 0.5 on the output gap. Thus, a one hundred basis-point rise in interest rates would be necessary to offset a 2% of GDP increase in output. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Neutral Relative share price gains for the S&P managed health care index are nearly exhausted. In Tuesday's Weekly Report, we acted on our late-March downgrade alert and took profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place (top panel). Industry revenue growth is fraying around the edges. The second panel shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. The implication is that enrollment may also be nearing a peak. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of relative valuations, which are already trading one standard deviation above the historical mean (bottom panel). Bottom Line: Downgrade the S&P managed health care index to neutral. Please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.

Highlights The 10-year Italian BTP yield at 4% yield marks a 'line in the sand' at which the current drama could escalate into something considerably worse. The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stay underweight in the classically cyclical sectors: banks, basic materials and industrials. Prefer France's CAC over Italy's MIB and Spain's IBEX. The equity market's range-bound pattern can continue, as long as the line in the sand isn't breached. It is a good time to own a small portfolio of high-quality 30-year government bonds. It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. Feature Italian politics have blindsided almost everybody, us included. Few anticipated that the unlikely bedfellows 5S and Lega would try and form a 'government of change'. In March we wrote: "The Italian election result is not an investment game changer. The one exception would be if 5S and Lega joined forces to govern, as it could throw EU integration into reverse. But the likelihood of this unholy alliance seems very low." Even fewer anticipated that Italy's President, Sergio Mattarella, would then scupper this government of change by vetoing the proposed Finance Minister. This has cast a new pall of uncertainty over Italian politics and Italian public support for EU rules and institutions. The 10-Year BTP Yield At 4% Marks A 'Line In The Sand' The market's response has been to fear the worst: shoot first, ask questions later. The danger is that this sets off a negative feedback loop. Higher bond yields weaken Italy's still-fragile banks; which threatens Italy's economic recovery; ahead of a possible new election, this increases the support for parties and policies that push back against EU rules; which further lifts bond yields; and then in a vicious circle until the fear of the worst becomes a self-fulfilling prophecy... Chart of the WeekItalian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% The Italian BTP versus German bund yield spread is effectively a fear gauge for Italy's future in the euro (Chart I-2). As these fears increase, and Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Chart I-2The BTP-Bund Yield Spread Is A Fear ##br## Gauge For Italy's Future In The Euro As a rule of thumb, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart I-3). Chart I-3Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4%.1 Hence, the 10-year BTP yield at 4% marks a 'line in the sand' at which the current drama could escalate into something considerably worse (Chart of the Week). To short-circuit the negative feedback loop, the financial markets would need to sense a discernible shift in Italian support for its populist parties; or an explicit de-escalation in the populist pushback against the EU. The question is: could this happen quickly enough? Global Growth Is In A Mini-Downswing The market's concerns about Italy come at a time when global growth has in any case been losing momentum. This is one development that did not blindside us, and has unfolded exactly as predicted. In January we wrote: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting." The theory underlying these mini-cycles is an economic model called the Cobweb Theorem.2 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a delay. The delay occurs because credit demand leads credit supply by several months (Chart I-4). Chart I-4Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months, and the regularity creates predictability. Moreover, as most investors are unaware of these cycles, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. The global 6-month credit impulse is now indisputably in a mini-downswing phase, and exactly as predicted in January, the majority of economically sensitive sectors have underperformed. The glaring anomaly is oil, whose supply-side dynamics have dominated price action (Chart I-5). Given oil's major impact on headline inflation, inflation expectations, and on central bank reaction functions, the global bond yield has also disconnected from the mini-cycle - until now. Chart I-5Oil Is The Glaring Anomaly Mini-downswings last six to eight months and the usual release valve is a decline in bond yields. So one concern is that the apparent disconnect between decelerating global activity and slow-to-react bond yields could extend the current mini-downswing phase beyond the summer. How To Invest Right Now From an equity market perspective, the relative performance of the classically cyclical sectors - banks, basic materials and industrials - very closely tracks the phases of the global credit impulse mini-cycle (Chart I-6 and Chart I-7). For example, in all five of the last five mini-downswings, banks have underperformed healthcare, and we are seeing exactly the same in the current mini-cycle. Chart I-6In A Mini-Downswing##br## Banks Underperform Chart I-7In A Mini-Downswing ##br##Basic Materials Underperform For the next few months at least, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. This strategy has worked extremely well since we initiated it at the start of the year, and it should continue to do so. Sector strategy necessarily impacts stock market allocation. Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. The defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks (Chart I-8 and Chart I-9). Irrespective of the political uncertainties, our sector allocation establishes our near-term caution on these two markets. Prefer France's CAC over Italy's MIB and Spain's IBEX. Chart I-8Italy's MIB = Long Banks Chart I-9Spain's IBEX = Long Banks For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the global economy provide a natural cap and a tradeable reversal in yields. Hence, it is a good time to own a portfolio of high-quality 30-year government bonds. Regarding currencies, the recent developments in Italy have hurt our 50:50 combined long position in EUR/USD and SEK/USD; but this has been countered by gains in our short position in EUR/JPY. We have no tactical conviction on any of these crosses, but we will maintain this medium term currency portfolio unless the Italian 10-year BTP yield breaches the 4% line in the sand. Finally, the hardest call to make is on the direction of equity market. This is because a mini-downswing in global growth creates a headwind to earnings expectations; conversely, if bond yields are capped, this will provide some support to equity market valuations. On balance, this suggests that the year-to-date pattern of a range-bound equity market is set to continue. The caveat is that if Italy's line in the sand is breached, it would warrant a substantial de-risking. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model* It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. This week, we note that the 65-day fractal dimension of the Polish zloty / U.S. dollar (or inverse) is approaching its lower limit. Go long PLN/USD with a profit target of 3.5% and 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-10 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Special Report

As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Chart II-7Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads.

Highlights The risk/reward balance for risk assets remains unappealing this month, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The number of items that could take equity markets to new highs appears to fall well short of the number of potential landmines that could take markets down. Tensions vis-à-vis North Korea have eased, but the U.S./China trade war is heating up. Trump's voter base and many in Congress want the President to push China harder. Eurozone "breakup risk" has reared its ugly head once again. The Italian President is trying to install a technocratic government, but the interim between now and a likely summer election will extend the campaign period during which the two contending parties have an incentive to continue with hyperbolic fiscal proposals. The next Italian election is not a referendum on exiting the EU or Euro Area. Nonetheless, the risks posed by the Italian political situation may not have peaked, especially since Italy's economic growth appears set to slow. We are underweight both Italian government bonds and equities within global portfolios. It is also disconcerting that we have passed the point of maximum global growth momentum. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. One reason for the economic "soft patch" is that the Chinese economy continues to decelerate. Our indicators suggest that growth will moderate further, with negative implications for the broader emerging market complex. Dearer oil may also be starting to bite, although prices have not increased enough to derail the expansion in the developed economies. This is especially the case in the U.S., where the shale industry is gearing up. Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. Similar divergences are occurring in the inflation data. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. U.S. inflation is almost back to target and the FOMC signaled that an overshoot will be tolerated. Policymakers will likely transition from "normalizing" policy to targeting slower economic growth once long-term inflation expectations return to the 2.3%-2.5% range. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Feature The major stock indexes are struggling, even though 12-month forward earnings estimates continue to march higher (Chart I-1). One problem is that a lot of good earnings news was discounted early in the year. The number of items that could take markets to new highs appear to fall well short of the number of potential landmines that could take markets down. Not the least of which is ongoing pain in emerging markets and the return of financial stress in Eurozone debt markets. Last month's Overview highlighted the unappealing risk/reward balance for risk assets, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The advanced stage of the business cycle and our bias for capital preservation motivated us to heed the recent warnings from our growth indicators and 'exit' timing checklist. We also were concerned about a raft of geopolitical tensions. Fast forward one month and the backdrop has not improved. Our Equity Scorecard Indicator edged up, but is still at a level that historically was consistent with poor returns to stocks and corporate bonds (see Chart I-1 in last month's Overview). Our 'exit' checklist is also signaling that caution is warranted (Table I-1). Meanwhile, the "global synchronized expansion" theme that helped to drive risk asset prices higher last year is beginning to unravel and trade tensions are escalating. Chart I-1Struggling To Make Headway Table I-1Exit Checklist For Risk Assets U.S./Sino Trade War Is Back? The "on again/off again" trade war between the U.S. and China is on again as we go to press. Investors breathed a sigh of relief in mid-May when the Trump Administration signaled that China's minor concessions were sufficient to avoid the imposition of onerous new tariffs. However, the proposed deal did not go down well with many in the U.S., including some in the Republican Party. The President was criticized for giving up too much in order to retain China's help in dealing with North Korea. Trump might have initially cancelled the summit with Kim in order to send a message to China that he is still prepared to play hard ball on trade, despite the North Korean situation. We expect that U.S./North Korean negotiations will soon begin, and that Pyongyang will not be a major threat to global financial markets for at least the near term. It is a different story for U.S./China relations. Trump's voter base and many in Congress on both sides of the isle want the President to push China harder. This is likely to be a headwind for risk assets at least until the U.S. mid-term elections. The Return Of Eurozone Breakup Risk Turning to the Eurozone, "breakup risk" has reared its ugly head once again. Italian President Sergio Mattarella's decision to reject a proposed cabinet minister has led to the collapse of the populist coalition between the anti-establishment Five Star Movement (M5S) and the euroskeptic League. President Mattarella's choice for interim-prime minister, Carlo Cottarelli, is unlikely to last long. It is highly unlikely that he will be able to receive parliamentary support for a technocratic mandate, given the fact that he cut government spending during a brief stint in government from 2013-14. As such, elections are likely this summer. Chart I-2Italy: No Euro Support Rebound Investors continue to fret for two reasons. First, the interim period will extend the campaign period during which both M5S and the League have an incentive to continue with hyperbolic fiscal proposals. Second, M5S has suggested that it will try to impeach Mattarella, a long and complicated process that would heighten political risk, though it will likely fail in our view. As our geopolitical strategists have emphasized throughout 2017, Italy will eventually be the source of a major global risk-off event because it is the one outstanding major European country capable of reigniting the Euro Area break-up crisis.1 While a majority of Italians support the euro, they are less supportive than any other major European country, including Greece (Chart I-2). Meanwhile a plurality of Italians is confident that the future would be brighter if Italy were an independent country outside of the EU. That said, the next election is not a referendum on exiting the EU or Euro Area. The current conflict arises from the coalition wanting to run large budget deficits in violation of Europe's Stability and Growth Pact fiscal rules. Given that the costs of attempting to exit the Euro Area are extremely severe for Italy's households and savers, and that even the Five Star Movement has moderated its previous skepticism about the euro for the time being, it is likely going to require a recession or another crisis to cause Italy seriously contemplate an exit. We are still several steps away from such a move. Nonetheless, the risks posed by the Italian political situation may not have peaked. Italy's leading economic indicator points to slowing growth, which will intensify the populist push for aggressive fiscal stimulus. We are underweight both Italian government bonds and equities within global portfolios. Global Growth Has Peaked Chart I-3Past The Point Of Max Growth Momentum It is also disconcerting that we have passed the point of maximum global growth momentum, as highlighted by the indicators shown in Chart I-3. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. What is behind this year's loss of momentum? First, growth in 2017 was flattered by a rebound from the oil-related manufacturing recession of 2015/16. That rebound is now topping out, while worries regarding a trade war are undoubtedly weighing on animal spirits and industrial activity. Second, the Eurozone economy was lifted last year by the previous recapitalization of parts of the banking system, which allowed some pent-up credit demand to be satiated. This growth impulse also appears to have peaked, which helps to explain the sharp drop in some of the Eurozone's key economic indicators. Still, we do not expect European growth to slip back below a trend pace on a sustained basis unless the Italian situation degenerates so much that contagion causes significantly tighter financial conditions for the entire Eurozone economy. The third factor contributing to the global growth moderation is China. The Chinese economy surged in 2017 in a lagged response to fiscal and monetary stimulus in 2016, as highlighted by the Li Keqiang Index (LKI) and import growth (Chart I-4). Both are now headed south as the policy backdrop turned less supportive. Downturns in China's credit and fiscal impulses herald a deceleration in capital spending and construction activity (Chart I-4, bottom panel). The LKI has a strong correlation with ex-tech earnings and import growth. In turn, the latter is important for the broader EM complex that trade heavily with China. Weaker Chinese import growth has also had a modest negative impact on the developed world (Chart I-5). We estimate that, for the major economies, the contribution to GDP growth of exports to China has fallen from 0.3 percentage points last year to 0.1 percentage points now.2 Japan and Australia have been hit the hardest, but the Eurozone has also been affected. Interestingly, U.S. exports to China have bucked the trend so far. Chart I-4China Growth Slowdown... Chart I-5...Is Weighing On Global Activity China is not the only story because the slowdown in global trade activity in the first quarter was broadly based (Chart I-5). Nonetheless, softer aggregate demand growth out of China helps to explain why manufacturing PMIs and industrial production growth in most of the major developed economies have cooled. Our model for the LKI is still moderating. We do not see a hard economic landing, but our analysis points to further weakening in Chinese imports and thus softness in global exports and manufacturing activity in the coming months. Oil's Impact On The Economy... Finally, oil prices are no doubt taking a bite out of consumer spending power as Brent fluctuates just below $80/bbl. Our energy experts expect the global crude market to continue tightening due to robust growth and ongoing geopolitical tensions. Chief among these are the continuing loss of Venezuelan crude production and the re-imposition of U.S. sanctions on Iran. At the same time, we expect OPEC 2.0 to keep its production cuts in place in the second half of the year. Increasing shale output will not be enough to prevent world oil prices from rising in this environment, and we expect oil prices to continue to trend higher through 2018 and into early 2019 (Chart I-6). Brent could touch $90/bbl next year. There are a few ways to gauge the size of the oil shock on the economy. Chart I-7 shows the U.S. and global 'oil bill' as a share of GDP. We believe that both the level and the rate of change are important. Price spikes, even from low levels, do not allow energy users the time to soften the blow by shifting to alternative energy sources. Chart I-6Oil: Stay Bullish Chart I-7The Oil Bill The level of the oil bill is not high by historical standards. The increase in the bill over the past year has been meaningful, both for the U.S. and at the global level, but is still a long way from the oil shocks of the 1970s. U.S. consumer spending on energy as a share of disposable income, at about 4%, is also near the lowest level observed over the past 4-5 decades (Chart I-8). The 2-year swing in this series shows that rapid increases in energy-related spending has preceded slowdowns in economic growth, even from low starting points. The swing is currently back above the zero line but, again, it is not at a level that historically was associated with a significant economic slowdown. Chart I-8Oil's Impact On U.S. Consumer Spending Moreover, the mushrooming shale oil and gas industry has altered the calculus of oil shocks for the U.S. The plunge in oil prices in 2014-16 was accompanied by a manufacturing and profit mini recession in the developed countries, providing a drag on overall GDP growth. Chart I-9 provides an estimate of the contribution to U.S. growth from the oil and gas industry. We have included capital spending and wages & salaries in the calculation, and scaled it up to include spillover effects on other industries. Chart I-9Oil's Impact On Consumer Spending And Shale The oil and gas contribution swung from +0.5 percentage points in 2012 to -0.4 percentage points in 2016. The contribution has since become only slightly positive again, but it is likely to rise further unless oil prices decline in the coming months. We have included the annual swing in consumer spending on energy as a percent of GDP in Chart I-9 (inverted) for comparison purposes. At the moment, the impact on growth from the shale industry is roughly offsetting the negative impact on consumer spending. The bottom line is that the rise in oil prices so far is enough to take the edge off of global growth, but it is not large enough to derail the expansion in the developed countries. This is especially the case in the U.S., where the shale industry is gearing up. ...And Asset Prices As for the impact on asset prices, it is important to ascertain whether rising oil prices represent more restrictive supply or expanding demand. A mild rise in oil prices might simply be a symptom of increased demand caused by accelerating global growth. Higher oil prices are thus reflective of robust demand, and thus should not be seen as a threat. In contrast, the 1970s experience shows that supply restrictions can send the economy into a tailspin. In order to separate the two drivers of prices, we regressed WTI oil prices on global oil demand, inventories and the U.S. dollar. By excluding supply-related factors such as production restrictions, the residual of the regression model gives an approximate gauge of supply shocks (panel 2, Chart I-10). This model clearly has limitations, but it also has one key benefit: it estimates not just actual disruptions in supply, but also the premium built into prices due to perceived or expected future supply disruptions. For example, the 1990 price spike appears as quite a substantial deviation from what could be explained by changes in demand alone. Similar negative supply shocks are evident in 2000 and 2008. Chart I-10Identifying Supply Shocks In The Oil Market We then examined the impact that supply shocks have on subsequent period returns for both Treasury and risk assets. We divided the Supply Shock Proxy into four quartiles corresponding to the four zones shown in Chart I-10: strong positive shock, mild positive shock, mild negative shock and strong negative shock; the last of these corresponds to the region above the upper dashed line, which we have shaded in the chart. The performance of risk assets does not vary significantly across the bottom three quartiles of the supply shock indicator (Chart I-11). However, performance drops off precipitously in the presence of a strong negative supply shock. This is consistent with the "choke point" argument: investors are initially unconcerned with a modest appreciation in oil prices. It is only when prices are driven sharply above the level consistent with the current demand backdrop that risk assets begin to discount a more pessimistic future. The total returns to the Treasury index behave in the opposite manner (Chart I-12). Treasury returns are below average when the oil shock indicator is below one (i.e. positive supply shock) and above average when oil prices rise into negative supply shock territory. In other words, an excess of oil supply is Treasury bearish, as it would tend to fuel more robust economic growth. Conversely, a supply shock that drives oil prices higher tends to be Treasury bullish. This may seem counterintuitive because higher oil prices can be inflationary and thus should be bond bearish in theory. However, large negative oil supply shocks have usually preceded recessions, which caused Treasurys to rally. Chart I-11Effect On Risk Assets Chart I-12Effect On Treasurys The model clearly shows that the drop in oil prices in 2014/15 was a positive supply shock, consistent with the oil consumption data that show demand growth was fairly stable through that period. The model indicator has moved up toward the neutral line in recent months, suggesting that the supply side of the market is tightening up, but it is still in "mild positive supply shock" territory. The latest data point available is April, which means that it does not capture the surge in oil prices over the past month. Some of the recent jump in prices is clearly related to the cancelled Iran deal and other supply-related factors, although demand continues to be supportive of prices. The implication of this model is that it will probably require a significant further surge in prices, without a corresponding ramp up in oil demand, for the model to signal that supply constraints are becoming a significant threat for risk assets. A rise in Brent above US$85 would signal trouble according to this model. As for government bonds, rising oil prices are bearish in the near term, irrespective of whether it reflects demand or supply factors. This is because of the positive correlation between oil prices and long-term inflation expectations. The oil bull phase will turn bond-bullish once it becomes clear that energy prices have hit an economic choke point. Desynchronization Last year's "global synchronized growth" story is showing signs of wear. First quarter U.S. GDP growth was underwhelming, but the long string of first-quarter disappointment points to seasonal adjustment problems. Higher frequency data are consistent with a robust rebound in the second quarter. Forward looking indicators, such as the OECD and Conference Board's Leading Economic Indicators, continue to climb. This is in contrast with some of the other major economies, such as the Eurozone, U.K., Australia and Japan (Chart I-13). First quarter real GDP growth was particularly soft in Japan and the Eurozone, and one cannot blame seasonal adjustment in these cases. Chart I-13Growth & Inflation Divergences The divergence in economic performance likely reflects Washington's fiscal stimulus that is shielding the U.S. from the global economic soft patch. Moreover, the U.S. is less exposed to the oil shock and the China slowdown than are the other major economies. Similar divergences are occurring in the inflation data. While U.S. inflation continues to drift higher, it has lost momentum in the euro area, Japan and the U.K. (Chart I-13). Renewed stresses in the Italian and Spanish bond markets have sparked a flight-to-quality in recent trading days, depressing yields in safe havens such as U.S. Treasurys and German bunds. Nonetheless, prior to that, the divergence in growth and inflation was reflected in widening bond yield spreads as U.S. Treasurys led the global yields higher. Long-term inflation expectations have risen everywhere, but real yields have increased the most in the U.S. (prior to the flight-to-quality bond rally at the end of May). This is consistent with the growth divergence story and with our country bond allocation: overweight the U.K., Australia and Japan, and underweight U.S. Treasurys within hedged global portfolios. The dollar lagged earlier this year, but is finally catching up to the widening in interest rate spreads. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. Expect More Pain In EM Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. We do not see the recent selloff across EM asset classes as a buying opportunity since markets have only entered the first stage of the classic final chapter; EM assets underperform as U.S. bond yields and the dollar rise, but commodity prices are resilient. In the second phase, U.S. bond yields top out, but the U.S. dollar continues to firm and commodity prices begin their descent. If the current slowdown in Chinese growth continues, as we expect, it will begin to weigh on non-oil commodity prices. Thus, emerging economies may have to deal with a deadly combination of rising U.S. interest rates, a stronger greenback, falling commodity prices and slowing exports to China (Chart I-14). Which countries are most exposed to lower foreign funding? BCA's Emerging Market Strategy services has ranked EM countries based on foreign funding requirements (Chart I-15). The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-14EM Currencies Exposed To China Slowdown Chart I-15Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. These mostly stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen as it becomes more difficult to service the foreign debt.3 It is too early to build positions even in Turkish assets. Our EM strategists believe that it will require an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms, to create a buying opportunity in Turkish financial instruments. FOMC Expects Inflation Overshoot Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. The FOMC is monitoring stress in emerging markets and in the Eurozone, but is sticking with its "gradual" tightening pace for now (i.e. 25 basis points per quarter). May's FOMC minutes signaled a rate hike in June. However, the minutes did not suggest that the Fed is getting more hawkish, despite the Staff's forecast that growth will remain above trend and that the labor market will continue to tighten at a time when core inflation is already pretty much back to target. Some inflation indicators, such as the New York Fed's Inflation Gauge, suggest that core inflation will overshoot. The minutes signaled that policymakers are generally comfortable with a modest overshoot of the 2% inflation target because many see it as necessary in order to shift long-term inflation expectations higher, into a range that is consistent with meeting the 2% inflation target on a "sustained" basis (we estimate this range to be 2.3-2.5% for the 10-year inflation breakeven rate). The fact that the FOMC took a fairly dovish tone and did not try to guide rate expectations higher contributed to some retracement of the Treasury selloff in recent weeks. Nonetheless, an inflation overshoot and rising inflation expectations will ultimately be bond-bearish, especially when the FOMC is forced to clamp down on growth as long-term inflation expectations reach the target range. As discussed in BCA's Outlook 2018, one of our key themes for the year is that risk assets are on a collision course with monetary policy because the FOMC will eventually have to transition from simply removing accommodation to targeting slower growth. Timing that transition will be difficult, and depends importantly on how much of an inflation overshoot the FOMC is prepared to tolerate. Is 2½% reasonable? Or could inflation go to 3%? The makeup of the FOMC has changed, but we expect Janet L. Yellen4 to shed light on this question when she speaks at the BCA Annual Investment Conference in September. Investment Conclusions The risks facing investors have shifted, but we do not feel any less cautious than we did last month. Geopolitical tensions vis-à-vis North Korea have perhaps eased. But trade tensions are escalating and investors are suddenly faced with another chapter in the Eurozone financial crisis. The major fear in the first and second chapters was that bond investors would attack Italy, given the sheer size of that economy and the size of Italian government debt. That dreadful day has arrived. The profit backdrop in the major economies remains constructive for equity markets. However, even there, the bloom is coming off the rose. Global growth is no longer synchronized and the advanced economies have hit a soft patch with the possible exception of the U.S. While far from disastrous, our short-term profit models appear to be peaking across the major countries (Chart I-16). Chart I-16Profit Growth: Solid, But Peaking The typical U.S. late cycle dynamics are also threatening emerging markets, at a time when investors are generally overweight and many EM countries have accumulated a pile of debt. U.S. inflation is set to overshoot the target, the FOMC is tightening and the dollar is rising. Throw in slowing Chinese demand and the EM space looks highly vulnerable. If the global economic slowdown is pronounced and drags the U.S. down with it, then bonds will rally and risk assets will take a hit. If, instead, the soft patch is short-lived and growth re-accelerates, then the U.S. Treasury bear market will resume. Stock indexes and corporate bond excess returns would enjoy one last upleg in this scenario, but downside risks would escalate once the Fed begins to target slower economic growth. Either way, EM assets would be hit. Our base case remains that stocks will beat government bonds and cash on a 6-12 month horizon. However, the risk/reward balance is unattractive given the geopolitical backdrop. Thus, we remain tactically cautious on risk assets for the near term. We still expect that the 10-year Treasury yield will peak at close to 3½% before this economic expansion is over. Nonetheless, this would require a calming of geopolitical tensions and an upturn in the growth indicators in the developed world. The risk/reward tradeoff for corporate bonds is no better than for equities and we urge caution in the near term. On a 6-12 month cyclical horizon, we still expect corporate bonds to outperform government bonds, at least in the U.S. European corporates are subject to the ebb and flow of the Italian bond crisis, and face the added risk that the ECB will likely end its QE program later this year. Looking further ahead, this month's Special Report, beginning on page 19, analyzes the Eurozone corporate sector's vulnerability to the end of the cycle that includes rising interest rates and, ultimately, a recession. We find that domestic issuers into the Eurozone market are far less exposed than are foreign issuers. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2018 Next Report: June 28, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available on gps.bcaresearch.com 2 This underestimates the impact on the major countries because it does not account for third country effects (i.e. trade with other countries that trade with China). 3 For more information, please see BCA Emerging Market Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018, available on ems.bcaresearch.com 4 Janet L. Yellen, Chair, Board of Governors, Federal Reserve System (2014-2018). II. Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Chart II-7Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in May. We remain cautious, despite the supportive profit backdrop. The U.S. net earnings revisions ratio fell a bit in May, but it remains well in positive territory. Forward earnings continued their ascent, and the net earnings surprise index rose further to within striking distance of the highest levels in the history of the series. Normally, an earnings backdrop this strong would justify an overweight equity allocation within a balanced portfolio. Unfortunately, a lot of good earnings news is discounted based on our Composite Valuation Indicator and extremely elevated 5-year bottom-up earnings growth expectations (see the Bank Credit Analyst Overview, May 2018). Moreover, our equity indicators are sending a cautious signal. Our U.S. Willingness-to-Pay indicator continued to decline in May. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Our Revealed Preference Indicator (RPI) for stocks remained on its 'sell' signal in May, for the second month in a row. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Moreover, our composite equity Technical Indicator is on the verge of breaking down and our Monetary Indicator moved further into negative territory in May. Meanwhile, market froth has not been completely extinguished according to our Speculation Indicator (which is a negative sign for stocks from a contrary perspective). As for bonds, the powerful rally at the end of May has undermined valuation, but the 10-year Treasury is not yet in expensive territory. Our technical indicator suggests that previously oversold conditions are easing, but bonds are a long way from overbought. This means that yields have room to fall further in the event of more bad news on Italy or on the broader geopolitical scene. The dollar has not yet reached overbought territory according to our technical indicator. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst