Equities

Dear Client, We had intended to send you the second part of our two-part special report on long-term inflation risks this week, but given the sharp moves in the dollar and emerging market assets, we decided to write this bulletin instead. Barring any further major market turbulence, we will send you the sequel to the inflation report next week. Best regards, Peter Berezin, Chief Global Strategist Highlights The dollar rally and EM selloff have further to go. The U.S. economy is firing on all cylinders, while the rest of the world is sputtering. Turkey is not an isolated case. Emerging markets as a whole have feasted on debt over the past decade, and now will be held to account. We remain neutral on global equities, while underweighting EM relative to DM and overweighting defensives relative to deep cyclicals. Brewing EM stresses could cause the 10-year Treasury yield to temporarily fall to 2.5%, leading to a further flattening of the yield curve. However, the long-term path for yields is up. Feature King Dollar Reigns Supreme Our expectation going into this year was that the dollar would strengthen, triggering turmoil in emerging markets. This thesis has panned out, raising the question of whether it is time to declare victory and move on. We don't think so. While market positioning has clearly shifted closer towards our own views, we still think that the stronger dollar/weaker EM story has further to run. To understand why, it is useful to review the reasoning behind our thesis. Our bullish dollar view was based on a simple observation, which is that the U.S. had finally reached a point where aggregate demand was starting to outstrip supply. This implied that the dollar would need to strengthen in order to shift demand away from the United States. It is amazing how many commentators still think that the U.S. can divert spending towards imported goods without any change in the value of the dollar. Americans do not care what the CBO's or IMF's estimate of the domestic output gap is when they are deciding whether to buy U.S. or foreign-made goods. They care about relative quality-adjusted prices. Since the U.S. is a fairly closed economy - imports are only 15% of GDP - we reckoned that the dollar would need to strengthen considerably in order to displace a significant amount of domestic production with foreign-made goods. This is exactly what happened. Still More Upside For U.S. Rates Currency values tend to track interest rate differentials (Chart 1). As such, our prediction of a stronger dollar entailed the expectation that investors would increasingly price in a more hawkish path for the fed funds rate. This has indeed occurred. Since the start of the year, the expected fed funds rate has risen by 34 basis points for end-2018 and by 65 basis points for end-2019 (Chart 2). Chart 1Historically, The Dollar Has Moved In Line With Interest Rate Differentials Chart 2Rate Expectations Have Increased, ##br##But There Is Still A Long Way To Go Our sense is that U.S. interest rate expectations can rise further. Faster wage growth will boost consumption. The household savings rate can also fall from its current elevated level, which will give consumer spending an additional boost (Chart 3). Business investment should remain firm. Chart 4 shows that capex intentions are strong, while bank lending standards for commercial and industrial loans, which tend to lead loan growth, continue to ease. Fiscal stimulus will also goose the economy. Chart 3Consumption Could Accelerate As The Savings Rate Drops Chart 4U.S. Capex Investment Going Strong Could interest rate expectations move up more in the rest of the world than in the U.S., causing the dollar to tumble? It is possible, but unlikely. In contrast to most other central banks, the Fed wants to tighten financial conditions in order to keep the economy from overheating. A weaker dollar would entail an easing of financial conditions, and hence would require an even more hawkish response from the Fed. Currency Intervention Is Unlikely To Succeed Some have speculated that the Trump administration will intervene in the foreign exchange market in order to drive down the value of the dollar. We doubt this will happen, but even if such interventions were to take place, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck out those dollars from the financial system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs This brings us to emerging markets. EM equities almost always fall when U.S. financial conditions are tightening (Chart 5). One can believe that emerging market stocks will go up; one can also believe, as we do, that the Fed will do its job and tighten financial conditions. But one cannot believe that both of these things will happen at the same time. Some pundits think that the plunge in the Turkish lira is not emblematic of the problems facing emerging markets. We are skeptical of this sanguine conclusion. Chart 6 shows that as a share of both GDP and exports, EM dollar-denominated debt is now as high as it was in the late 1990s. Turkey may be the worst of the lot, but it is hardly an isolated case. Chart 5Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Chart 6EM Dollar Debt Is High Chart 7 presents a vulnerability heat map for a number of key emerging markets.1 We consider fourteen variables (expressed as a share of GDP, unless otherwise noted): 1) Current account balance; 2) Net international investment position; 3) External debt; 4) Change in external debt during the past five years; 5) External debt-servicing obligations coming due over the next 12 months as a share of exports; 6) External funding requirements over the next 12 months as a share of foreign exchange reserves; 7) Private sector savings-investment balance; 8) Private-sector debt; 9) Change in private-sector debt over the past five years; 10) Government budget balance; 11) Government debt; 12) Change in government debt over the past five years; 13) Share of domestic debt held by overseas investors; and 14) Inflation. Our analysis suggests that Turkey, Argentina, Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia are all vulnerable to balance of payments stresses. Chart 7Vulnerability Heat Map For Key EM Markets Of course, asset markets in some of these economies have already moved quite a bit over the past few months, so it is useful to benchmark their stock markets and currencies to the underlying macro risks they face. For stock markets, we do this by comparing the heat map score with a composite valuation measure that incorporates price-to-book, price-to-sales, price-to-forward earnings, price-to-cash flow, and the dividend yield. Our analysis suggests that stocks in Russia and Korea are rather cheap, while equities in Indonesia, Mexico, South Africa, and Argentina are still quite expensive (Chart 8, top panel). Chart 8Some EM Stock Markets And Currencies Have Not Fully Priced In Macro Risks For currencies, we compare the heat map score with the level of the real effective exchange rate relative to its ten-year average. The Mexican peso, Brazilian real, Chilean peso, Indonesian rupiah, and South African rand still look pricey on this basis (Chart 8, bottom panel). In contrast, the Turkish lira and the Argentine peso are starting to look fairly cheap, although they could still get quite a bit cheaper before finding a floor. The China Wildcard The last time emerging markets seemed at risk of melting down was in 2015. Fortunately for them, China came to the rescue, delivering a massive double dose of fiscal and credit easing. Things may not be so straightforward this time around. China does not want to let its economy falter, but high debt levels and an overvalued housing market have made the usual policy prescriptions less appealing. As such, we would not necessarily conclude that the recent decline in the Chinese three-month interbank rate is a signal that the authorities want to see much faster credit growth (Chart 9). They may simply want to see a weaker currency. This is an important distinction because while faster credit growth would boost demand for EM exports, a weaker yuan would hurt other emerging markets by giving China a leg up in competitiveness. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. It is too soon to know what policy mix the Chinese authorities will choose to pursue. Investors should pay close attention to the monthly data on the growth rates of social financing and local government bond issuance. So far, the combined credit and fiscal impulse has continued to weaken, suggesting that the authorities are in no hurry to open the stimulus floodgate (Chart 10). Chart 9Is China Trying To Stimulate Credit ##br##Growth Or Weaken The Yuan? Chart 10China Has Been Slow To Open The Credit And Fiscal Spigots Worries About The Euro Area Slower EM growth is likely to take a bigger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks. Notably, Spanish banks have sizeable exposure to Turkey and other vulnerable emerging markets (Chart 11). Meanwhile, worries about Italy have resurfaced. The 10-year Italian bond yield has moved back above 3%, not far from its May highs. The gap in fiscal policy between what Italy's new populist government has promised voters and what the European Commission is willing to accept remains a mile wide. Italian banks have become increasingly wary of financing their spendthrift government. With the ECB stepping back from asset purchases, two critical buyers of Italian debt are moving to the sidelines. The credit impulse in the euro area turned negative even before concerns about emerging markets and Italian politics came to the fore. As Chart 12 shows, the credit impulse has reliably tracked euro area growth. Right now, there is little reason to think that European banks will open the credit spigots, suggesting that euro area growth will be lackluster. Chart 11Who Has More Exposure To EM? Chart 12Euro Area Credit Impulse Suggests Growth Will Remain Lackluster Investment Conclusions If last year was the year of global growth resynchronization, this year is turning into one of desynchronization. The U.S. economy is outperforming the rest of the world, and the dollar is benefiting in the process. As we go to press, the broad trade-weighted dollar is up 6.1% year-to-date and stands only 2.2% below its December 28, 2016 high (Chart 13). From a long-term perspective, the greenback has become expensive, so we are inclined to close our strategic long DXY trade for a potential carry-adjusted profit of 15.7% if it reaches our target of 98 (as of the time of writing, the DXY is at 96.5). However, even if we were to close this trade, our tactical bias would be to remain long the dollar until clearer evidence emerges that the brewing EM crisis is about to abate. We moved from overweight to neutral on global equities on June 19. The MSCI All-Country World index has fluctuated a lot since then, but is currently up only 0.7% in dollar terms. Developed markets have gained 1.4%, while emerging markets have lost 3.8% (Chart 14). We have yet to reach a capitulation point for EM equities. The number of shares in the iShares MSCI Turkey ETF has almost doubled since August 3rd, as a stampede of bottom fishers have plowed into the fund (Chart 15). Equity investors should maintain our recommendation to underweight emerging markets relative to DM and to favor defensive sectors over deep cyclicals. We expect euro area stocks to perform in line with their U.S. peers in local-currency terms, but to underperform in dollar terms over the remainder of the year. Chart 13The Dollar Is Back Near Its Highs Chart 14Stock Market Performance: Roller Coaster Ride Chart 15Foreign Investors And Turkish Stocks: ##br##Trying To Catch A Falling Knife In the fixed-income realm, the long-term trend in global bond yields remains to the upside, but near-term EM stresses could cause the 10-year Treasury yield to temporarily fall back towards 2.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 We collaborated with our colleague Mathieu Savary and his team at BCA’s Foreign Exchange Strategy to build this heat map. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Overweight On Monday of this week, President Trump signed the John S. McCain National Defense Authorization Act into law. Most significantly, the bill authorizes $717 billion in defense funding for FY2019, a small increase from the $696 billion in FY2018, which was a significant increase from the FY2016 $580 billion budget. The administration's commitment to returning military funding to wartime levels (regardless of budget constraints or geopolitical threat) are confirmed by defense spending surging at the fastest rate in nearly a decade (second panel). This is further reflected in the recovery in defense investment (bottom panel). We highlighted earlier this week that defense stocks should be winners in a trade war, particularly if such a war increases the threat of a more conventional one. Tack on above-normal earnings growth from exceptional government funding and defense stocks look even more appealing; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL.

Turkey's unorthodox macroeconomic policies have backfired. The pursuit of economic growth at all costs has created major macroeconomic imbalances including surging inflation, a large current account deficit, extreme reliance on foreign portfolio inflows and foreign borrowing as well as an over-expansion of domestic credit. The nation's financial markets have been in freefall since early this year, hit by external shocks as well as investors' realization that President Erdogan is reluctant to adopt requisite and orthodox macroeconomic policies. The political spat between Turkey and the U.S. over the detention of American pastor Andrew Brunson in the past two weeks was a trigger - not the cause - of the selloff in Turkish financial markets. The basis for the ongoing selloff since early this year has been unsustainable macro policies, and the resulting macroeconomic imbalances. The key questions for investors are whether these ongoing adjustments in Turkey's financial markets and economy have further to go, and how to position in terms of investment strategy going forward. Valuations Have Become Attractive With share prices having dropped by 60% in U.S. dollar terms since their peak at the beginning of the year, Turkish equity valuations have become utterly depressed. The same can be said about the lira. In brief, there is now good value in Turkish financial markets. The lira has reached two standard deviations below fair value, according to the unit labor cost-based real effective exchange rate - which is our favorite currency valuation measure (Chart 1). At the moment, the lira is cheap. That said, if high inflation persists (Chart 2), the currency will appreciate in real terms, even if the nominal exchange rate stays around these levels. Chart 3 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is now, two standard deviations below the historical average. Chart 1The Lira Has Become Cheap Chart 2Turkey: Inflation Breakout Chart 3Turkish Equities Are Cheap Nevertheless, it is essential to recognize that the CAPE ratio is a structural valuation measure - i.e., it is intended to work in the long term, beyond short-term business cycle fluctuations. Furthermore, structural valuation measures assume there is no structural shift in financial markets or the economy. If the Turkish authorities move to impose capital controls and double down on their unorthodox macro policies, there will arguably be a structural shift in the nation's economy and financial markets, and any indicator based on the past, including this CAPE ratio, will lose its relevance. In short, investors who buy Turkish stocks now will have a high probability of making money in the long run - possibly in the next three years or beyond barring structural regime shift. That said, the CAPE ratio is not a useful gauge for investors with short- and medium-term time horizons. Turkish U.S. dollar credit spreads are now the widest in the EM corporate space (1300 basis points). Sovereign spreads have also spiked to 590 basis points, the widest in 9 years, although still below levels that prevailed in the early 2000s (Chart 4). Local currency bonds are yielding 23%, and their total return in U.S. dollars have plunged to new lows (Chart 5). Bottom Line: Valuations, especially for equities and the currency, have become cheap. Chart 4Turkish Sovereign Spreads ##br##Have Broken Out Chart 5Turkish Local Currency ##br##Bonds Have Collapsed   Adjustment: How Complete Is It? From a macroeconomic perspective, Turkey has been over-spending, especially on foreign goods. Thus, a cheaper currency and higher borrowing costs were needed to force an adjustment - i.e. squeeze spending in general and imports in particular. Although the Turkish exchange rate has weakened dramatically, making imports more expensive, an adjustment in interest rates is still pending. The policy rate - the one-week repo rate - still stands at 17.75% while 3-month interbank rates have spiked to 22% compared with core inflation of 15%. Provided core inflation will rise further following the latest plunge in the lira's value, it is reasonable to conclude that the policy rate in Turkey in real (inflation-adjusted) terms is still low. As we have argued in the past,1 the pre-conditions for turning bullish on Turkey are (1) a very cheap currency (as well as low valuations for other asset classes), (2) reasonably high real policy rates (say between 2-4%) and (3) a switch and an adherence to orthodox macro policies, including the elimination of capital control risks. The first pre-condition - valuations - has been met, as we discussed above. The second pre-condition - high real interest rates - has only partially been met: market-driven interest rates have spiked, yet policy rates are still low. Finally, there has been no sign that Turkish policymakers have embraced more orthodox macro policies. Consequently, the risk of capital controls or additional unorthodox measures remains reasonably high. In term of the real economy, there is presently little doubt that it is heading into a major recession with the banking system under siege. This necessitates considerable bad-asset restructuring. However, financial market valuations have probably already priced these developments in. Bottom Line: Out of three pre-conditions for turning positive, only one and a half have been met. Investment Strategy: Book Profits On Shorts The investment strategy with respect to Turkish financial markets should take into account that valuations have become very attractive, yet uncertainty over policy remains unusually high. In particular, in the case of imposition of capital controls, investors will suffer more losses. Capital controls or other unorthodox measures would represent a structural breakdown, and historical valuation metrics will be of little value. It is impossible to forecast and quantify the probability of capital controls being imposed by Turkey because it is a decision only one individual can take: President Erdogan. Nevertheless, disciplined investors should never ignore extreme valuations. As shown in Charts 1 and 3 above, the currency and equities now trade at two standard deviations below their fair value. Therefore, balancing cheap valuations on the one hand and lingering risks of further unorthodox policies (capital controls in particular) on the other, we recommend the following: 1. Investors who are short should take profits. We are doing this on the following positions: Short TRY / long USD - we reinstated this position on April 19, 2017, and it has generated a 41% gain since that time. The cumulative gain on our short lira position is 65% since January 17, 2011 (Chart 6, top panel). Short Turkish bank stocks - we recommended this trade on April 19, 2017; it has produced a 65% gain since. Prior to this, we shorted banks from June 4, 2013 to January 25, 2017. The cumulative gain on our short bank stocks is 124% in U.S. dollar terms since June 4, 2013 (Chart 6, bottom panel). 2. For absolute return investors, we do not yet recommend going long Turkish assets, even if they are in distressed territory. Domestic policy uncertainty remains high, the U.S. dollar will advance further and the broad EM selloff will continue. It will be difficult for Turkish markets to rally meaningfully in absolute terms amid these headwinds. 3. As to dedicated EM equity and fixed income portfolios (both credit and local currency bonds), we recommend shifting from an underweight to neutral allocation. The odds of continued underperformance and risk of capital controls are somewhat offset by cheap valuations and oversold conditions (Chart 7). Chart 6Book Profits On Turkish Shorts Chart 7Turkish Fixed Income Markets ##br##Have Been Slammed   A neutral stance on Turkey within fully invested EM portfolios would mean that dedicated investors eliminate the risk of being on the wrong side of the market in the case of either potential outperformance or continued underperformance. A Word On Contagion Although the plunge in Turkish markets this past week has certainly unnerved investors and caused selloffs in other vulnerable EMs, it is a mistake to blame this selloff on Turkey alone. BCA's Emerging Markets Strategy team maintains that many EM economies have poor fundamentals and are vulnerable for various reasons.2 In fact, a broad-based selloff in EM financial markets had already commenced earlier this year before the latest events in Turkey began to unfold. In short, recent events in Turkey have acted as an additional trigger - not a cause - for the EM carnage. For example, on the surface, it may seem that the South African rand has plunged due to the turmoil in Turkey. However, this is an incorrect rationalization. Chart 8 demonstrates that the rand and metals prices are very highly correlated. Therefore, the rand's selloff since early this year should be attributed to the broad strength in the U.S. dollar, falling metals prices (negative terms of trade) and poor domestic economic fundamentals that we have discussed extensively in our reports on South Africa. As we outlined in our June 14 report,3 bear markets and crises often develop in phases, where some markets plunge while others show temporary resilience. However, if our big-picture view - that EMs are in a bear market - is correct, then it is only a matter of time before the markets that are still resilient re-couple to the downside with the rest. That said, there are always going to be outperformers and underperformers. Our country allocation recommendations are presented at the end of each report (please refer to pages 9 and 10). Furthermore, investors should not focus solely on the impact of the Turkish crisis on developed financial markets. BCA's Emerging Markets Strategy team maintains that EM financial markets will continue to sell off, and that the downturn will eventually affect DM markets. Remarkably, DM ex-U.S. share prices have failed to recover from the January selloff along with the U.S. equity markets and still hover around their lows for the year (Chart 9). Chart 8The Rand Is Driven By ##br##Metal Prices Not By Turkey Chart 9No Recovery In DM ##br##ex-U.S. And EM Stocks   Bottom Line: Woes in EM markets will persist, weighing on DM equities as well. The headwinds are slower global trade (for DM ex-U.S.) and a strong U.S. dollar for the S&P 500. The path of least resistance for the U.S. dollar is up, and U.S. stocks will continue to outperform European and Japanese equities in common currency terms. EM will be the worst performer among all regions. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Footnotes 1 Please see the section on Turkey in Emerging Markets Weekly Report titled "The Dollar Rally And China's Imports," dated May 24, 2018, available on page 11. 2 Please see Emerging Markets Strategy Weekly Report titled "Understanding The EM/China Cycles," dated July 19, 2018, available on page 11. 3 Please see Emerging Markets Strategy Weekly Report titled "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available on page 11. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Dear Client, This week we are sending you a Special Report written by Mark McClellan, Chief Strategist, The Bank Credit Analyst, Marko Papic, Chief Strategist, Geopolitical Strategy and our very own Chris Bowes, Associate Editor, U.S. Equity Strategy. This report deals with the implications of the U.S./Sino trade war for U.S. equity sectors. It identifies the next products to be targeted with higher tariffs on both sides of the dispute. A higher U.S. tariff wall will shield some industries from competition, but rising input costs will be widely felt because of extensive supply chains between and within industries. There is only a small handful of industries that will be winners in absolute terms. I trust you will find his report insightful. Kind regards, Anastasios Avgeriou, Vice President U.S. Equity Strategy In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) Table II-3China Tariffs On U.S. Goods What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State Chart II-3Value Of U.S. Products Tariffed By China (By State) Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors Appendix Table II-2 Exports By U.S. Red States Appendix Table II-3 Exports By U.S. Swing States Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs

On January 22nd and again on January 29th we cautioned investors that a sentiment driven technical in nature pullback was in order. Once the near 10% drawdown occurred, on February 8th our "buy the dip" analysis suggested that it was a great time to deploy capital with a cyclical time horizon. The top two panels of the chart update our "buy the dip" cycle-on-cycle research. While this iteration has been more volatile than the average of the previous 16, the SPX has climbed the proverbial wall of worry and is set to vault to new all-time highs. Already, on a total return basis, the S&P 500 has breached the previous highs and is in uncharted territory. Organic profit growth euphoria, stock buybacks and firming corporate pricing power alongside anemic wage growth will continue to prove powerful tailwinds for equities. Bottom Line: Fresh all-time highs loom for the SPX, sustain a cyclical over defensive portfolio bent.

Special Report

According to market lore, one should never say, "It's Different This Time". But every time is always different: there is a never a previous period that perfectly matches the current environment. That is why forecasting is so difficult and why all model-based predictions should be treated with caution. Yet, some basic common sense can go a long way in helping to assess investment risks and potential rewards. As I look at the world, it looks troubled enough to warrant a very conservative investment stance, but that clearly puts me at odds with the majority of investors. In aggregate, investors and market analysts are upbeat. Major equity indexes are close to all-time highs, earnings expectations are ebullient and surveys of investor sentiment do not imply much concern about the outlook. There is a strong consensus that a U.S. recession will not occur before 2020, meaning that risk assets still have decent upside. That may indeed turn out to be true, but I can't shake off my concerns about a number of issues: The consensus may be too complacent about the timing of the next U.S. recession. The dark side of current strong growth is growing capacity pressures that warn of upside surprises for inflation and thus interest rates. Uncertainty about trade wars represents a risk to the global economic outlook beyond the direct impact of tariffs because it also gives companies a good reason to hold back on investment spending. Profit growth in the U.S. has remained much stronger than I expected, but the forces driving this performance are temporary. Rising pressures on wages suggest that labor's share of income will rise, leading to lower margins. The geopolitical environment is ugly, ranging from a shambolic Brexit process to rising populist pressures in Europe, a flaring in U.S./Iran tensions and possible disappointment with North Korea negotiations. The Debt Supercycle may be over, but global debt levels remain worryingly high in several major economies. This could become a problem in the next economic downturn. It would be easier to live with the above concerns if markets were cheap, but that is far from the case - especially in the U.S. Credit spreads in the corporate bond market are below historical averages while equities continue to trade at historically high multiples to earnings. Even if equity prices do move higher, the upside from current levels is likely to be limited. Yes, there could be a final, dramatic blow-off phase similar to that of the late 1990s, but that would be an incredibly risky period and not one that I would want to participate in. Timing The Next Recession Sad to say, economists do a very poor job of forecasting recessions. As I showed in a report published last year, the Fed has missed every recession in the past 60 years (Table 1).1 One could argue that the Fed could never publish a forecast of recession because it would be an admission of policy failure: they generally have to be seen aiming for soft landings. But private forecasters have not done any better. For example, the consensus of almost 50 private forecasters published in mid-November 2007 was that the U.S. economy would grow by 2.5% in the year to 2008 Q4.2 The reality was that the economy was then at the precipice of its worst downturn since the 1930s. Table 1Fed Economic Forecasts Versus Outcome The U.S. economy currently is very strong, but that often is the case just a few quarters before a recession starts. Strong growth today is not a predictor of future strong growth. As has been widely acknowledged, the yield curve has been one of the few indicators to give advance warning of economic trouble ahead. Yet, in the past, its message typically was ignored or downplayed, with the result that most forecasters stayed too bullish on the economy for too long. History is repeating itself with a flurry of reports explaining why the recent flattening of the yield curve is giving a misleading signal. The principal argument is that term premiums have been artificially depressed by the Fed's bond purchases. However, the curve has flattened even as the Fed has pulled back from quantitative easing. As usual, the flattening reflects the tightening in monetary policy and, therefore, should not be discounted. To be fair, there is still a positive slope across the curve, so this indicator is not yet flashing red. But it is headed in that direction (Chart 1). Chart 1Recession Indicators: Not Flashing Red...Yet The other series to watch closely is the Conference Board's Leading Economic Index. Typically, the annual rate of change in this index turns negative ahead of recessions, although once again, there is a history of forecasters ignoring or downplaying the message of this signal. Currently, the growth in the index is firmly in positive territory, so no alarm bells are ringing. Overall, there are no indications that a U.S. recession is imminent. At the same time, late cycle pressures and thus risks are building. Anecdotal evidence abounds of labor shortages and supply bottlenecks in a number of industries. Wage growth has stayed relatively muted given the low unemployment rate, but that is starting to change. My colleague Peter Berezin has shown compelling evidence of a "kinked" relationship between wage growth and unemployment whereby the former accelerates noticeably after the latter drops below its full employment level (Chart 2). We are at the point where wage growth should accelerate and it is significant that the 2.8% rise in the employment cost index in the year to the second quarter was the largest rise in a decade. It also should be noted that the Fed's preferred inflation measure (the core personal consumption deflator) has been running at around a 2% pace in the past three quarters, in line with its target (Chart 3). As capacity pressures build, an overshoot of 2% seems inevitable, forcing the Fed to react. Current market expectations that the funds rate will rise by only 25 basis points over the remainder of this year and by 100 basis points in 2019 are likely to prove too optimistic. Chart 2Faster Wage Growth Ahead Chart 3Core Inflation At The Fed's Target Admittedly, there is huge uncertainty about what interest rate level will be restrictive enough to damage growth. Historically, recessions did not occur until the fed funds rate reached at least the level of potential GDP growth. The Congressional Budget Office estimates that potential GDP growth will average around 4% over the coming year, and the funds rate probably will not reach that level in 2019. However, additional restraint is coming from the strong dollar, and lingering high debt burdens mean that rates are likely to bite at lower levels than past relationships would suggest. Chart 4U.S. Trade Performance: No Major Surprises Trade Wars Etc. President Trump appears to believe that the large U.S. trade deficit is largely a reflection of unfair trade practices. The reality is obviously more complicated, even if there is truth to the claim that the playing field with China is far from level. The key drivers of trade imbalances are relative economic growth rates and relative real exchange rates. The trend in the volume of U.S. non-oil merchandise imports has been exactly in line with that of domestic demand for goods (Chart 4). In other words, there is no indication that the U.S. is being "taken advantage of". The growth in U.S. non-oil exports has been a little on the soft side relative to overseas growth in recent years, but that occurred against the background of a rising real dollar exchange rate. Overall, the trend in the ratio of U.S. real non-oil imports to exports has broadly followed the ratio of U.S. real GDP to that of other OECD economies. The periods where the trade ratio deteriorated somewhat faster than the GDP ratio were times when the real trade-weighted dollar was strong, such as in the past few years. The irony, which seems to escape the administration, is that recent policy actions - tax cuts and efforts to boost private investment spending - are bound to further boost the trade deficit. This may partly explain the clumsy attempt to encourage the Fed to slow down its rate hikes in order to dampen the dollar's ascent. Of course, that will not work - the Fed will not be deflected from its policy course by political interference. Meanwhile, the administration's imposition of tariffs will not change the underlying drivers of the U.S. trade deficit. I have no way of knowing whether current trade skirmishes will degenerate into an all-out war. There are some glimmers of hope with the EU and U.S. promising to engage in talks about reducing trade barriers. But the more important issue is what happens with China. While China has an economic incentive to make concessions, I cannot imagine that President Xi wants to be seen as giving ground in the face of U.S. bullying. My rather unhelpful conclusion is that trade wars are a serious risk that need watching but are unforecastable at this stage. Earnings Galore, But... It's confession time. The performance of U.S. corporate earnings has been far better than I have been predicting during the past few years. In several previous reports, I argued that earnings growth was bound to slow sharply as labor's share of income eventually climbed from its historically low level. I certainly had not expected that the annual growth in S&P 500 operating earnings would average 20% in the two years to 2018 Q2 (Chart 5). In defense, my original argument was not completely wrong. Labor's share of corporate income bottomed in the third quarter of 2014 and that marked the peak in margins, based on national income data of pre-tax profits (Chart 6). Margins have fallen particularly sharply for the national income measure of non-financial profits before interest, taxes and depreciation (EBITD). I believe this is a good measure of the underlying performance of the corporate sector as it is unaffected by policy changes to taxes, depreciation rates and monetary policy. This measure of margins used to be very mean reverting but currently is still far above its historical average. Given the tightness in the labor market, there is still considerable downside in margins as wage costs edge higher. Chart 5Spectacular U.S. Earnings Growth Chart 6Profit Margins Have Peaked An unusually large gap has opened up in recent years between S&P earnings data and the national accounts numbers. While there are several definitional differences between the two datasets, this cannot explain the large divergence shown in Chart 7. The national income data are generally believed to be less susceptible to accounting gimmicks and are thus a better reflection of underlying trends. Analysts remain extraordinarily bullish on future earnings prospects. Not only are S&P 500 earnings forecast to rise a further 14% over the next 12 months, but the current expectation of 16% per annum long-run earnings growth was only exceeded at the peak of the tech bubble (Chart 8). And we know how that episode ended! Chart 7A Strange Divergence in Profit Data Chart 8Insanely Bullish Long-Term Earnings Expectations I am inclined to stick to my view that earnings surprises will disappoint over the next year. The impact of corporate tax cuts will disappear, and both borrowing costs and wage growth are headed higher. A marked slowdown in earnings growth will remove a major prop under the bull market. Brexit As a Brit, I am totally appalled with the Brexit fiasco. It was all so unnecessary. Yes, the EU has an intrusive bureaucracy that imposes some annoying rules and regulations on member countries. However, OECD data show that the U.K. is one of the world's least regulated economies and it scores high in the World Bank's Ease of Doing Business rankings. In other words, there is no compelling evidence that EU bureaucratic meddling has undermined business activity in the U.K. The vote for Brexit probably had more to do with immigration than anything else, and that also makes little sense given that the U.K. has a tight labor market and needs a plentiful supply of immigrant workers. History likely will dictate that former Prime Minister David Cameron's decision to call for the Brexit referendum was the U.K.'s greatest political miscalculation of the post-WWII period. Not only was the decision to hold the referendum a mistake, but it also was foolhardy to base such a momentous vote on a simple majority rather than a super-majority of at least 60%. Adjusting the referendum result by voter turnout, those backing Brexit represented only around 37% of the eligible voting public.3 Clearly, the government was unprepared for the vote result and divorce proceedings have moved ahead with no viable plan to achieve an acceptable separation. Meanwhile, the inevitable confusion has created huge uncertainty for businesses and is doing significant damage to the economy. This is not the place to get into the minutiae of the Brexit morass such as the Northern Ireland border issue and the difficulty of agreeing new trade relationships. Those have been well aired in the press and by many other commentators. My lingering hope is that the enormous challenges of coming up with a mutually acceptable deal with the EU will prove intractable, resulting in a new referendum or election that will consign the whole idea to its grave. We should not have to wait too long to discover whether that is a futile wish. Investment Strategy Chart 9The U.S. Equity Market Is Expensive Equities are still in a bull market and we are thus in a period where investors are biased to be optimistic. Bears have been discredited and the current strength of the economy gives greater credence to the market's cheerleaders. I have been in the forecasting business for long enough (45+ years) to be suitably humble about my ability to forecast where markets are headed. I am very sympathetic to the famous Keynes quote that "the market can stay irrational longer than you can stay solvent". Investors will have their own set of preferences and constraints about whether it makes sense to stay heavily invested during times when markets appear to have diverged from fundamentals. The U.S. equity market's price-earnings ratio (PER) currently is about 20% above historical averages, based on both trailing and 12-month forward earnings and more than 30% above based on cyclically-adjusted earnings (Chart 9). Yes, interest rates are low by historical standards, giving scope for higher PERs, but rates are going up and profit margins are at historically elevated levels with lots of downside potential. I fully accept that equity markets can continue to rise over the next year, beating the meagre returns available from cash and bonds. For those investors being measured by quarterly performance, it is difficult to stay on the sidelines while prices march higher. Nevertheless, I believe this is a time for caution. The perfect time for equity investing is when markets are cheap, earnings expectations are overly pessimistic and the monetary environment is highly accommodative. Currently, the opposite conditions exist: valuations are stretched, earnings expectations are euphoric and the Fed is in tightening mode. It does not seem a propitious time to be aggressive. The future is always shrouded in mist, but there currently is an unusually large number of important economic and political questions hanging over the market. These include the timing of the next recession, the related path of monetary policy, the outcome of the U.S. midterm elections, trade wars, U.S.-Sino relations and Brexit, just to name a few. The good news is that our Annual Investment Conference on September 24/25 will be tackling these issues head on with an incredible group of experts. I am looking forward to hearing, among others, from Janet Yellen on monetary policy, Leland Miller and Elizabeth Economy on China, Greg Valliere on U.S. politics, and Stephen King and Stephen Harper on global trade. It promises to be an exceptional event and I hope to see you there. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 BCA Special Report "Beware The 2019 Trump Recession," March 7, 2017. Available at bca.bcaresearch.com. 2 Source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters (www.philadelphiafed.org). 3 The referendum result was 51.9% in favor of Brexit, with a voter turnout of close to 72%.

Highlights Global QE has made bonds as risky as equities. Thereby, global QE has forced investors to accept identically depressed returns from equities and from bonds, requiring equity and other risk-asset valuations to surge. The good news is that record high valuations of risk-assets are fully justified if global bond yields remain at current levels or fall. The bad news is that risk-asset valuations will become dangerously unstable if global bond yields march much higher. The 'rule of 4' for equity/bond allocation: sum the three 10-year yields - the German bund, the U.S. T-bond, and the JGB. Above 3.5 means a neutral stance in equities... ... Above 4 means it's time to go underweight equities and overweight bonds. Feature Chart of the WeekAt Higher Bond Yields, The Correlation With Equity Prices Has Flipped From Positive To Negative The end is nigh for QE. The ECB will exit its asset purchase program at the end of the year. In doing so, it will mark the end of an epoch which began in the aftermath of the global financial crisis, a ten year period in which at least one of the world's major central banks has been buying a defined quantity of assets every month (Chart I-2). Approaching the end of the epoch, it is fitting to ask: how did the global QE stimulant work, and what will be the withdrawal symptoms? Chart I-2The End Is Nigh For QE As far back as 2011, in a provocative report titled QE And Riots we predicted that: "QE... will exacerbate already extreme income inequality and the consequent social tensions that arise from it" Events in the subsequent seven years have fully vindicated our prediction. Simply put, QE has front-loaded asset returns which would ordinarily have accrued in the distant future to the here and now - in the form of sharply higher capital values. So if you were invested in the financial markets or most housing markets, congratulations, you have received a bonanza; if you weren't, bad luck, there's not much left for you (Chart I-3). Chart I-3Equities Are Now Priced To Generate A Measly Long-Term Return To understand why, we need to delve deeper into behavioural economics. QE: Why The Stimulant Was So Powerful Central banks admit that there is a lower bound for interest rates below which there would be an exodus of bank deposits. Once policy rates hit the lower bound, central banks can unleash a 'plan B': a commitment to keep policy rates at this lower bound for an extended period. QE is simply a powerful signalling tool for this commitment. As ECB Chief Economist Peter Praet explains: "There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound)" The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too (Chart I-4). Chart I-4The Credible Commitment To Keep Policy Rates##br## Low Pulls Down Bond Yields Now comes the part of the story that is not well understood, even by central bankers, because it derives from recent breakthroughs in behavioural economics. When bond yields approach the lower bound, the asymmetry in their future direction makes bonds very risky investments. The short-term potential for capital appreciation - nominal or real - vanishes, while the potential for vicious losses increases dramatically (Chart I-5). The technical term for this unattractive asymmetry is negative skew. Years of research in behavioural economics has led Nobel Laureate Professor Daniel Kahneman to conclude: negative skew is the measure that best encapsulates our perception of an investment's risk. Chart I-5Bonds Become Much Riskier ##br## At Low Bond Yields Professor Kahneman's work reveals a profound truth: global QE has made bonds as risky as equities (Chart I-6). The ramification is that equities and other risk-assets no longer need to lure investors with an excess return over bond returns. QE has forced investors to accept identically depressed returns from equities and from bonds, requiring equity and other risk-asset valuations to surge.1 Chart I-6Global QE Has Made Bonds ##br##As Risky As Equities One counterargument we hear is that bonds offer investors a diversification benefit and, because of this, investors will still accept a lower return from bonds. But this argument is flawed. Just as bonds are a diversifier for equity investors, equities are a diversifier for bond investors. Indeed in recent years, equities have protected bond investors during vicious sell-offs in the bond market such as after Trump's shock victory in 2016. So we could equally argue that equities require the lower return. In fact, with the same negative skew and symmetrical diversification properties, both assets must offer the same prospective return. The breakthroughs in behavioural economics provide some good news and some bad news. The good news is that record high valuations of risk-assets are fully justified if bond yields remain at current levels or fall. The bad news is that risk-asset valuations will become dangerously unstable if bond yields march much higher (Chart I-7). Chart I-7At Low Bond Yields The Required Return On ##br##Equities Plunges, So Equity Valuations Surge Financial Markets Dwarf The World Economy One common misunderstanding about QE is that it has been the bond purchasing itself that has held down bond yields. This seems a natural assumption because we connect the act of buying with higher prices (lower yields). Moreover, the $10 trillion of bonds that the 'big four' central banks have bought is not far short of the size of the euro area economy. But let's put this into context. The global bond market exceeds $100 trillion. Long-term bank loans amount to something similar. In this $217 trillion2 global fixed income market, $10 trillion of QE is peanuts. To reiterate, QE's impact came not from the $10 trillion of central bank purchases in itself, but from the signal that interest rates would remain at the lower bound for a long time, mathematically requiring bond yields to approach the lower bound too;3 and from the consequent equalization of negative skew on bonds and risk-assets, mathematically requiring an exponential rerating of all risk-asset valuations (Chart I-8). Chart I-8Equities Are Now Priced To Generate A Measly Long-Term Return Now note that the combination of equities and correlated risk-assets such as corporate and EM debt is worth around $160 trillion, and real estate is worth $220 trillion. World GDP is worth much less, around $80 trillion. So if returns from these richly valued risk-assets were reallocated from the here and now back to the distant future, through lower capital values today, there would be a very real risk that current spending could take a dive. Supporting this broad thesis, central bank measures of 'financial conditions easiness' are just tracking the level of the stock market (Chart I-9). Chart I-9Financial Conditions Are Just##br## Tracking The Stock Market The 'Rule Of 4' For Equities And Bonds On February 1 this year, we advised that the big threat to risk-asset valuations "comes from the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1% or the U.S. 10-year T-bond yield rising to 3%." This advice has proved to be remarkably prescient. Whenever bond yields have been at the lower end of recent ranges, the correlation with equities has been positive, meaning equities have risen in tandem with bond yields. But whenever bond yields have moved to the upper end of recent ranges, the correlation has abruptly flipped to negative, meaning equities have fallen as bond yields have risen (Chart of the Week). While many strategists and commentators are fixated on the risks from trade wars and/or the global economy, our non-consensus call is that the biggest threat to risk-assets comes from rich valuations which will become dangerously unstable if bond yields march much higher. In this regard the bond yield that matters is the global bond yield. Previously we defined this in terms of the German 10-year bund yield and the U.S. 10-year T-bond yield. But today for completeness, we would like to add another important component: the Japanese 10-year government bond yield. The global bond yield is a weighted average of the three components. But for a useful rule of thumb, just sum the three 10-year yields - the German bund, the U.S. T-bond, and the JGB. A sum above 3.5 means a neutral stance to equities. A sum above 4 - which broadly equates to the global yield rising above 2% - means it's time to go underweight equities and overweight bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative skew than 10-year bonds. So investors will demand a comparatively higher return from equities, let’s say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative skew. So investors will demand the same return from equities as they can get from bonds, 2% a year. At the lower bond yield, the bond must deliver 2% a year less for ten years compared to previously, meaning its price must rise by 22%. But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%. 2 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017 3 In contrast, if the market feared bond purchases would cause inflation and thereby imply a higher path of interest rates, QE would push up bond yields! Fractal Trading Model* This week we note that the underperformance of emerging market versus developed market equities is technically stretched and ripe for at least a brief countertrend reversal. The 65-day trade is long EM versus DM with a profit target of 2.5% and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-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 ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Special Report

Highlights The regulatory or "stroke of pen" risk is rising on FAANG stocks - Facebook, Apple, Amazon, Netflix, and Google; The U.S. anti-trust regulatory framework was designed to curb anti-competitive actions but has evolved to focus mostly on consumer welfare and prices; A shift toward the original regulatory regime would threaten the FAANGs, particularly Google and Amazon; A trade war hit to tech earnings could be the catalyst for a more general selloff today - but this is not our base case; For now, the market will view regulatory risk as noise and tech stocks will likely enter a blow-off phase; We remain neutral, preferring S&P software and hardware while underweighting semiconductors. Feature "I don't know what Twitter is up to." Rep. Devin Nunes (R-California), Chairman of the House Intelligence Committee, July 29, 2018 "I have stated my concerns with Amazon long before the Election. Unlike others, they pay little or no taxes to state & local governments, use our Postal System as their Delivery Boy (causing tremendous loss to the U.S.), and are putting many thousands of retailers out of business." President Donald J. Trump, March 29, 2018 "If we will not endure a king as a political power, we should not endure a king over the production, transportation, and sale of any of the necessities of life. If we would not submit to an emperor, we should not submit to an autocrat of trade, with power to prevent competition and to fix the price of any commodity." Senator John Sherman, 1890 Social media companies have had a terrible week, with Twitter falling 21% on July 27th and Facebook 19% on July 26th. Facebook posted weaker than expected earnings, but investors appeared to be particularly concerned with a miss in monthly active users. The shortfall in active users may have been affected by the new EU privacy rules, which came into force in May. Twitter's fall from grace came even though its revenues were up 24% on the year, with a record profit of $100 million. However, its effort to delete "bots" and suspicious user accounts brought its user total down to 335 million, from 336 million, prompting fears that the platform was slowing down. Twitter's and Facebook's enormous price volatility, despite decent earnings figures, reveals that investors are jittery about the performance of technology stocks, epitomized by the so-called FAANGs - Facebook, Apple, Amazon, Netflix, and Google. They are right to be, given that there are three broad risks to these companies: The next big thing: Before Facebook, there was MySpace. It is not inconceivable that new platforms - for instance, ones that emphasize privacy or that redistribute a portion of advertising revenue with users - could replace current market leaders. Revenue model: Although they are perceived to be cutting-edge technology companies, social media firms generate vast amount of their revenue through advertising. Facebook and Google have captured 25% of global media advertising revenues.1 At some point, Internet companies will reach a ceiling on this revenue as the attrition rate of local newspapers slows, as foreign markets introduce local alternatives (RenRen or Weibo in China, VKontakte in Russia), and as non-tariff barriers to trade begin impacting their international expansion (China's Internet Security Law). Regulation: Finally, regulatory pressure could grow for a number of reasons. First, European concerns regarding user privacy could migrate to the U.S. where a majority of voters already believe that tech companies need greater oversight (Chart 1). In fact, Americans now see tech companies as having as pernicious an influence as energy companies (Chart 2). Second, the U.S. approach to anti-trust problems could evolve away from the current paradigm that focuses on delivering lower prices to consumers. Third, President Trump and his conservative allies could target social media companies with perceived liberal bias for purely political reasons. Chart 1Majority Of Americans Want Tech Regulated Chart 2Tech And Energy Companies Now In Same Boat We have no particular insight into the competitive landscape of social media, web browsing, and Internet retail industries, so we will leave the first two threats to the experts in the field. Instead, we will focus in this report on the third threat, the "stroke of pen" regulatory risk. From Standard Oil To The Chicago School - America's Anti-Trust Framework Today's anti-trust regulatory framework has significantly deviated from the original intent behind the 1890 Sherman Act. As Lina M. Khan argues in "Amazon's Antitrust Paradox," "Congress enacted antitrust laws to rein in the power of industrial trusts, the large business organizations that had emerged in the late nineteenth century. Responding to a fear of concentrated power, antitrust sought to distribute it."2 Railroad construction in the late nineteenth century, largely financed by the municipal debt of farm-belt states, evolved from a shrewd capex investment in a new technology to a mania. To boost sagging profits, railroad barons fixed their prices to reduce competition. State anti-trust laws that emerged out of this era, the so-called "Granger laws," sought to curb monopolistic behavior by giving states control over railroad operations. These state laws ultimately coalesced into federal legislation, the 1890 Sherman Act. No trust had a larger impact on the U.S. legal and regulatory infrastructure than the case of Standard Oil in the early twentieth century.3 Although the company faced criticism in the immediate aftermath of the 1880s recession - particularly from the famous muckraking journalist Henry Demarest Lloyd - the dam broke for Standard Oil when the oil-price bubble popped in Kansas in 1904. A Standard Oil subsidiary - the Prairie Oil and Gas Company - decided to purchase oil by a specific gravity test, forcing some of the Kansas oil from the market. At the time, the oil boom in Kansas had turned many into stockholders in some prospecting company. When oil prices fell, so did the fortunes of these locals. The shock of the price collapse radicalized Kansas politics at the turn of the twentieth century. An idea for a state-owned oil refinery picked up steam in the state despite being labeled socialist. Ultimately, Kansas' delegation in the U.S. House of Representatives requested that the Secretary of Commerce investigate the causes of the low price of crude oil in the state. After several disastrous performances of Standard Oil executives on witness stands and in testimony, the federal government filed a petition against the company in November 1906. A large fine followed in August 1907. The 1890 Sherman Act and subsequent anti-trust policies were grounded in the theory of economic structuralism. "This view holds that a market dominated by a very small number of large companies is likely to be less competitive than a market populated with many small- and medium-sized companies." Through the 1960s, courts blocked mergers - both horizontal and vertical - and policed markets not only for size, or effect on consumer welfare, but also for conflicts of interest.4 In the 1970s and 1980s, however, the Chicago School approach gained prominence. The Chicago School rested on "faith in the efficiency of markets, propelled by profit-maximizing actors."5 While economic structuralists believed that the structure of an industry leads to market outcomes, Chicago School saw structure as the outcome of market dynamics, which themselves are sacrosanct. Chicago School adherents focused primarily on price dynamics and consumer welfare, ignoring how economic structures could create barriers to entry and thus uncompetitive markets. The most influential economist behind the Chicago School was Robert Bork, who asserted in his highly influential The Antitrust Paradox that the "only legitimate goal of antitrust is the maximization of consumer welfare."6 That said, his definition of consumer welfare was incredibly broad and revealed a clear corporate, if not a pro-monopoly, bias.7 The influential Chicago School ultimately impacted the Supreme Court, which declared in 1979 that "Congress designed the Sherman Act as a 'consumer welfare prescription.'"8 The Reagan Administration subsequently rewrote the 1968 merger guidelines to shift the focus purely to consumer welfare in the form of preventing monopolistic price increases and output restrictions. The government also stopped bringing anti-trust cases under the 1936 Robinson-Patman Act, which prohibits price discrimination by retailers among producers and vice versa. Bottom Line: The U.S. anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions "include not only cost but also product quality, variety, and innovation."9 However, through subsequent regulatory evolution, the Chicago School has taken hold of the U.S. anti-trust process, solely focusing on consumer welfare and prices. We can draw two immediate conclusions from this historical overview of U.S. anti-trust policy. First, the laws on the books have not changed since World War Two. Despite the laws remaining the same, the theory of how to apply them in courts of law has dramatically changed, as economic structuralism gave way to the Chicago School's focus on prices and consumer welfare. If President Reagan and the courts could change how these laws are administered in the 1980s, then so can subsequent administrations and courts in the future. Second, a long period of slow growth, income inequality, and economic volatility - such as the 1870s-80s - can produce a political impetus for anti-trust policy. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. While the U.S. has not experienced a recession in almost a decade, it will eventually - and besides, income inequality is a prominent theme once again and a potential source of consumer discontent.10 A narrative could emerge - particularly if politically expedient - that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. Will FAANGs Be De-FAANGed? At BCA Research, we are neither regulatory nor policy experts. As such, we do not have insight into current regulatory activity involving social media companies, Google, or Amazon. The preceding section merely illustrates that the federal government's approach to the anti-trust process could change. Indeed, the Obama administration signaled that its approach could become more active. One quantitative approach that investors can use to assess the risk of anti-trust legislation is the Herfindahl-Hirschman Index (HHI). It is the most commonly accepted measure of market concentration, used by the Department of Justice in assessing whether a particular market is controlled by a single firm.11 Chart 3 shows our reconstruction of the HHI for the present-day era, with three examples from the past. Chart 3Market Concentration By Industry And Eras The 1911 refined petroleum sector harkens back to the aforementioned Standard Oil case; The 2001 Internet browser market refers to the United States v. Microsoft Corp that led to the June 2000 decision (later reversed on appeal) to break-up the software giant; The 1983 telecommunication sector illustrates the HHI for the telecom market at the time of the AT&T divestiture. The data is clear: of the five FAANG companies, only Google reaches a concerning level on the HHI measure. This has already made it a target of European authorities. On the other hand, competition within both streaming (Netflix, Amazon) and social networks (Facebook) appears relatively healthy. However, social networks could be at risk of European-style privacy protections. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes considerable compliance burdens on any company handling user data. California has already signed its own version of the law - the Consumer Privacy Act - which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest U.S. market. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. Given that advertising revenue is crucial to the business model of social media companies and Google, a significant uptick in privacy regulation could hurt their bottom line. On the other hand, as we discuss below, the new regulatory rules create massive barriers to entry for small firms looking to replace the tech giants. Furthermore, many of the targeted social media companies have run afoul of President Trump in particular and the broader conservative movement in general. As such, privacy advocates - who tend to lean left - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs (Chart 4). Finally, there is the question of Amazon. We do not construct an HHI for Amazon's place in the retail market because E-commerce only accounts for about 9.5% of total U.S. retail sales (Chart 5). Amazon has been leading the charge, but it still accounts for just under half of that 9.5% total figure (Chart 6). Chart 4Conservatives Distrust Tech Companies Chart 5E-Commerce: Steady Increase In Market Share Chart 6Amazon Dominates Amazon's strength is that, in the current anti-trust framework, it conforms fully to the "consumer welfare" priorities elucidated by the Chicago School. Amazon, by and large, lowers prices for consumers. However, several of its practices could be seen as predatory in the more expansive, economic structuralist, approach.12 In addition, President Trump has reserved most of his Twitter scorn on the firm, particularly because CEO Jeff Bezos owns the liberal-leaning Washington Post. Bottom Line: Investors are correct to fret that the "stroke of pen" risk is rising when it comes to FAANG companies. Google scores considerably higher than either Standard Oil or Microsoft on the Department of Justice HHI. Social media companies are already under the microscope by conservative legislators and voters, who perceive them to be biased. Liberals, on the other hand, support toughened-up privacy rules that could undermine the business model of social media companies. Amazon's market dominance is overstated. However, several of its business practices could come under greater scrutiny if any administration should revert back to the original reading of the 1890 Sherman Law. Technology Stocks Have Brought The S&P 500 Up; Could They Bring It Down? It is now a well-worn understanding that the reason why the S&P 500 has performed well is largely due to the performance of a few (enormous) technology stocks (see Chart 7 and Table 1) who have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history. The preceding section certainly suggests that frothy valuations and the rising regulatory impetus imply that future upside potential is swamped by downside risk. Chart 7FAANG Stocks + Microsoft Have##br## Dramatically Outperformed... Table 1...Generating 50% Of The##br## 2018 S&P 500 Return! If this negative scenario is what actually plays out in the market, the implications could be more severe than in the past. Indexed fund inflows have replaced actively managed fund outflows, as our colleagues in BCA's Global ETF Strategy recently pointed out (Chart 8).13 Considering the rise of these few technology stocks and their increasing weight in the S&P 500 and, necessarily, in the majority of ETFs, more people than ever before are invested in technology stocks, whether they know it or not. Accordingly, the performance of these stocks has become material to the household balance sheet, which is a driver of consumption and, hence, the economy. Thus, it may not be hyperbole to say the economy depends to some extent on Amazon maintaining a high valuation multiple. Chart 8ETF Inflows Offset Actively Managed Outflows Adding some weight to this thesis is the mounting concern over a global trade war. The technology sector in general is by far the most international (as defined by foreign-sourced revenues) of GICS 1 sectors. More specifically, the top three semiconductor & semiconductor equipment companies (INTC, NVDA & TXN), which collectively represent more than 50% of the weight of that index, generate on average only 17% of their revenues in the U.S. Moreover, the more dangerous and lasting trade risk emanates from the U.S.-China showdown, which centers on the technology sector. Should the worst trade outcomes occur, it is not unreasonable to see impaired technology earnings being the catalyst for a more general sell-off. We recommend underweight positions in both the S&P semiconductors and S&P semiconductor equipment indexes. We Think Not Despite the foregoing, we think a more likely scenario is actually a blow-off phase where technology stocks accelerate rather than decline in an increasingly restrictive regulatory environment. In a recent report analyzing sector performance in the last stages of the bull market, we noted that across seven iterations dating back to the 1960's, the information technology sector delivered a median 14% outperformance relative to the S&P 500 (Table 2).14 And, while returns in these stocks have been excellent this year, their gains seem modest compared to the performance in the 1999-2000 iteration. Table 2Tech Stocks Are Strong Late Cycle Performers Underpinning our expectations is the recent stock reactions to regulatory actions. Beginning with Facebook, in the week of March 26, 2018, the firm was hit with severely negative headlines. First, the Cambridge Analytica scandal pointed out that the firm may be caught on the wrong side of EU GDPR rules, followed by the firm being investigated for an EU antitrust suit for the online ad market; the stock fell 15% from the week prior. However, within two months, the stock had fully recovered and a further two months later the stock was up 18% from its starting point. Recently the stock has fallen significantly on the back of very weak guidance; the company noted that revenue growth would decelerate and operating margins would fall to the mid-30% range from the current mid-40% range. It is not unreasonable to think management may be sandbagging earnings growth to defray some of the elevated regulatory scrutiny into its outrageous profitability. Google too has seen negative regulatory headlines, having been hit with a $5 billion fine in the EU for abusing the dominance of the Android mobile operating system in July this year. The stock responded by closing higher and then rose a further 10% in the following two weeks. Overall, we think the market views regulatory risk as noise. For now. But What About The Earnings? Do They Matter? While the earnings implications of yet-to-be-proposed regulatory changes are unknowable, we believe even the pursuit of an answer is a red herring. As shown by Chart 9, the market does not appear to care about next year's earnings as valuation multiples have little consistency with either themselves or the broad market. The implication is that near-term earnings are of relatively little importance, at least compared to the long-term growth outlook. Chart 9Tech Valuations Are Meaningless Further, these companies are a collection of businesses that are not necessarily cohesive. For example, Facebook includes Instagram, WhatsApp and Oculus while Amazon Web Service is a non-retail business that delivers half of Amazon's profit. A reasonable case could be made that breaking up these companies into their components could actually unlock considerable value. Lastly, new regulation, particularly with respect to privacy and data protection, is likely to create significant barriers for new entrants as compliance costs will be relatively more onerous for those companies with fewer resources. Thus, incoming privacy legislation may neuter the impact of any anti-trust legislation. Be Wary With Technology But For The Right Reasons We fully expect more regulation to remain a significant part of the conversation with respect to FAANG stocks and further expect that conversation to promote higher than normal volatility in the sector. However, we also expect the market to mostly look through this risk; buying the dip has thus far been the right approach to headline risk in technology. We think there are better reasons to remain cautious with technology. As noted above, they are heavily international and a strengthening U.S. dollar will be a headwind to 2019 earnings to a greater extent than to the broad market (please see our June 4th Weekly Report for more details). Supporting the dollar, BCA expects higher interest rates in 2018 on the back of rising inflation. Overall, we prefer old tech (S&P software and S&P technology hardware, storage & peripherals, both which are high-conviction overweights) that is levered to our synchronized global capex upcycle theme. It also boasts high cash flow and low valuations. We are less sanguine about technology early cyclicals (S&P semiconductors and S&P semiconductor equipment) which we rate as underweight. Net, we think risks are balanced in the tech sector and maintain a neutral recommendation for the S&P information technology sector. BCA Geopolitical Strategy Housekeeping In light of several announcements regarding China's efforts to ease up on economic policy, we are closing several of our trades: Short China-exposed S&P 500 Companies versus U.S. financials and telecoms - opened on May 30 for a 7.13% gain; Long DXY - opened on January 31 for a 5.85% gain; Short GBP/USD - opened on February 14 for a 6.21% gain; Long Indian equities / short Brazilian equities - opened on March 6 for a 27.54% gain. Long French industrial equities / short German industrial equities - opened on May 16 for a 2.21% gain. We still believe that Chinese structural reforms will continue, weighing on domestic and global growth. In the face of ongoing U.S. fiscal stimulus, the interplay between the two major economies will therefore continue to produce a dollar-bullish environment. However, the dollar's stretched positioning and the Chinese reflation narrative could hurt the greenback while reflating global risk assets in the near term. We will therefore look for an opportunity to reassert our negative EM view. Over the next two weeks, our reports will focus on Chinese stimulus and ongoing structural reforms. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see WARC, "Mobile is the world's second-largest ad medium," dated November 30, 2017, available at warc.com. 2 Please see Lina M. Khan, "Amazon's Antitrust Paradox," The Yale Law Journal 126:710 (2017). 3 Please see Steven L. Piott, The Anti-Monopoly Persuasion (Westport, Connecticut: Greenwood Press, 1985). 4 Khan 718. 5 Khan 719. 6 Please see Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself (New York: Free Press, 1978). 7 By Bork's broad definition of "consumer welfare," even Jeff Bezos is a consumer whose rights have to be protected by anti-trust policy. "Those who continue to buy after a monopoly is formed pay more for the same output, and that shifts income from them to the monopoly and its owners, who are also consumers. This is not dead-weight loss due to restriction of output but merely a shift in income between two classes of consumers. The consumer welfare model, which views consumers as a collectivity, does not take this income effect into account," Bork, 32, our emphasis. 8 Please see Reiter v. Sonotone Corp., 442 U.S. 330, 342 (1979). 9 Khan 737. 10 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 11 Please see The U.S. Department of Justice, "Herfindahl-Hirschman Index," available at justice.gov. 12 Please see Olivia LaVecchia and Stacy Mitchell, "Amazon's Stranglehold: How the Company's Tightening Grip Is Stifling Competition, Eroding Jobs, and Threatening Communities," Institute for Local Self-Reliance, dated November 2016, available at ilsr.org. 13 Please see BCA Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018, available at etf.bcaresearch.com. 14 Please see BCA U.S. Equity Strategy Special Report, "Portfolio Positioning For A Late Cycle Surge," dated May 22, 2018, available at uses.bcaresearch.com.

Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of July 31, 2018. The quant model lifted its U.S. allocation to be in line with the benchmark weight at the expense of Spain. No major changes in other country weights, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 59 bps in July, largely driven by Level 2 model which outperformed its benchmark by 146 bps. Level 1 model slightly unperformed its MSCI world benchmark by 5 bps in July. Since going live, the overall model has outperformed its benchmarks by 132 bps, driven by the Level 2 outperformance of 375 bps offset by the 2 bps of Level 1 underperformance. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Mode (Chart 4) is updated as of July 31, 2018. Following the developments on the trade front and increasing worries of a growth slowdown, the model continues to maintain a defensive bias with an aggregate overweight of 5.8% relative to cyclical sectors. The relative tilts within cyclicals and defensives remain the same as the previous month. However, both discretionary and financials are going through unfavorable technical and momentum indicators. Energy remains the only resource based sector with an overweight, primarily driven by attractive long-term valuations. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com

Feature Downside Risks Haven't Gone Away We downgraded risk assets to neutral in last month's Quarterly Portfolio Outlook,1 citing an increasing number of risks to the equity bull market. Specifically, we warned about the slowdown and desynchronization of global growth, rising U.S. inflation, further deterioration in the trade war, and the ongoing slowdown in China. Markets - particularly in the U.S. - have stabilized somewhat over the past few weeks on the expectation that these risks are not particularly grave, that global growth remains robust, and that central banks will be slow to tighten. We accept that there remain upside risks (which is why we are neutral, not underweight, equities) but think many investors remain too sanguine about the downside risks. On desynchronized growth, it is true that the slowdown in the euro zone seems to have bottomed. The Citi Economic Surprise Indexes (Chart 1) suggest that downward surprises to euro zone and Japanese growth have ended, and that the U.S. is no longer surprising significantly to the upside. However, the likely path of inflation in the two regions looks very different, with U.S. core PCE inflation likely headed towards 2.5% over the next few quarters, while euro zone core inflation is stuck around 1% (Chart 2). Table 1Recommended Allocation Chart 1A Resynchronization Of Growth? Chart 2Core Inflation: Higher In The U.S. Than In The Euro Zone In particular, we think it is only a matter of time before U.S. wages start to accelerate. Unemployment has not been this low since the late 1960s. As happened then, there is typically a lag between the labor market becoming tight and inflation emerging (Chart 3). With the employment/population ratio for the key working-age demographic now back close to its 2007 level (Chart 4), and 601,000 new entrants to the labor force last month alone, that point is probably not far away. Note, too, that people switching jobs are now seeing large wage rises; those staying are not (Chart 5). With strong corporate profit growth, companies will soon start to raise wages to keep staff and fill vacancies. Chart 3Just A Matter Of Time Before Inflation Accelerates Chart 4Little Slack Left In The Labor Market Chart 5Switchers Getting Wage Rises; Stayers Not This all suggests that markets are too nonchalant about the risk of further Fed tightening. The futures market is pricing in only four rate hikes from the Fed over the next 24 months (Chart 6). We think it likely that the Fed will continue to hike by 25 basis points a quarter until something gives. By contrast, the ECB has clearly signaled that it will wait until at least September next year before raising rates; when it does so, it may hike by only 10 basis points. The futures market is close to pricing this correctly (Chart 6, panel 2). We remain concerned about further exacerbation of the retaliatory tariff war. In late July, the European Union and President Trump seemed to agree a truce, especially with regard to auto tariffs. But, even if this proves more than transitory, it is unlikely to be repeated between the U.S. and China. Both sides have raised the stakes so much that it will be politically difficult for either to back down. Further aggressive moves are likely, including a 10% tariff on all USD500 billion of Chinese imports into the U.S, and the Chinese authorities engineering a further depreciation of the Chinese yuan, and making life difficult for U.S. companies that manufacture and sell in China (where their sales total USD350 billion). Businesses around the world have woken up to this risk: capex intentions among U.S. companies have slipped recently and, in the Global ZEW survey, future expectations are now the lowest relative to current conditions since 2007, a bearish indicator (Chart 7). Chart 6Fed Is Likely To Hike more Than This Chart 7Businesses Expect Things To Get Worse Moreover, we don't see China launching a massive reflationary stimulus, as it did in 2009 and 2015. In the past few weeks, it has announced some minor easing of monetary policy, targeted tax cuts, and an acceleration of this year's fiscal spending. This will be enough to cushion the downside. But interest rates have not fallen anything like as much as in previous episodes (Chart 8). The authorities have reiterated that structural reform remains the priority. Given the significant slowdown in credit growth over the past year, we expect a further deceleration in the Chinese industrial economy (and, therefore, in imports) through the end of the year. If our macro outlook is correct, it is likely to have the following consequences for financial markets: further rises in long-term interest rates (we forecast 3.3-3.5% for the 10-year U.S. Treasury bond yield by early 2019), a further appreciation of the U.S. dollar (as monetary policy divergences with the euro area and Japan widen further), and negative performance for emerging market assets (hurt by higher U.S. rates, the rising USD, and the slowdown in China). This points to small negative returns from global government bonds over the next 12 months. Equities are more complicated. Earnings growth remains strong. If S&P500 companies really achieve the 20% EPS growth this year and 10% next year that analysts (and BCA's models) are forecasting, the forward multiple will fall from 16.5x now to 14.0x by end-2019. We would expect to see low single-digit positive returns from global equities over the rest of the year. We accordingly remain neutral on equities, where we can see both upside and downside risks. One key is the timing of the peak in profit margins. This has typically come a few quarters before the start of a recession. Currently margins continue to improve (Chart 9). They are likely to peak around the end of this year, when wages (and input prices, partly because of higher import tariffs) begin to rise faster than sales. We expect to move underweight equities around that time, when this and other recession indicators start to flash warning signals. Chart 8Not 2015 Redux In China Chart 9Watch For The Peak In Profit Margins Currencies: The outlook for the USD remains the key to the performance of other asset classes, particularly emerging markets and commodities. We see the risk of a short-term pullback, since long speculative positions in the dollar have recently built up (Chart 10). But differences in growth, inflation, monetary policy, and long-term rates between the U.S. and other developed economies suggest further moderate dollar appreciation over the coming 12 months. We remain very negative on EM currencies. Central banks in many emerging markets have been forced to raise rates sharply in recent weeks to defend their currencies. This is likely to slow growth over coming quarters. Those central banks that have resisted hiking (for example, Turkey and Brazil) are likely to see sharp rises in inflation. Equities: We prefer developed market equities over emerging ones. Our two overweights are the U.S. and Japan. The U.S. is a defensive market, with a beta to global equities of only 0.9 over the past 20 years. But, if there were to be a last-year equity market melt-up (along the lines of 1999), it is likely to be led by internet stocks, in which the U.S. is particularly overweight, and so the U.S. overweight also acts as a hedge against this upside risk. Our overweight in Japan is based on our view that the Bank of Japan will continue its ultra-accommodative monetary policy (bolstered by the recent tweaks to the operation of the policy), even while other DM central banks are moving towards tightening. There are also some signs of wage growth picking up, which should be positive for consumer sectors. Fixed Income: We remain underweight bonds and, within the asset class, are neutral between government bonds and spread product. U.S. junk bonds continue to have some attraction as long as economic growth remains strong (and the oil price does not fall). But junk bonds typically peak one or two quarters before equities. And, in this cycle, U.S. corporate leverage began to rise rather early, which suggests that at the start of the next recession leverage will be worryingly high (Chart 11) and that junk bonds will, therefore, perform particularly poorly. Chart 10Dollar Long Positions Building Up Again Chart 11Leverage Is High For This Stage Of The Cycle Commodities: Oil has become much harder to forecast in recent weeks, with downside risk to the price of crude coming from the recently announced OPEC production increases, but upside risk from Iran (which is threatening to close the straits of Hormuz in the face of renewed U.S. sanctions) and the collapse in Venezuelan production. BCA's energy strategists see Brent falling a little to average USD70 a barrel in 2H, and at USD75 on average next year, with greater risk of upside surprises than downside.2 Industrial metals prices are likely to remain under pressure if the USD appreciates and China slows further, as evidenced by significant downside moves in copper, iron ore and other metals over the past few weeks. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Global Asset Allocation Quarterly Portfolio Review, "Lowering Risk Assets To Neutral," dated 2 July 2018, available at gaa.bcaresearch.com 2 Please see Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated 19 July 2018, available at ces.bcaresearch.com GAA Asset Allocation