Equities

Special Report

Highlights Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is highly concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely elevated debt service ratio. Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the current message from our DRM is that the odds of a deleveraging event over the coming year are low. Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Feature Hong Kong has appeared in the headlines of the financial press for two reasons over the past few months. The first is due to the recent weakness in the Hong Kong dollar (HKD), a topic that we addressed last week.1 The second was prompted by the BIS' March 2018 Quarterly Review, which noted that mainland China, Hong Kong, and Canada stood out among 26 jurisdictions as being the most vulnerable to a banking crisis according to their research. The BIS's warning is rooted in the fact that Hong Kong is a highly leveraged economy, but there are two additional reasons for investors to be cautious about the region: China's industrial sector is slowing, and monetary policy is tightening due to the region's direct link to U.S. interest rates. While Hong Kong has avoided the full brunt of rising U.S. rates over the past year thanks to plentiful interbank liquidity (which has limited the rise in 3-month HIBOR), we noted in last week's report that the weakness in the HKD likely means that gap between interbank rates and the base rate cannot get much wider. This means that further Fed rate hikes over the coming year are likely to feed more fully into tighter Hong Kong monetary conditions. In this report we review the extent and disposition of Hong Kong's indebtedness, and develop an indicator for investors to monitor in order to gauge the risk of a serious private sector deleveraging event. We conclude that while it is too early to position aggressively against Hong Kong stocks, the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn. For now, however, that appears to be a story for another day, and as we explain below, potentially a distant one. Breaking Down Hong Kong's Debt Chart 1 presents the basis for concern about Hong Kong's debt. The chart shows the BIS' nonfinancial private sector debt service ratio ("DSR", which includes both households and nonfinancial corporations) for the G10 countries alongside that of China, Hong Kong, and Canada. The chart shows that Hong Kong's DSR has risen nearly to 26%, a full 10 percentage points higher than the G10 average, and is now the highest among the 32 economies that the BIS has debt service data for. One important point to note is that among the three countries that the BIS recently singled out for concern, the disposition of Hong Kong's private sector debt is more similar to that of China than Canada. Chart 2 highlights that the private sector debt in China and Hong Kong is predominantly owed by the nonfinancial corporate sector, whereas in Canada the debt is more equally split among the two sectors, with households owing more in total. Chart 1Hong Kong's Debt Burden Hits##br## A New High Chart 2Unlike In Canada, Hong Kong's Leverage##br## Is A Corporate Sector Problem Normally we would be inclined to suggest that the skew in Hong Kong's debt towards the corporate sector makes it less risky than in other jurisdictions where elevated leverage is a household sector problem. The rationale is that while corporations can (and often do) misallocate their capital, firm borrowing is usually employed to acquire income-producing assets, with problems arising only when the value of those assets (or their potential to generate income) declines sharply. Household leverage problems, on the other hand, are almost always the result of a sharp rise in residential mortgage credit, and our view is that the purchase of residential property is fundamentally an act of consumption rather than a true investment. In addition, the past experiences of several countries have shown that housing-related leverage busts are particularly pernicious, in that the resulting recessions tend to be followed by long periods of subpar economic growth. But unlike in China where the majority of nonfinancial corporate sector debt is held on the balance sheets of state-owned enterprises, Hong Kong's corporate debt does not have de-facto state backing and appears to be enormously concentrated in the real estate and financial sector. Over 80% of Hong Kong's total nonfinancial sector debt (which includes households) is provided by domestic banks, and Chart 3 shows that among bank loans to firms, 35% have been granted to property building & construction companies and another 22% to "financial concerns" and stockbrokers. This high concentration of corporate sector debt in the real estate sector means that investors should be legitimately concerned over Hong Kong's extremely high DSR. On the household side, we have made the case in a previous report that a replay of another spectacular housing bust (similar to what occurred in 1997) is highly unlikely despite the fact that Hong Kong house prices have vastly outstripped income over the past decade2 (Chart 4). Chart 3Loans To Businesses Are Highly Concentrated ##br##And Exposed To Property Chart 4Lofty House Prices Are A Red Herring: ##br##The Risk Is On The Business Side This suggests that, despite extremely elevated residential property prices, investors should be more concerned about a shock that will destabilize the commercial real estate market. Hong Kong households would not likely escape the impact of such a shock, since commercial and residential real estate prices move strongly in tandem (Chart 5). But in terms of watching for a "tipping point" that could push Hong Kong's private sector into a balance sheet recession, the trigger seems more likely to occur in the market for the former, rather than the latter. Bottom Line: Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is extremely concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely high debt service ratio. Chart 5Still, Households Will Be Hurt##br## If CRE Prices Fall Chart 6The BIS' Warning Thresholds ##br##Don't Seem To Apply To Hong Kong Timing The Onset Of A Balance Sheet Recession Our analysis above supports the recent warnings from the BIS that the risk of a banking crisis / private sector deleveraging event in Hong Kong is nontrivial. This raises the obvious question of how to gauge the timing of such an event in order for investors to properly position their exposure towards Hong Kong's financial markets. The BIS has itself investigated this question, and has published several reports on its "Early Warning Indicator" (EWI) approach.3 Table 1 presents a list of these indicators for several countries, and highlights that the two of the most informative measures (the credit-to-GDP gap4 and the overall debt service ratio) are flashing red for Hong Kong. In fact, Table 1 served as the basis for the BIS' warning in their most recent Quarterly Review that we noted above. The BIS' EWI research has focused on identifying thresholds for these measures that can predict a banking crisis within a three-year window based on the historical record. But in the case of Hong Kong, it is not clear that these thresholds apply. Chart 6 shows the credit-to-GDP gap and overall private sector DSR along with the more stringent BIS threshold noted in Table 1, and highlights that these measures have been flashing red for 4-8 years. Based on this approach, Hong Kong should have experienced a banking crisis long ago. Table 1BIS Early Warning Indicators For Stress In Domestic Banking Systems Rather than relying on the BIS' framework, we have instead constructed our own private-sector debt risk monitor for Hong Kong. In contrast to the BIS' measures, which have been specifically constructed to predict a banking crisis, the goal of our indicator is to help predict a serious credit-driven downturn regardless of its character (i.e. we abstract from whether the result of the downturn is a full-blown financial crisis or simply a prolonged period of economic stagnation). Chart 7Low Risk Of A Serious Credit-Driven ##br##Downturn, For Now Chart 7 presents our BCA Hong Kong Debt Risk Monitor (DRM) and its five equally-weighted components, a summary of which is provided below. All series have been scaled such that an increase in the DRM represents higher risk. Alpha: We have highlighted the importance of examining the alpha as well as the beta of regional equity returns in a previous report,5 and we include a composite indicator of Hong Kong's rolling alpha versus the global benchmark as a measure of Hong Kong-specific stock performance that adjusts for Hong Kong's riskiness. While this component of our DRM was quite elevated in early-2016 (signaling weak Hong Kong stock performance), it is presently in line with its historical average, and thus is not flashing a warning sign. Property Prices: Given the high concentration of Hong Kong's corporate sector debt in the real estate sector, our DRM includes the deviation of office & retail property prices from their 9-month moving average. Similar to the first component of our indicator, Hong Kong property prices are roughly in line with their trend and are not signaling serious economic weakness. Credit Impulse: The third component of our DRM is a simple bank credit impulse, calculated as the flow of credit over the past year as a percent of GDP. While this component has fallen well into "low risk" territory, over the past year, there are some tentative signs of a reversal that investors should monitor. Monetary Policy Stance: The fourth component of our DRM is a structural variable that attempts to measure whether U.S. (and thus Hong Kong) interest rates are either consistent or out of alignment with economic conditions in Hong Kong. This component is an average of two measures of the stance of monetary policy: 1) the difference between U.S. 10-year government bond yields and Hong Kong nominal GDP growth, and 2) the difference between the base rate and a Taylor Rule estimate for the region (with the latter acting purely as an estimate of the cyclical equilibrium interest rate).6 The chart shows that despite the onset of tighter monetary policy in the U.S. over the past few years, our gauge of Hong Kong's policy stance suggests that conditions are still easy, and that material further increases would likely be required in order to see this component rise to +1 sigma territory. Debt Service Ratio: The final component of our DRM is the BIS' total private sector DSR shown in Chart 6, acting as a second structural variable that captures the underlying debt servicing risk that the BIS has warned about. We extent the BIS' series back to the early-1990s on a best efforts basis, by adjusting the product of Hong Kong's prime rate and the total private sector debt-to-GDP ratio to best align with the official DSR series over the course of its history. Our extended series suggests that Hong Kong's debt servicing burden is indeed the highest that it has been over the past three decades, underscoring that our DRM is likely to rise materially if the cyclical factors included in the indicator deteriorate. The overall message of our DRM is that a threat to Hong Kong's economy from excessive debt does not appear to be imminent, despite the underlying risks highlighted by the BIS. While the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn, the odds of this occurring over the coming 6-12 months appear to be low. Bottom Line: Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the message from our DRM is that the odds of a deleveraging event over the coming year are low. The Spooky Implications Of The Natural Interest Rate Gap Interestingly, at least part of the benign reading of our DRM is due to the fourth component of the indicator, our gauge of Hong Kong's monetary policy stance, which suggests that there is ample room for further rate increases. In fact, in our view this observation carries much deeper significance than many may initially perceive, as it may explain why the BIS' early warning indicator thresholds have not worked in the case of Hong Kong, and why the region may avoid a debt crisis for a further significant period (but ultimately experience a much more painful collapse when it finally arrives). At root, the reason that U.S. 10-year Treasury yields remain exceedingly low relative to U.S. nominal GDP growth is because investors believe that real U.S. policy rates are likely to be much lower on average over the next 10-years than they have been historically (Chart 8). Abstracting from calendar-based cyclical considerations (such at the timing of the next U.S. recession), this fundamentally reflects the prevalent view among fixed-income investors that the U.S. natural rate of interest (or "r-star") has likely permanently declined. If true, this is of enormous importance for Hong Kong, as it suggests that the region will permanently "enjoy" easy monetary policy. This is because the substantial leveraging that has occurred in Hong Kong in response to low interest rates implies that there has been no impairment (yet) to Hong Kong's natural rate of interest (Chart 9). Chart 8A Low Estimate Of R-Star Has Depressed##br## U.S. Bond Yields Chart 9No Evidence Of A Low R-Star##br## In Hong Kong In some ways the dynamic we are describing is not new: the importation of easy monetary policy from the U.S. via competitive currency devaluation over the past decade has been a well-known phenomenon that was quite prominent during the early phase of the global economic recovery. But the fixed exchange rate regime in Hong Kong means that this process cannot be avoided without abandoning the peg, an event that itself could trigger a deleveraging event via a sharp decline in asset prices. The key point for investors is that if the U.S. natural rate of interest has indeed fallen materially and permanently below potential GDP growth, then Hong Kong will not experience tight monetary conditions even once the Fed has normalized short-term interest rates, unless it raises them well above equilibrium levels. This suggests that Hong Kong's private sector may perpetually leverage itself until debt service burdens reach some, as yet, unknown maximum level, precipitating what would likely become a cataclysmic recession. The fact that no crisis erupted in late-2015/early-2016 when the cyclical components of our DRM deteriorated significantly suggests that this level may be materially higher than is presently the case. Bottom Line: Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Investment Implications: Stay Neutral, For Now Chart 10Room For A Rise In Relative Earnings Momentum The picture painted by our above analysis suggests that a benign cyclical outlook for Hong Kong is arrayed against a negative (and potentially horrific) structural outlook. How should investors position towards Hong Kong equities in response? First, as noted above, our Debt Risk Monitor does not signal that there is an imminent threat facing the Hong Kong economy that would herald the potential for a major deleveraging event over the near-term. Second, while Hong Kong's earnings momentum is stretched in absolute terms, Chart 10 highlights there is room for a catchup versus global stocks, which could boost relative performance over the coming year. Third, relative valuation and technical conditions are at neutral levels (Chart 11), and thus do not provide any compelling basis to avoid Hong Kong stocks. But to us, the weight of this modestly positive assessment over the coming year is overshadowed by the structural outlook, meaning that we continue to recommend a neutral allocation towards Hong Kong stocks over the coming 6-12 months. The most investment-relevant conclusion from our analysis is that investors will one day be able to earn significant risk-adjusted returns from underweighting / shorting Hong Kong stocks once a serious credit-driven downturn begins. As an example, Chart 12 shows the impact of the Asian financial crisis on Hong Kong's relative performance, a period where our DRM rose sharply and persistently into "high risk territory". It took 12½ years for Hong Kong to rise to a new high in relative total return terms, and it has yet to do so in price terms. Chart 11Neutral Relative Valuation And ##br##Technical Conditions Chart 12One Day, Shorting Hong Kong Stocks##br## Will Be Enormously Profitable So while the economic and financial market conditions are not yet in place to act on a bearish structural view, we will be closely watching our Debt Risk Monitor over the coming months and years for signs of a significant deterioration, as it will likely provide a major opportunity for investors to earn outsized returns. Stay tuned! Bottom Line: Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please 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 "Hong Kong Housing Bubble: A Replay Of 1997?", dated June 29, 2017, available at cis.bcaresearch.com. 3 For example, please see "Evaluating early warning indicators of banking crises: Satisfying policy requirements" by Mathias Drehmann and Mikael Juselius, BIS Working Paper No. 421, August 2013. 4 The BIS defines the credit-to-GDP gap as the difference between the credit-to-GDP ratio and its long-run trend, derived using a one-sided (i.e. backward-looking) Hodrick-Prescott (HP) filter. 5 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 6 Our Taylor Rule estimate for Hong Kong is constructed in a fashion similar to what we showed for China in our January 18 Weekly Report, using a neutral policy rate estimate of 5%. Cyclical Investment Stance Equity Sector Recommendations

A return of volatility, spurred on by Fed tightening, caused an SPX pullback in February, and while the market pushed through that rough patch, it has since been replaced with fears of a trade war, exacerbated by musical chairs in the Trump administration. Despite shaky markets, our portfolio positioning has not changed and we remain firmly behind cyclicals over defensives, driven principally by our key 2018 investment themes: synchronized global capex growth (top and second panels) and higher interest rates on the back of a pickup in inflation (bottom panel). Still, the return of volatility warrants a review of our macro, valuation and technical indicators. The best combination in our review is S&P financials (Overweight) with an elevated and accelerating cyclical macro indicator (CMI), fed by both of our key capex growth and rising interest rate themes, combined with a modest undervaluation. The worst combination is S&P telecom services (Underweight, high-conviction), whose CMI recently touched a 30-year low as sector deflation hit acute levels. Valuations make the sector look cheap, but every indication is that telecoms are a value trap. Please see this week's Cyclical Indicator Update for more details.

Highlights Key Portfolio Highlights Our portfolio positioning remains firmly behind cyclicals over defensives, driven principally by our key 2018 investment themes: synchronized global capex growth (Chart 1A) and higher interest rates on the back of a pickup in inflation (Chart 1B). The positioning has been lifted by synchronized global growth and a soft U.S. dollar (Chart 1C), while the key risk to our portfolio of a hard landing in China looks to be mitigated (Chart 1D). A return of volatility, spurred on by Fed tightening (Chart 1E), caused an SPX pullback in February, and while the market pushed through that rough patch, it has since been replaced with fears of a trade war, exacerbated by musical chairs in the Trump administration (Chart 1F). Our buy-the-dip strategy remains appropriate on a cyclical time horizon (Chart 1G), given a dearth of evidence of a recession in the next year. SPX forward EPS estimates still show near-20% increases this calendar year (corroborated by our EPS growth model, Chart 1H) which should underpin outsized equity returns in the absence of a major valuation rerating. Still, the return of volatility warrants a review of our macro, valuation and technical indicators. The best combination in our review is S&P financials (Overweight) with an elevated and accelerating cyclical macro indicator (CMI), fed by both of our key capex growth and rising interest rate themes, combined with a modest undervaluation. The worst combination is S&P telecom services (Underweight, high-conviction), whose CMI recently touched a 30-year low as sector deflation hit acute levels. Valuations make the sector look cheap, but every indication is that telecoms are a value trap. Chart 1AGlobal Trade Is Rising... Chart 1B...But So Too Is Inflation Chart 1CA Weaker Dollar Is A Boon To Growth Chart 1DSoft Landing In China Seems Likely Chart 1EThe Return Of Vol May Spoil The Party... Chart 1F...And Policy Uncertainty Doesnt Help Chart 1GBuy The Dip Has Worked Out Nicely Chart 1HHeed The Message From A Booming EPS Model Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI, Chart 2) has climbed to new cyclical highs with significant upward momentum, driven by broad improvement in virtually all of its underlying components. More than any other variable, rising yields and the accompanying higher price of credit are a boon to financials. Higher interest rates is one of BCA's key themes for 2018 and an ongoing selloff in the bond market bodes well for profits in the heavyweight banks sub-index and should deliver the next up leg in bank stocks performance (top panel, Chart 3). Another of BCA's key themes for 2018 is a global capex upcycle; higher demand for capital goods should drive outsized capital formation in the year to come. Our U.S. commercial banks loans and leases model echoes this positive outlook, pointing to the best loan growth of the past 30 years (middle panel, Chart 3). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 3). Despite the much-improved cyclical outlook and a revival of overall animal spirits, our valuation indicator (VI) suggests that financials are modestly undervalued. At this point in the cycle, we would expect a modest overvaluation; the implication is that financials should be a core portfolio overweight. Our technical indicator (TI) has approached overbought levels several times over the course of this bull market, though history suggests it can stay at elevated levels for a considerable time. Chart 2S&P Financials (Overweight) Chart 3RS1 Rising Yields Are A Boon To Financials Earnings S&P Industrials (Overweight) Our industrials CMI (Chart 4) has gone vertical and is very near its all-time high. A combination of a supportive currency, a recovery in commodity prices and synchronized global growth are responsible for the rise. A falling U.S. dollar and capital goods producers' top line growth acceleration have historically moved hand-in-hand as this group is one of the most international of the S&P 500. The trade-weighted U.S. dollar has fallen by more than 10% from its most recent peak at the end of 2016 which suggests U.S. industrials should have a leg up in sales for the year to come (top panel, Chart 5). The slide in the U.S. dollar is coming at an opportune time; global growth is remarkably synchronized (and remains a key BCA theme for 2018) and has proven an excellent harbinger of industrials margins (bottom panel, Chart 5). Overall, an expanding top line and widening margins imply solid relative EPS gains. Our valuation gauge is near the neutral zone, where it has been for much of the past 3 years as the market has failed to capture the sector's outlook strength. Our TI echoes the neutral message, having unwound a significant overbought position at the beginning of last year. Chart 4S&P Industrials (Overweight) Chart 5Global Euphoria Should Lift Industrials S&P Energy (Overweight) Our energy CMI (Chart 6) has maintained its upward trajectory after bouncing off all-time lows last year. Importantly, the relative share performance does not yet reflect the drastically improved cyclical conditions, underpinning our overweight recommendation. Falling oil inventories and rising prices (top and second panel, Chart 7) combined with solid gains in domestic production underlie the CMI recovery. Our key themes for 2018 of a global capex expansion and synchronized global growth should be the most important drivers for energy stocks this year. With respect to the former, the capex intentions from the Dallas Fed survey hit their highest level in a decade, which usually presages domestic oil patch expansion and energy stock outperformance (third panel, Chart 7) With respect to global growth, emerging markets/Chinese demand is the swing determinant of overall oil demand, and non-OECD demand has been moving higher for most of the past year (bottom panel, Chart 7). Our VI has retreated far into undervalued territory, a result of the aforementioned failure of stocks to react to the enticing macro outlook. The TI too is in deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are so appealing. Chart 6S&P Energy (Overweight) Chart 7Energy Share Prices Have Trailed Oils Recovery S&P Consumer Staples (Overweight) Our consumer staples CMI (Chart 8) has turned up recently, following a two year decline. Strong employment gains and positive retail sales are the key pillars underlying the modest recovery. The euphoric consumer continues to push our consumer staples EPS model higher, now pointing to the best earnings growth of the past 5 years (middle panel, Chart 9). Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (bottom panel, Chart 9). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put our positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. Further, our VI is waving a green flag as consumer staples are now nearly two standard deviations below their 30-year mean valuation. Technical conditions too are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 8S&P Consumer Staples (Overweight) Chart 9Robust Consumer Confidence Bodes Well S&P Utilities (Neutral) Our utilities CMI (Chart 10) has spent the last decade in a long-term downtrend, albeit one with periodic countertrend moves. The key underlying factors are natural gas prices and relative spending on utilities, both of which have been retreating since 2008 (middle panel, Chart 11). Encouragingly, the sector's wage bill has slowed from punitively high levels, though pricing power has followed it down, implying muted margin changes (bottom panel, Chart 11). Like other defensive sectors, utilities have underperformed cyclical sectors in the last year; utilities equities trade as fixed income proxies, and a rising interest rate environment is punitive. As a result of the underperformance and relatively constant earnings, valuations have collapsed to the neutral zone. We reacted by booking solid gains and upgrading to a benchmark allocation earlier this year; synchronized global growth and higher interest rates are headwinds for this niche defensive sector and prevent us from lifting positions further. Our TI has fallen steeply over the past year and is now closing in on two standard deviations below the 30-year average. Chart 10S&P Utilities (Neutral) Chart 11Pricing Is Falling But Margins Look Neutral S&P Real Estate (Neutral) Our real estate CMI (Chart 12) has been in decline since its most recent peak at the end of 2016. This is confirmed by a darkened outlook for REITs; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (top panel, Chart 13). Further, bankers appear less willing to extend commercial real estate credit, despite recent stability in underlying prices; declines in credit availability will directly impact REIT valuations (bottom panel, Chart 13). Our VI is consistent with BCA's Treasury bond indicator (not shown), indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 12S&P Real Estate (Neutral) Chart 13Peaking Rents and Tight Credit Are Headwinds S&P Materials (Neutral) Our materials CMI (Chart 14) has maintained its downward trajectory, largely due to the ongoing Fed tightening cycle. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as rates are moving higher (top panel, Chart 15). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018, representing a substantial headwind to sector performance. Still, the news is not all negative. Exceptionally strong global demand growth has revitalized chemicals prices (bottom panel, Chart 15). Combined with the industry's relatively newfound restraint, capacity has not overextended and the resulting productivity gains bode well for earnings growth. Despite the improving outlook, valuations have been retreating for much of the past year and our VI has fallen back to the neutral zone. Our TI has been hovering near the neutral line for the past year, though a recent hook downward indicates a loss of momentum and downside relative performance risks. Chart 14S&P Materials (Neutral) Chart 15Rising Rates Are Offset By Improving Demand S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI (Chart 16) has fallen back after reaching highs earlier in 2017, though remains elevated relative to the long term trend. Rising interest rates (top panel, Chart 17) are more than offsetting higher home prices and real wage growth, both have which have recently stalled. This rising short-term interest rate backdrop is not conducive to owning the extremely interest rate-sensitive equities that fall into the S&P consumer discretionary index. Both the household financial obligation ratio and household debt service payments have bottomed and are actually increasing. A higher interest rate backdrop will sustain the upward pressure on both and likely weigh on consumer discretionary relative share prices (third and bottom panels, Chart 17). This underpins our recent downgrade to a below benchmark allocation. Elevated valuations support our negative thesis as our valuation indicator has been rising recently out of the neutral zone. Our TI has fully recovered from oversold levels, and is now well into overbought territory, though historically this indicator has been excessively volatile. Chart 16S&P Consumer Discretionary (Underweight) Chart 17Higher Borrowing Costs Bode Ill For Consumer Discretionary S&P Health Care (Underweight) Our health care CMI (Chart 18) rolled over last year and has been treading water at these lower levels, driven by weak fundamentals in the key pharmaceuticals sector. Poor pricing power, a soft spending backdrop and a depreciating U.S. dollar have been pressuring the sector and keeping a tight lid on the CMI (top and second panels, Chart 19). Other non-pharma indicators are mixed as lower healthcare consumer spending is offset by a tick up in overall pricing power. Relative valuations have fallen deep into undervalued territory and are approaching one standard deviation below the 25 year average. Our TI too has reversed course and is well into oversold territory. However, the message from our health care earnings model is that sector earnings will continue to decelerate; this environment in not conducive for a sector re-rating (bottom panel, Chart 19). Chart 18S&P Health Care (Underweight) Chart 19Pharma Pricing Power Continues To Collapse S&P Telecommunication Services (Underweight) Our telecom services CMI (Chart 20), after moving sideways for much of the past decade, has recently fallen to a new 30-year low. Extreme deflation continues to reign in the beleaguered sector as relative consumer outlays on telecom services have nosedived (top panel, Chart 21) which is broadly matched by melting selling prices (middle panel, Chart 21) as demand contracts. This is reflected in our S&P telecom services revenue growth model, which remains deep in contractionary territory (bottom panel, Chart 21). The sector remains chronically cheap, exacerbated by the recent sell-off, and is currently as cheap as it has ever been. Still, given the brutal operating environment, we think such valuations have created a value trap. Our Technical Indicator has sunk but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. We recently downgraded the sector to underweight and added it to our high-conviction underweight list based on the factors noted above.1 Chart 20S&P Telecommunication Services (Underweight) Chart 21Telecom Services Remain A Value Trap S&P Technology (Underweight, Upgrade Alert) The technology CMI (Chart 22) has been falling for the past three years, driven by ongoing relative pricing power declines and new order weakness. However, the sector has proven resilient, at least until recently, as a handful of stocks (the FANGs, excluding the consumer discretionary components) and the red-hot semiconductor group have provided support. Still, market euphoria aside, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods; inflation is gradually rising after a prolonged disinflationary period (bottom panel, Chart 23). Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is extremely overbought, though it has been at this high level for several years. Chart 22S&P Technology (Underweight, Upgrade ALert) Chart 23Inflation Is No Friend To Tech Size Indicator (Neutral Small Vs. Large Caps) Our size CMI (Chart 24) has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher (top panel, Chart 25). A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. Earlier this year, we downgraded our recommendation on small caps vs. large caps to a neutral allocation, based on a deterioration in small cap margins and too-high leverage.2 Recent NFIB surveys would suggest this move was prescient; firms reporting planned labor compensation increases have steadied near a two decade high, while price increases are trailing far behind (middle panel, Chart 25). With "quality of labor" having overtaken "taxes" as the single most important problem facing businesses, labor compensation growth seems likely to continue moving up at an elevated pace and small cap margins should likely continue to trail large cap peers (bottom panel, Chart 25). Valuations have improved and small caps are relatively undervalued, though our TI echoes a neutral message. Chart 24Size Indicator (Neutral Small Vs. Large Caps) Chart 25Small Businesses Remain Exceptionally Confident Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of March 30, 2018. There are no significant changes in the model's allocation this month. The small overweight in the U.S. is scaled back to neutral with the proceeds mostly going to the euro area. In terms of absolute bet, the model still favors the euro area (mainly Italy, Germany, Netherland and Spain) vs. Japan and the U.K. , as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 19 bps in March, largely driven by Level 2 model which outperformed by 58 bps. Since going live, the overall model outperformed MSCI World by 127 bps, due to the 421 bps of outperformance from the Level 2 model which allocates funds among 11 non-U.S. countries. The Level 1 model (which allocates funds between U.S. and the non-U.S.) is on par with the MSCI World benchmark. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD, %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Chart 4Overall Model Performance Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of March 30, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Following last month's switch to a defensive positioning, the model generated alpha of 40 bps for the month of March. Increasing risk of a global trade war has damaged growth forecasts, and the model consequently continues to produce negative signals from its growth component. As cyclical sectors such as financials and technology continue to falter, momentum signals remain unfavorable. Energy is the only cyclical sector with an overweight on the back of favorable long-term valuations. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Recommended Allocation Due to the boost from U.S. fiscal stimulus, we do not expect recession until 2020. Despite some signs that growth is peaking, global economic fundamentals remain robust. Markets have wobbled because of the risk of trade war and rising inflation. We think neither likely to derail growth. Not one of our recession indicators is yet sending a warning signal. We are late cycle and volatility is likely to remain high (particularly if the trade war intensifies). But, given strong earnings growth and three further Fed rate hikes this year, we expect global equities to beat bonds over the next 12 months. Except for particularly risk-averse investors, who care mostly about capital preservation, we continue to recommend overweights in risk assets. We are overweight equities (especially euro area and Japan), cyclical equity sectors such as financials and industrials, credit (especially cross-overs and high-yield), and return-enhancing alternative assets such as private equity. Feature Overview Stimulus Trumps Tariffs Risk assets have been choppy so far this year, with global equities flat in the first quarter and the stock-to-bond ratio turning down (Chart 1). Markets were battered by worries about a trade war, signs of growth peaking, a rise in inflation, and bad news from the tech sector. This late in the cycle, with stock market valuations stretched and investors skittish about what might go wrong, we expect volatility to stay high. But the global economy remains robust - and will be boosted by U.S. fiscal stimulus - earnings are growing strongly, and the usual signs of recession and equity bear markets are absent. Though the going will be bumpy over coming quarters, we continue to expect risk assets to outperform at least through the end of this year. U.S. tariffs on steel and aluminum and the threat of $50 billion of tariffs on Chinese imports so far represent a trade skirmish, not a trade war. The amounts pale by comparison with the positive impact coming though from U.S. tax cuts, increased fiscal spending, and repatriation (Chart 2). In history, fights over trade have rarely had a serious impact on growth. They flared up frequently in the 1980s, which was a period of strong economic growth. Even the infamous Smoot-Hawley tariff increase of 1930 is now viewed by most economic historians as having played only a minor role in the collapse of trade during the Great Depression.1 Of course, trade war could escalate. China, as the biggest part of the U.S. trade deficit, is the White House's clear target (Chart 3). Japan in the 1980s, an ally of the U.S., agreed to voluntary exports restraints and to relocate production to the U.S. But China is a global rival.2 Chart 1A Tricky Quarter Chart 2Stimulus Tops Tariffs Chart 3China Is The Target For now, we expect the impact to be limited since some degree of compromise is the most likely outcome. President Trump sees the stock market as his Key Performance Indicator and would be likely to back off if stocks fell sharply. China knows that it has the most to lose in a prolonged fight. It might suit Xi Jinping's reformist agenda to boost consumption, cut excess capacity, and allow the RMB to appreciate modestly. While the U.S. has some justification for arguing that China's investment rules are unfair, China can also argue that it has made significant progress in recent years in reducing its dependence on exports, its current account surplus, and the undervaluation of its currency (Chart 4). But jitters will continue for a while. May could be a particularly tricky month, with the Iran sanctions waiver expiring on May 12, and the 60-day consultation period for China tariffs ending on May 21. Investors should expect that volatility, which in early January was remarkably low in all asset classes, should stay significantly higher until the end of this cycle (Chart 5). Chart 4...But Has Reduced Dependence On Exports Chart 5Volatility Likely To Stay High? Meanwhile, economic fundamentals generally remain strong. The Global Manufacturing PMI has dipped slightly from its cycle-high level in December, with recent currency strength causing some softness in the euro area and Japan (Chart 6). But the diffusion index shows that only three out of the 48 countries currently have PMIs below 50 (Egypt, Indonesia and South Africa). Consensus forecasts expect 2018 global GDP growth to come in at around 3.3%, similar to last year, and as yet show no signs of faltering (Chart 7). On the back of this, BCA's models suggest that global earnings growth will continue to grow at a double-digit pace for at least the rest of this year (Chart 8). Despite the strong growth, we see U.S. inflation picking up only steadily towards the Fed's 2% target.3 Jerome Powell in his first congressional testimony and press conference as Fed Chair showed no rush to accelerate the pace of rate hikes. We think the Fed is likely to hike four times, not three, but the market should not find this unduly hard to digest, as long as it is against a background of robust growth. Chart 6Dip In Growth Momentum? Chart 7Economists' Forecasts Not Faltering Chart 8Earnings Still Growing Strongly For the past year, we have highlighted a number of simple indicators we are watching carefully that have previously been reliable indicators of recessions and equity bear markets. Several have started to move in the wrong direction, but none is yet flashing a warning signal (Table 1, Chart 9). Table 1What To Watch For Chart 9No Warnings Flashing Here In February, BCA pushed out its forecast of the next recession to 2020, on the back of the U.S. fiscal stimulus. That would suggest turning more cautious on risk assets towards the end of this year - at which time some of these indicators may be flashing. But, until then we continue to recommend - except for the most risk-averse investors who care mainly about capital preservation and not about maximizing quarterly performance - an overweight allocation to risk assets. Garry Evans, Senior Vice President garry@bcaresearch.com Chart 10Not A Full Blown Trade War... For Now! What Our Clients Are Asking What Are The Implications Of U.S. Tariffs? Following recent announcements of tariffs on steel and aluminum and possible broad-based tariffs on Chinese imports, investors have started to worry about the future of global trade. But these moves should be no surprise since President Trump is merely delivering on electoral promises. From a macro-perspective, here are the key implications of rising trade barriers: An all-out trade war would certainly hurt U.S. growth, but a minor skirmish would have little impact. The U.S. is the advanced economy least exposed to global trade, which makes it harder for nations to retaliate. Running a large trade deficit, with imports from China representing 2.7% of GDP whereas exports to China are just 1.0% of U.S. GDP, gives the U.S. considerable leverage in negotiations. Additionally, the majority of Chinese imports from the U.S. are agricultural products, making it harder for China to retaliate with tariffs since these would raise prices for Chinese consumers (Chart 10). On the other hand, U.S. trade partners also have a case. With trade growth trailing output growth, other nations will be less willing to give in to U.S. threats. Additionally, unlike the Cold War era, when the U.S. had a greater influence on Europe and Japan, the world is moving toward a more multipolar structure. However, we do not believe nations will retaliate by dumping U.S. Treasuries, as that would deliver the U.S.'s desired end result of a weaker dollar. Chart 11Rising Wages Are The Missing Factor Finally, if tariffs lead to a smaller trade deficit and firms start to move production back to the U.S., aggregate demand will increase. And, given a positive output gap in the U.S., the Fed would be forced to turn more hawkish, ultimately forcing the dollar up. Equity markets do not like tariffs, and bonds will follow the path that real growth and inflation take. How the situation will develop depends on whether Trump embraces America's traditional transatlantic alliance with Europe and harnesses it for the trade war against China. If he does so, the combined forces of the U.S. and Europe will likely force China to concede. But if Trump goes it alone, a prolonged U.S.-China trade war could turn into a significant risk to global growth. How Quickly Will U.S. Inflation Rise? The equity sell-off in early February was triggered by a slightly higher-than-expected average hourly earnings number. In recent meetings, we find that clients, who last year argued that the structural pressures would keep inflation depressed ("the Philips Curve is dead"), now worry that it will quickly exceed 2%. And it is true that the three-month rate of change of core CPI has jumped recently (Chart 11, panel 1). Investors are clearly skittish about the risk of higher inflation, which would push the Fed to accelerate the pace of rate hikes. We continue to argue that core PCE inflation (the Fed's main measure) will rise slowly to 2% over the next 12 months, but we do not see it accelerating dramatically. Inflation tends to lag GDP growth by around 18 months and the pickup in growth from Q2 last year should start to feed through. This will be magnified by the 8% weakness in the US dollar over the past 12 months, which has already pushed up import prices by 2% YoY. What is missing, however, is wage pressure. Average hourly earnings are growing only at 2.6% YoY. We find that wage growth tends to lag profits by around 24 months (panel 2) and, since profits moved sideways for close to two years until Q2 last year, it may be a few quarters yet before companies feel confident enough to raise wages. Note, too, that wages have been weak compared to profits in this cycle. This is likely partly because of automation, but also because the participation rate for the core working population continues to recover towards its 2007 level, indicating there is more slack in the labor market than the headline unemployment data suggest (panel 3). Should Investors Still Own Junk Bonds? Chart 12Credit Cycle Still On The current late stage of the economic cycle has investors worried about the credit cycle and the outlook for corporate credit, in particular high-yield bonds. The number-one concern is stretched valuations. Spreads are close to all-time lows, which means investors should not expect significant capital gain. However, spreads can stay low for extended periods, especially in the late stages of the credit cycle. Junk bonds are a carry trade at this point, and investors can continue to pick up carry before a sustained period of spread widening sets in (Chart 12). A flattening yield curve is bad for junk returns, as it signals monetary policy is too restrictive. But, as inflation continues to trend higher, the curve is likely to steepen while allowing the Fed to deliver rate hikes close to its median projection. The key risk is a scenario in which inflation falters, but the Fed continues to hike. In this case a risk-off episode in credit markets would be likely, but this would be a buying opportunity and not the end of the cycle. Corporate balance-sheets have weakened, and logically investors should demand greater compensation to hold high-yield bonds. But spreads have diverged from this measure since early 2016. However, we expect improvements in corporate health since the outlook for profit growth is strong. However, a great deal of bond issuance has been used for share buybacks. If capital structures have less of an equity cushion, then recovery rates are likely to be lower when defaults do start to rise. Cross-asset volatility has returned. But credit spreads have remained calm thanks to accommodative monetary policy and easing bank lending standards. Also, stricter post-crisis bank capital regulations have mitigated the risk. Finally, the growing presence of open-ended junk bond funds and ETFs increases the risk that, once spreads start to widen, they will widen much more quickly than they would have otherwise. Who Should Invest In Hedged Foreign Government Bonds? In a recently published Special Report,4 we found that hedged foreign government bonds are a good source of diversification for bond portfolios. Hedging not only reduces the volatility of the foreign bonds, it reduces it so much that the risk-adjusted return ratio has significantly improved for investors with home currency in USD, GBP, AUD, NZD, CAD and EUR (Table 2). This is true across different time periods for most fixed income investors other than those in Japan, as shown in Chart 13. Table 2Domestic And Foreign Government Risk Return Profile (December 1999 - January 2018) Chart 13Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time So the answer depends on investors' objectives and constraints: If investors are comfortable with the volatility in their local aggregate bond indexes, which are already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K. and Canada are better off investing a large portion overseas. Global Economy Overview: Global growth remains robust, though momentum has slowed slightly in recent weeks. No recession is likely before 2020 at the earliest due to strong U.S. fiscal stimulus. Inflation will slowly rise towards central bank targets but there is little reason to expect it to accelerate dramatically, and so we see no need for aggressive monetary tightening. U.S.: Short-term, growth looks to have softened, with the Citigroup Economic Surprise Index turning down (Chart 14, top panel), and the regional Fed NowCasts for Q1 GDP growth pointing to 2.4%-2.7%. However, growth over the next two years should be boosted by the recent tax cuts and government spending increases, which we estimate will push up GDP growth by 0.8% in 2018 and 1.3% in 2019. Wages should start to rise from their current sluggish levels (average hourly earnings only up 2.6% YoY) given the tight labor market, which should boost consumption. Capex (panel 5) is likely to continue to recover due to tax cuts and a high level of businesses confidence. Euro Area: Growth has been steady in recent quarters, with Q4 GDP rising 2.5% QoQ annualized. However, lead indicators such as the PMI (Chart 15, top panel) have rolled over, probably because of the strong euro (up 6.2% in trade-weighted terms over the past 12 months). The effect has yet to be seen in exports, which continue to grow strongly, 6.2% YoY in February, but earnings results for Q4 surprised much less on the upside in the euro area than in the U.S. Chart 14Growth Robust, But Momentum Slowing Chart 15Strong Currencies Denting EU And Japanese Growth Japan: As an export-oriented, cyclical economy, Japan has also benefitted from better global conditions, with GDP rising by 1.6% QoQ annualized in Q4. However, like Europe, the stronger currency has begun to dent the external sector, with industrial production and the leading index slowing (Chart 15, panel 2). However, more encouraging signs are appearing domestically: retail sales rose by 2.5% YoY in January and part-time wages are up 2.0% YoY. As a result, inflation is finally emerging, with CPI (excluding food and energy) up 0.3% YoY. Emerging Markets: China's growth remains steady, with the Caixin PMI at 51 (panel 3). However, credit and money supply growth continue to point to a slowdown in coming months. This may be evident when March data (unaffected by the shifting timing of Chinese New Year) becomes available. Elsewhere in EM, growth has picked up moderately: Q4 GDP growth came in at an annualized rate of 7.2% in India, 3.0% in Korea, and even 2.1% in Brazil and 1.8% in Russia. Interest rates: A modest rise in inflation expectations (panel 4) has led to a rise in long-term rates, with the U.S. 10-year yield rising from 2.5% to almost 3% during Q1 before slipping back a little. We expect the Fed to hike four times this year, and think this will push up the 10-year Treasury yield to 3.3-3.5% by year-end. The ECB continues to emphasize that it will move only slowly to raise rates after halting asset purchases later this year, and we think the market has correctly priced the timing of the first hike for Q4 2019. We see no reason why the BoJ will end its Yield Curve Control policy, with inflation still well below the 2% target. Chart 16Cautiously Optimistic Global Equities Tip-Toeing Through The Late Cycle. Global equities experienced widespread corrections in the first quarter after a very strong start in January gave way to fear of rising inflation in the U.S., fear of slowing growth in China, and fear of rising geopolitical tensions globally. The return of macro volatility was so violent that it pushed the VIX to high readings not seen since 2015. Granted, a background of stretched valuations, complacency, and the "fear of missing out" also contributed to the market correction. The healthy correction of global equities from the high in late January has seen valuations contracting as earnings continued to grow at strong pace (Chart 16). BCA's house view is that global growth may be peaking, but should remain strong and above trend, underpinning decent earnings growth for the next 9-12 months. As such, we retain our pro-cyclical tilts in global equity allocations, overweight cyclical sectors and underweight defensive sectors; overweight high-beta DM markets (Japan and euro area); neutral on the U.S. and Canada; and underweight EM and Australia, the markets that would suffer most from a deceleration in Chinese growth. However, we are late in the cycle and valuations remain stretched by historical standards despite the recent correction. With macro volatility returning, investors should be very conscious of potential risks that could derail the uptrend in equities. For investors with higher aversion to risk, we suggest raising cash by selling into strength or dialing down the overweight of cyclicals vs defensives. Anatomy Of EM/DM Outperformance Since their low in early 2016, EM equities have outperformed DM in total return terms by more than 20%, of which 262 bps came in the first quarter of 2018, despite the rising volatility in all asset classes recently. As show in Chart 17, the outperformance of EM over DM has been dominated by three sectors: Technology, Financials and Energy. In the two-year period ending December 2017, over half of the EM outperformance came from the Tech sector, followed by Financials and Energy, accounting for 32% and 14% respectively. In Q1 2018, however, Tech's contribution dropped sharply to 0.3%, while Financials and Energy shot up to 51% and 33% respectively. Even though Energy is a relatively small sector, accounting for 6-7% of benchmark weights in both EM and DM, the diverging performance between EM and DM Energy sectors has played an important role in the EM outperformance. In the two years ending December 2017, EM Energy outperformed its DM counterpart by 32%, the same magnitude as the Tech sector (Table 3). In Q1 2018, EM Energy gained 7.6% while DM Energy suffered a 5.2% decline, resulting in a staggering 13% outperformance (Table 4). Chart 17Sector Contributions To EM/DM Outperformance Table 3Two-Year Performance Attribution* (December 2015 - December 2017) Table 4Q1/2018 Attribution* (December 2015 - December 2017) Country-wise, Brazil and China led the outperformance, helped by the Brazilian real's 30% appreciation against the U.S. dollar. BCA's EM Strategy believes that Brazilian equities and the real will both weaken given the country's weak governance and poor fiscal profile. Chart 18Style Performance We are neutral on Tech globally, and the general reliance of EM equities on Chinese growth, and the high leverage in EM do not bode well for EM equities. Remain underweight EM vs. DM. A Sector Approach To Style Year to date, the equal-weighted multi-factor portfolio has outperformed the global benchmark slightly, largely driven by the strong outperformance of Momentum and Quality, while Value and Minimum Volatility (MinVol) have underperformed (Chart 18, top three panels). This is in line with our previous regime analysis that indicated rising growth and inflation is a good environment for Momentum and Quality, but a bad one for Min Vol.5 As we have argued before, we prefer sector positioning to style positioning because 1) the major style tilts such as Value/Growth, Min Vol and Small Cap/Large Cap have seen significant sector shifts over time, and 2) sector selection offers more flexibility. As shown in Chart 18 (bottom three panels), the relative performance of Min Vol is a mirror image of Cyclicals vs Defensives, while Value/Growth is highly correlated with Cyclicals/Defensives. In a Special Report,6 we elaborated in-depth that sector selection is a better alternative to size selection, especially in the U.S. We maintain our neutral view on styles, and continue to favor Cyclicals versus Defensives. Given that we are at the late stage of the business cycle, investors with lower risk tolerance may consider gradually dialing down exposure to cyclical tilts. For stock pickers, this would mean favoring stocks with low volatility, high quality and strong momentum. Government Bonds Maintain Slight Underweight On Duration. Despite rising volatility due to changes in inflation expectations and uncertain developments in geopolitics, the investment backdrop has been evolving in line with our 2018 Strategy Outlook. Global growth continues at a strong pace (Chart 19) and our U.S. Bond Strategy has increased its yield forecast to the range of 3.3-3.6%, from 2.80-3.25% previously, reflecting both a higher real yield and higher inflation expectations. The U.S. 10-year Treasury yield increased by 34 bps in Q1 to 2.74%, still lower than our fair value estimate, implying that there is still upside risk for global bond yields. As such, investors should continue to underweight duration in global government bonds. Favor Linkers Vs. Nominal Bonds. The base case forecast from our U.S. Bond Strategy is that the U.S. TIPS breakeven will rise to 2.3-2.5% around the time that U.S. core PCE reaches the Fed's 2% target rate, likely sometime in 2H 2018. Compared to the current level of 2.05, this means the 10-year TIPS has upside of 25-45 bps, an important source of relative return in the low-return fixed income space (Chart 20). Maintain overweight TIPS vs. nominal bonds. In terms of relative value, however, TIPS are no longer cheap. For those who have not moved to overweight TIPS, we suggest "buying TIPS on dips". In addition, inflation-linked bonds (ILBs) in Australia and Japan are still very attractive vs. their respective nominal bonds (Chart 20, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Chart 19Further Upside In Bond Yields Chart 20Favor Inflation linkers Corporate Bonds We continue to favor both investment grade and high-yield corporate bonds within the fixed-income category. High-yield spreads barely reacted to the sell-offs in equities in February and March (Chart 21). We see credit spreads as a useful indicator of recessions and equity bear markets and so the fact that they did not rise suggests no broad-based risk aversion. Moreover, this resilience comes despite significant outflows from high-yield ETFs, $4.4 billion year-to-date, almost completely reversing the inflows over the previous three quarters. We still find spreads in this space attractive. BCA estimates the default-adjusted spread is still around 250 basis points (assuming default losses of 1.3% over the coming 12 months) which, while not cheap, is less overvalued than other fixed-income categories (Chart 22). Investment grade spreads, however, have widened in recent weeks (Chart 21), with the rise concentrated in the highest-quality credits. This is most likely because investors see little value in these securities. We keep our overweight but we focus on cross-over credits and sectors where valuations are still reasonable, for example energy, airlines and insurance companies. Excessive leverage remains a concern for corporate bond losses in the next recession. BCA's Corporate Health Monitor (Chart 23) has improved in recent quarters, mostly due to stronger profitability. But the deterioration in interest coverage ratios in recent years makes companies vulnerable to higher rates. We estimate that a 100 basis point increase in interest rates across the corporate curve would lead to a drop in the ratio of EBITDA to interest expenses from 4.0 to 2.5.7 Sectors such as Materials, Technology, Consumer Discretionary and Energy appear especially at risk.8 Chart 21IG Spreads Have Widened, But Not HY Chart 22Junk Bonds Still Offer Some Value Chart 23Leverage Is A Worry For The Next Recession Commodities Chart 24OPEC Agreements Hold The Key Energy (Overweight): Demand/supply fundamentals have been driving prices in crude oil markets (Chart 24). Fundamentals remain favorable as strong global demand is keeping the market in physical deficit. However, the outlook for demand has turned cloudy as the market may start to price in the possibility of a trade war which would dent growth. Also, threats of renewed sanctions against Iran and deeper ones against Venezuela could potentially disrupt supply sufficiently to push up the crude price. Given rising uncertainties with the demand and supply outlook, we expect increased volatility in the crude price. We maintain our forecasts for the average 2018 prices for Brent and WTI at $74 and $70 respectively. Industrial Metals (Neutral): As President Trump moves ahead with protectionist policies, markets are being spooked by the possibility of a trade war. Looking past the noise, since China remains the largest source of demand, price action will follow domestic Chinese market fundamentals which are a function of how authorities handle a possible growth slowdown. The possibility of global trade disruptions, coupled with a recovery in the U.S. dollar, suggests increased price volatility. We are particularly negative on zinc. Spanish zinc has been flooding into China, depressing physical premiums and causing inventory accumulation (Chart 24, panel 3). Precious Metals (Neutral): Rising trade protectionism, geopolitical tensions, and diverging monetary policy will be sources of increased market volatility for the rest of the year. When equity markets went through a minor correction earlier this year, gold outperformed global equities by 6%. However, rising interest rates and a potentially stronger U.S. dollar are two headwinds for the gold price. We continue to recommend gold as a safe haven asset against unexpected market volatility and inflation surprises (Chart 24, panel 4). Currencies Chart 25Dollar Will Stage A Recovery Rally U.S. Dollar: Following its 7% depreciation last year, the greenback is flat year to date. A positive output gap and strong inflation readings are giving the Fed enough reasons not to fall behind the curve. Secondly, the proposed fiscal stimulus is likely to increase the U.S.'s twin deficits which has historically been bullish for the currency, as long as it is accompanied by rising real rates. Finally, speculative positions in the dollar are net short, which means any positive surprises will be bullish for the currency. We expect the U.S. dollar to stage a recovery rally in the coming months (Chart 25, panel 1). Carry Trades: Cross-asset class volatility is making a strong comeback. Carry trades fare poorly in volatile FX markets. High-yielding EM currencies like the BRL, TRY, and ZAR will underperform, whereas low yielding safe-haven funding currencies like the Swiss franc and Japanese yen, in countries with outsized net international investment positions, will be the winners. Finally, the return of volatility could hurt global economic sentiment and possibly weigh on growth-sensitive currencies like the KRW, AUD and NZD (Chart 25, panel 2). Euro: Analyzing the euro's strength, we see a 9% divergence in performance between the EUR/USD pair and the trade-weighted euro. Global synchronized growth was driven predominantly by a recovery in manufacturing which benefited the euro area more than the U.S. Also looking at history, the euro tends to appreciate relative to USD in the last two years of economic upswings driven by strong growth. Finally, the recent divergence in relative interest rates is a clear sign that other fundamental factors, such as the current account balance, have been exerting pressure. Sentiment and positioning remain extremely euro bullish, hence any disappointment with economic data will force a correction (Chart 25, panel 3). GBP: Since 2017, the pound has strengthened by over 16% vs. USD. An appreciating currency has dented inflation readings, thereby limiting the pass-through effects via the Bank of England hiking rates. A hurdle to further appreciation is negative growth in real disposable income and declining household confidence. Finally, weak FDI inflows will hurt the U.K.'s basic balance. Since the BoE will find it difficult to tighten policy much, we expect a correction in the next few months (Chart 25, panel 4). Alternatives Investors have been increasing their allocation to alternatives, pushing AUM to a record $7.7 trillion. We continue to recommend allocations through three different buckets: 1) among return enhancers, we favor private equity vs hedge funds; 2) favor direct real estate vs. commodity futures in inflation hedges; 3) favor farmland & timberland vs. structured products as volatility dampeners. But alternatives have a few challenges that require special consideration. Private Equity: Key drivers of returns have changed. In the past, managers were able to succeed by "buying low/selling high". But today, investors need to pick general partners (GPs) who can identify attractive targets and effect strategic and operational improvements. $1.7 trillion of dry powder. Global buyout value grew by 19% in 2017, but deal count grew by only 2%. High valuations multiples, stiff competition, and an uncertain macro outlook will force funds to be selective. Competition from corporate buyers. GPs are fighting with large corporations looking for growth through acquisition. Private equity's share of overall M&A activity globally declined in 2017 for the fourth year running. Competition for targets is boosting entry multiples in the middle-market segment. Hedge Funds: Net exposure for long/short managers has remained static over market cycles, which means investors pay too much for market exposure. But if we see market rotation or increased dispersion of single stock returns, this hedge fund group will benefit. Discretionary macro will benefit from differing growth outlooks, idiosyncratic events, and local rate cycles. Also, potential for more dispersion in the large-cap space and at the index level will benefit systematic macro. Event-driven funds have been hurt by deal-spread volatility as shareholder opposition, anti-trust concerns and political issues led to deal delays. But we continue to favor short-term special situations in less-followed markets such as Asia. Real Estate: After strong growth in capital values, driven by low rates and cap rate compression, investors need to focus on income-driven total returns. Additionally, income returns do not vary across markets nearly as much as capital value growth. Increase focus on core strategies. Look for properties in prime locations with long and stable lease contracts. Investors can also consider loans made to high-quality borrowers which are secured against properties with stable cash flows. Private Debt: With ultra-low yields, private debt offers attractive risk-adjusted return, diversification, and a potential cash flow profile ideal for institutional investors. However, it is critical to source a differentiated pipeline of opportunities. Infrastructure debt, with a long expected useful life, can provide effective duration for liability matching. Risk-adjusted returns can be enhanced by directly sourcing and structuring. Risks To Our View We see the risks to our main scenario (strong growth continuing through 2019, moderate inflation, late cycle volatility, and rising geopolitical risks) as balanced. There are a number of obvious downside risks, including an escalating trade war, a sharp upside surprise to inflation, and the Fed turning more hawkish (perhaps in an attempt to demonstrate its independence if President Trump pressures it not to raise rates). Among the risks less appreciated by investors is a slowdown in China. Leading indicators of the Chinese economy, particularly money supply and credit growth, continue to slow (Chart 26). Xi Jinping's recent senior appointments suggests he is serious about structural reform, which would mean accepting slower growth in the short-term to put China on a sounder long-term growth path. Linked to this, we also think investors are insufficiently concerned about the impact of rising rates on emerging market borrowers. If, as we expect, U.S. long rates rise to close to 3.5% over the next year and the dollar strengthens, the $3.5 trillion of foreign-currency borrowing by EM borrowers could become a burden (Chart 27). Chart 26What If China Slows? Chart 27Highed Indebted EM Borrowers Are A Risk Chart 28Presidents Like Markets To Rise Upside risk centers on a continuation of strong growth and dovish central banks. We may be underestimating the impact of U.S. fiscal policy. Our assumption that it will peter out in 2020 may be wrong, if President Trump goes for further stimulus ahead of the presidential election - the third and fourth years of presidential cycles are usually the best for stocks (Chart 28). Wages may stay low because of automation. In the face of this the Fed may stay dovish: it already shows some signs of allowing an overshoot of its 2% inflation target, to balance the six years that it missed it to the downside. All this could produce a stock market meltup, similar to 1999. 1 See, for example, Clashing Over Commerce: A History of U.S. Trade Policy, Douglas J, Irwin, Chicago 2017, chapter 8. 2 For an analysis of the geopolitical implications, please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 27, 2018. 3 Please see the What Our Clients Are Asking: How Quickly Will U.S. Inflation Rise? on page 8 of this Quarterly Portfolio Outlook for the reasons why this is our view. 4 Please see Global Asset Allocation Special Report, "Why Invest In Foreign Government Bonds?" dated March 12, 2018 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?" dated July 8, 2016, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation Special Report, "Small Cap Outperformance: Fact Or Myth?" dated April 7, 2017, available at gaa.bcaresearch.com 7 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 8 Please see also What Our Clients Are Asking: Should Investors Still Own Junk Bonds, on page 9 of this Quarterly Update, for more analysis of this asset class. GAA Asset Allocation

Highlights Global growth has peaked, but will remain firmly above trend for the remainder of the year. The composition of global growth is shifting back towards the U.S. As often happens in the late stages of business-cycle expansions, asset markets have entered a more volatile phase. A global recession is likely in 2020. Equities: The correction is nearing an end, which will set the stage for a blow-off rally into year-end. For the time being, favor DM over EM stocks, Europe over the U.S., and value over growth. The "real" bear market will start next year. Government bonds: Global bond yields will trend higher over the next 12 months, but will begin moving lower by the middle of next year as recession risks mount. Over the long haul, yields are going higher - much higher. Credit: Spread product will eke out small gains relative to government bonds over the next 12 months. Spreads will blow out as the recession approaches. Investors will be shocked to learn that a lot of what they thought is investment-grade debt is really junk (or worse). Currencies: The U.S. dollar will bounce before resuming its bear market next year. The yen could weaken slightly against the dollar in 2018, but will hold its own against most other currencies. Energy-sensitive currencies such as the CAD will outperform other commodity currencies. Feature Booyah Writing frantically on October 8, 1998, CNBC commentator and former hedge fund manager Jim Cramer entitled his TheStreet.com piece with the indelible words "Get Out Now". Long-Term Capital Management had just imploded. Emerging Markets were crashing. Coming off the heels of a stratospheric ascent, the S&P 500 was down 22% from its highs. The tech-heavy NASDAQ had swooned 33%. The equity bull market had finally ended. Or so he thought. As fate would have it, the S&P 500 bottomed literally the very same minute that Cramer's piece came out.1 It went on to rise 68% before ultimately peaking in March 2000. Cramer would go on to avenge his 1998 call, wisely counseling his readers on October 6, 2008 to "take your money out of the stock market right now, this week." But on that fateful day in 1998, he was wrong. There are many differences in the economic environment between now and then, but on the crucial question of which way global equities are heading, history is likely to rhyme. As was the case in the late 1990s, the shakeout this year may be a prelude to a blow-off rally that takes stocks to new highs. Historically, equity bear markets and recessions almost always overlap (Chart 1). In fact, the most useful lesson I have learned over the past 25 years studying macro and markets is that unless you think a recession is around the corner, you should overweight stocks. It's as simple as that. Chart 1Recessions And Bear Markets Usually Overlap Fortunately, another recession is not around the corner. Interest rates are rising but are not yet in restrictive territory. Fiscal policy is being loosened, particularly in the U.S. Easy fiscal policy and still-accommodative monetary policy rarely produce recessions. As we discuss below, a global recession will eventually arrive - probably in 2020 - but that is still two years away. Stocks normally sniff out recessions before they start. However, the lead time is usually about six months. As Table 1 illustrates, equities typically do well in the second-to-last year of business-cycle expansions. We are probably in that window now. Table 1Too Soon To Get Out A Whiff Of Stagflation So why the newfound angst? Partly, it is because markets were technically overbought and due for a correction. We warned clients as much in a report entitled "Take Out Some Insurance", published on February 2nd, one day before the VIX spike began.2 Fears of stagflation are also escalating. Inflation appears to be rising at the same time as global growth is slowing. Real potential GDP has increased at a snail's pace in the G7 economies over the past decade, the result of disappointing productivity gains and sluggish labor force growth (Chart 2). If the world is running out of spare capacity - and GDP growth is forced to climb down towards what many fear is an anemic trendline - then revenue and earnings growth are apt to decelerate. Chart 2Lackluster Productivity Gains And Anemic Labor##br## Force Growth Have Weighed On Potential GDP Escalating protectionism has further exacerbated anxieties about stagflation. President Trump has threatened to hike tariffs on steel and aluminum, go after China for allegedly stealing U.S. intellectual property, and pull out of NAFTA if a new deal is not negotiated in America's favor. An all-out global trade war would raise consumer prices and reduce output by impairing the efficient allocation of resources across countries. Investors have taken notice. None of these stagflationary concerns can be summarily dismissed, but they are less worrisome than they might appear. Let's start with trade wars. A Trade Spat, Not A Trade War We have long thought that we are in a secular bull market in populism. This is why we argued that investors were greatly understating the risks of Brexit in the weeks leading up to the referendum. It is also why we ignored the derision of others and predicted that Trumpism would prevail back in 2015 and that Trump himself would win the presidency by securing a larger-than-expected share of disgruntled white blue-collar workers in the Midwest.3 Trade protectionism, of course, is a major part of most populist agendas. However, the attractiveness of protectionism tends to ebb and flow depending on the state of the business cycle. There is a reason why the Smoot-Hawley tariff act was introduced during the Great Depression and not the Roaring Twenties. Both economically and politically, beggar-thy-neighbor policies are more appealing when unemployment is high and one more job abroad means one less job at home. That is not the case today, at least not in the U.S. Moreover, while the U.S. legal system gives the president free rein to impose tariffs and other trade barriers, Donald Trump is still constrained by the reaction of the business community and financial markets. After all, this is a president who likes to measure his self-worth by the value of the S&P 500. Needless to say, investors do not like protectionism. It is not surprising, therefore, that Trump has watered down his tariff rhetoric every time the stock market has sold off. It also not surprising that Trump has increasingly focused his wrath on China, a country with which the U.S. business community has had a love-hate relationship. A blue-ribbon commission recently estimated that intellectual property theft - most of it originating from China - costs the U.S. $225 billion-to-$600 billion per year.4 That is a lot of money that American companies could be making but aren't. China will undoubtedly complain that it is being unfairly singled out. It will also threaten retaliatory measures if the Trump administration imposes trade barriers on Chinese imports. In the end, those threats are likely to ring hollow. A war is only worth fighting if you think you can win. China has a very asymmetric trading relationship with the U.S., and one that gives it very little leverage. U.S. exports to China amount to less than one percent of U.S. GDP. That's peanuts - in some cases literally: Nearly half of U.S. goods exports to China consist of soybeans, wheat, cotton, nuts, and other agricultural products and raw materials. It would be difficult to tax them without hurting Chinese consumers. Of course, China could try to punish the U.S. by dumping Treasurys. But why would it? This would only drive down the value of the dollar, giving U.S. exporters a greater advantage. Trump wants that! Saying that you will retaliate against Trump's tariffs by no longer manipulating your currency is not exactly a credible threat.5 In the end, far from retaliating, China will try to placate Trump by easing restrictions on trade and foreign investment and making some politically-calculated purchases of U.S.-made goods. Boeing's stock sold off in the wake of escalating trade tensions. It probably should have risen. Peak Growth? In contrast to last year, global growth is no longer accelerating. Our Global Leading Economic Indicator is still rising, but the diffusion index, which measures the proportion of countries with rising LEIs, is down from its October 2017 high (Chart 3). Changes in the diffusion index have often foreshadowed changes in the composite LEI. An even more worrisome picture is painted by the OECD's LEI, which has actually dipped slightly over the past two months. The OECD's LEI diffusion index has also fallen below 50%. The Chinese economy appears to be slowing on the back of tighter monetary conditions (Chart 4). The Keqiang index, which combines data on electricity production, freight traffic, and bank lending, has come off its highs and our leading indicator for the index is pointing to further weakness. Property price inflation in tier 1 cities has fallen to zero. A number of clients noted during my visit to China last week that a wave of supply has hit the market over the past month following President Xi's warning that homes are for living and for not investing. A weaker Chinese property market could drag down construction spending, with adverse knock-on effects to commodity prices. Slower Chinese growth is rippling across the global economy (Chart 5). Korean exports - a bellwether for global trade - have decelerated. Japanese machinery orders have rolled over. The Baltic dry index has plunged by 40% from its December highs. The expectations component of the German IFO index has fallen to its lowest level since January 2017. Chart 3Global Growth Will Remain Above Trend,##br## But Has Probably Peaked For This Cycle Chart 4China's Industrial Sector Is Set ##br##To Slow Further China Is Slowing Chart 5Signs Of Slowing##br## Global Growth So far, the slowdown in global growth has been fairly modest. Goldman's global Current Activity Indicator (CAI), which combines both soft and hard data to gauge underlying economic momentum, was still up 4.9% in March, only slightly below recent cycle highs (Chart 6). The deterioration in a number of leading economic indicators suggests that the slowdown may have further to run. However, we would be surprised if it proves to be especially deep or long-lasting. Global financial conditions are still quite accommodative (Chart 7). Bank balance sheets are in good shape and rising capex intentions should support credit demand over the coming months, even in the face of somewhat higher borrowing costs. Improving labor markets should also bolster consumer confidence. Chart 6But Global Slowdown Has Been Fairly Modest Chart 7Global Financial Conditions Are Still Fairly Easy Back To The USA If global growth were decelerating because capacity constraints were starting to bite, this would be more worrying because it would mean any effort to stimulate demand would simply lead to more inflation rather than stronger economic growth. Reassuringly, that does not appear to be the case. The U.S. has slowed less than other large economies, even though it is closer to full employment. Notably, the manufacturing PMI has continued to rise in the U.S., but has dipped most everywhere else. Both Citigroup's and Goldman's economic surprise indices are still positive for the U.S., but have fallen into negative territory in Europe and Japan (Chart 8). Granted, Bloomberg consensus estimates suggest that U.S. growth will edge down to 2.5% in the first quarter. However, this may reflect ongoing seasonal adjustment problems. First quarter growth has averaged 1.7 percentage points less over the past decade than in the rest of the year. We are particularly skeptical of recent data showing that consumer spending has slowed, which is completely at odds with strong employment growth, rising home prices, and near record-high levels of consumer confidence. Looking out, U.S. demand growth should benefit from all the fiscal stimulus coming down the pike. We expect the fiscal impulse to rise from 0.3% of GDP in 2017 to 0.8% of GDP in 2018, and 1.3% of GDP in 2019 (Chart 9). The actual numbers could be even higher as our estimates do not include any additional expenditures on infrastructure, the possible restoration of earmarks (which could inflate pork-barrel spending), or the high likelihood that recent changes to the tax code will spawn all sorts of unforeseen loopholes, leading to lower-than-expected tax receipts. Chart 8U.S. Is The Standout Chart 9Fiscal Stimulus Bode Well For Growth Unfortunately, all this fiscal stimulus is coming at a time when the economy does not need it (Chart 10). The U.S. unemployment rate currently stands at 4.1%, 0.4 percentage points below the Fed's estimate of NAIRU. Given the prospect of continued above-trend growth, the unemployment rate is likely to be close to 3.5% by early next year, which would be below the 2000 low of 3.8%. Chart 10Now Is Not The Time For Fiscal Profligacy Rebalancing Global Demand: The Role Of The Dollar What happens when fiscal stimulus pushes aggregate demand beyond an economy's productive capacity? One possibility is that imports go up, thereby allowing the additional demand to be satiated with increased production from the rest of the world. For this to happen, however, the prices of foreign-made goods sold in the U.S. need to decline relative to the prices of domestically-produced goods. U.S. imports account for only 15% of GDP. Thus, if the prices of U.S.-made goods do not change relative to the prices of foreign-made goods, only 15 cents or so of every additional dollar of income will fall on imports. After all, consumers do not care about the intricacies of balance of payments statistics when they are deciding whether to buy a foreign or domestic automobile. They care about relative prices. This means that either the nominal trade-weighted dollar must appreciate or the U.S. price level must rise relative to foreign prices. Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.6 In theory, one can envision a scenario where the nominal dollar exchange rate depreciates while the real exchange rate appreciates over the long haul because inflation rises significantly in the U.S. relative to its trading partners. Much of the market commentary has implicitly focused on just such an outcome. Massive fiscal stimulus, as the story goes, will lift U.S. inflation by so much that the dollar will fall over time. The problem with this narrative is that it is difficult to square with the facts. Long-term inflation expectations have actually risen more in the euro area and Japan since Trump got elected (Chart 11). The true puzzle is that rising U.S. real yields have not translated into a stronger dollar (Chart 12). Chart 11Long-Term Inflation Expectations Have ##br##Risen More In Japan And The Euro Area##br## Than The U.S. Since Trump Took Over Chart 12The Dollar Has ##br##Decoupled From Interest##br## Rate Differentials A Trump Risk Premium? What happened, as Hillary Clinton might ask? One answer is that Trump happened. Larry Summers has argued that political uncertainty around Trump's antics (protectionism, the Mueller probe, the porn stars, etc.) has made holding U.S. assets more risky.7 This risk has been exacerbated by the prospect of large current account and fiscal deficits - the so-called "twin deficits" - stretching for as far as the eye can see. If this theory is correct, the increase in U.S. real bond yields may be less the result of better growth expectations and more the consequence of a rising risk premium on long-term government debt. It's an intriguing hypothesis, but it cannot explain why business confidence is near all-time highs or why the S&P 500, despite this year's selloff, has risen by 23% since the U.S. presidential election. It also cannot explain why the yield curve has flattened recently, which is not what you would expect if investors were shunning long-term bonds. Perhaps it is best not to overthink things. The dollar is a high-momentum currency (Chart 13). At the start of 2017, the greenback was overbought (Chart 14). Then global growth began to accelerate, which has historically has been bad news for the dollar (Chart 15). The lion's share of that growth also came from outside the U.S. None of this is true today, but the downward trend in the dollar has remained intact, and that is proving hard to break. Chart 13USD Is A Momentum Winner Chart 14USD Was Overbought At The Start Of 2017 Hard but not impossible. The dollar could get a bit of a reprieve. USD Libor has broken out recently (See Box 1 for details). As Chart 16 illustrates, there has been an extremely close relationship between the dollar index and the 3-month lagged value of the Libor-OIS spread. The cost of shorting the dollar is about to spike as borrowing rates linked to Libor reset over the next few weeks. The Libor spread will eventually come down, but perhaps not before the negative momentum against the dollar has turned into positive momentum. Chart 15Slowing Global Growth Tends##br## To Be Bullish For The Dollar Chart 16Shorting The Dollar Is About##br##To Get A Lot More Expensive Fixed-Income: Hedged Or Unhedged? Chart 17Bond Yields, Currency-Hedged When European investors buy U.S. bonds, they take on exposure to both the value of the bond and what happens to the euro-dollar exchange rate. If they do not want to assume the currency risk, they can sell the dollar forward, effectively locking in the number of euros they will receive for every dollar sold. The purchase of the bond increases the demand for dollars, while the commitment to sell the dollar increases the supply of dollars. For the value of the dollar, it is largely a wash.8 Likewise, if U.S. investors do not want to bear currency risk when purchasing German bunds, they can sell the euro forward. This also entails two offsetting transactions: One that boosts the demand for euros and one that raises the supply of euros. The spike in USD Libor has increased the currency-hedged return of non-U.S. bonds relative to U.S. bonds. Chart 17 shows that the yield on 10-year Treasurys, hedged into euros, has fallen to 0.06%, which is below the 0.5% yield offered by German bunds. In contrast, the 10-year bund yield, hedged into dollars, has risen to 3.16% - which is above the 2.78% yield offered by Treasurys. All things equal, it becomes less attractive for foreign investors who wish to buy U.S. bonds to hedge currency risk as USD Libor rises. In contrast, it becomes more attractive for U.S. investors to currency-hedge their overseas bond purchases when USD Libor goes up. Unhedged bond purchases bid up the currency of the issuer, but hedged purchases do not. If a smaller share of foreign investors decide to hedge currency risk when buying Treasurys, while a larger share of U.S. investors decide to hedge currency risk when purchasing foreign bonds, the net demand for dollars will rise. This could help the dollar over the coming months. Go Long Treasurys/Short German Bunds, Currency-Unhedged The correlation between the German-U.S. 30-year bond spread and EUR/USD was extremely tight in 2017 but has completely broken down this year (Chart 18). At this juncture, betting on a normalization of this correlation - effectively, a bet that U.S. Treasurys will outperform bunds in currency-unhedged terms - has become too good to resist. In fact, it is almost a "can't lose" wager. Consider the fact that 30-year Treasurys are yielding 182 basis points above comparable-maturity bunds. The euro would have to rise to 1.23*(1.0182)^30=2.11 against the dollar over the next 30 years for investors to lose money on this investment. Chart 18Unsustainable Divergence? Granted, inflation is likely to be lower in the euro area. CPI swaps are forecasting that euro area inflation will be roughly 40 bps lower compared to the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.49. In other words, long-term investors betting on the euro are effectively betting on a major euro overshoot. The discussion above raises a more fundamental point. Investors often equate their view about the direction in which a currency is heading with whether to be bullish or bearish on it. We completely agree that the trade-weighted dollar will weaken over the long haul because most valuation metrics suggest that the greenback is still expensive. However, given the carry advantage the U.S. enjoys, long-term investors would still be better off overweighting U.S. fixed-income assets. Regional Equity Allocation U.S. equities have outperformed their global peers since the start of 2017 in local-currency terms but have underperformed in common-currency terms (Chart 19). If the dollar rebounds over the next few months, as we expect, this should boost the local-currency value of European stocks since many large multinational European companies generate sales in dollars. Sector skews should also work in Europe's favor. Financials are the largest overweight in euro area bourses, while technology is the biggest overweight in the U.S. (Table 2). Chart 19U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency Table 2Global Sector Skews: Tech Resides In The U.S. And Growth Indexes,##br## Financials Live In The Eurozone And Value Indexes While global growth has peaked, it will remain firmly above trend. This will ensure that spare capacity continues to shrink, taking global bond yields higher. Since the ECB will not raise rates for at least another year, the yield curve in the euro area will steepen, boosting the profitability of European banks (Chart 20). Tech companies are particularly sensitive to changes in discount rates since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening (more than 50% of U.S. tech sales are derived from abroad). Recent concerns over the way Facebook and other tech companies have handled privacy issues could further sour sentiment towards the sector. The outlook for Japanese stocks is a tough call. Japan, like Europe, is trading at a discount relative to the U.S. based on our in-house valuation metrics (Chart 21). However, we do not see much downside for the yen, even after its recent appreciation. The currency remains very cheap by historic standards, Japan's current account surplus has widened to 4% of GDP, and unlike the euro, speculative positioning is short. While Japanese corporate earnings have been able to expand rapidly over the past 16 months without the support of a weaker currency, now that profit margins are near record highs (Chart 22), further gains in profits and equity prices are likely to be limited. Chart 20Euro Area Yield Curve ##br##Steepening Will Boost Banks Chart 21Japanese And Euro Area##br##Stocks Are Relatively Cheap The combination of higher U.S. rates, a stronger dollar, and weaker Chinese growth will weigh on EM equities over the coming months. There is $17 trillion in U.S. dollar-denominated debt held outside the U.S., most of it in emerging markets. Ironically, weaker Chinese growth will hurt other EMs more than it hurts China. China accounts for more than 50% of base metal demand compared to only 13.5% for oil (Chart 23). This means that the outlook for metal producers such as Brazil, South Africa, Chile, and Australia is more challenging than for energy producers such as Canada and Norway. Chart 22Global Profit ##br##Margin Picture Chart 23Base Metals Are More Sensitive##br## To Slower Chinese Growth Favor Value Over Growth We expect global value stocks to start outperforming growth stocks after more than a decade of deep underperformance (Chart 24). The valuation measures constructed by Anastasios Avgeriou and his global equity sector strategy team suggest that value stocks are trading more than two standard deviations cheap relative to growth stocks. Earnings revisions are also starting to move in favor of value names9. Similar to the U.S./euro area equity split, financials are overrepresented in value indices, while technology is overrepresented in growth indices. The weights of the energy and consumer discretionary sectors in the U.S. index are roughly the same as the weights of those two sectors in the euro area index. However, energy is overrepresented in global value indices while consumer discretionary is overrepresented in growth indices. Despite our outlook for a somewhat stronger dollar, our commodity strategists see upside for oil prices this year thanks to continued discipline by OPEC 2.0. This should help energy stocks. On the flipside, consumer discretionary stocks often struggle in a rising rate environment, so this should tilt the playing field in favor of value (Chart 25). Chart 24Value Versus Growth: ##br##Compelling Entry Point Chart 25Consumer Discretionary Stocks Do##br## Poorly In A Rising Rate Environment With all this in mind, we are initiating a trade recommendation to go long the All-Country World Value Index relative to the corresponding Growth Index starting today. Investment Conclusions Volatility typically rises in the late stages of business-cycle expansions, as inflation picks up and monetary policy becomes progressively less accommodative (Chart 26). We have entered such a phase. This does not mean that equities cannot go higher. Chart 27 shows that the VIX rose in the late 1990s, even as stocks zoomed to new highs. We are probably at the tail end of an equity correction now. A blow-off rally into year-end is likely. Chart 26A More Hawkish Fed Usually Means A Higher VIX Chart 27Volatility Can Increase As Stock Prices Rise We expect the fed funds rate to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, the U.S. fiscal impulse will have dropped back to zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to increasingly binding supply-side constraints, the economy could easily stall out in 2020. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller PE ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 3% over the next decade (Chart 28). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault investors for taking some money off the table now. A somewhat more defensive posture would certainly be warranted. Recall that the NASDAQ bubble burst in March 2000, but the S&P 500, excluding the technology sector, did not peak until May 2001. During the intervening period, S&P tech stocks underperformed the rest of the market by 70% (Chart 29). As was the case back then, a shift away from tech leadership may be afoot. This would support our value over growth, and euro area over the U.S., recommendations. Chart 28Demanding U.S. Valuations Point##br## To Low Long-Term Returns Chart 29The Force Of Tech At ##br##The Turn Of The Century Spread product should be able to eke out small gains relative to government bonds over the next 12 months. Ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 30). Spreads will blow out as the recession approaches. In this month's issue of The Bank Credit Analyst, my colleague Mark McClellan simulated the effect on investment grade credit from: 1) A 100 basis-point increase in interest rates across the curve; and (2) A more severe scenario where interest rates rise by 100 basis points and corporate profits fall by 25% peak- to-trough. Mark's calculations suggest that the next recession will see the interest coverage ratio drop more than in previous downturns (Chart 31).10 Investors may be shocked to discover that a lot of what they thought is investment-grade debt is really junk (or worse). Chart 30Ratings Migration Is Supportive For Credit But... Chart 31...Corporate Leverage Will Take Its Toll We suggested going long the dollar in August 2014. This view worked well for a while but struggled mightily last year. However, the broad trade-weighted dollar index has been fairly stable since September, and is actually up 2.3% since its January lows (Chart 32). The greenback is due for another rally, one that no doubt would catch many traders by surprise. After a heated internal debate, BCA shifted its house view on bonds towards a more bearish stance in July 2016. As fate would have it, our note entitled "The End Of The 35-Year Bond Bull Market" came out on the same day that the U.S. 10-year yield reached an all-time closing low of 1.37%.11 We observed in February that bond positioning had become extremely short and, thus, tactically, yields could come down a bit. This has indeed happened. Over a 12-month horizon, however, we continue to see yields rising more than what is currently priced in. Both the TIPS 10-year and 5-year/5-year forward breakeven rates are 20-40 basis point below the 2.3%-to-2.5% range that prevailed in the pre-recession period (Chart 33). Somewhat higher oil prices should also boost inflation expectations. Chart 32Up Then##br## Down Chart 33Breakevens Still Below Levels Consistent##br## With 2% Inflation Mandate In addition, the real yield component could rise as the market revises up its expectation of the terminal rate. Revealingly, the mean and median terminal dots in the Fed's Summary of Economic Projections increased by 8.3 and 12.5 bps, respectively, in March, but are still more than 100 bps below where they were five years ago. Bond yields will increase in the euro area, as the ECB continues to taper asset purchases. We see less scope for yields to rise in the U.K., as the Brexit hangover continues to weigh on growth. Yields in Japan will remain repressed due to the continuation of the Bank of Japan's Yield Curve Control regime. As the next recession approaches, global bond yields will fall, but are unlikely to take out their 2016 lows. As we discussed in a series of recent reports, both yields and inflation will make a series of "higher highs" and "higher lows" in the U.S. and most other countries over the next decade and beyond.12 Appendix B shows stylistic diagrams of how we expect returns across the major asset classes to evolve over the next decade. The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Box 1 What's Up With Libor? The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. 1 In his book, Confessions Of A Street Addict, which I highly recommend, Cramer wrote: On October 8, a dreary, chilly rainy Thursday in New York ... the stock market bottomed. At eighteen minutes after 12:00 P.M. I ought to know. I caused it. At 12:18 P.M. I capitulated. I couldn't take it anymore. I gave up both literally, at my fund, and virtually, on my website, TheStreet.com, where I penned a piece entitled "Get Out Now". And the prop wash from that article marked the low point in the most vicious bear market of the last century. 2 Please see BCA Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com. 3 Please see BCA Global Investment Strategy reports, "Trumponomics: What Investors Need To Know," dated September 4, 2015; "Worry About Brexit, Not Payrolls", dated June 10, 2016; "Three (New) Controversial Calls", dated September 30, 2016, available at gis.bcaresearch.com. Also see BCA New York Investment Conference presentations: "Five Controversial Calls - Call #5: The Trumpists Will Win" (September 2015), and "Three Controversial Calls - Call #1: Trump Wins And The Dollar Rallies" (September 2016). 4 Please see "Update To The IP Commission Report - The Theft Of American intellectual Property: Reassessments Of The Challenge And United States Policy," The Commission on the Theft of American Intellectual Property (The National Bureau of Asian Research), (2017). 5 The fact that China's foreign exchange reserves have been trending sideways since early last year does not mean that past interventions should be disregarded. Just as both theory and evidence suggest that quantitative easing affects bond yields primarily through the "stock channel" (how many bonds central banks own) rather than the "flow channel" (the purchase or sales of bonds in any given period), the yuan's value is also more affected by the stock of foreign assets the PBOC controls rather than its recent interventions. This makes intuitive sense. If a central bank drives down its currency by buying a lot of foreign assets, and then suspends further purchases, one might expect the currency to stop falling, but one would not expect it strengthen to where it was before the intervention began. 6 Expressed mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 7 Larry Summers, "Currency Markets Send A Warning On The US Economy," March 5, 2018. 8 We say "largely" a wash because while selling the dollar forward is not exactly the same as short-selling it in the spot market due to the presence of the so-called currency basis swap spread, it is economically similar. When European investors short-sell the dollar, they are effectively borrowing dollars at Libor, selling them for euros, and parking the proceeds in a short-term account that pays Euribor. Three-month U.S. Libor is 230 bps these days, while three-month Euribor is -33 bps. Thus, European investors lose 263 bps by currency-hedging their U.S. bond purchases. Conversely, when U.S. investors go short the euro, they are effectively borrowing euros, selling them for dollars, and then parking the proceeds in a short-term account paying Libor. Thus, they gain the equivalent amount from the decision to currency-hedge purchases of euro area bonds. 9 Please see BCA Global Alpha Sector Strategy Weekly Report, "Global Size And Style Update," dated March 9, 2018, available at gss.bcaresearch.com. 10 Please see BCA The Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?" dated March 29, 2018, available at bca.bcaresearch.com. 11 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 12 Please see BCA Global Investment Strategy Weekly Report, "What Central Bankers Don't Know: A Rumsfeldian Taxonomy," dated March 16, 2018; Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. Appendix A APPENDIX A CHART 1Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 2Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 3Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 4Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B APPENDIX B CHART 1Market Outlook: Bonds APPENDIX B CHART 2Market Outlook: Equities APPENDIX B CHART 3Market Outlook: Currencies APPENDIX B CHART 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights With North Korean diplomacy on track, Taiwan is the country most exposed to U.S.-China trade and strategic tensions. The Taiwanese public supports the status quo; however, a majority sees itself as exclusively Taiwanese, and the desire for independence may grow over time. Domestic political changes in mainland China and in the United States are also conducive to greater geopolitical tensions affecting Taiwan. Beijing will likely refrain from excessive pressure in the lead-up to Taiwan's November local elections ... but an independence-leaning outcome could change that. Stay overweight Taiwan within Emerging Market portfolios, but be prepared to downgrade if latent geopolitical risks begin to materialize. Feature The decision by the United States to toughen its enforcement of trade rules with China marks a shift that will have lasting ramifications.1 The U.S. is concerned not only about the trade imbalance but also the national security risk posed by China's economic might and increasing technological prowess. Hence President Donald Trump has imposed trade measures on China despite Chinese President Xi Jinping's cooperation on North Korea. Xi has enforced sanctions on the North and thus forced Kim Jong Un to the negotiating table, even getting him to consider denuclearization (Chart 1). Global financial markets may "climb the wall of worry" about the latest tariffs because the Trump administration has moderated its rhetoric in practice, notably by choosing to prosecute China in the World Trade Organization. However, the protectionist shift in U.S. policy is a lasting one. American power is declining relative to China, and the two countries no longer share the same economic interdependency that acted as a deterrent to conflict in the past (Chart 2).2 Chart 1China Gives Kim To Trump Chart 2Structural Increase In U.S.-China Tensions Taiwan is the country that is most exposed to both trade and strategic tensions between the U.S. and China (Chart 3). Indeed, BCA's Geopolitical Strategy has held since January 2016 that Taiwan is a potential geopolitical black swan.3 Does this warrant shifting to an underweight stance in EM portfolios? Not yet. But it is a left tail risk that investors should have on their radar. Taiwan Is Filled With Dry Powder There are three reasons to suspect that Taiwan geopolitical risk is understated. First, Chinese President Xi Jinping has consolidated power and made himself into Chairman Mao Zedong's peer in the Communist Party's ideological hierarchy. He is in power indefinitely. Xi has also followed his predecessor Jiang Zemin, in the 1990s, in taking a tough approach to security and defense. Implicitly he wants to make sure that unification occurs by 2049, but some argue that he wants to achieve it within his lifetime, namely by 2035. The Taiwanese public is resolutely opposed to any timetable. The fundamental risk is that economic slowdown could disappoint the aspirations of a big and ambitious middle class, which could force Xi to pursue nationalism and foreign aggression as a way to maintain domestic control (Chart 4). Beijing is still unlikely to attack Taiwan other than as a last resort, due to the American alliance system protecting it: this remains a hard constraint for now. But aggressive economic sanctions and military posturing with the intention to coerce Taiwan are much more likely than investors realize today. Chart 3Taiwan's Economy As Well As Security On The Line Chart 4China's Stability Vulnerable To Growth Slowdown Second, Taiwan's independence-leaning Democratic Progressive Party (DPP) has gained control of every level of government on the island - the presidency, the legislature, the municipalities - since the large-scale, anti-mainland "Sunflower" protests of 2014. President Tsai Ing-wen, who replaced the outspokenly pro-China President Ma Ying-jeou, is vocally uncomfortable with the status quo. She has refused to positively affirm the "1992 Consensus," which holds that there is only "One China" but two interpretations. Beijing sees this idea as the basis of smooth cross-strait relations. Tsai has not in practice tried to break the status quo, but she is clearly interested in enhancing Taiwan's autonomy. Moreover, a youthful "Third Force" has emerged in Taiwanese politics, with the backing of former presidents Lee Teng-hui and Chen Shui-bian, arguing for independence and the right to hold popular referendums on the question of sovereignty. Any success of this movement will provoke a massive response from China. Third, U.S. President Trump has suggested in several poignant ways that his tougher approach to China will entail a more robust American guarantee of Taiwan's security. While he has promised Xi to uphold the "One China policy," he is actively upgrading diplomatic and possibly naval relations with Taiwan and considering more substantial arms sales to Taiwan.4 His negotiation style suggests that he is not afraid to touch this "third rail" in Sino-American relations. Moreover, in the wake of the 1995-96 Third Taiwan Strait Crisis, and again in the wake of the Global Financial Crisis, a hugely important shift in Taiwanese national identity accelerated. Today the public mostly identifies solely as Taiwanese, as opposed to both Taiwanese and Chinese (Chart 5). This trend has abated somewhat since the DPP rose to full control in 2014-16, but a 55% majority still sees itself as exclusively Taiwanese. Among the youth, that number is 70%. This dynamic raises the possibility that a political independence movement could one day emerge. Beijing, at any rate, is watching with great concern. Of course, this shift in national identity does not imply that Taiwanese want to declare independence for the state of Taiwan anytime soon. Only about 22% want the country to move toward formal independence, and only 5% want to declare independence today. Whereas 69% are comfortable maintaining the status quo for a long time (Chart 6). The Taiwanese want to preserve their de facto independence and continue to prosper. But support for independence has grown faster than support for the status quo since the 1994 consensus. The status quo barely, if at all, holds majority support if one removes from its ranks those who eventually want to see the country declare independence. And younger cohorts have larger majorities than older cohorts in favor of independence. Chart 5Majority Of Taiwanese Are Exclusively Taiwanese ... Chart 6... Yet Majority Support Status Quo For Now The point is that there is a lot of "dry powder" in Taiwanese public opinion that could be ignited against China in the event of a change of circumstances, i.e. another military crisis or economic shock. Essentially, China is worried that someday this national identity could be weaponized. Chart 7China Gains Leverage Over Time How will China respond to the situation? So far it has not overreacted. Xi Jinping has launched more intimidating military drills and has hardened his rhetoric - including in key reports at the 2017 party congress and this year's National People's Congress. His administration has also pursued policies to emphasize its dominance, such as setting up new air traffic routes over the strait that Taiwan claims violate its rights.5 Nevertheless, the cross-strait status quo has not yet changed in any fundamental way that would suggest relations are about to explode. And this is fitting because the status quo is beneficial to the mainland, having created a vast imbalance of economic influence over Taiwan (Chart 7). This imbalance gives China the ability to use economic coercion to dissuade Taiwan's leaders from trying anything too daring. This year, in particular, there is reason to think that Xi Jinping may want to limit any provocations. Taiwan will hold local elections on November 24, an opportunity for the pro-China Kuomintang (KMT) to at least begin to claw back the political stature it has lost (Chart 8). A good showing in 2018 is essential for the KMT if it is to rebuild momentum for the 2020 general election. Tsai's and the DPP's approval ratings have fallen precipitously since her inauguration (Chart 9). Xi may deem that saber-rattling would be counterproductive by giving Tsai and the DPP a foil, when in fact the tide is already working against them. If the KMT's performance is abysmal in the November elections, then Beijing faces a problem. Its strategy of gaining influence over Taiwan through economic integration has not prevented the emergence of an exclusively Taiwanese identity. So far Beijing has not given up on this strategy but that might become a concern if the Xi administration treads softly this year and yet the DPP broadens its control of local offices. Worse still for Beijing would be sweeping gains for outspoken, pro-independence candidates, since China cannot expel them from the legislature as easily as it did their peers in Hong Kong. Chart 8Kuomintang Needs A Win In 2018 Chart 9DPP Only Leads KMT By A Little Now Bottom Line: Political changes in China, Taiwan, and the United States are conducive to souring relations across the strait. Moreover, Taiwanese national identity is dry powder that Beijing fears could be exploited by independence-leaning politicians - potentially with American backing from an aggressive President Trump. This three-way dynamic means that Taiwanese geopolitical risk is understated, despite the fact that these powers are all familiar with the dynamics and Beijing may not want to overly provoke voters ahead of local elections, knowing that heavy-handedness in 1995-96 encouraged Taiwanese uniqueness. Macro Backdrop And Trade Tensions Undermine DPP The problem for President Tsai and the ruling DPP, as local elections approach, is that the Taiwanese economy faces headwinds as Chinese and Asian trade slows down and as the Trump administration converts its protectionist rhetoric into action. Since last year, China has tightened financial conditions and regulation and has cracked down on corruption in the financial sector. The result is a slump in broad money supply that is now pointing to a drop in EM and Taiwanese exports (Chart 10). Indeed, a cyclical slowdown is emerging in Taiwan: The short-term loans impulse is weakening which suggests that Taiwanese export growth will slow further (Chart 11, top panel). The basis for this relationship is that short-term loans are used by Taiwanese businesses to fund their working capital needs as well as purchase inputs to fill their export orders. Further, broad money is also weak (Chart 11, bottom panel). Chart 10China Slowdown Spells Trouble For Taiwan Chart 11Taiwanese Money/Credit Growth Slowing The manufacturing sector is slowing, with the shipments-to-inventories ratio weak and manufacturing PMI dipping sharply (Chart 12). Worryingly, the new orders, export orders, and electronic-sector employment components of the manufacturing PMI are approaching a precarious level. Various prices of semiconductors are also starting to show signs of weakness globally which does not bode well for a market that relies heavily on this trade. The semiconductor shipment-to-inventory ratio has rolled over (Chart 13). Taiwanese exports to ASEAN are also slowing, which signifies that final demand for semiconductors is softening, as ASEAN economies lie at the final stage of the semiconductor supply chain process. Chart 12Manufacturing Indicators Rolling Over Chart 13Softness In Key Semiconductor Exports Further, global trade tensions have the potential to harm global growth and especially heavily trade-exposed economies like Taiwan. Taiwan is not guaranteed to benefit from the U.S.'s more aggressive posture toward China. Theoretically, if the U.S. imposes tariffs on goods from China that can be substituted by Taiwan, then Taiwan will benefit. But in practice, the U.S. is using tariffs as a threat to force China to open its market more to U.S. exports. One way that Beijing may respond is by purchasing American goods instead of goods that come from American allies like Taiwan. Beijing has already attempted this strategy by offering to increase imports of American semiconductors at the expense of Taiwan and South Korea. At the moment there are no details on how much of an increase China is proposing. In Table 1 we show several scenarios to assess the damage that could be inflicted on Taiwan if China substituted away from it. The impact on Taiwan's exports is not negligible. For instance, under the benign scenario, if U.S.'s share of semiconductor exports to China rise from 4%6 to 10%, then Taiwan's share of semiconductor exports to China would drop from 15% to 12%. That would amount to a $4 billion loss for Taiwan, approximately, which represents 1.4% share of its total exports and 4% of its overall semiconductor exports. This analysis assumes that the trade losses resulting from China's shift to its semiconductor import mix would harm Taiwan somewhat more than Korea. The latter holds a competitive advantage on Taiwan as Korea designs and manufactures unique semiconductors that are not as easily substitutable. At any rate, the damage to Taiwan's geopolitical and trade outlook would be more concerning than the loss of revenue. Table 1China's Trade Concessions To U.S. Could Impose Costs On U.S. Allies It is unlikely that the Trump administration is willing to accept such a deal, which is flagrantly designed to appease the U.S. at the expense of its allies. But the exercise illustrates a broader dynamic in which U.S. negotiations with China threaten to disrupt trade relationships and supply chains that have benefited Taiwan in recent decades. The result will be greater uncertainty and a higher potential for negative shocks. Chart 14China Punishes Taiwan For 2016 Election Moreover, the Trump administration has not entirely exempted allies from trade pressure. For instance, Taiwan has appreciated the dollar a bit in response to the threat of punishment for currency manipulation from the U.S. Washington has also just secured assurances from South Korea that it will not competitively depreciate the won. If agreements like these stand, and yet China makes less robust or less permanent agreements regarding its own currency, South Korea and Taiwan could suffer marginal losses of competitiveness. Taiwan is also exposed to coercive economic measures from China. Since Tsai's election, Beijing has made a notable effort to reduce tourist travel to Taiwan, which is reflected in tourism and flight data (Chart 14). Given the context of political tensions, the risk of discrete sanctions will persist and could flare up at any time if an incident occurs that aggravates the distrust between the two governments. How will investors know if Taiwanese geopolitical risk is about to spike upwards? At the moment, geopolitical risk is subdued, according to a proxy based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 15). This indicator tracks well with previous cross-strait crises. It even jumped upon the heightened tensions around the 2016 election of Tsai, and her controversial phone call with Donald Trump after his election. At the moment it suggests that cross-strait tensions have subsided significantly, despite the cutoff in formal diplomatic communication. However, the low point of the measure, and the underlying political factors outlined in the previous section, suggest that it should rise going forward. Chart 15Taiwanese Geopolitical Risk Likely To Rise From Here In the short run, it will be important to watch the Trump administration's handling of diplomatic visits and arms sales to Taiwan. Trump's signing of the Taiwan Travel Act has elevated diplomatic exchanges in a way that is mostly symbolic but could still spark an episode of heightened tension with China that would result in economic sanctions. An unprecedented naval port call could turn into an incident. At the same time, the U.S. guarantees Taiwan's security and in token of that guarantee periodically provides Taiwan with weapons packages. Beijing, for its part, always protests these sales, more or less vigorously depending on the military capabilities in question. The currently slated one is not too big but there is a rumor that it will include F-35 stealth fighter jets; other surprises could occur. Traditionally, the biggest spikes in sales have fallen under Democratic, not Republican, administrations. However, Trump may change that. There is a consensus in Washington that policy toward China should get tougher. The Taiwan Travel Act, upgrading diplomatic ties, passed with unanimous consent in both the House and Senate. Taiwanese governments have a record of increasing military spending when Republican presidents sit in Washington. And the first DPP government, under Chen Shui-bian from 2000-08, marked a clear upturn in Taiwanese military spending growth (Chart 16). If the Trump administration decides to sell Taiwan weapon systems that make a qualitative difference in the military balance, it will raise tensions with Beijing and likely prompt economic sanctions against Taiwan. Chart 16Arms Sales Could Reemerge As An Irritant In the long run, there are three key negotiations taking place in the region that could increase Taiwanese geopolitical risk: U.S.-China trade negotiations: Taiwan has benefited from China's engagement with the U.S., and with the West more broadly, and stands to suffer if they disengage. That would herald rising strategic tensions that would put Taiwan's trade and security in jeopardy. Geopolitical risk would go up. North Korean diplomacy: Kim Jong Un has met with Xi Jinping and formally agreed to hold bilateral summits with Presidents Trump and Moon Jae-in of South Korea. He has also indicated that denuclearization is on the table. If the different parties enter onto a path towards a peace treaty and denuclearization, then Taiwan might worry that the U.S. will eventually remove troops from the peninsula - far-fetched but not out of the question. Taiwan would fear abandonment and could attempt to entangle the U.S. For its part, China could believe that cooperation on North Korea requires the U.S. to give China greater sway over Taiwan. Geopolitical risk would go up. The South China Sea: These sea lanes are vital to Taiwan as well as China, South Korea, and Japan. If the U.S. washes its hands of the matter, ceding China a maritime sphere of influence, Taiwan will face both greater supply risk and greater anxiety about American commitment to its security. Beijing might be emboldened to pressure Taiwan, or Taiwan might act out to try to secure American support. Geopolitical risk would go up. Bottom Line: Taiwan's economy is entering a cyclical slowdown on the back of China's slowdown and rollover in the semiconductor industry. At the same time, trade tensions emanating from the U.S.-China negotiations and political tensions emanating from the other side of the strait suggest that Taiwan's geopolitical risk premium will rise. Over the short term, Taiwan's local elections, the referendum movement, or U.S. diplomacy or arms sales could provide a catalyst for a cross-strait crisis. Over the long term, significant changes in U.S.-China relations, North Korea, or the South China Sea could put Taiwan in a more precarious position. Investment Conclusions While the absolute outlook for Taiwanese stock prices is negative, the potential downside in share prices in U.S. dollar terms is lower than for the EM benchmark. BCA's Emerging Markets Strategy recommends that EM-dedicated investors remain overweight Taiwanese risk assets relative to the EM benchmark. First, the epicenter of China's slowdown is capital spending in general and construction in particular. Various Chinese industrial activity indicators have already begun decelerating. This is negative for industrial commodity prices and countries that produce them. Taiwan is less exposed to China's construction slump than many other EM economies. Second, China's spending on technology will not slow much. As a part of its ongoing reforms, Beijing will encourage more investment in technology as well as upgrading industries across the value-added curve. Hence, China's tech spending will outperform its expenditure on construction and infrastructure. Taiwan is poised to benefit from this relative shift in China's growth priorities. Third, there are no fresh credit excesses in Taiwan like in some other EMs. Taiwan's banking system worked out bad assets extensively following the credit excesses of the 1980s-90s. Hence it is less vulnerable than its peers in the developing world. Finally, Taiwan has an enormous current account surplus of 14% of GDP and, contrary to many other EMs, foreign investors hold few Taiwanese local bonds. When outflows from EM occur, the Taiwanese currency will fall under less pressure and its financial system under much less stress. This will allow Taiwanese stocks to act as a low-beta defensive play. Crucially, despite some appreciation to appease Trump, the Taiwanese dollar is among the cheapest currencies in EM (Chart 17). Chart 17Cheap Taiwanese Dollar Removes Risk As for heightened geopolitical risk, BCA's Geopolitical Strategy would note that while we view Taiwan as a potential "black swan," nevertheless tail risks are not the proper basis for an investment strategy. We will continue to monitor the situation so that we can alert clients when a major, market-relevant deterioration in cross-strait relations appears imminent, based largely on the factors highlighted above. If the DPP remains dominant after the local elections later this year, or if "Third Forces" make notable gains, we would suspect that the Xi administration will shift to using more sticks than carrots. This could include economic sanctions and military saber-rattling. The question then will be whether Beijing (or Washington or Taipei) attempts a material change to the status quo. Ultimately - from a bird's eye point of view - a war is more likely in the wake of Xi Jinping's elimination of term limits, consolidation of power, and the secular slowdown in China's economy and rise of Chinese nationalism. But we see no reason to fear such a catastrophic outcome in the near term. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 Trump began, as president-elect, by holding an unprecedented telephone call with the Taiwanese president. His administration has since requested a new $1.4 billion arms package, opened legal space for port calls (including potentially naval port calls) in the 2018 Defense Authorization Act, and for higher-level diplomatic meetings via the Taiwan Travel Act, which became public law on March 16, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. Military drills have involved symbolic shows, like sailing China's only operational aircraft carrier along the mid-line of the Taiwan Strait, as well as more poignant maneuvers, like drilling north and south of Taiwan simultaneously. As for rhetoric, Xi omitted from his 2017 party congress speech any reference to hopes that the Taiwanese "people" would bring about unification; in his speech after the March National People's Congress, he warned of the "punishment of history" for those who would promote secession. 6 Shown as the average of 2015 and 2017.

Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow Chart I-4A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Continue to underweight the most cyclical sectors - Banks, Basic Materials, and Energy. As predicted, global growth is losing steam. This implies that the Eurostoxx50 will struggle to outperform the S&P500. Continue with a currency pecking order of "yen first, euro second, pound third, dollar fourth." The sell-off in bonds is due a retracement, or at least a respite. Stock markets' rich valuations are contingent on low bond yields. Feature The views in this report do not necessarily align with the BCA House View Matrix. Chart I-2Cyclicals Were Underperforming##br## Long Before The Trade Skirmishes Stock markets have experienced turbulence this year, and it would be very simple to blame the first skirmishes of a global trade war. It would also be simplistic. The sharp underperformance of cyclical stocks started in January, well before any inkling of the Trump tariffs (Chart I-2). The trade skirmishes have merely accelerated a process that was already underway. In this week's report, we make sense of the market turbulence from three broad perspectives: the global economic mini-cycle; market technicals; and valuation. The Economic Mini-Cycle Has Likely Turned Down When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but this headwind is felt with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but the tailwind is felt with a delay. This delay occurs because credit supply lags credit demand by several months. But if credit supply lags demand, an economic theory called the Cobweb Theorem1 points out that both the quantity of credit supplied and its price (the bond yield) must undergo 'mini-cycle' oscillations. The theory is supported by compelling empirical evidence (Chart I-3). Furthermore, as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same mini-cycle oscillations (Chart I-4). Chart I-3Compelling Evidence For Mini-Cycles In##br## Credit Supply And The Bond Yield... Chart I-4...And ##br##Economic Activity These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months. Their regularity creates predictability. And as most investors are unaware of these cycles, the next turn is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. Mini half-cycles average eight months, and the latest mini-upswing started last April. Hence, on January 4 we predicted that "contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018." The predicted deceleration is precisely what we are now witnessing, and we expect this to continue through the summer months. From an equity sector perspective, the relative performance of the most cyclical sectors - Banks, Basic Materials, and Energy - very closely tracks the regular mini-cycles in global growth. In a mini-downswing these cyclical sectors always underperform (Chart of the week). Accordingly, continue to underweight these sectors through the summer months. Chart of the weekCyclicals Always Underperform In An Economic Mini-Downswing For the time being, this implies that the Eurostoxx50 will struggle to outperform the S&P500 - because euro area bourses have an outsize exposure to the most cyclical sectors. From a currency perspective, the stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. In essence, as the ECB and BoJ are at the realistic limit of ultra-loose policy, long-term expectations for their policy rates possess an asymmetry: they cannot go significantly lower, but they can go significantly higher. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they can go either way, lower or higher. Hence, on January 18 we advised a currency pecking order of "yen first, euro second, pound third, dollar fourth." This currency pecking order has also worked perfectly this year, and we expect it to continue working through the summer months. Cyclical Sectors Had Bullish Groupthink Groupthink in any investment is a warning sign that the investment's trend is approaching exhaustion, because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when market participants disagree with each other. Consider a stock whose price is rising strongly: a momentum trader wants to buy it, while a value investor wants to sell it. Hence, the market participants trade with each other with plentiful liquidity. Liquidity starts to evaporate when too many market participants agree with each other. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders fuel the trend. But when all the value investors have become momentum traders, the trend reaches a tipping point. If a value investor suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, our proprietary fractal analysis measures whether groupthink in a specific investment has become excessive, signalling the end of its price trend. Furthermore, using a 130-day groupthink indicator (fractal dimension), the fractal framework provides a powerful and independent reinforcement of our mini-cycle framework. This is because 130 (business) days broadly aligns with the mini half-cycle length. Fractal analysis reinforces our decision to underweight cyclical sectors, because it shows excessive (bullish) 130-day groupthink in these economically sensitive sectors (Chart I-5). Chart I-5Excessive Bullish Groupthink In Cyclical Sectors It also shows excessive (bearish) 130-day groupthink in government bonds, suggesting that the sell-off in bonds is due a retracement, or at least a respite (Chart I-6). Chart I-6Excessive Bearish Groupthink In Government Bonds Rich Valuations Are Contingent On Low Bond Yields On price to sales, world equities are as richly valued as they were at the peak of the dot com boom in 2000. The observation is important because price to sales has proved to be a near-perfect predictor of future 10-year returns. It shows that in 2010, world equities were priced to generate 8% a year compared with 4% a year available from global bonds. Today, richer valuations mean that both world equities and global bonds are priced to generate a paltry 2% a year (Chart I-7). Chart I-7World Equities As Richly Valued As At The Peak Of The Dot Com Boom Nevertheless, this makes perfect sense, because when bond yields are at 2%, bonds and equities are equally risky as each other. It follows that they must offer the same return as each other. One of the biggest errors in finance is to define an investment's risk in terms of its (root mean squared) volatility. This is incorrect because nobody fears sharp gains, they only fear sharp losses. Consider an investment whose price goes up sharply one day and then sideways the next day ad infinitum. The investment has a very high volatility, but it has no risk. You can never lose money, you can only make money. This leads us to the correct definition of risk, as defined by Professor Daniel Kahneman. He proved that investors are not concerned about volatility per se, they are concerned about the ratio of potential short-term losses versus short-term gains, a measure known as 'negative skew'. The important point is that at low bond yields, bond returns start to exhibit negative skew. Intuitively, this is because the lower bound to yields forces an unattractive asymmetry on bond returns: prices can fall a lot, but they cannot rise a lot. Specifically, at a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-8). And as the two asset classes are equally risky, they must offer the same return, 2% (Chart I-9). Chart I-8At A 2% Bond Yield, 10-Year Bonds##br## Have The Same Negative Skew As Equities... Chart I-9...So At A 2% Bond Yield, ##br##Equities Must Also Offer A 2% Return Therefore, equities find themselves in a precarious equilibrium. Rich valuations are justified if bond yields remain at low levels or fall, but rich valuations become increasingly hard to justify if bond yields march higher. Seen through this lens, the rise in bond yields at the start of the year is one important reason why equities have experienced a turbulent 2018 so far. What lies ahead? The combination of our economic mini-cycle, market technicals and valuation perspectives suggests that the equity sector and currency trends established since the start of the year should persist into the summer. As for equities in aggregate, the greatest structural threat would arise if bond yields gapped upwards. But for the time being, this is not our expectation. Happy Easter! Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model Given the Easter holidays, there are no new trades this week. But we are pleased to report that our long global utilities versus market trade achieved its 3.5% profit target and is now closed. Out of our four open trades, three are in profit with the short nickel / long lead trade already up sharply in its first week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations