Equities

The long S&P homebuilding/short S&P REITs pair trade is off to a flying start. Already, this market- and industry-neutral trade has generated alpha for our portfolio to the tune of 7% since the early-July inception.1 There is a long runway ahead for additional gains in this pair trade. Importantly, the recent slew of bank earnings releases had a common thread: across the board, banks are pulling in their horns with regard to extending commercial real estate (CRE) loans. This represents a bearish backdrop for the overextended CRE sector (second panel). As the Fed continues to tighten the monetary screws, delinquency rates have nowhere to go but up, especially in CRE that currently enjoys an ultra-low starting point (fourth panel). Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

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

Overweight - Downgrade Alert We put the S&P banks index on downgrade alert in mid-May and removed it from the high-conviction overweight list for a relative gain of 6%, on the back of budding evidence that the bank/yield curve correlation was getting re-established as the one with the 10-year Treasury yield was getting shattered. We also warned that were banks not to participate in the next bond market selloff we would pull the trigger and downgrade to neutral. On the eve of Q2 earnings season there is hope for a reversal of fortunes in this key financials sub-index. The U.S. economy is overheating and pricing pressures are making their way through to the CPI. This should be fertile ground for bank equities as they represent the nervous system of the economy by providing much needed credit. Indeed, commercial & industrial (C&I) loans - the largest credit segment in bank balance sheets - have soared; not only are they making new all-time highs in level terms, but momentum is gaining steam (middle panel). This is not only centered on C&I loans, but other categories are also expanding nicely, especially residential mortgage loans. Loan origination is synonymous with profit growth at a time when the regulatory noose is getting relaxed and banks anew passed the Fed's strict stress tests. Tack on shareholder friendly activities and there is much to like about banks this earnings season. Bottom Line: Stay overweight banks, but stay tuned.

Highlights Investors are too complacent about the risks of a trade war. Standard economic models understate the potential economic damage that a trade war could cause. Global equities would suffer mightily from a trade war. Deep cyclical sectors would be hardest hit. Financial equities would also fare poorly. Regionally, European and EM stock markets would underperform. A trade war would benefit Treasurys and other safe-haven government bonds. A contained trade war would likely be somewhat dollar-bearish. In contrast, a full-out war could send the greenback soaring. Feature From Phony War To Real War? After months of posturing, Trump's trade war is starting to heat up. The U.S. imposed tariffs of 25% on $34 billion of Chinese goods last Friday. Tariffs on another $16 billion of goods are set to go in effect on July 20th. China has stated that it will retaliate in kind. On Tuesday, Trump further upped the ante, announcing that he will levy a 10% tariff on an additional $200 billion of Chinese imports by August 31. He also threatened tariffs on another $300 billion on top of that if China still refuses to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than what China exported to the U.S. last year! China is not the only country in Trump's crosshairs. The Trump administration levied tariffs of up to 25% on steel and aluminum from the EU, Canada, Mexico, and other U.S. allies on June 1, 2018. The affected regions have retaliated with their own tariffs. As Marko Papic, BCA's chief geopolitical strategist, has repeatedly stressed, there is little reason to think that trade tensions will ease over the coming months. Protectionism is popular with the American public (Chart 1). Trump ran on a protectionist platform and now he is trying to fulfill his campaign promises. It does not help that Trump is accusing foreign governments of doing things they are not doing. Chart 2 shows that U.S. tariffs are actually higher than in most other G7 economies. As we have argued in the past, the U.S. runs a persistent current account deficit because it has a higher neutral real rate of interest - otherwise known as r-star - than most other countries.1 Standard interest rate parity equations imply that a country with a relatively high neutral rate will have an "overvalued" currency that is expected to weaken over time, whereas a country with a low neutral rate will have an "undervalued" currency that is expected to strengthen over time. Intuitively, this must happen because investors will only hold low-yielding bonds if they expect a currency to strengthen. The result is a current account deficit for countries with overvalued currencies such as the U.S., and a current account surplus for regions with undervalued currencies such as the euro area (Chart 3). Chart 1Free Trade Is Not In Vogue In The U.S. Chart 2Tariffs: Who Is Robbing The U.S.? Chart 3Interest Rates And Current Account Balances The Economic Costs Of A Trade War How much damage could a trade war do to the global economy? As it turns out, this is a surprisingly difficult question to answer. Standard economic theory offers little guidance on the matter. By definition, global exports are always equal to imports. In a conventional Keynesian model, countries with trade deficits would gain some demand from a trade war, while countries with surpluses would lose some demand. However, the contribution of net exports to global demand would always be zero. Granted, there would be some efficiency losses, but in the standard Ricardian model of comparative advantage, they would not be that large. As Box 1 explains, the deadweight loss from a tariff can be computed as one-half times the change in the tariff rate multiplied by the percentage-point decline in imports that results from the tariff. Suppose, for example, that a trade war leads to a 10% across-the-board increase in U.S. tariffs, which causes U.S. imports to fall by 30%.2 Given that imports are 15% of U.S. GDP, the resulting deadweight loss would be 0.5*0.1*0.3*15=0.225% of GDP. That's obviously not a lot. The True Cost Of A Trade War Is Likely To Be High Our sense is that the true cost of a trade war would be much greater than these simple models suggest. There are at least six reasons for this: Most simple models assume that labor and capital are completely fungible and that the economy is always at full employment. In practice, it is doubtful that workers could easily move to companies that would benefit from tariff protection from those that would suffer from retaliatory measures. Workers have specialized skills. Likewise, a piece of machinery that is useful in one sector of the economy may be completely useless in another. Industries are often concentrated in particular regions. As such, a trade war could severely degrade the value of the existing stock of human and physical capital. This would result in lower potential GDP. It would also result in temporarily higher unemployment as workers, laid off from firms which have been adversely affected by tariffs, are forced to scramble for a new job elsewhere. Comparative advantage is not the only source of trade gains. Arguably more important are economies of scope and scale. A firm that has access to a global market can spread fixed costs over a larger quantity of output, thus lowering average costs (and ultimately prices). The existence of large global markets also allows companies to offer niche products that might not be worthwhile to develop for smaller markets. Modern trade is dominated by the exchange of intermediate goods within complex supply chains (Chart 4). This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. U.S. firms are particularly vulnerable to supply-chain disruptions because the Trump administration has dotardly chosen to levy tariffs mainly on intermediate and capital goods (Chart 5). This stands in contrast to China and the EU, which have raised tariffs mainly on final goods in a politically strategic manner (agricultural products in Trump-supporting rural areas and Harley Davidson bikes, which are manufactured in Paul Ryan's home district in Wisconsin). Chart 4Trade In Intermediate Goods Dominates Chart 5The U.S. Is Not Very Smart In ##br## Implementing A Protectionist Agenda Uncertainty over the magnitude and duration of a trade war could cause companies to postpone new investment spending. A vast economic literature pioneered by Avinash Dixit and Robert Pindyck has shown that firms tend to defer capital expenditure decisions when faced with rising uncertainty.3 Furthermore, as I discussed in an academic paper which was published early on in my career, business investment is typically higher when firms have access to larger markets.4 Higher tariffs could lead to an implicit tightening in fiscal policy. If the U.S. raises tariffs by an average of ten percentage points across all imports, a reasonable estimate is that this would imply a tightening in fiscal policy by around 1% of GDP - enough to wipe out the entire stimulus from Trump's tax cuts. Of course, the tariff revenue could be injected back into the economy through more tax cuts or increased spending. However, given the possibility that gridlock will increase in Washington if the Republicans lose the House of Representatives in November, it is far from obvious that this would happen. A trade war would lead to lower equity prices and higher credit spreads. This would translate into tighter financial conditions. Historically, changes in financial conditions have been highly correlated with changes in real GDP growth (Chart 6). Changes in financial conditions have, in turn, led the stock market. The S&P 500 index has risen at an annualized pace of 10% since 1970 when BCA's Financial Conditions Index (FCI) was above its 250-day moving average, while gaining only 1.5% when the FCI was below its 250-day average (Chart 7). Given today's elevated valuations across many asset markets, the risk is that a trade war triggers a sizable correction in asset prices. Chart 6Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Chart 7The Link Between Financial Conditions ##br##And The Stock Market Protecting Your Equity Portfolio From A Trade War We think investors are understating the risks of a trade war. This, along with a host of other reasons, prompted us to downgrade global risk assets from overweight to neutral on June 20.5 As bad as a trade war would be for Main Street, it would be even worse for Wall Street. The mega- cap companies that comprise the S&P 500 have a lot more exposure to foreign markets and global supply chains than the broader U.S. economy. The "beta" of corporate profits to changes in GDP growth is also quite high (Chart 8). Chart 9 shows how U.S. equity sectors performed during days when the S&P 500 suffered notable losses due to heightened fears of protectionism. We identified seven separate days, including Wednesday's selloff, which was spurred by Trump's threat to impose tariffs on another $200 billion of Chinese imports. Chart 8Profits Are Much More Volatile Than GDP Chart 9This Is How Markets Trade When They Are Worrying About Trade Wars The chart shows that deep cyclical sectors such as industrials, materials, and energy fared badly during days of protectionist angst. Financials also underperformed, largely because such days saw a flattening of the yield curve. Tech, health care, and telecom performed broadly in line with the S&P 500. Consumer stocks outperformed the market, but still declined in absolute terms. Utilities and real estate were the only two sectors that saw absolute price gains. Considering that the sector composition of European and EM bourses tends to be more tilted towards cyclicals than the U.S., it is not surprising that the former have underperformed during days of increased protectionist worries. Bonds: Yields Likely To Rise, But A Trade War Is A Risk To That View In contrast to equities, a trade war would benefit Treasurys and other safe-haven government bonds. Admittedly, the imposition of tariffs would push up import prices. However, the effect on inflation would be temporary. Just as the Fed tends to disregard one-off increases in commodity prices, it will play down any transient boost to inflation stemming from a trade war. Instead, the Fed will focus on the growth impact, which is likely to be negative. To be clear, trade jitters are not the only thing affecting bond yields. Judging by numerous business surveys, the U.S. economy is starting to overheat (Chart 10). Last week's employment report does not alter this conclusion. While the unemployment rate rose by 0.2 percentage points, this was mainly because of a jump in the participation rate. Considering that the number of workers outside the labor force who want a job is near a record low, the ability of the economy to draw in additional workers is limited (Chart 11). Chart 10The U.S. Economy Is Overheating Chart 11A Small Pool Of People Want ##br##To Jump Into The Labor Market Historically, continuing unemployment claims have closely tracked the unemployment rate over time (Chart 12). The fact that continuing claims have dropped by 9% since the end of January, while the unemployment rate has dipped by only 0.1 percentage points, suggests that the unemployment rate will fall further over the coming months. On balance, we continue to maintain our bearish recommendation on Treasurys, but acknowledge that a trade war is a risk to that view. Trade Wars And Currencies Unlike safe-haven bonds, whose yields are likely to decline in proportion to the magnitude of the trade war, the impact on the dollar is more difficult to predict. On the one hand, a modest trade dispute is likely to be somewhat dollar bearish, inasmuch as it hurts U.S. growth and forces the Fed to slow the pace of rate hikes. Since most other major central banks are not in a position to cut rates, expected rate differentials between the U.S. and its trading partners would narrow. On the other hand, a severe trade war would probably be dollar bullish. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. still tend to attract capital inflows into the safe-haven Treasury market. The U.S. is a fairly closed economy, and hence would be relatively less affected by a breakdown in global trade. Commodities are also likely to suffer if trade flows decline (Chart 13). Lower commodity prices tend to be bullish for the greenback. Moreover, as we discussed in our latest Strategy Outlook, a tit-for-tat trade war with China could force the Chinese government to devalue the yuan. That would have a knock-on effect on other emerging market currencies. Chart 12Unemployment Can Fall Further Chart 13Commodities Are A Potential Victim Of Trade War Notably, the greenback has fared better recently than it did earlier this year during days when protectionist rhetoric intensified. On Wednesday, the broad trade-weighted dollar gained 0.3% while the DXY picked up 0.6%. This supports our view that the dollar will strengthen over the remainder of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 2 This assumes an elasticity of import demand of 3, which is broadly consistent with most academic estimates. 3 Avinash K. Dixit, and Robert S. Pindyck, "Investment Under Uncertainty," Princeton University Press, (1994). 4 Peter Berezin, "Border Effects Within A Dynamic Equilibrium Trade Model," The International Trade Journal, 14:3 (2000), 235-282. 5 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. BOX 1 The Deadweight Loss From A Trade War Box Chart 1Tariffs Increase Budget Revenues, But Lead To A Bigger Loss In Consumer Surplus In the simplest models of international trade, an increase in tariffs leads to higher prices, resulting in a loss of consumer surplus. This is depicted by the blue region (ABCE) in Box Chart 1. The government collects revenue from the tariff shown by the red-colored rectangle (ABDE). The difference between the loss in consumer surplus and the gain in revenue - often referred to as the "deadweight loss" from a tariff - is depicted by the green-colored triangle (BCD). Arithmetically, the area of the triangle can be calculated as: Deadweight loss = 0.5 x Tariff x (Pre-tariff level of imports - Post-tariff level of imports) If one divides both sides by GDP, the formula reduces to: Deadweight loss/GDP = 0.5 x Tariff x Percentage Point Change In Import Share of GDP Resulting From Tariff There are many things in the real world that are not captured by this equation. For example, if the country that imposes the tariff is sufficiently large, this could push down the international price of the goods that it imports. The country would then benefit from an improvement in its terms of trade. As Robert Torrens showed back in the 19th century, if a country has any degree of market power (i.e., it is not a complete price-taker on international markets), there will always be a level of tariffs that makes it better off. The caveat is that this "optimal tariff" only exists if other countries do not retaliate. If everyone retaliates against everyone else, everyone will be worse off from a trade war. Moreover, as discussed in the main text, there are many factors that this simple model does not capture which could result in significant economic damage from raising tariffs even when retaliation does not take place, especially in cases where the tariffs are imposed on intermediate and capital goods. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Neutral As noted in yesterday's Daily Insight, we lifted the S&P pharma and biotech indexes to neutral earlier this month. These sectors command roughly a 50% weighting in the S&P health care sector and, accordingly, the July 3rd upgrade to a benchmark allocation in both of these sub-groups also lifts the health care sector to a neutral portfolio weighting. Such a move may be well timed as we move into the second quarter earnings season; the bar for upward surprises is extremely low as analysts have thrown in the towel on the sector. As shown in the second panel at the side, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how valuations have fallen despite a depressed denominator (third panel). Further, any sector profit outperformance could prove sticky if the Trump Administration does not clamp down on pharma pricing power as initially feared and allows health care companies to resume their long term outsized revenue growth trend. We would not hesitate to lift exposure further to overweight were the federal government to put forth a bill with minimal damage inflicted upon drug prices, were the greenback to keep on appreciating and were a steep 'risk off' phase to grip the broad equity market. Bottom Line: We have lifted the S&P health care sector to neutral. Please see our July 3rd Weekly Report for more details.

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist Highlights The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on mainland growth. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets, including commodities and EM. The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. A narrowing interest rate differential between China and the U.S. will continue exerting downward pressure on the RMB's value versus the dollar. Our credit stress test on Turkish banks suggests their stocks are not yet cheap assuming the non-performing loan ratio rises to 15%. Stay short banks and the lira. Feature China's economic slowdown, ongoing trade wars and accumulating U.S. inflation pressures will continue propping up the U.S. dollar, thereby sustaining a perfect storm for EM financial markets. This is taking place amid the poor structural fundamentals in the developing economies and the existing overhang of investor positions in EM. Altogether this argues for more downside in EM financial markets. A strong dollar is also a bad omen for developed markets' stock indexes. The reason being that the dollar is a countercyclical variable, and the greenback's rallies usually coincide with global trade downturns that are bearish for global cyclical equity sectors (Chart I-1). Needless to say, tariffs on imports are ultimately negative for global trade, and will exacerbate the global growth slowdown that has been occurring since early this year. In fact, there is anecdotal evidence that global trade has so far temporarily benefited from mounting expectations of tariffs.1 Companies have ordered more inputs and shipped more goods in advance of higher tariffs coming into effect. This is why global shipments and manufacturing production have so far held up reasonably well, while business expectations have plummeted (Chart I-2). Consequently, global trade and manufacturing production will likely record considerable weakness later this year. Since markets are typically forward looking, asset prices will adjust beforehand. Chart I-1Global Industrial Stocks And U.S. Dollar Chart I-2Global Trade Is Heading South We are maintaining our negative stance on EM stocks, currencies, credit markets and high-yielding local bonds. China Is Easing Liquidity, But Don't Hold Your Breath Chart I-3Chinese Interest Rates And EM Stocks: ##br##Positively Correlated China's softening industrial data, growing anecdotal evidence of a worsening credit crunch in the economy, U.S. tariffs, and plunging domestic share prices have been sufficient for the authorities to ease liquidity conditions in the Chinese banking system. Not surprisingly, many investors are wondering whether the worst is over for Chinese stocks and China-related financial markets worldwide, including those in EM. At the current juncture, liquidity easing by the PBOC is a necessary but not sufficient condition to turn positive on this nation's industrial cycle as well as EM risk assets. We have the following considerations on this topic: First, China's risk-free interest rates - government bond yields - led the selloff in both EM and Chinese stocks (Chart 3). These bond yields have plunged since November, foreshadowing the slowdown in China's growth and the carnage in EM/Chinese financial markets. By and large, there has been a positive correlation between EM share prices and China's local bond yields and interbank rates as illustrated on Chart I-3. For example, EM stocks, currencies and credit markets rallied substantially in 2017 in the face of rising interest rates in China. Likewise, they dropped in the second half of 2015 as bond yields and money market rates in China plunged. The rationale behind the positive correlation between EM risk assets and Chinese interest rates is that the latter rise and EM risk assets rally when the mainland economy is improving. The opposite is also true. At the moment, Chinese risk-free bond yields will likely continue to drop as additional slowdown in growth is in the cards. This heralds a further drop in EM financial markets. Second, any major stimulus will constitute a retraction of the Chinese government's policy of deleveraging and containing financial risks. The latter is the code phrase Chinese authorities use to stop fueling bubbles and speculative excesses. Hence, any policy stimulus will for now be measured and insufficient to boost growth this year. China is saddled with massive debt and money overhangs and a bubbly property market. Ongoing enormous expansion in money supply (i.e., RMB deposits)2 (Chart I-4) and a narrowing interest rate differential over the U.S. will continue exerting downward pressure on the RMB's value (Chart I-5). Chart I-4'Helicopter Money' In China Chart I-5The RMB Will Depreciate Further Even though capital controls have tightened since 2015, the capital account is not perfectly closed. As such, shrinking interest rate deferential versus the U.S. warrants further yuan depreciation. In short, the authorities cannot reduce interest rates further and expand money/credit growth at a double-digit rate without tolerating sizable currency deprecation. If the Chinese authorities opt for a large fiscal and credit stimulus again, the nation's structural imbalances will grow further. In this scenario, the Middle Kingdom's secular growth outlook will deteriorate, and policymakers' manoeuvring room to stimulate in the future will narrow. Chart I-6China: The Industrial Cycle Is Slumping Crucially, China's enormous money and credit creation are entirely unrelated to its high savings rate. Money and credit in China have been driven by speculative behavior of Chinese banks and borrowers not households' high savings rate. We have discussed these issues in detail in our past special reports3 and will not expand on them here. Third, there has been money/credit tightening on three fronts in China - liquidity, regulatory and anti-corruption. Even though liquidity conditions in the banking system are now ameliorating, as evidenced by the plunge in interbank rates, the regulatory clampdown on the shadow banking system as well as the anti-corruption campaign targeting the financial industry are still underway. The latter policy initiatives will continue to curb credit creation by suppressing banks' and shadow banking institutions' ability and willingness to finance the real economy. In fact, it is not inconceivable that the regulatory clampdown and anti-corruption campaign will have a larger impact on credit supply than the decline in borrowing costs. Finally, policy easing and tightening works with a time lag. China's business cycles and related financial markets do not always respond swiftly to changes in policy stance. Specifically, monetary and fiscal policies were easing substantially from the middle of 2015, yet EM/China-related risk assets continued to plummet for six months until February 2016. Conversely, policy was tightening in China throughout 2017, yet EM/China-related asset markets did well in 2017. In brief, there could be a long lag between a change in policy stance and a reversal in financial markets. For now, we reckon that the cumulative effect of policy tightening of the past 18 months will continue to seep through the Chinese economy till the end of this year. Chart I-6 demonstrates that various industrial cycle indicators continue to deteriorate. Bottom Line: The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on Chinese growth and China-related risk assets, including commodities and EM. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets. More Downside The indicators that have been useful in foretelling the turmoil in EM financial markets this year are signaling that a negative stance is still warranted: One indicator that gave an early warning signal for the current EM selloff was EM sovereign and corporate bond yields. At the moment, the average of EM dollar-denominated corporate and sovereign bond yields continues to presage lower EM stock prices, as demonstrated in Chart I-7 - bond yields are shown inverted in this chart. Chart I-7Rising EM Borrowing Costs Are Bearish For Their Stocks Notably, EM share prices display lower correlation with U.S. bond yields and U.S. TIPS yields than with EM corporate and sovereign bond yields (Chart I-8). Why are EM share prices exhibiting a stronger correlation with EM bond yields rather than with U.S. Treasury yields? The basis is that EM equities are sensitive to EM - not U.S. - borrowing costs. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate and sovereign U.S. dollar bond yields - i.e. EM borrowing costs in dollars - will decline, and EM share prices will rally (Chart I-7). But when EM corporate (or sovereign) yields rise - irrespective of whether because of rising U.S. Treasury yields or widening EM credit spreads - EM borrowing costs in dollars rise, and consequently equity prices come under considerable selling pressure. In other words, a drop in U.S. bond yields on its own is not enough for EM share prices to advance, and conversely, a rise in U.S. bond yields is not sufficient for EM stocks to drop. It is movements in EM U.S. dollar bond yields, which are comprised of U.S. Treasury yields and EM credit spreads, that matter for the direction of EM equity prices. Regarding local bond yields, EM share prices typically exhibit a strong negative correlation with EM domestic government bonds yields - the latter are shown inverted on this chart (Chart I-9). Since we expect EM currencies to depreciate further and, given the negative correlation between EM currency values and their local bond yields, the latter will continue rising. Chart I-8EM Stocks And U.S. Rates: ##br##Mixed Relationship Chart I-9EM Equities And Local Bond Yields: ##br##Strong Correlation The risky-to-safe-haven currency ratio4 continues to fall after experiencing a major breakdown early this year (Chart I-10, top panel). Historically, this ratio has been correlated with EM share prices and currently heralds further downside (Chart I-10, bottom panel). This ratio also is agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the general trend in the greenback. Hence, this indicator answers the question of the direction of EM share prices, regardless of the dollar's trend. Finally, key to EM performance has been corporate profits. Presently, the outlook for EM corporate profits is still negative, as suggested by the negative readings on China's money and credit (Chart I-11). Chart I-10Are Risk Assets In A Bear Market? Chart I-11EM Corporate Profits Will Likely Shrink Bottom Line: EM risk asset will continue selling off and underperforming their DM counterparts. Stay short/underweight EM risk assets. The Dollar's Trend Is Still Up The U.S. dollar is instrumental to EM financial market trends. We expect the dollar rally to persist for now - at least through the end of this year. The underlying inflation gauge measure calculated by New York Fed points to further acceleration in U.S. consumer price inflation (Chart I-12). Furthermore, America's job market is continuing to tighten. In brief, U.S. domestic demand will stay robust even as global trade slumps. These will limit the Federal Reserve's ability to back off from tightening, even if EM financial markets continue to sell off. Chart I-12U.S. Inflation Risks Are To The Upside Remarkably, a strong U.S. exchange rate is needed to cap America's growth and inflation and to boost growth in the rest of the world, especially in Asia. Given the widening growth momentum between the U.S. and Asia, the dollar will likely need to rally significantly to reverse the growth differential currently moving in favor of America. This will be especially true if more trade tariffs are imposed. Odds are that the RMB will depreciate further given the backdrop of lower interest rates in China - discussed above. That will cause a downturn in emerging Asian currencies. A strong dollar, a slowdown in Chinese/EM demand for commodities and large net long positions by investors in oil and copper all argue for a considerable drop in commodities prices in the months ahead. This is bearish for Latin American and many other EM exchange rates. Bottom Line: The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. With respect to currency positions, we recommend investors to continue to short a basket of EM currencies such as BRL, ZAR, TRY, MYR and IDR versus the dollar. CLP and KRW are also among our shorts given our bearish outlook for copper prices, global trade and Asian currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkish Banks: A Bargain Or Value Trap? 12 July 2018 Turkish bank stocks have now fallen by 40% in local currency terms and by 55% in U.S. dollar terms since their peak early this year (Chart II-1), prompting the question whether they have become a bargain or are still a value trap. Banks represent 30% of the Turkey MSCI index and are integral to the performance of this bourse. Although Turkish banks appear to be cheap with their price-to-trailing earnings ratio at 4.5 and their price-to-book value ratio at 0.62, they are still vulnerable to a substantial rise in non-performing loans (NPL) and ensuing provisioning, write-off and equity dilution. Turkey has been experiencing an enormous credit binge for years and its interest rates have risen by 600 basis points since the start of the year. Yet, current NPLs and provisions stand at a mere 3% and 2.3% of total outstanding loan, respectively (Chart II-2). Chart II-1Turkish Stocks: A Long-Term Perspective Chart II-2Turkish Banks Are Underprovisioned The creditworthiness of debtors is worse when one takes into account that Turkish companies have large foreign currency debt and a record amount of foreign debt obligations due in 2018 (Chart II-3). In our credit stress test, we assume that in the baseline scenario the non-performing credit assets (NPCA) ratio will rise to 15% (Table II-1). Taking into account that the NPL-to-total loan ratio reached 18% in 2002 after the 2001 currency crisis, we believe 15% is a reasonable estimate. Chart II-3Turkey: Record High Foreign Debt Obligations Table II-1Credit Stress Test For Turkish Banks To put this number further into perspective, India - one of the very few countries within the EM universe to have somewhat fully recognized its NPLs - currently has an NPL ratio of 15% on its public banks. Chart II-4Turkish Equities: ##br##A Cyclically-Adjusted P/E Ratio If we assume that Turkish bank stocks at the end of this cycle will trade at a price-to-book ratio of 1 after adjusting for all credit losses, then banks' stock prices are currently about 17% overvalued in the baseline scenario of 15% NPCA (Table II-1, the middle row). In all three scenarios, we assume a recovery rate of 40%. With regards to the overall equity market, Chart II-4 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is currently around 5, compared to the historical average of 8. For the bourse's CAPE ratio to drop to two standard deviations below its mean, share prices have to fall by another 20-25%. This is plausible given the outlook for more populist economic policies following the recent elections. Besides, corporate profits will contract considerably because of the monetary tightening that has occurred since early this year. The exchange rate is critical for Turkish financial markets. As such, revisiting currency valuation is also important. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of July 11 the lira was slightly more than one standard deviation below its historical mean (Chart II-5). For it to reach two standard deviations below its mean, it would roughly take another 15-17% depreciation, versus an equal-weighted basket of the dollar and euro. Given the current macroeconomic backdrop and the outlook for more unorthodox policies, including possible capital controls following President Erdogan's appointment of his son-in law as the key economic policymaker, the lira will likely undershoot. Meantime, foreign holdings of Turkish local bonds and stocks were not yet depressed as of June 29 (Chart II-6). Chart II-5Turkish Lira: An Undershoot Is Likely Chart II-6Foreign Ownership Is Still High Bottom Line: Provided Turkey's political outlook has deteriorated further after the recent elections, we assess that only after a 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with a 15-20% drop in stocks in local currency terms, will Turkish equities be a true bargain and warrant a positive stance. For now, dedicated EM equity and fixed income portfolios (both credit and local currency bonds) should continue to underweight Turkey. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the following article Global automakers hail more ships as trade battles heat up. 2 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available on ems.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, link is available on page 17. 4 Average of cad, aud, nzd, brl, clp & zar total return indices relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. John Canally, Chief U.S. Investment Strategist Highlights Late in the business cycle, investors should remain overweight risk assets generally, as long as margins are still rising. A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector. The bar remains high for Q2 2018 EPS, but investors are already focused on 2019 and the impact of trade policy on corporate results. Economic surprise is rolling over as inflation surprise climbs. Feature U.S. equities prices rose last week as U.S.-China tariffs kicked in. The U.S. dollar and 10-year Treasury yields dipped, while oil and gold held steady to start the first quarter. Despite the relative calm, investors remain concerned about the impact of trade policy and rising labor and raw materials costs on corporate margins. BCA expects S&P 500 margins to peak later this year. In the next section of this report, we examine the performance of a broad range of asset classes after the economy reaches full employment. Higher labor and input costs, along with the impact of global trade disputes, will be key topics of discussion as the Q2 earnings seasons kicks off this week. We provide a preview later in this report. Market participants are also worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. We explore those concerns in the second section below. Although the June jobs report (see below) was mixed relative to consensus expectations, the Citigroup Economic Surprise Index (CESI) is poised to turn negative. In the final section of this week's report, we discuss how investors should positions as CESI troughs and how to prepare for the inevitable bounce higher. The rise in the U.S. unemployment rate to 4% in June is not the start of a new trend. The labor market continues to tighten and the FOMC is noticing (Chart 1, panels 1 and 2). Chart 1Don't Be Fooled By The Uptick##BR##In The U.S. Unemployment Rate The June Establishment Survey revealed a 213k rise in payrolls, along with upward revisions to the previous two months. The three-month average, at 211k, remains well above the underlying trend in labor force growth. In contrast, the Household Survey showed a more modest 102k increase in jobs in the month. Moreover, the number of people entering the workforce surged by 601k, which caused the unemployment rate to rise from 3.8% to 4%. We doubt this signals a trend change in the unemployment rate. The Household Survey is quite volatile relative to the Establishment Survey, suggesting that employment gains in the former are likely to catch up next month. The surge in the labor force in June could reflect the possibility that the tight labor market is finally drawing people into the workforce who were not previously looking for work. The participation rate rose by 0.2 percentage points to 62.9% (panel 4). However, this rate bounces around from month-to-month and is still in its post-2015 range. Moreover, the typical wave of college and high school students entering the workforce at this time of the year may have distorted the labor force figures due to seasonal adjustment problems. The real story is that the underlying labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. Average hourly earnings edged up by 0.2% m/m in June. The y/y rate held at 2.7% in the month, but the trend in wage growth remains up (panel 3). Moreover, the June non-manufacturing ISM report highlighted that economic momentum remains very strong, and the respondents' comments noted widespread building cost pressures related to labor shortages, rising commodity prices and a shortage of transportation capacity. China: It's Not 2015...Yet Investor concerns escalated last week over emerging markets and specifically China. Market participants are worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. BCA's Foreign Exchange Strategy's view1 is that Beijing is letting the CNY depreciate at a faster pace against the U.S. dollar for two reasons. First, it is a means to reflate the economy because the proposed U.S. tariffs on Chinese goods would inflict a non-negligible blow to China that would need to be softened if it materializes. Secondly, letting the yuan depreciate sends a message to the U.S.: China can weaponize its currency if necessary. Meanwhile, our China Investment Strategy service remains cautious on Chinese equities, but notes that the recent selloff in domestic stocks may be overdone (we remain neutral on the investable market).2 Chart 2China's Borrowing Costs Have Climbed... A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector, which would be very problematic for financial markets given our view that China has a higher pain threshold for stimulus than in the past. But tight monetary policy was a key driver of China's 2015 slowdown, and while monetary conditions have tightened since late-2016, they remain easier than what prevailed four years ago (Chart 2). There are key differences between 2015 and today from a U.S./global perspective as well. In late 2015, the dollar had moved up by 27% from its mid-2014 low, business capital spending was in freefall, credit spreads widened and oil dropped by over 50% year-over year. None of those conditions are currently in place. The key difference between 2015 and today is that three years ago there was no threat of a trade war with China, or the widespread imposition of protectionist measures more generally. Late Cycle Asset Return Performance Some of our economic and policy analysis over the past year has focused on previous late-cycle periods, especially those that occurred at the end of long expansions such as the 1980s, 1990s and the 2000s.3 Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment - NAIRU). This week we look at asset class returns during late-cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart 3). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM or a peak in the S&P 500 index itself. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table 1 (and Appendix) presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the next recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in margins to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart 3Profit Margins Peak Late##BR##In The Late Cycle Period Table 1Historical Returns; Average Of##BR##Late 1990s And Mid-2000s We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cycles the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a 6-12 month horizon. Similar to Treasuries, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasuries after margins peaked and into the recession. High-yield (HY) bonds followed a similar pattern, but suffered negative returns in absolute terms after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but after margins peaked relative performance was mixed. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value before and after margins peaked, but tended to outperform in the recessions. Dividend aristocrat returns performed well relative to the overall equity market after margins peaked and into the recession on average, but the performance is not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge funds are supposed to be able to perform well in any environment, but returns have been a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns are attractive across all periods and cycles, except for Timberland during recessions where the return performance was mixed. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The return analysis underscores that investing late in an economic cycle is risky because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears promising. Based on this approach, investors should remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investor should scale back in most of these areas as soon as margins peak, although they can hold onto Farmland, Timberland, structured products, real estate (including REITs) for a while after margins peak because it may not be as important to exit these areas before the next recession begins. For fixed income, investor should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. S&P 500 margins are still rising at the moment which, on its own, suggests that investors should be fully-exposed to all risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market (e.g. trade war, economic China slowdown, and EM economic and financial vulnerabilities). We are not yet ready to go underweight on risk assets, but the risk/reward balance at the moment suggests that risk tolerance should be no more than benchmark. Still Going Strong The consensus predicts a 21% year-over-year increase in the S&P 500's EPS in Q2 2018 versus Q2 2017, and 22% in calendar year 2018. Expectations are high; at the start of 2018, analysts projected 11% growth in Q2 and 12% in 2018. Energy, materials, technology and financials will lead the way in Q2 earnings growth, while real estate and utilities will struggle. Excluding the energy sector, the consensus expects a robust 18% increase in profits. The stout profit environment for Q2 2018 and the year ahead reflects sharply higher oil prices compared with Q2 2017, and the impact of last year's Tax Cut and Jobs Act on share buybacks and management confidence. However, global growth, which was a tailwind for S&P 500 results in 2017 and early 2018, has stalled. Moreover, rising costs for raw materials and labor will erode margins, but not until later this year. S&P 500 revenues are forecast to rise by 8% in Q2 2018 versus Q2 2017, matching the Q1 2018 year-over-year increase. The consensus expects a year-over-year gain in Q2 sales in all 11 sectors. Trade policy will continue to be at the forefront as managements discuss Q2 outcomes and provide guidance for 2H 2018 and beyond. In addition, capacity constraints, labor shortages and rising input costs will be key topics. Elevated corporate debt levels4 and climbing interest rates also will be debated as CEOs and CFOs provide guidance to Wall Street for Q3 2018 and beyond. Their counsel is more vital than the actual Q2 results. The markets probably have already priced in a robust 2018 earnings profile linked to the Tax Cut and Jobs Act, and are looking ahead to 2019 and 2020 (Chart 4). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 22% increase expected this year. Chart 4High Bar For 2018... But Focus Will Quickly Turn To 2019 At 9%, the consensus estimate for S&P 500 EPS growth in 2020 is too high (Chart 4). BCA's view5 is that the next recession in the U.S. will commence in 2020. Since 1980, S&P 500 profits have dwindled by 28%, on average, in the first year of a recession. Chart 5 (panel 1) shows that elevated readings on the ISM manufacturing index still provide a very favorable backdrop for S&P 500 profit growth in 2018. However, the top panel also illustrates that the index rarely stays above 60 (it was 60.2 in June), especially late in the business cycle. The ISM is a good proxy for S&P 500 forward earnings (panel 2) and sales (panel 3). The implication is that while the near-term environment for S&P 500 earnings and sales is solid, there is not much more upside. Chart 5Domestic Backdrop For S&P Profits In ''18 Still Looks Solid... Global growth is peaking despite the rosy domestic economic environment. At close to 3%, the consensus view of U.S. GDP growth in 2018 is still accelerating thanks to pro-cyclical fiscal, monetary and legislative policies in the U.S.6 However, in early April, analysts estimates for 2019 GDP growth in the U.S. reached a zenith at 2.5% and have since rolled over (Chart 6). The FOMC projects real GDP growth at 2.8% in 2018 and 2.4% in 2019.7 Meanwhile, global GDP growth estimates for 2018 began flattening near 3.5% in early April 2018, about a month after President Trump announced the first round of tariffs. Estimates for 2019 economic growth peaked in mid-May, near 3.25% (Chart 6). Chart 6Consensus GDP Estimates For U.S., World Are Rolling Over BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. The trade-weighted dollar is up by 2.5% year-to-date, and by 7% from its recent (February 2018) trough. Nonetheless, the dollar is down by 2% year-over-year and should not have a major impact on Q2 results. Furthermore, based on the minimal references to a robust dollar (only eight in the past eight Beige Books), the dollar probably will not be an issue for corporate profits in Q2 2018 (Chart 7). The handful of recent references is in sharp contrast with a surge in comments during 2015 and early 2016. The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The implication is that a robust dollar may get a few mentions during the earnings season, but those mentions will be drowned out by concerns over global trade. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically-focused corporations versus globally-oriented ones. Economic growth trends, discussed above, also play a role. Chart 8 shows that sales of domestically-oriented firms in the U.S. are still in a clear uptrend (panel 2). However, revenues of U.S. companies with a global focus stalled in recent quarters, even before the first round of tariffs were announced (panel 4). Margins at domestically-focused firms are still accelerating (panel 1), while margins at global businesses are topping out, albeit at a higher level than domestic ones. Moreover, since the start of 2017, the weaker dollar has allowed profit and sales gains of global corporations to rebound and outpace those companies with only domestic concerns. BCA expects that margins for S&P 500 companies will peak later this year. Investors are skeptical that S&P 500 margins can advance in Q2 2018 for the eighth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate and raw materials costs escalate. Bottom Line: BCA expects that the earnings backdrop will support equity prices in 2018 (Chart 9). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on the upcoming 2019 and 2020 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 9). In late June,8 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Chart 7The Dollar Should Not Be##BR##A Big Concern In Q2 Earnings Season Chart 8Global Sales,##BR##Margins Stalled... Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Look Out Below Citi's Economic Surprise Index (CESI) is poised to turn negative (Chart 10) after hitting a four-year high in late 2017. Since then, a harsh winter and early spring in the U.S., coupled with elevated expectations following the introduction of the tax bill, saw most economic data fall short of expectations. Moreover, a slowdown in global growth and uncertainty around U.S. and global trade policy negatively affected U.S. economic data in the spring and early summer months. Chart 10Citi Economic Surprise Poised To Turn Negative In our late March 2018 report,9 we noted that there have been six other episodes since 2011 when the CESI behaved similarly. These phases lasted an average of 96 days; the median number of days from peak to trough was 66 days. Moreover, in our March 2018 report we stated that a trough in CESI may be a month or two away, but there are no signs that has occurred. Table 2 illustrates the performance of key U.S. dollar-based investments, commodities and the dollar itself as the CESI moves from zero to its ultimate trough. We identified eight periods since 2010 when the CESI moved lower from zero. Table 2U.S. Stocks, Credit And Commodities As Economic Surprise Turns Negative On average, these episodes lasted 43 days, with the longest (81 days) in early 2015 and the shortest (13 days) in January-February 2013. During these phases, U.S. equities posted minimal gains and underperformed Treasuries (Chart 11). Moreover, investment-grade and high-yield credit tracked Treasuries, and there was little difference between the performance of small cap and large cap equities. Gold and oil struggled, while the dollar barely budged. Chart 11U.S. Financial Assets, Commodities And The Dollar As Economic Surprise Troughs While the CESI is rolling over, the Citigroup Inflation Surprise index is on the upswing (Chart 12). We identified seven stages when the CESI rolled over while the Citi Inflation Surprise Index: 2003-2004, 2007-2008, 2009, 2011, 2012-13, 2014 and this year. The late 2007 period is most similar to today; the other five episodes occurred either during early cycle (2003-2004, 2009 and 2011) or mid-cycle (2012-13 and 2014). In late 2007, the U.S. economy was in the late stages of an expansion, the unemployment rate was below full employment and the Fed was raising rates. The stock-to-bond ratio fell, credit underperformed Treasuries and gold and oil rose. Furthermore, small caps outperformed large caps, and the dollar fell (Chart 13). Chart 12Episodes Of Rising Inflation Surprise##BR##When Economic Surprise Is Falling Chart 13U.S. Financial Assets,##BR##Commodities And The Dollar As... Our work10 shows that these periods were associated with higher wage and compensation metrics, and higher realized core inflation. Moreover, these phases tended to occur when the economy was at full employment and the Fed funds rate was above neutral. The implication is that inflation indices are poised to move higher in the coming year, and prompt the Fed to continue to boost rates gradually at first, but then more aggressively starting in mid-2019. Bottom Line: The disappointing run of economic data is not over. Treasury bond yields will likely dip as the CESI troughs. However, the weakness in the economic data does not signal recession. We expect that the Inflation Surprise Index will continue to grind higher, while unemployment dips further into excess demand territory and oil prices rise. After the CESI forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb.11 Fed policymakers have signaled that they will not mind an overshoot of their 2% inflation target. However, because core PCE inflation is already at the Fed's target, the central bank will be slower to defend the stock market in the event of a swoon. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix 1 Please see BCA Research's Foreign Exchange Strategy Weekly Report "What Is Good For China Doesn't Always Help The World", published June 29, 2018. Available at fes.bcaresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report "Standing On One Leg", published July 5, 2018. Available at cis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Weekly Report "Till Debt Do Us Part", published May 8, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Third Quarter 2018: The Beginning Of The End", published June 29, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Line Up," published March 12, 2018. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180613.pdf 8 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways," published June 25, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Waiting", published March 26, 2018. Available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report "Wait A Minute", published May 28, 2018. Available at usis.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Solid Start," published January 8, 2018 and "The Revenge Of Animal Spirits," published October 30, 2017. Both available at usis.bcaresearch.com.

Using valuations as equity market turning points, either at tops or bottoms, is useless as there is no simple rule of thumb that clearly spells out when to buy and when to sell. Even using the cyclically adjusted P/E (CAPE) that professor Shiller is credited with creating fails to deliver on the timing front (look no further than Japan in the late 1980's when its CAPE overshot 80). However, the way we use valuations is to gauge overshoot or undershoot territory. Clearly, we are in overshoot territory as the S&P 500 Shiller P/E stands north of 30. Conducting a thought experiment is in order. Assuming CPI grows at 2.2%/annum for the next 2.5 years, SPX EPS grow 20% this year and 10% in each of the next two years and the SPX moves sideways, then the SPX CAPE drops nearly 10 points to 23 by the end of 2020. Not only are the Great Recession trough EPS filtered out, but also the tax turbo charged 20% growth 2018 EPS are included in the projected 10-year average EPS. Bottom Line: While at first glance the SPX appears overvalued, a simple thought experiment argues that stocks are more fairly valued assuming EPS follow-through. Our view remains that at this stage of the cycle and with the Fed in tightening monetary policy mode, EPS have to continue to do the heavy lifting with regard to returns, while the multiple takes the back seat.

Highlights Domino dynamics continue escalating within the EM universe confirming that a major bear market is underway. Several global cyclical market segments have recently experienced technical breakdowns. This confirms that global growth is slowing. It is not too late to short/sell EM risk assets. We reiterate the long Indian / short Chinese banks equity trade. Feature The selloff in global risk assets continues to exhibit a pattern of falling dominos. It began with the breakdown in the weakest spots of the EM world, Turkey and Argentina, and then spread to Brazil and Indonesia. Only weeks later it hit other vulnerable EM markets such as South Africa. During this period, north Asian stocks and currencies - Chinese, Korean and Taiwanese - displayed resilience. It was tempting to argue that the EM selloff was being driven by idiosyncratic risks and was limited to current account deficit countries vulnerable to U.S. Federal Reserve tightening. However, in recent weeks these north Asian markets have plunged - making the EM selloff largely broad-based and pervasive. In our June 14 report,1 we argued that major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. Since then, the domino effect has escalated confirming our bias that EMs are in a major bear market. Several important markets and cyclical market segments have recently broken down, and investors should heed messages from them: Copper prices fell below their 200-day moving average; they have also broken down the trading range that had persisted since last September (Chart I-1, top panel). The precious metals price index seems to be sliding through the floor of its trading range of the past 18 months (Chart I-1, bottom panel). Global cyclical equity sectors and sub-sectors such as mining, steel, chemicals and industrials have also broken their 200-day moving averages in absolute term (Chart I-2). They have also been underperforming the global equity index, which is consistent with the global trade slowdown that is beginning to escalate. Chart I-1Breakdown in Metals Prices Chart I-2Global Equities: Cyclicals Have Broken Down Although Chinese PMI data have not been particularly weak, anecdotal evidence from the ground suggests that the credit tightening of the past 18 months is taking its toll on China's financial system and economy. There are numerous reports about bankruptcies of Peer-to-peer lending platforms and struggles in other parts of the shadow banking system. The selloff in Chinese onshore A shares confirms this. Presently, this market has become less driven by retail investors as it was back in 2015. Hence, one can argue that portfolio managers on the mainland are selling their stocks because they believe economic conditions are worsening. Meanwhile, international investors have so far been more sanguine. Importantly, EM corporate and sovereign U.S. dollar bond yields are rising, heralding lower share prices (Chart I-3). Bond yields are shown inverted on this chart. The top panel is for EM overall and the bottom panel is for Asia only. Chart I-3EM Credit Markets Entail More Downside In EM Share Prices Chart I-4EM Versus U.S.: New Lows Lie Ahead Finally, the resilience of the U.S. equity index and corporate spreads has been due to robust domestic demand - the slowdown in global trade has not affected the U.S. However, odds are that the current global selloff continues to develop in a typical domino fashion. If so, the U.S. markets - equities and credit - will be the last dominos to fall but they will outperform their global peers. It is very unlikely that American stocks and credit markets will be able to sail through this EM storm unscathed. Notably, the resilience of the S&P 500 can be attributed to 10 large-cap stocks that are extremely overbought and likely expensive. This gives us more confidence to argue that this EM riot will meaningfully affect U.S. equity and credit markets. The link will be the U.S. dollar. The greenback will continue its unrelenting rally, which will trim U.S. multinationals' profits and weigh on the S&P 500. Bottom Line: EM risk assets are in a major bear market, and there is still a lot of downside. It is not too late to sell or underweight EM. This is despite EM's relative performance versus the S&P 500 is back to its early 2016 lows, as is the JP Morgan EM currency index (Chart I-4). News lows lie ahead. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018 available on page 17. Chart II-1More Upside In Long Indian/Short ##br##Chinese Bank Stocks Reiterating Long Indian / Short Chinese Banks Trade This week we revisit our long Indian / short Chinese banks trade that we initiated on January 17.1 The trade is up only 5.7% since inception (Chart II-1), and with more monetary policy easing occurring in China and the recent sharp rise in non-performing loans (NPL) in India, it is appropriate to reassess this recommendation. Having updated the stress tests on the largest public banks in both countries and performed a new stress test on five Indian private banks, we are reiterating our strategy of being long Indian / short Chinese banks. A Perspective On Credit Cycles In India And China Both India and China have gone through major credit binges over the past 10-15 years, albeit over different time periods (Chart II-2A and Chart II-2B). Chart II-2ACredit Boom Was Smaller In India...Than In China Chart II-2BCredit Boom Was Smaller In India...Than In China India's public banks have, in recent years, recognized bad loans and provisioned meaningfully for them. Non-performing loans (NPLs) for Indian public banks now stand at a whopping 15% of total outstanding loans, while provisioning levels have spiked to 7% of total loans (Chart II-3). Chart II-3NPLs And Their Provisions: India And China By comparison, Chinese public banks - the largest five banks, excluding policy banks, where the central government owns 70-80% of equity - are at the early stages of dealing with their troubled assets. Their NPLs and provisions stand at mere 1.8% and 3.3% of total outstanding loans, respectively (Chart II-3). Does such a wide disparity in NPL ratios between Chinese and Indian banks make sense? We do not think so. It is unlikely that Indian public banks are more poorly managed vis-a-vis Chinese public banks. All are run by government-appointed officials and are equally prone to politically driven and inefficient lending. Further, the magnitude of the Chinese credit boom since 2009 was considerably greater than India's during the 2003-2012 period. It is therefore highly unlikely that the resulting NPLs are substantially smaller in China than in India. In fact, several cases of Chinese banks hiding bad assets have recently been publicized.2 We strongly believe this phenomenon is widespread on the mainland, and that NPLs among Chinese public banks are being grossly underreported. It's All About Regulation The true vindication for this disparity lies in the drastically different stances that financial regulators in both countries have adopted to deal with the non-performing and stressed assets that their banks sit on. The Chinese authorities have been exhibiting greater forbearance with their commercial banks. For instance, in March, they lowered the provision coverage ratio for commercial banks. This is ameliorating Chinese commercial banks' short-term profitability and capitalization ratios. In brief, Chinese regulators have been very accommodative by allowing commercial banks to pursue "window dressing" of their financial statements and ratios. Indian regulators, by contrast, have been exerting relentless pressure on their banks to swiftly deal with their stressed assets at the cost of short-term profitability. For instance, the Reserve Bank of India (RBI) recently introduced an extremely stringent framework for the recognition and resolution of NPLs. Indian commercial banks now have to immediately recognize stressed assets and find a resolution within 180 days. Failure to resolve a stressed account forces banks to take the defaulter to court in order to initiate bankruptcy procedures. Bottom Line: India has taken painful measures to push its banks to clean up their balance sheets. By comparison, China has so far been kicking the can down the road with respect to its banking system. As a result, the banks' balance sheet cleansing cycle is much more advanced in India than in China. Public Banks Stress Tests Below we present our updated stress tests which we performed on India's top seven public banks and China's top five public commercial banks (excluding policy banks). We used the following assumptions in our analysis (Tables II-1 and II-2): Table II-1Stress Test Of Top 7 Indian Public Banks Table II-2Stress Test Of Top 5 Chinese Public Banks Indian non-performing risk-weighted assets (NPA) to rise to 16% (optimistic), 18% (baseline), and 19% (pessimistic), up from 15% currently. For China, we assume NPAs to rise to 10% (optimistic), 12% (baseline), and 13% (pessimistic), up from 1.6% currently. Provided the magnitude and duration of China's credit boom has considerably surpassed that of India, the assumption of this stress test that NPAs will rise to 12% in China but 18% in India implies that Chinese public banks allocated credit much better than their Indian peers. Hence, this exercise in no way favored Indian banks over Chinese ones. We used risk-weighted assets to calculate losses. Risk-weighting adjusts bank assets for their riskiness which in turn makes comparisons between the two banking systems more sensible. Finally, we assumed a 30% recovery ratio (RR) for both countries. The RR on Chinese banks' NPLs from 2001 to 2005 was 20%. This occurred amid much stronger nominal and real growth. Thus, a 30% RR rate today is not low. The outcome of the tests are as follows: Under the baseline scenario of 18% NPA in India and 12% NPA in China, losses post recovery and provisions amount to 1.8 trillion rupees in the former (1.3% of GDP) and RMB 3.3 trillion in the latter (3.9% of GDP) (Tables II-1 and II-2, column 6). These losses would impair 41% of equity capital in India and 44% in China (Tables II-1 and II-2, column 7). Adjusting the current price-to-book value (PBV) ratios for public banks in both countries to the equity impairment under the baseline scenario lifts their PBV ratios to 1.5 in India and 1.7 in China (Tables II-1 and II-2, column 8). Assuming a 1.3 fair PBV ratio3 for banks in both countries, Indian banks appear overvalued by 15% and Chinese banks by 29% (Tables II-1 and II-2, last column). In other words, after the recognition and provisioning of reasonable levels of NPA, Indian public banks appear less overvalued than their Chinese counterparts. These results make sense to us; Indian public banks have been provisioning aggressively for their troubled assets, and bad news is somewhat discounted in their share prices. Chart II-4Loan Write-Offs Have Been Much ##br##Greater In India Than In China Remarkably, Indian public banks have also been writing off more bad loans than their Chinese counterparts. Chart II-4 shows cumulated write-offs of these public banks in India and China since 2010. Bad asset write-offs have so far amounted to RMB 1.2 trillion in China and 3 trillion rupees in India. This is equivalent to 2% and 8% as a share of current risk-weighted assets, respectively. Another way to compare and analyze NPA cycles between two countries is to assess the progress that each country has made toward resolving the full amount of outstanding bad assets - i.e. a full NPA cycle. We define a full NPA cycle in the following way: Total NPA losses under our baseline scenario, plus cumulated past write-offs. In order to measure progress toward resolving the full NPA cycle, we take the ratio of the stock of provisions plus cumulated write-offs and divide that by the full NPA cycle losses (i.e. [provisions + write-offs] / full NPA cycle losses). In India, assuming that NPAs on its largest public banks reach 18% of risk weighted assets - then the full NPA cycle for India would amount to 9.4 trillion rupees, or 26% of current risk-weighted assets (i.e. 6.4 trillion rupees in NPA remaining plus 3 trillion in write-offs made). Meanwhile, India's public banks' progress amounts to 5.6 trillion rupees. This is equal to 60% of India's full NPA cycle. By contrast, Chinese public banks' full NPA cycle would amount to RMB 8 trillion (or 14% of risk-weighted assets) under our baseline scenario. Further, China's banks progress amounts to RMB 2.6 trillion. This is equivalent to only 33% of the full NPA cycle in China. Hence, Indian public banks are closer to their peak NPA cycle versus their Chinese counterparts. Note that this particular analysis assumes no recovery in bad loans in either country. Further, the above analysis does not attune for the fact that Chinese banks have more risky off-balance sheet assets than their Indian peers. Incorporating off-balance sheet assets and liabilities would make the stress tests much more favorable for Indian public banks relative to China. Stress Test For India's Private Banks Private banks are a part of our long Indian / short Chinese banks trade. Indian private banks are also not insulated from regulatory clean-up efforts. In recent years, these lenders significantly boosted their credit to the consumer and service sectors. Higher than normal defaults have not yet transpired but this is a scenario that cannot be ruled out given the frantic pace of lending (Chart II-5). We performed a stress test on five4 large Indian private banks as well (Table II-3): Chart II-5India: Consumer And Service ##br##Credit Is Booming Table II-3Stress Test Of 5 Large Indian Private Banks We assumed the following NPA scenarios: 6% (optimistic), 8% (baseline), and 9% (pessimistic), up from 5% currently. Similar to the above analysis, we used risk-weighted assets to calculate asset losses, though we used a recovery ratio of 50% for private banks instead of 30% for public banks. The basis is that private banks' lending has been concentrated on consumer loans and mortgages and the recovery ratio on these loans will likely be higher - especially taking into consideration the quality of collateral. Our results are as follows: Under the baseline scenario of an 8% NPA ratio, 7% of these private banks' equity would be impaired (Table II-3, column 7). The adjusted PBV would move to 3.9. This compares to a fair value of 3.3 for Indian private banks (Table II-3, column 8), which is the historical PBV mean of private banks in India. In other words, Indian private banks are overvalued by 18% - slightly more than their public peers (Table II-3, column 9). Bottom Line: Indian private banks are overvalued too but less so than Chinese public banks. Investment Conclusions We reiterate our long Indian / short Chinese banks equity trade, initiated on January 17. We track the performance of this recommendation using the BSE's Bankex index for India and the MSCI Investable bank index for China in common currency terms - currency unhedged. In addition, among Chinese-listed banks, we maintain our short small / long large banks (Chart II-6). Smaller banks are more leveraged as well as exposed to non-standard assets and regulatory tightening than large public banks. Finally, the Indian bourse's relative performance against the EM equity benchmark negatively correlates with oil prices - the oil price is shown inverted on this chart (Chart II-7). Chart II-6Stay Short Chinese Small / Long Large Banks Chart II-7India's Relative Equity Performance To EM And Oil Prices Given BCA's Emerging Markets Strategy service expects oil prices to drop meaningfully in the second half of this year,5 this should help Indian equities outperform their EM peers. Besides, Indian banks are more advanced than many of their EM peers in terms of bad assets recognition and provisioning and that should also help the Indian bourse outperform the EM overall equity index in common currency terms. We reiterate our overweight stance on Indian equities within a fully invested EM equity portfolio. In contrast, we are neutral on China's investable stock index's relative performance versus the EM stock index. The main reason why we have not underweighted the Chinese bourse - despite our negative view on China - is the exchange rate; the potential downside in the value of the RMB versus the U.S. dollar in the next six months is less than potential downside in many other EM exchange rates. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Long Indian / Short Chinese Banks" dated January 17, 2018 available at ems.bcaresearch.com. 2 Please see the following article: http://www.scmp.com/business/banking-finance/article/2139904/pressure-chinas-banks-report-bad-debt-good-news-foreign 3 It is the average PBV ratio for EM banks since 2011. 4 HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, and IDFC Bank. 5 Please see Emerging Markets Strategy Special Report "China's Crude Oil Inventories: A Slippery Slope" dated June 21, 2018 available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights A positive tailwind from exports has prevented China's old economy from decelerating over the past year as much as money & credit trends would have predicted. Barring a response from policymakers, a serious export shock, were it to materialize, would likely cause a material further slowdown in Chinese economic activity. Several observations point to the selloff in domestic Chinese stocks being advanced. Investors should avoid trying to catch a falling knife, but should be on the lookout for any signs of an improvement in the economic outlook as a catalyst for a turnaround in A-shares. We are opening the following "shadow" trade: long MSCI China A Onshore index / short MSCI China index, which we will consider implementing in response to a 5% rally in relative performance. Feature The month of June was an extraordinarily difficult time for Chinese stock prices. Chart 1 presents the magnitude of the peak-to-trough selloff in the MSCI China Index, the A-share market, and the S&P 500, all relative to their 1-year highs. The chart shows that the decline in Chinese stocks intensified significantly following President Trump's threat on June 18 that the U.S. would impose a 10% tariff on an additional $200 billion worth of imports from China. The selloff was also magnified by disappointing May economic data; Chart 2 highlights that the Citigroup economic surprise index fell sharply into negative territory in the middle of the month. Chart 1A Significant Selloff In Chinese Stocks Chart 2Recent Economic Data Has Disappointed The Market The selloff in Chinese equities occurred in response to risks that BCA's China Investment Strategy service has repeatedly outlined over the past several months. We have argued since last October that China's "old economy" was likely to slow and characterized the slowdown as benign and controlled in terms of its contribution to global growth. But we have warned over the past few months that the risks of an old economy slowdown were growing for China's equity market and recommended that investors place Chinese ex-tech stocks on downgrade watch over the course of Q2 in our March 28 Weekly Report.1 In last week's report we presented our thoughts on the potential for stimulus from Chinese policymakers,2 and opened a new trade that investors can use to profit from periods of Chinese equity market weakness. In this week's report we review the macro data series that we have been following closely over the past several months, and provide some insight on the outsized selloff in China's domestic market relative to investable stocks. Trade: China's Crutch Table 1 presents the dashboard of select macro series that we have showed in several reports over the past few months. It highlights the evolution of the key six components of our BCA Li Keqiang Leading Indicator, four housing market series that we have found to have strongly leading properties, as well as the NBS and Caixin manufacturing PMIs. Table 1Measures Of Money & Credit Are Telling A Consistently Bearish Story The table highlights that all six components of our leading indicator are in a downtrend and are deteriorating on a sequential basis, whereas our house price indicators remain strong. Housing sales volume, one of the most important leading indicators for the housing sector, ticked up in May but remains below its 200-day moving average. Finally, both manufacturing PMIs deteriorated in May, and are below their 12-month averages. The table highlights another important point, which is that the Li Keqiang index (LKI) itself has risen for two months in a row, which is in stark contrast to the trend in our leading indicator. What has driven this increase, and does it suggest that a renewed uptrend in Chinese economic activity is at hand? In our view, the answer to the first question suggests that the answer to the second is "no". Chart 3 shows that 60% of the May increase in Bloomberg's measure of the LKI occurred due to a significant increase in rail cargo volume, with the remaining 40% due to an increase in electricity production. Li Keqiang originally included rail cargo volume in his list of variables to watch because it is an indicator of trade flows, and we strongly suspect that recent trade activity in China has been influenced by actions on the part of exporters to front-load shipments prior to the imposition of tariffs by the U.S. This includes the possibility that import growth is currently stronger than it otherwise would be due to manufacturers stocking up on intermediate goods whose price could be affected by the previously announced tariffs on steel and aluminum (which were not China-specific). This suspicion is supported by Chart 4, which highlights that the rolling 2-year volatility of monthly changes in the LKI has increased significantly since the beginning of the year. Chart 3Both Electricity Production ##br##And Freight Turnover Picked Up In May Chart 4The Li Keqiang Index ##br##Has Been Relatively Volatile This Year We highlighted past reports that a positive export tailwind has been boosting Chinese economic activity beyond what measures of money and credit would have predicted, and Chart 5 highlights that the deviation of the LKI from what is suggested by our indicator has strongly correlated with export growth over the past year. This implies that China's old economy is standing on one leg (with export growth as the crutch), at a time when the risk of a serious export shock is high. This is concerning, given the strongly positive relationship between the export sector and real investment in China (Chart 6). Chart 5Export Strength Appears ##br##To Be Propping Up The LKI Chart 6China's Export Sector##br## Is Highly Investment-Intensive We acknowledge that the surge in electricity production is more of a challenge to our view, but here too we would resist the argument that it heralds a bullish turning point for the economy. Chart 7 shows a 3-month moving average of overall electricity consumption, alongside consumption excluding the residential sector and tertiary industry (i.e., services). The chart shows that while both series rebounded in May, electricity consumption in the old economy recently contracted for the first time in two years (and has been trending lower). As such, the recent tick higher in the old economy series likely just reflects a move away from extremely weak/contractionary growth rates, but still within the context of an ongoing downtrend. Chart 7Electricity Consumption Has Been Weaker##br## In Primary And Secondary Industries As a final point, Table 1 also highlighted that Chinese house prices are rising broadly, and that floor space sold ticked up again in May on a smoothed basis. Housing construction has also been strong over the past year, and it is likely that this has somewhat boosted Chinese import demand above what it otherwise would have been. However, we have highlighted in several reports the leading relationship between floor space sold and housing starts, which suggests that the recent strength in housing construction is unlikely to continue over the coming year unless sales pick up materially. Until evidence of a durable uptrend in sales presents itself, we are sticking with our view that the cyclical trajectory of China's economy will be determined by the trends in money & credit and the external sector. Bottom Line: A positive tailwind from exports has prevented China's old economy from decelerating as much as money & credit trends would suggest. Barring a response from policymakers, a serious export shock, were it to materialize, would likely cause a material further slowdown in Chinese economic activity. A-Shares: Is The Selloff Overdone? Chart 1 highlighted that Chinese domestic stocks have fallen 25% from their late-January peak, compared with approximately 15% for the MSCI China index. It is too soon to conclude that A-shares have fully priced a slowdown in China's economy given the considerable uncertainty surrounding the outlook for external demand, but several observations point to the selloff being advanced: A 25% peak-to-trough decline in A-shares represents roughly half of the total decline that occurred in 2015 and early-2016, when the global economy experienced a coordinated economic slowdown, Chinese monetary policy was considerably tighter than it is today, and valuation ratios had more than doubled in the year prior to the peak. Chart 8 highlights how much lower trailing multiples were for A-shares at the start of the year compared with their peak in 2015, implying that the deterioration in investment sentiment has already been severe. Chart 9 supports the idea of an outsized collapse in sentiment, by showing the rolling 3-month correlation between daily A-share returns and percent changes in CNY/USD. In our view, the recent spike in the correlation reflects fears among investors (perhaps among domestic retail investors) that the decline in CNY/USD is a harbinger of the global financial market panic that followed the PBOC's decision to devalue the RMB in August 2015. Chart 8Versus 2015, A-Shares Are Selling Off##br## From A Cheaper Starting Point Chart 9The Sharp Decline In CNY/USD Is Panicking ##br##Some Buyers Of Domestic Stocks The panic that occurred following China's 2015 devaluation occurred in the context of a much weaker global economy: Chart 10 highlights that while global import demand and manufacturing PMIs have deteriorated somewhat recently, this decline is from a much stronger level. In short, it remains far from clear that the tariff-related decline in global business sentiment represents a shock of the same magnitude as what occurred in late-2015/early-2016, which suggests that panic selling in the A-share market may be overdone. Chart 11 shows that the selloff in the domestic market has largely been indiscriminate, not isolated to export-sensitive sectors (which presumably would fare worse if the shock to China's economy is externally-driven). This has pushed our technical indicator for A-shares down to deeply oversold territory (panel 2). Two crucial market indicators that we recommended investors watch closely are not yet providing warning of a crisis. Chart 12 shows that China's relative sovereign CDS spread, while rising, is well below levels that prevailed in the lead-up to China's 2015 currency devaluation, and panel 2 shows that there has been no breakdown in large bank alpha versus global banks. Small banks in China have sold off aggressively over the past few weeks, but this also occurred in late-2016 and in the first half of 2017 without consequence. Chart 10The Global Economy Is Stronger Now##br## Than It Was In 2015 Chart 11An Indiscriminate Selloff Has Rendered##br## A-Shares Deeply Oversold Chart 12The Outlook Has Darkened, ##br##But A Crisis Appears Unlikely We have highlighted in previous research that while China's domestic stock market is relatively volatile, it is not a "casino" market that is untethered from fundamentals.3 This suggests that investors should be on the lookout for any signs of an improvement in the economic outlook as a catalyst for a turnaround in A-shares. To be clear, we are not recommending that investors try to catch a falling knife: the export outlook remains highly uncertain, and a more pronounced slowdown in the global economy may unfold if President Trump follows through with his threat to expand the imposition of tariffs on other G7 countries. However, considering the observations above, we are opening the following shadow trade: long MSCI China A Onshore index / short MSCI China index, which we will consider implementing in response to a 5% rally in relative performance. Bottom Line: Several observations point to the selloff in domestic Chinese stocks being advanced. Investors should avoid trying to catch a falling knife, but should be on the lookout for any signs of an improvement in the economic outlook as a catalyst for a turnaround in A-shares. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Weekly Reports " A-Shares: Stay Neutral For Now", dated March 14, 2018 and "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations