Fixed Income

Highlights The global trade slowdown will intensify, even if U.S. domestic demand remains robust. The large emerging Asian bourses will recouple to the downside with their EM peers. Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. In Chile, receive 3-year swap rates. Continue to overweight stocks relative to the EM benchmark. Short the Colombian peso versus the Russia ruble. Stay neutral on Colombian equities and local bonds but overweight sovereign credit within their respective EM universes. Feature Performance of large equity markets in north Asia - Korean, Taiwanese and Chinese investable stocks -- has been relatively resilient compared with other EM bourses. Specifically, the EM ex-China, Korea and Taiwan equity index has already dropped 16% in U.S. dollar terms, while the market cap-weighted index of investable Chinese, Korean and Taiwanese stocks is down only 8% from its peak in late January.1 These three markets account for 60% of the MSCI EM stock index. A pertinent question is whether these North Asian markets will de-couple from or re-couple with the rest of EM. Our bias is that they will re-couple to the downside. Global equity portfolios should continue to underweight Asian stocks versus the DM bourses in general, and the S&P 500 in particular. That said, dedicated EM equity portfolios should overweight Korea and Taiwan and maintain a neutral stance on China and Hong Kong relative to the EM and Asian equity benchmarks. The Global Trade Slowdown Will Intensify Emerging Asian stock markets are very sensitive to global trade cycles. Slowing global trade is typically negative for them. There is growing evidence that the global trade deceleration will intensify: The German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart I-1). Chart I-1Global Trade Slowdown Will Persist Global Trade Slowdown Will Persist Global Trade Slowdown Will Persist Export volume growth has already slowed across manufacturing Asia (Chart I-2). The most recent data points for these series are as of April. Asia's booming tech/semiconductor industry is also slowing. Both Taiwan's export orders growth and Singapore's technology PMI new orders-to-inventory ratio have relapsed (Chart I-3). Chart I-2Asian Exports Growth: Heading Southward Asian Exports Growth: Heading Southward Asian Exports Growth: Heading Southward Chart I-3Asian Tech: Feeling The Pinch Asian Tech: Feeling The Pinch Asian Tech: Feeling The Pinch One of the causes of weakness in the global semiconductor cycle could be stagnating global auto sales (Chart I-4). The latter are being weighed down by weakness in auto sales in China and the U.S. Cars require a significant amount of semiconductors, and lack of improvement in global auto sales will suppress semiconductor demand. So far, China has not been at the epicenter of investors' concerns, but this will soon change as its growth slowdown intensifies. Credit conditions continue to tighten in China, which entails downside risks to mainland capital spending and consequently imports. China's imports are set to slump considerably, reinforcing the global trade downturn.2 First, China's bank loan approvals have dropped considerably in the past 18 months, suggesting a meaningful slowdown in bank financing and in turn the country's investment expenditures (Chart I-5). Chart I-4Global Auto And Semiconductor Sales Global Auto And Semiconductor Sales Global Auto And Semiconductor Sales Chart I-5China: Bank Loan Approval And Capex China: Bank Loan Approval And Capex China: Bank Loan Approval And Capex Second, not only are bank loan standards tightening but costs of financing are also rising. The share of loans extended above the prime lending rate has risen to a 15-year high (Chart I-6, top panel). This represents marginal tightening. Finally, onshore corporate bond yields as well as offshore U.S. dollar-denominated corporate bond yields have broken to new highs in this cycle (Chart I-6, bottom panels). Mounting borrowing costs and tighter credit standards in China point to further deceleration in credit-sensitive spending such as investment expenditures and property purchases. On the whole, rising interest rates and material currency depreciation in EM ex-China and credit tightening in China will prompt a considerable slump in imports, depressing world trade. EM including Chinese imports account for 30% of global imports, while the U.S. and EU together make up 24% of global imports values. Hence, global trade will disappoint if and as EM and Chinese imports stumble. A final word on the history of de-coupling among EM regions is in order. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - when they plummeted (Chart I-7, top panel). Chart I-6China: Rising Borrowing Costs China: Rising Borrowing Costs China: Rising Borrowing Costs Chart I-7De-coupling Between Asia And Latin America De-coupling Between Asia And Latin America De-coupling Between Asia And Latin America In 2007-'08, emerging Asian equities tumbled along with the S&P 500, but Latin American bourses fared well until the middle of 2008 due to surging commodities/oil prices (Chart I-7, middle panel). Finally, the bottom panel of Chart I-7 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Bottom Line: Global trade is set to head southward, even if U.S. demand remains robust. China's growth slump will be instrumental to this global trade slowdown. Consequently, Chinese, Korean and Taiwanese equities will be vulnerable. Heeding To Market Signals Financial markets often move ahead of economic data, and simply tracking data is not always helpful in gauging turning points in business cycles. By the time economic data change course, financial markets would typically have already partially adjusted. Besides, past economic and financial market performance is not a guarantee of future performance. This is why we rely on thematic fundamental analysis and monitor intermediate- and long-term trends in financial markets to navigate through markets. There are presently several important market signals that investors should be heeding to: EM corporate bond yields are surging, which typically foreshadows falling EM share prices (Chart I-8). Meanwhile, there is no robust correlation between EM equities and U.S. bond yields. Chart I-8EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening, offsetting the drop in U.S. bond yields. Hence, a drop in U.S. bond yields is not in and of itself sufficient to halt a decline in EM share prices. So long as EM corporate and sovereign credit spreads are widening by more than the decline in U.S. Treasury yields, EM corporate and sovereign bond yields will rise, heralding lower EM share prices. The ratio of total return (including carry) of six commodities currencies relative to safe-haven currencies3 is breaking below its 200-day moving average after having bounced from this technical support line several times in the past 12 months (Chart I-9). This could be confirming that the bull market in EM risk assets is over, and a bear market is underway. Chinese property stocks listed onshore have broken down, and those trading in Hong Kong seem to be forming a head-and-shoulder pattern (Chart I-10). In the latter case, such a technical formation will likely be followed by a considerable down-leg. Chart I-9An Important Breakdown bca.ems_wr_2018_05_31_s1_c9 bca.ems_wr_2018_05_31_s1_c9 Chart I-10Chinese Property Stocks Look Very Vulnerable Chinese Property Stocks Look Very Vulnerable Chinese Property Stocks Look Very Vulnerable Further, China's onshore A-share index has already dropped by 15% from its cyclical peak in late January. Finally, both emerging Asia's relative equity performance against developed markets, as well as the emerging Asian currency index versus the U.S. dollar (ADXY) seem to be rolling over at their long-term moving averages (Chart I-11). The same technical pattern is presenting itself for global energy and mining stocks in absolute terms, and also in the overall Brazilian equity index (Chart I-12). Chart I-11Asian Equities And Currencies Are ##br##At Critical Juncture Asian Equities And Currencies Are At Critical Juncture Asian Equities And Currencies Are At Critical Juncture Chart I-12Commodity Equities And Brazil ##br##Are Facing Technical Resistance Commodity Equities And Brazil Are Facing Technical Resistance Commodity Equities And Brazil Are Facing Technical Resistance The failure of these markets to break above their long-term technical resistance levels may be signalling that their advance since early 2016 has been a cyclical - not structural - bull market, and is likely over. These technical chart profiles so far confirm our fundamental analysis that the EM and commodities rallies since early 2016 did not represent a multi-year secular bull market. If correct, the downside risks to EM including Asian markets are substantial, and selling/shorting them now is not too late. Bottom Line: EM including Asian stocks, currencies and credit markets are at risk of gapping down. Absolute-return investors should trade these markets on the short side. Asset allocators should underweight EM markets relative to DM in general and the U.S. in particular. A complete list of our currency, fixed-income and equity recommendations is available on pages 20-21. An EM Equity Sector Trade: Long Consumer Staples / Short Banks EM consumer staples have massively underperformed banks as well as the overall EM index since January 2016 (Chart I-13). The odds are that their relative performance is about to reverse. Equity investors should consider implementing the following equity pair trade: long consumer staples / short banks: Consumer staples are a low-beta sector because their revenues are less cyclical. As EM growth downshifts, share prices of companies with more stable revenue streams will likely outperform. Bank stocks are vulnerable as local interest rates in many EMs rise in response to the selloff in their respective currencies (Chart I-14). Consumer staples usually outperform banks when local borrowing costs are rising. Chart I-13Go Long EM Consumer Staples / ##br##Short EM Banks Go Long EM Consumer Staples / Short EM Banks Go Long EM Consumer Staples / Short EM Banks Chart I-14EM Banks Stocks Are Inversely Correlated With##br## EM Local Bond Yields EM Banks Stocks Are Inversely Correlated With EM Local Bond Yields EM Banks Stocks Are Inversely Correlated With EM Local Bond Yields We expect more currency depreciation in EM, which will exert further upward pressure on local rates, including interbank rates. Further, growth weakness in EM economies typically leads to rising non-performing loan (NPL) provisions. Chart I-15A and Chart I-15B demonstrates that weakening nominal GDP growth (shown inverted on the charts) leads to higher provisioning. Hence, a renewed EM growth slowdown will hurt bank profits. Chart I-15AWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Chart I-15BWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Our assessment is that banks in many EM countries have provisioned less than what is probably necessary following years of a credit boom. Indeed, in the last 12-18 months or so, many banks have even been reducing their NPL provisions to boost profits. Hence, a reversal of these dynamics will undermine banks' earnings. Bottom Line: Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. This is in addition to our long-term strategy of shorting EM banks versus U.S. banks as well as shorting banks in absolute terms in individual markets such as Brazil, Turkey, Malaysia and small-cap banks in China. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These calculations are done using MSCI investible stock indexes in U.S. dollars terms. 2 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports", dated May 24, 2018, available at ems.bcaresearch.com. 3 Average of cad, aud, nzd, brl, clp & zar total returns (including carry) relative to average of jpy & chf total returns (including carry). Chile: Stay Overweight Equities, Receive Rates 31 May 2018 Chart II-1Chilean Equities Relative Performance And Copper Prices Chilean Equities Relative Performance And Copper Prices Chilean Equities Relative Performance And Copper Prices It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. Chart II-2Chile: Economic Conditions Chile: Economic Conditions Chile: Economic Conditions Chart II-3Interest Rates In Chile Can Fall When Peso Depreciates Interest Rates In Chile Can Fall When Peso Depreciates Interest Rates In Chile Can Fall When Peso Depreciates First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Chart II-4Chile: Output Gap And Inflation Chile: Output Gap And Inflation Chile: Output Gap And Inflation Chart II-5Chile: Inflation Is Very Low And Falling Chile: Inflation Is Very Low And Falling Chile: Inflation Is Very Low And Falling Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Chart II-6Chile: Wage Growth Is Very Weak Chile: Wage Growth Is Very Weak Chile: Wage Growth Is Very Weak Chart II-7Chile: Rising Labor Force Chile: Rising Labor Force Chile: Rising Labor Force Chart II-8Chile: Excessive Labor Supply... Chile: Excessive Labor Supply... Chile: Excessive Labor Supply... Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). Chart II-9...Despite Robust Employment Growth ...Despite Robust Employment Growth ...Despite Robust Employment Growth Chart II-10Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Colombia: The Currency Will Be A Release Valve The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). Chart III-1Colombia's Achilles' Hill: Trade Balance Excluding Oil Colombia's Achilles' Hill: Trade Balance Excluding Oil Colombia's Achilles' Hill: Trade Balance Excluding Oil Chart III-2The Colombian Peso Is Fairly Valued The Colombian Peso Is Fairly Valued The Colombian Peso Is Fairly Valued The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Chart III-3Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Chart III-4Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Chart III-5Colombian Banks: NPL And NPL Provision Continue Rising bca.ems_wr_2018_05_31_s3_c5 bca.ems_wr_2018_05_31_s3_c5 Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The 10-year Italian BTP yield at 4% yield marks a 'line in the sand' at which the current drama could escalate into something considerably worse. The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stay underweight in the classically cyclical sectors: banks, basic materials and industrials. Prefer France's CAC over Italy's MIB and Spain's IBEX. The equity market's range-bound pattern can continue, as long as the line in the sand isn't breached. It is a good time to own a small portfolio of high-quality 30-year government bonds. It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. Feature Italian politics have blindsided almost everybody, us included. Few anticipated that the unlikely bedfellows 5S and Lega would try and form a 'government of change'. In March we wrote: "The Italian election result is not an investment game changer. The one exception would be if 5S and Lega joined forces to govern, as it could throw EU integration into reverse. But the likelihood of this unholy alliance seems very low." Even fewer anticipated that Italy's President, Sergio Mattarella, would then scupper this government of change by vetoing the proposed Finance Minister. This has cast a new pall of uncertainty over Italian politics and Italian public support for EU rules and institutions. The 10-Year BTP Yield At 4% Marks A 'Line In The Sand' The market's response has been to fear the worst: shoot first, ask questions later. The danger is that this sets off a negative feedback loop. Higher bond yields weaken Italy's still-fragile banks; which threatens Italy's economic recovery; ahead of a possible new election, this increases the support for parties and policies that push back against EU rules; which further lifts bond yields; and then in a vicious circle until the fear of the worst becomes a self-fulfilling prophecy... Chart of the WeekItalian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% The Italian BTP versus German bund yield spread is effectively a fear gauge for Italy's future in the euro (Chart I-2). As these fears increase, and Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Chart I-2The BTP-Bund Yield Spread Is A Fear ##br## Gauge For Italy's Future In The Euro The BTP-Bund Yield Spread Is A Fear Gauge For Italy's Future In The Euro The BTP-Bund Yield Spread Is A Fear Gauge For Italy's Future In The Euro As a rule of thumb, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart I-3). Chart I-3Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By €35Bn Italian Banks' Equity Capital Exceeds Net NPLs By €35Bn It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4%.1 Hence, the 10-year BTP yield at 4% marks a 'line in the sand' at which the current drama could escalate into something considerably worse (Chart of the Week). To short-circuit the negative feedback loop, the financial markets would need to sense a discernible shift in Italian support for its populist parties; or an explicit de-escalation in the populist pushback against the EU. The question is: could this happen quickly enough? Global Growth Is In A Mini-Downswing The market's concerns about Italy come at a time when global growth has in any case been losing momentum. This is one development that did not blindside us, and has unfolded exactly as predicted. In January we wrote: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting." The theory underlying these mini-cycles is an economic model called the Cobweb Theorem.2 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a delay. The delay occurs because credit demand leads credit supply by several months (Chart I-4). Chart I-4Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months, and the regularity creates predictability. Moreover, as most investors are unaware of these cycles, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. The global 6-month credit impulse is now indisputably in a mini-downswing phase, and exactly as predicted in January, the majority of economically sensitive sectors have underperformed. The glaring anomaly is oil, whose supply-side dynamics have dominated price action (Chart I-5). Given oil's major impact on headline inflation, inflation expectations, and on central bank reaction functions, the global bond yield has also disconnected from the mini-cycle - until now. Chart I-5Oil Is The Glaring Anomaly Oil Is The Glaring Anomaly Oil Is The Glaring Anomaly Mini-downswings last six to eight months and the usual release valve is a decline in bond yields. So one concern is that the apparent disconnect between decelerating global activity and slow-to-react bond yields could extend the current mini-downswing phase beyond the summer. How To Invest Right Now From an equity market perspective, the relative performance of the classically cyclical sectors - banks, basic materials and industrials - very closely tracks the phases of the global credit impulse mini-cycle (Chart I-6 and Chart I-7). For example, in all five of the last five mini-downswings, banks have underperformed healthcare, and we are seeing exactly the same in the current mini-cycle. Chart I-6In A Mini-Downswing##br## Banks Underperform In A Mini-Downswing, Banks Underperform In A Mini-Downswing, Banks Underperform Chart I-7In A Mini-Downswing ##br##Basic Materials Underperform In A Mini-Downswing, Basic Materials Underperform In A Mini-Downswing, Basic Materials Underperform For the next few months at least, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. This strategy has worked extremely well since we initiated it at the start of the year, and it should continue to do so. Sector strategy necessarily impacts stock market allocation. Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. The defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks (Chart I-8 and Chart I-9). Irrespective of the political uncertainties, our sector allocation establishes our near-term caution on these two markets. Prefer France's CAC over Italy's MIB and Spain's IBEX. Chart I-8Italy's MIB = Long Banks Italy's MIB = Long Banks Italy's MIB = Long Banks Chart I-9Spain's IBEX = Long Banks Spain's IBEX = Long Banks Spain's IBEX = Long Banks For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the global economy provide a natural cap and a tradeable reversal in yields. Hence, it is a good time to own a portfolio of high-quality 30-year government bonds. Regarding currencies, the recent developments in Italy have hurt our 50:50 combined long position in EUR/USD and SEK/USD; but this has been countered by gains in our short position in EUR/JPY. We have no tactical conviction on any of these crosses, but we will maintain this medium term currency portfolio unless the Italian 10-year BTP yield breaches the 4% line in the sand. Finally, the hardest call to make is on the direction of equity market. This is because a mini-downswing in global growth creates a headwind to earnings expectations; conversely, if bond yields are capped, this will provide some support to equity market valuations. On balance, this suggests that the year-to-date pattern of a range-bound equity market is set to continue. The caveat is that if Italy's line in the sand is breached, it would warrant a substantial de-risking. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model* It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. This week, we note that the 65-day fractal dimension of the Polish zloty / U.S. dollar (or inverse) is approaching its lower limit. Go long PLN/USD with a profit target of 3.5% and symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long PLN/USD Long PLN/USD The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

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

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

Highlights In this Weekly Report, we review all of the individual trades in our Tactical Overlay portfolio. These are positions that are intended to complement our strategic Model Bond Portfolio, typically with shorter holding periods, and sometimes in smaller or less liquid markets that are outside our usual core bond coverage (like Swedish government bonds or euro area CPI swaps). This report includes a summary of the rationale for each position, as well as a decision on whether to retain the position, close it or switch it into a new trade that has more profit potential for the same theme underlying the original trade (Table 1). Table 1Global Fixed Income Strategy Tactical Overlay Trades Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades Feature U.S. Long 5-year U.S. Treasury bullet vs. 2-year/10-year duration-matched barbell (CLOSE AND SWITCH TO NEW TRADE) Long U.S. TIPS vs. nominal U.S. Treasuries (HOLD) Short 10-year U.S. Treasuries vs. 10-year German Bunds (HOLD) Chart 1UST Curve Trading More Off The Funds##BR##Rate Than Inflation Expectations UST Curve Trading More Off The Funds Rate Than Inflation Expectations UST Curve Trading More Off The Funds Rate Than Inflation Expectations We have three U.S.-focused tactical trades that are all expressions of our core views on U.S. inflation expectations and future Fed monetary policy moves. We first recommended a U.S. butterfly trade, going long the 5-year U.S. Treasury bullet and short a duration-matched 2-year/10-year Treasury barbell (Chart 1), back on December 20th, 2016. We have kept the recommendation during periodic reviews of our tactical trades since then. This is a position that was expected to benefit from a bearish steepening of the U.S. Treasury curve as the market priced in higher longer-term inflation expectations. The trade has not performed according to our expectations, however, generating a loss of -0.40% since inception.1 There was a positive correlation between the slope of the Treasury curve, the butterfly spread and TIPS breakevens shortly after trade inception. However, the Treasury curve flattened through 2017 as the Fed continued to hike rates, even as realized inflation fell (2nd panel), pushing the real fed funds towards neutral levels as measured by estimates like r* (3rd panel). This has left the 2/5/10 Treasury butterfly cheap on our valuation model (bottom panel), Looking ahead, the case for a renewed bear-steepening of the U.S. Treasury curve, and widening of the 2/5/10 butterfly spread, rests on the Fed accommodating the current rise in U.S. inflation by being cautious with future rate hikes. Recent comments from Fed officials suggest that policymakers are in no hurry to rapidly raise rates in order to cool off an "overheating" U.S. economy. Yet at the same time, U.S. inflation continues to rise and the economy is in good shape, so the Fed can't take a pause on rate hikes. This will likely leave the Treasury curve range bound, with the potential for some periods of bear-steepening as inflation expectations rise. Our conviction on this Treasury butterfly spread trade has fallen of late. Yet with our model suggesting that the belly of the curve is somewhat cheap to the wings, and given our view that U.S. inflation expectations have not reached a cyclical peak, we are reluctant to completely exit this position. Instead, we are opting to switch out of the 2/5/10 U.S. Treasury butterfly into another butterfly that our colleagues at BCA U.S. Bond Strategy have identified as cheap within their newly-expanded curve modeling framework - the 1/7/20 butterfly (long the 7-year bullet vs. short a duration-matched 1/20 barbell).2 That butterfly offers better carry than the 2/5/10 butterfly (Chart 2), and is nearly one standard deviation cheap to estimated fair value. Another of our U.S.-focused tactical trades has been to directly play for rising U.S. inflation expectations by going long TIPS versus nominal U.S. Treasuries. This is a long-held trade (initiated on August 23rd, 2016) which has performed very well, delivering a return of 4.13%.3 We continue to see the potential for TIPS breakevens to widen back to levels consistent with the market believing that inflation can sustainably return to the Fed's 2% target on the PCE deflator, which is equivalent to 2.4-2.5% on CPI-based 10-year TIPS inflation expectations. Given the persistent strong correlation between oil prices and breakevens, and with the BCA Commodity & Energy Strategy team continuing to forecast Brent oil prices jumping above $80/bbl over the next year (Chart 3), there is still solid underlying support for wider breakevens. This is especially true given the uptrend in overall global inflation (middle panel), and the likelihood that core U.S. inflation can also continue to rise alongside an expanding U.S. economy (bottom panel). We are sticking with our long TIPS position vs. nominal Treasuries. Chart 2Switch The UST Butterfly##BR##Trade From 2/5/10 to 1/7/20 Switch The UST Butterfly Trade From 2/5/10 to 1/7/20 Switch The UST Butterfly Trade From 2/5/10 to 1/7/20 Chart 3Stay Long U.S. TIPS##BR##Vs. Nominal Treasuries Stay Long U.S. TIPS vs. Nominal Treasuries Stay Long U.S. TIPS vs. Nominal Treasuries Our final U.S.-focused tactical trade is actually a cross-market trade where we are short 10-year U.S. Treasuries versus 10-year German Bunds. We initiated that trade on August 8th, 2017 when the Treasury-Bund spread was at 179bps. With the spread now at 252bps, the trade has delivered a solid total return of 4.23%. This was driven primarily by the rapid move higher in Treasury yields in response to faster U.S. growth (Chart 4), more rapid U.S. inflation and Fed rate hikes versus a stand-pat European Central Bank (ECB).4 From a medium-term perspective, those three fundamental drivers of the Treasury-Bund spread continue to point to U.S. bond underperformance (Chart 5). From this perspective, the peak in the spread will not be reached until U.S. economic growth and inflation peak and the Fed signals an end to its current tightening cycle. None of those outcomes is on the horizon, and we continue to target an eventual cyclical top in the 10-year Treasury yield in the 3.25-3.5% range as inflation expectations move higher. Yet the Treasury-Bund spread has reached an overvalued extreme according to our "fair value" model (Chart 6). In other words, the markets have moved to more than fully discount the cyclical differences between the U.S. and euro area - a trend that surely reflects the huge short positioning in the U.S. Treasury market. Yet it is also important to note that the fair value spread continues to steadily climb higher. In our model, the spread is primarily a function of differences in central bank policy rates between the Fed and ECB, relative unemployment rates and relative headline inflation rates. All three of those factors continue to move in a direction favorable to a wider Treasury-Bund spread, and the gap is only growing wider with both growth and inflation in the euro zone losing momentum. Chart 4Stay Long 10yr UST##BR##Vs. 10yr German Bund Stay Long 10yr UST vs 10yr German Bund Stay Long 10yr UST vs 10yr German Bund Chart 5UST-Bund Spread Widening##BR##Due To Relative Fundamentals... UST-Bund Spread Widening Due To Relative Fundamentals... UST-Bund Spread Widening Due To Relative Fundamentals... Chart 6...But The Spread##BR##Has Overshot A Bit ...But The Spread Has Overshot A Bit ...But The Spread Has Overshot A Bit The spread is currently being pushed to even wider extremes by the current turmoil in Italy, which is pushing money out of Italian BTPs into safer assets like Bunds. The situation remains fluid and new elections are likely in Italy later this year, thus it is unlikely that any more to restore investor confidence in Italy is on the immediate horizon. This will keep Bund yields depressed versus Treasuries, even as the ECB continues to signal that it will fully taper its asset purchases by year-end (rate hikes remain a long way off in Europe, however). We continue to recommend staying short Treasuries versus Bunds, and would view any tightening of the spread back towards our model estimate of fair value as an opportunity to enter the position or add to an existing position. Euro Area Long 10-year euro area CPI swaps (HOLD, BUT ADD A STOP AT 1.5%) Short 5-year Italy government bonds vs. 5-year Spain government bonds (HOLD) Chart 7Stay Long 10-Year Euro Area CPI Swaps Stay Long 10-Year Euro Area CPI Swaps Stay Long 10-Year Euro Area CPI Swaps We have two tactical trades that are purely within the euro area: positioning for higher inflation expectations through a long position in 10-year euro CPI swaps, and playing relative credit quality within the Peripheral countries by shorting 5-year Italian bonds versus a long position in 5-year Spanish debt. The long 10-year CPI swaps trade, which was initiated on December 20th, 2016, has generated a total return of +0.45% over the life of the trade so far (Chart 7).5 The rationale for the recommendation, and our conviction behind it, has evolved over that time. We first recommended the trade when the ECB was aggressively easing monetary policy and there was clear positive momentum in euro area economic growth that was driving down unemployment. At a time when oil prices were steadily climbing and the euro was very weak, the case for seeing some improvement in inflation expectations in the euro area was a strong one. Inflation expectations stayed resilient in 2017, however, despite the unexpected strength of the euro. Continued gains in oil prices and above-trend economic growth that rapidly absorbed spare capacity in the euro area more than offset any downward pressure on inflation from a stronger currency. Looking ahead, the combination of renewed weakness in the euro and firm oil prices should allow headline inflation in the euro area to drift higher from current levels in the next 3-6 months (2nd panel). However, the euro area economy has lost the positive momentum seen last year with steady declines in cyclical data like manufacturing PMIs, industrial production and exports (3rd panel). Admittedly, that deceleration has come from a high level and leading indicators are not yet pointing to a prolonged period of below-potential growth that could raise unemployment and reduce domestic inflation pressures. Yet with core inflation still struggling to climb beyond the 1% level (bottom panel), any worsening of euro area economic momentum could lead to inflation expectations stalling out well before getting close to the ECB's 2% target level. Thus, we continue to recommend this long 10-year CPI swaps position, but we are adding a new stop-out level at 1.5% to protect against downside risks if the euro area growth outlook darkens. On our other euro area tactical trade, we have been recommending shorting Italian government bonds versus Spanish equivalents. We initiated that trade on December 16th, 2016 and it has produced a total return of +0.57% over the life of the trade. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign debt fundamentals and political stability were all much worse than that of Spain (Chart 8), yet Italian bond yields were still trading at too low a spread to Spanish debt. The cyclical improvement in the Italian economy in 2017 helped pushed Italian yields even closer to Spanish yields, yet we stuck with the trade given the looming political risk from the Italian parliamentary elections. The recent political turmoil in Italy has justified our persistence with this trade, with the 5-year Italy-Spain spread widening out by 46 bps over just the past two weeks. With the situation remaining highly fluid as the Italian coalition partners (the 5-Star Movement and the League) struggle to form a new government, Italian assets will continue to trade with a substantial risk premium to Spain and other European bond markets. Yet with the Italian economy now also showing signs of losing cyclical momentum, the case for continued Italian bond underperformance is a strong one, and we moved to a strategic underweight stance on Italian debt last week.6 Looking ahead, we see the potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth, the deficit outlook is worsening for Italy with the new coalition government proposing a stimulus that could widen the budget deficit by as much as 6% of GDP, and Spanish support for the euro currency is far higher than it is in Italy. All those factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 9). Chart 8Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Chart 9Stay Short 5-Year Italy Versus 5-Year Spain Stay Short 5-Year Italy Versus 5-Year Spain Stay Short 5-Year Italy Versus 5-Year Spain Our view on Italian debt, both from a tactical and strategic viewpoint, is bearish. We are maintaining our tactical trade, and we also advise selling into any rallies in Italy rather than buying the dips. U.K. Long 5-year Gilt bullet vs. duration-matched 2-year/10-year Gilt barbell (HOLD) We entered into a U.K. Gilt butterfly trade, long the 5-year bullet versus the duration-matched 2-year/10-year barbell, back on March 27th, 2018.7 The logic of the trade was a simple one. We simply did not believe that the Bank of England (BoE) would follow through on its hawkish commentary by hiking rates as much as was discounted in the Gilt curve. Our view came to fruition as the BoE held rates steady at the May monetary policy meeting, which resulted in a bullish steepening at the front end of the Gilt curve. Our butterfly trade has returned +0.25% since inception, and we see more to come in the coming months.8 The U.K. economy has lost considerable momentum, with no growth shown in Q1 (real GDP only expanded +0.1%). The OECD leading economic indicator for the U.K. is at the weakest level in five years, and now consumer confidence is rolling over as rising oil costs are offsetting the pickup in wages (Chart 10). Overall headline inflation has peaked, however, after the big currency-fueled surge in 2016 and 2017 (bottom panel). With both growth and inflation slowing, and with the lingering uncertainty of the Brexit negotiations weighing on business confidence and investment, the BoE will have a tough time hiking rates even one more time this year. There are still 34bps of rate hikes priced into the U.K. Overnight Index Swap (OIS) curve, which leaves room for 2-year Gilts to decline as the BoE stays on hold for longer (Chart 11). This will cause the front-end of the Gilt curve to steepen. Meanwhile, longer-term Gilt yields will have a difficult time falling given the deceleration of global central bank asset purchase programs that is slowly raising depressed term premia on government bonds (3rd panel). Another factor that will help keep the Gilt curve steeper, all else equal, is the path of the inflation expectations curve. Shorter-dated expectations are likely to fall faster as growth slows and headline inflation continues to drift lower (bottom panel). Chart 10Fading Momentum For##BR##U.K. Growth & Inflation Fading Momentum For U.K. Growth & Inflation Fading Momentum For U.K. Growth & Inflation Chart 11Stay Long The 5yr U.K. Gilt Bullet##BR##Vs. The 2/10 Gilt Barbell Stay Long The 5yr U.K. Gilt Bullet vs The 2/10 Gilt Barbell Stay Long The 5yr U.K. Gilt Bullet vs The 2/10 Gilt Barbell Although some narrowing of the butterfly spread is already priced in the forwards (top panel), we see that outperformance of the 5-year happening faster, and by a greater amount, than the forwards. Stay long the belly of the Gilt curve versus the wings. Canada Long 10-year Canada inflation-linked government bonds vs. nominal Canada government bonds (HOLD) We recommended entering a long Canada 10-year breakeven inflation trade on January 9th, 2018.9 Since then, the 10-year breakeven inflation rate rose by 6bps along with the rise in oil prices denominated in Canadian dollars (Chart 12). This has helped our tactical trade deliver a return of +0.64% since inception.10 More fundamentally, the breakeven has risen as strong Canadian growth has helped close the output gap and push realized Canadian inflation back to the middle of the Bank of Canada (BoC)'s 1-3% target band. The rapid rate of real GDP growth has decelerated a bit after approaching 4% last year, and the OECD leading economic indicator for Canada may be peaking at a high level (Chart 13). Growth in consumer spending is also look a bit toppy, with bigger downside risks evident in the sharp declines in the growth of retail sales and house prices (3rd panel). Both were affected by a harsher-than-usual Canadian winter, but the cooling of the overheated Canadian housing market (especially in Toronto) is a welcome development for financial stability. Chart 12Stay Long Canadian##BR##Inflation Breakevens Stay Long Canadian Inflation Breakevens Stay Long Canadian Inflation Breakevens Chart 13Canadian Inflation At BoC Target,##BR##But Has Growth Peaked? Canadian Inflation At BoC Target, But Has Growth Peaked? Canadian Inflation At BoC Target, But Has Growth Peaked? On balance, however, the current state of Canadian economic data shows an economy that is slowing a bit from a very overheated pace, but is still likely to grow above potential with no spare capacity available. Both headline and core inflation will remain under upward pressure against this backdrop, at a time when the BoC's policy rate is still well below neutral. We continue to recommend staying long Canadian inflation-linked government bonds over nominal equivalents with a near-term target of 2% on the 10-year breakeven inflation rate. We will re-evaluate the position with regards to Canadian growth and inflation trends once that target is reached. Australia Long December 2018 Australian Bank Bill futures (SELL AND SWITCH TO NEW TRADE). We entered into a long December 2018 Australian Bank Bill futures trade on October 17, 2017 as a focused way to express the view that the Reserve Bank of Australia (RBA) would stay on hold for longer than markets expect. The trade has worked out nicely, generating a profit of +0.25%. The potential for further upside is fairly low at these levels so we are now closing the trade. However, our view remains that the RBA will not be able to hike as early as markets are pricing. As such, we are opening a new position - long October 2019 Australia Bank Bill futures. Markets expect the first rate hike will occur in nine months' time. The October 2019 Australia Bank Bill futures are currently pricing in a massive 180bps of rate hikes over the next sixteen months. That will not happen. The RBA will not be able to hike this much given the lack of inflation pressures and a wide output gap. Our Australia Central Bank Monitor, which measures cyclical growth and inflation pressures, has pulled back to the zero line, confirming that there is no current need to tighten policy (Chart 14). Real GDP growth slowed to 2.4% in Q4 2017, from 2.9% the previous quarter. Weakness in the OECD leading economic indicator and Citigroup economic surprise index for Australia suggest that the Q1 reading will also disappoint. Consumer spending will be dampened by weak wage growth, softening consumer sentiment and the recent decline in house prices in multiple major cities. As a result of easing house prices, the growth rate of household net wealth was considerably lower in 2017 relative to the previous four years. Additionally, credit growth has been slowing, even before the recent news of the bank scandals that will force banks to be more stringent with lending practices. Most importantly, however, inflation remains below the RBA's target and there is a lack of inflationary pressures. The inflation component of our Central Bank Monitor has collapsed and is now well below the zero line. Both headline and core inflation readings are stable but remain persistently below 2%. Tradeable goods prices have declined for nine consecutive months despite the currency weakness seen in the Australian dollar over the past twelve months. The IMF is not projecting Australia to have a closed output gap until 2020, and that is with the optimistic expectation that Australia achieves 3% growth. Labor markets have plenty of slack as evidenced by rising unemployment rate, nonexistent wage growth and elevated level of underemployment. The RBA estimates that the current unemployment rate is still approximately 0.5% above full employment. Against this backdrop, it is unlikely that inflation will sustainably rise enough to force the RBA's hand, leaving scope for interest rate expectations to decline (Chart 15). Chart 14The RBA Will##BR##Stay Dovish The RBA Will Stay Dovish The RBA Will Stay Dovish Chart 15Switch Long Australia Bank Bill Futures##BR##Trade From Dec/18 Contract To Oct/19 Contract Switch Long Australia Bank Bill Futures Trade From Dec/18 Contract To Oct/19 Contract Switch Long Australia Bank Bill Futures Trade From Dec/18 Contract To Oct/19 Contract New Zealand Long 5-year New Zealand government bonds vs. 5-year U.S. Treasuries, currency-hedged into U.S. dollars (HOLD) Long 5-year New Zealand government bonds vs. 5-year German government bonds, with no currency hedge (HOLD) One of our more successful tactical trades has been in New Zealand (NZ) government bonds. We entered long positions in 5-year NZ debt versus 5-year U.S. Treasuries and 5-year German Bunds on May 30th, 2017, but we reviewed, and decided to maintain, those positions in a recent Weekly Report.11 The NZ-US spread trade has returned 4.67% since inception, hedged into U.S. dollars (Chart 16).12 The NZ-Germany trade, however, was a very rare instance where we recommended a cross-country spread trade on a currency UN-hedged basis, based on the negative view on the euro that we had last year. With the euro rising sharply against the New Zealand dollar, the unhedged return on that trade has been -2.87% (a return that, if hedged back into the euro denomination of the German bonds, would have generated a return of +3.56%). Looking ahead, we see continued scope for NZ bond outperformance, although the return potential is far less than it was when we first put on the trade. NZ economic growth is in the process of peaking, with export growth already rolling over (Chart 17, top panel). Net immigration inflows, which have been a major support for the NZ housing market and overall consumer spending over the past five years, have already begun to slow with the Reserve Bank of New Zealand (RBNZ) projecting bigger declines in the next couple of years (2nd panel). Both headline and core CPI inflation took a surprising downward turn in Q1 of this year, and both are well below the midpoint of the RBNZ target band (3rd panel). Chart 16Stay Long NZ 5yr Bonds##BR##Vs. The U.S. & Germany... Stay Long NZ 5yr Bonds Vs The U.S. & Germany... Stay Long NZ 5yr Bonds Vs The U.S. & Germany... Chart 17...With NZ Growth &##BR##Inflation Losing Momentum ...With NZ Growth & Inflation Losing Momentum ...With NZ Growth & Inflation Losing Momentum With both growth and inflation slowing, the RBNZ can remain dovish on monetary policy. An additional factor is the NZ government has recently changed the mandate of the RBNZ to include both inflation targeting and "maximizing employment" in a similar fashion to the Federal Reserve. With inflation posing no threat, the RBNZ can focus on its employment mandate by maintaining highly accommodative policy settings. With the NZ OIS curve still discounting one full 25bp RBNZ hike over the next year (bottom panel), there is scope for NZ bonds to outperform as that hike will not happen. This will allow NZ bond spreads to tighten, or at least outperform versus the forwards where some modest widening is currently priced. We are sticking with both spread trades, but we are choosing to leave the NZ-Germany trade currency unhedged given the renewed weakness in the euro (the unhedged return has already improved by over two full percentage points since the euro peaked earlier this year). We will monitor levels of the NZD/EUR currency cross rate to determine when to potentially hedge the currency exposure of our trade back into euros. Sweden Long Sweden 10-year government bond vs. 2-year government bond Short 2-year Sweden government bond vs. 2-year German government bond We recently entered two Sweden tactical bond trades on May 8, 2018, going long the Swedish 10-year vs. the 2-year and shorting the Swedish 2-year vs. the German 2-year (Chart 18).13 We expect that strong growth momentum, rising inflation and a tight labor market will force the Riksbank to raise rates earlier, and by more, than markets expect. Since inception for these "young" trades, each has returned -1bp.14 Sweden's economy made a solid recovery in 2017, with year-over-year real GDP growth reaching 3.3% in Q4. Going forward, export growth will remain supported by strong global activity, low unit labor costs, and a weak krona. Our own Swedish export growth model is already signaling a pickup over the rest of 2018. Consumption has been resilient and should continue to be supported by steadily recovering wages. Capital spending has been robust and industrial confidence remains in an uptrend. Additionally, leading indicators are still signaling positive growth momentum. The Riksbank's preferred measure of inflation, CPIF, slowed to 1.9% in April after briefly touching the central bank's target last month (Chart 19). In our view, this is a minor pullback rather than the start of a sustained reversal. Our core inflation model projects a gradual increase in the coming months, driven by above-trend growth that has soaked up all spare capacity. Labor markets have tightened considerably, and the unemployment rate is now more than one percentage point below the OECD's estimate of the full-employment NAIRU. During the last period when unemployment was this far below NAIRU, wage growth surged to over 4%. Chart 18Stay In A Sweden 2/10 Curve Flattener##BR##& Short 2yr Swedish Bonds Vs Germany Stay In A Sweden 2/10 Curve Flattener & Short 2yr Swedish Bonds Vs Germany Stay In A Sweden 2/10 Curve Flattener & Short 2yr Swedish Bonds Vs Germany Chart 19The Riksbank Will Not Ignore##BR##The Coming Inflation Overshoot The Riksbank Will Not Ignore The Coming Inflation Overshoot The Riksbank Will Not Ignore The Coming Inflation Overshoot For the curve flattener trade, our expectation is that the Riksbank will shift to a more hawkish tone in the coming months, leading markets to reprice the shape of the Swedish yield curve, as too few rate hikes are discounted in the short-end. With their mandates met, the Riksbank will be forced to act more aggressively. Importantly, there is no flattening currently priced into the Swedish bond forward curve, thus there is no negative carry associated with putting on a flattener now. In the relative value trade, we shorted the Swedish 2-year relative to the German 2-year. Growth in Sweden is likely to outpace that of the euro area once again in 2018. Swedish inflation is almost at the Riksbank target while euro area inflation continues to undershoot the ECB benchmark. The ECB is signaling that it is in no hurry to begin raising interest rates, therefore policy rate differentials will drive the 2-year Sweden-Germany spread wider over the next 12-18 months, with no spread move currently priced into the forwards. South Korea Short Korea 10-Year Government Bonds Vs. Long 2-Year Korea Government Bonds (CLOSE) We first introduced this trade on May 30th, 2017, after the election of Moon Jae-In as the South Korean president.15 The new government made major campaign promises to greatly expand fiscal spending on social welfare, public sector job creation, and increased aid to North Korea. With the central government's budget balance set to worsen significantly, we expected longer-term Korean bond yields to begin to price in faster growth and rising future debt levels, resulting in a bearish steepening of the yield curve (Chart 20). Since the new president was elected, however, the Korean economy worsened - even as much of the global economy was enjoying a cyclical upturn - with the trend likely to continue (Chart 21). The OECD leading economic indicator for Korea is weakening, while the annual growth in industrial production now sits at -4.2% - the worst level since the 2009 recession. Capital spending and exports are also slowing rapidly. Chart 20Close The 2yr/10y Korean##BR##Government Bond Curve Steepener Close The 2yr/10y Korean Government Bond Curve Steepener Close The 2yr/10y Korean Government Bond Curve Steepener Chart 21Korean Curve Stable,##BR##Despite Slower Growth & Fiscal Stimulus Korean Curve Stable, Despite Slower Growth & Fiscal Stimulus Korean Curve Stable, Despite Slower Growth & Fiscal Stimulus Due to the slowdown in the economy, Korean firms' capacity utilization is now at the worst level since the middle of 2009. Although businesses were already suffering from downward pressure on revenues, the Moon administration dramatically increased the minimum wage last year, directly leading to a rise in bankruptcies for small and medium size firms (the bankruptcy rate rose from 1.9% in the first half of 2017 to 2.5% in the latter half). Looking ahead, the Moon government will continue to increase spending on welfare and financial aid for North Korea, especially if the domestic economy continues to struggle. We still believe that the rise in deficits and debt will eventually lead the market to price in some increase in the fiscal risk premium and a steeper Korean yield curve. Yet with the Bank of Korea (BoK) having already surprised the markets last November with a rate hike, and with Korean inflation now ticking higher alongside a stable won, we fear that any renewed steepening of the Korean curve awaits a shift to a more dovish BoK that is not yet on the horizon. For now, given the competing forces on the Korean yield curve, we are choosing to close our 2/10 Korea curve steepener at a loss of -0.63%.16 We will continue to monitor the Korean situation to look for opportunities to re-enter the trade at a later date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Returns are calculated using Bloomberg pricing of the total return of a 2/5/10 butterfly. 2 Please see BCA U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15th 2018, available at usbs.bcaresearch.com. 3 Return is taken directly from Bloomberg Barclays index data on the duration-adjusted excess return of the entire TIPS index versus the entire Treasury index. 4 This return is calculated using Bloomberg data on actual U.S. and German bonds, and is shown on a currency-hedged basis into U.S. dollars - the currency denomination of the bond we are short in this spread trade. 5 Returns are calculated using Bloomberg Barclays inflation swap index data for a euro area CPI swap with a rolling 10-year maturity. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. 7 Please see BCA Global Fixed Income Strategy Weekly Report, "Nervous Complacency", dated March 27th, 2018, available at gfis.bcaresearch.com. 8 Returns are calculated using Bloomberg data on actual Gilts, rather than bond index data. 9 Please see BCA Global Fixed Income Strategy Weekly Report, "Let The Good Times Roll", dated January 9th 2018, available at gfis.bcaresearch.com. 10 This return is measured as the total return of the Canadian inflation-linked bond index less that of the nominal Canadian government bond index from the Bloomberg Barclays family of bond indices. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Serenity Now", dated May 15th 2018, available at gfis.bcaresearch.com. 12 Returns are calculated using Bloomberg data on actual New Zealand government bonds, with our own adjustments for the impact on returns from currency hedging. 13 Please see BCA Global Fixed Income Strategy Special Report, "Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore", dated May 8th 2018, available at gfis.bcaresearch.com. 14 Returns are calculated using Bloomberg data for actual individual Swedish government bonds, rather than bond index data. Both legs of the trade are duration-matched. 15 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30th 2017, available at gfis.bcaresearch.com. 16 Returns are calculated using Bloomberg data for actual individual Korean government bonds, rather than bond index data. Both legs of the trade are duration-matched and funding costs are included. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The Fed Vs. The Market: The market believes the Fed will deliver on its "gradual" rate hike pace in a status quo economic scenario. But investors also view the odds of the Fed slowing the pace of hikes as greater than the odds of it hiking more quickly. Dovish Catalysts: The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. Hawkish Catalysts: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Feature In last week's report we recommended that nimble investors should position for a near-term (0-3 month) decline in Treasury yields.1 Since then, the 10-year Treasury yield has fallen from 3.06% to 2.93% but we are not yet ready to remove our recommendation. The two criteria we named in last week's report - extended net short bond positioning and a high likelihood of negative data surprises - remain in place. As such, we expect bond yields to fall further in the near-term, though we remain bond bears on a cyclical (6-12 month) investment horizon. This week we turn to Fed policy, and specifically the following three questions: What does the Fed mean when it says it will make "further gradual adjustments" to the stance of monetary policy? How do "gradual adjustments" relate to what is currently priced in the market? What factors would cause the Fed to deviate from its "gradual" path, leading to either a faster or slower pace of tightening? The Market Trusts The Fed...To A Point We have noted in previous reports that the Fed's "gradual" pace of rate hikes is quite clearly defined as one 25 basis point rate hike per quarter. The Fed has tightened policy at this pace since December 2016, with the exception of last September when it announced the winding down of its balance sheet in place of a hike. It seems to us that the Fed's policy intentions have rarely been more transparent. The Fed will continue to lift rates by 25 bps per quarter until either (i) something breaks in the economy causing the Fed to slow down, or (ii) inflation pressures mount causing the Fed to speed up. But what about market pricing? To be consistent with the Fed's "gradual" pace of one hike per quarter the market would need to be priced for 50 bps of tightening during the next six months, 100 bps of tightening during the next 12 months, etc... Chart 1 shows that the market believes the Fed will deliver on its "gradual" pace for the next six months, but that it will fall somewhat short during the next year. Looking beyond the next 12 months, the market is not priced for the Fed to deliver on its "gradual" hike pace during the next 18 or 24 months either (Chart 2). Chart 1The Fed Versus The Market Part I The Fed Versus The Market Part I The Fed Versus The Market Part I Chart 2The Fed Versus The Market Part II The Fed Versus The Market Part II The Fed Versus The Market Part II A more realistic interpretation of Charts 1 and 2 is that while the market believes the Fed will deliver on its "gradual" hike pace in a status quo economic scenario, investors also view the odds of something breaking in the economy as greater than the odds that inflation will force the Fed to move faster. We also agree that the odds of something breaking are greater than the odds that inflation will force the Fed's hand. However, we would still favor a cyclical (6-12 month) below-benchmark duration stance because the market is not priced for the most likely status quo / "gradual" rate hike environment. Identifying Breaking Points How will we be able to tell if something is breaking in the economy that will cause the Fed to slow its pace of hikes? Candidate 1: Domestic Economic Growth One way is to simply monitor leading indicators of U.S. economic growth, particularly the contribution of cyclical spending to overall GDP (Chart 3). The cyclical sectors of the economy (consumer spending on durable goods, residential investment and investment on equipment & software) are most sensitive to interest rates and often provide an early warning sign for the overall economy. At the moment we see no evidence that cyclical spending is poised to slow meaningfully. Recent data showed solid gains in April retail sales, while consumer sentiment remains near its all-time high (Chart 4, panel 1). On the investment side, core durable goods orders were stronger than expected in April and the regional manufacturing PMIs that have been released so far in May (Philadelphia, New York, Richmond and Kansas City) have all increased (Chart 4, panel 2). Recent housing data have been more disappointing relative to expectations, but even here we continue to see steady growth in building permits and a continued contraction in outstanding supply. Supply increases typically precede a decline in construction activity (Chart 4, bottom panel). Chart 3Domestic Economy Looks Strong Domestic Economy Looks Strong Domestic Economy Looks Strong Chart 4Focus On Cyclical Sectors Focus On Cyclical Sectors Focus On Cyclical Sectors Candidate 2: The Financial Markets Even if U.S. economic growth is robust, it is conceivable that a sharp tightening of financial conditions - a falling stock market, widening credit spreads and/or an appreciating dollar - could cause the Fed to slow its pace of hikes. After all, the Fed would interpret a large enough tightening of financial conditions as a signal that economic growth will slow in the future. To assess this risk we turn to our Fed Monitor (Chart 5). Our Fed Monitor is a composite of many different variables that fall into one of three categories (i) economic growth, (ii) inflation and (iii) financial conditions. It is constructed in such a way that a reading above zero means the Fed should be tightening policy and a reading below zero means the Fed should be easing. Chart 5Fed Monitor Recommends Tighter Policy Fed Monitor Recommends Tighter Policy Fed Monitor Recommends Tighter Policy The bottom panel of Chart 5 shows that we have in fact seen a relatively large tightening of financial conditions since the equity market sold off in February. However, our overall Fed Monitor has barely ticked down, and remains solidly above zero. There is an important message here. The Fed can tolerate more tightening in financial conditions when economic growth and inflation are higher. When a similar tightening of financial conditions occurred in 2015, it did in fact drive our overall Fed Monitor below zero. This is because the economic growth and inflation components of the Monitor provided less of an offset (Chart 5, panels 3 & 4). Now, with stronger readings from those components, the Fed will need to see a much larger tightening of financial conditions before reacting. We will pay close attention to our Fed Monitor going forward for any signs that a sell-off in financial markets might be severe enough to spook the Fed. Another financial market signal that bears monitoring is the slope of the yield curve (Chart 6). It is no secret that an inverted yield curve always precedes a recession, and the Fed could interpret a very flat curve as a signal that monetary policy is becoming restrictive. In fact, Atlanta Fed President Raphael Bostic said two weeks ago that: Chart 6Not Flat Enough To Worry The Fed Not Flat Enough To Worry The Fed Not Flat Enough To Worry The Fed I have had extended conversations with my colleagues about a flattening yield curve. It is my job to make sure that [yield curve inversion] doesn't happen. In contrast, the minutes from the May FOMC meeting reveal a more balanced tone from the committee as a whole. "Several" participants thought "it would be important to monitor" the slope of the curve, while "a few" thought that the slope of the curve could be less important this cycle because of several special factors. These factors include: depressed term premiums because of large central bank balance sheets and reductions in investors' estimates of the longer-run neutral real interest rate. Our sense is that the yield curve is a good economic indicator simply because it reflects market expectations about the path of the fed funds rate. When the curve is inverted, and long-maturity yields are below short-maturity yields, it means that investors expect rate cuts to occur in the future. In contrast, a very steep yield curve indicates that the market expects a large number of rate hikes. When the stance of monetary policy is perceived to be close to neutral, investors will expect very little future movement in the fed funds rate and the yield curve will be very flat.2 In an ideal world, the Fed will move the funds rate close to its neutral level by the time that inflation stabilizes around its 2% target. In other words, the Fed will not be overly concerned with a very flat yield curve as long as inflation is close to its target. A very flat curve will only worry policymakers if it coincides with below-target inflation, because that would suggest that the market does not believe that the Fed will hit its inflation goal. With inflation already close to the Fed's target, we don't think a flat yield curve will cause the Fed to turn dovish any time soon. Candidate 3: Foreign Economic Growth One final factor that could eventually cause the Fed to slow its pace of rate hikes is weak foreign economic growth. Here we already see mounting signs of stress. Chart 7 shows that while the U.S. Leading Economic Indicator is the strongest it has been in several years, our Global Leading Economic Indicator excluding the U.S. has begun to contract. This divergence in growth between the U.S. and the rest of the world is reminiscent of the 2014/15 period when the dollar came under strong upward pressure. Not surprisingly, the dollar is once again starting to appreciate (Chart 7, panel 2). Much like in 2014/15, a strengthening dollar is already putting pressure on Emerging Markets where CDS spreads are widening and currencies are weakening (Chart 7, bottom panel). As an aside, while USD-denominated Sovereign bond spreads have widened, they remain expensive compared to similarly-rated U.S. corporate bonds (Chart 8). We continue to recommend an underweight allocation to USD-denominated Sovereign debt. Turning back to U.S. monetary policy, the key reason the Fed might concern itself with weak foreign economic growth is that the resultant strengthening of the dollar will eventually cause financial conditions to tighten and domestic economic growth to slow. This is exactly what occurred in 2014/15, though unfortunately the Fed waited until the strong dollar culminated in a sell-off in equity and credit markets before it adopted a more dovish policy stance (Chart 9). We would once again expect the Fed to wait for divergent growth between the U.S. and the rest of the world (and the resultant stronger dollar) to be reflected in financial conditions indexes and domestic equity and credit markets before it responded by slowing the pace of hikes. Chart 7Global Growth Divergences##br## Are Back Global Growth Divergences Are Back Global Growth Divergences Are Back Chart 8Sovereigns Still##br## Expensive Sovereigns Still Expensive Sovereigns Still Expensive Chart 9Growth Divergences Led To ##br##Market Turmoil In 2014/15 Growth Divergences Led To Market Turmoil In 2014/15 Growth Divergences Led To Market Turmoil In 2014/15 Bottom Line: The Fed would slow its pace of rate hikes if the cyclical sectors of the U.S. economy started to slow, financial conditions tightened significantly, or if the slope of the yield curve moved close to zero while inflation was below the Fed's target. The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. What Would Make The Fed Hike More Quickly? The most obvious factor that would make the Fed increase its pace of rate hikes to greater than 25 bps per quarter would be if inflation rose above its 2% target and continued to accelerate. It is unclear how much of an inflation overshoot the Fed is willing to tolerate before it increases the pace of hikes, but our sense is that it's fairly substantial. The Fed has gone out of its way in recent months to stress the "symmetric" nature of its 2% inflation target and, as long as inflation expectations remained well contained, we think the Fed would stick with its "gradual" rate hike pace as long as core PCE inflation is below 2.5%. Inflation pressures in the economy would have to change dramatically for core PCE inflation to break above 2.5%. Chart 10 shows two hypothetical scenarios for year-over-year core PCE inflation. One scenario where core PCE inflation rises 0.2% every month going forward, and another where it rises 0.15% every month. In the 0.2% per month scenario, year-over-year core PCE inflation eventually levels off at around 2.4%. In the 0.15% per month scenario it levels off at 1.8%. Monthly core PCE inflation has only printed above 0.2% seven times since 2015 (Chart 11), meaning that we would need to see a huge shift in the inflation data for it to start worrying policymakers. Chart 10How Much Overshoot Will Fed Tolerate? How Much Overshoot Will Fed Tolerate? How Much Overshoot Will Fed Tolerate? Chart 11Prints Above 0.2% Have Been Rare Prints Above 0.2% Have Been Rare Prints Above 0.2% Have Been Rare Another important factor that we have flagged in recent research is the price of gold.3 We noted that the gold price tends to rise when Fed policy eases and fall when it becomes more restrictive. We also observed that Fed policy can ease/tighten in two ways: The Fed can alter market expectations about the pace of rate hikes The market can revise its assessment of the equilibrium (or neutral) fed funds rate Chart 12Gold Has Led The Fed Gold Has Led The Fed Gold Has Led The Fed Notice that the decline in the gold price between 2013 and 2016 foreshadowed downward revisions to the Fed's estimate of the long-run equilibrium fed funds rate, and that those estimates have leveled-off alongside the price of gold since then (Chart 12). It follows that an upside break-out in the price of gold would be a signal that monetary policy is becoming easier, and that current estimates of the equilibrium fed funds rate need to be revised up. This is another signal we are monitoring that could lead to a quicker pace of rate hikes from the Fed. Bottom Line: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 In practice, the term premium in long-dated Treasury yields will lead to a slightly positive yield curve slope when monetary policy is perceived to be neutral. 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Yields: Relative growth and inflation trends continue to favor the U.S., with divergences widening as non-U.S. is downshifting. This means that the cyclical peak in spreads between U.S. Treasuries and other developed market government bonds has not been reached yet, and the latest bout of U.S. dollar strength can continue. Stay underweight U.S. Treasuries in global government bond portfolios. Italy: Concerns over the future policies of the new Five-Star/League populist coalition government in Italy have triggered a selloff in Italian financial markets. While investors are right to be worried about the potential for greater fiscal stimulus and move vocal euroskepticism from those in charge in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns. Downgrade Italy to underweight (2 of 5) in global government bond portfolios. Feature After knocking on the door of the 3% threshold several times this year, the 10-year U.S. Treasury yield finally blew through that level last week. The ease with which this move occurred was a bit surprising, given that bond investor sentiment has stayed consistently bearish and Treasury market positioning remains extremely short. This raises the odds of a potential pullback in yields if the U.S. economy or inflation were to lose upside momentum. The only problem for the Treasury market is that neither of those trends is occurring at the moment. Chart of the WeekTreasuries Are Losing##BR##For The Right Reasons Treasuries Are Losing For The Right Reasons Treasuries Are Losing For The Right Reasons U.S. real GDP expanded at a 2.3% annualized rate in the first quarter of 2018, and the latest real-time GDP estimates for the second quarter from the Atlanta Fed (+4.1%) and New York Fed (+3.0%) are calling for an acceleration. The leading economic indicators produced by both the OECD and the Conference Board continue to climb higher, in stark contrast to the lost momentum in hard data and lead indicators in other major regions like Europe and Japan (Chart of the Week). Similar divergences are occurring in the inflation data, where core CPI inflation is accelerating in the U.S. and languishing elsewhere. The ability of U.S. Treasury yields to ignore the negative international headlines coming from typical trouble spots like Turkey, Argentina, Italy, Iran and North Korea is impressive. Clearly, none of these developments are big enough (yet!) to have any negative impact on U.S. growth expectations and, in turn, Fed rate hike expectations. At the same time, Fed officials continue to signal that another two or three rate increases are still likely over the remainder of the year. Add in the steady climb in inflation expectations, supported by oil prices reaching multi-year highs, and it is no surprise that those aggressive Treasury short positions have been on the right side of the market. If we were to apply a weather analogy to the global economy, conditions appear "partly sunny" if looking at the U.S, but "mostly cloudy" when looking elsewhere. This has major implications for the future path of U.S. Treasury yields versus other government bond markets, and for the U.S. dollar as well. Expect U.S. Bond Relative Underperformance To Continue From a more global perspective, the ability of non-U.S. bond yields to rise has become more limited. The overall OECD leading economic indicator - which is correlated to real global bond yields - looks to be rolling over, and our diffusion index of individual country indicators shows that this trend is broad-based (Chart 2). Within the major developed economies, only the U.S. stands out as having a rising leading economic indicator (although the Canadian index is holding up at a high level). The most depressed readings come from the three markets we are overweight in our model bond portfolio - the U.K., Japan and Australia (Chart 3). These growth divergences are not only visible in "soft" economic data like leading indicators and purchasing manager indices. U.S. retail sales showed a surprising burst of strength in April, and the release of that data last week was the trigger for pushing the 10-year Treasury yield above 3%. Meanwhile, readings on real GDP growth in the first quarter for the euro area and Japan were quite weak compared to the acceleration seen throughout 2017. In the case of Japan, GDP actually contracted at a 0.6% annualized rate in Q1, ending a run of eight consecutive quarters of positive growth which was the longest such streak in 28 years (Chart 4). Chart 2A Stagflationary Tug-Of-War##BR##On Global Yields A Stagflationary Tug-Of-War On Global Yields A Stagflationary Tug-Of-War On Global Yields Chart 3U.S. Growth##BR##Stands Out U.S. Growth Stands Out U.S. Growth Stands Out Chart 4Is China To Blame For##BR##Slowing Non-U.S. Growth? Is China To Blame For Slowing Non-U.S. Growth? Is China To Blame For Slowing Non-U.S. Growth? At the same time, China's domestic economy has seen some slowing of growth, as well, as evidenced by the rapid deceleration of import growth (bottom panel). For the economies in Europe and Japan where growth is still heavily geared towards exports, and where domestic demand still struggles to gain sustainable upward momentum in the absence of an export/production cycle, a slowing China poses a big problem - one that is less of an issue for the more domestically-focused U.S. economy. The divergence of growth and inflation accelerating in the U.S. but potentially peaking out elsewhere, can be seen in the widening of government bond yield spreads between the U.S. and its developed market peers. In Table 1, we show the change in the bond yield spread between 10-year U.S. Treasuries and similar maturity government debt from the U.K., Germany, Japan, Canada and Australia since the last major trough in global yields in September 2017. The spread changes are broken down into movements in inflation expectations and real yields to see which was more influential. For example, of the 75bps widening in the 10-year U.S. Treasury-German Bund spread, 55bps has been due to widening real yield differentials and only 20bps has come from higher inflation expectations in the U.S. Table 1Cross-Country Yield Spread Changes (in bps) Since The September 2017 Low In U.S. Treasury Yields Is It Partly Sunny Or Mostly Cloudy? Is It Partly Sunny Or Mostly Cloudy? These changes show that the underperformance of U.S. Treasuries (i.e. spread widening) has come mostly though higher real yields in the U.S. Inflation expectations are widening in the U.S., but are also moving higher in all other countries except the U.K. So the relative change in inflation expectations between the U.S. and the other countries has been more modest than the absolute change in U.S. TIPS breakevens (Chart 5). The fact that the real yield differentials are moving increasingly in favor of the U.S. has implications for the U.S. dollar. The greenback has finally begun to appreciate after the weakness seen in 2017, with potentially a lot more room to run judging by the levels implied by those wide real yield gaps. This is most evident for the euro, yen and British pound (Chart 6). Chart 5Higher Inflation Expectations##BR##& Yields In The U.S. Higher Inflation Expectations & Yields In The U.S. Higher Inflation Expectations & Yields In The U.S. Chart 6USD Finally Responding To Wide##BR##Real Yield Differentials USD Finally Responding To Wide Real Yield Differentials USD Finally Responding To Wide Real Yield Differentials The path of the U.S. dollar is the key to how this U.S./non-U.S. growth divergence story will end. If the dollar continues to strengthen as the Fed lifts rates in the coming months, then monetary conditions in the U.S. run the risk of moving into restrictive territory. This could spur a bout of renewed U.S. market turbulence not unlike that seen in 2015 and 2016 when the Fed was trapped in what we described at the time as a "policy loop", where a higher dollar and rising market volatility (especially in the emerging markets) prompted the Fed to delay planned rate hikes. The circumstances are different now compared to three years ago. The dollar is only mildly appreciating from the depressed levels of 2017, U.S. core inflation is approaching the Fed's 2% target, and the U.S. economy is at full employment with fiscal stimulus on the way. In other words, the hurdle for the Fed to alter its current rate hike plans is much higher than it was in 2015/16 when the U.S. economy and inflation were in more fragile states. For now, we continue to see relative growth and inflation trends pushing in a direction for continued U.S. government bond underperformance over the balance of 2018. One-sided bearish positioning may create a backdrop where Treasury yields could fall for a brief period, but the true cyclical peak in yields - somewhere in the 3.25-3.5% range - and in U.S./non-U.S. yield spreads has not been reached yet. Bottom Line: Relative growth and inflation trends continue to favor the U.S., with divergences widening as non-U.S. is downshifting. This means that the cyclical peak in spreads between U.S. Treasuries and other developed market government bonds has not been reached yet, and the latest bout of U.S. dollar strength can continue. Stay underweight U.S. Treasuries in global government bond portfolios. Italy: Worry More About Slowing Growth Than Politics Italian political risk returned to European financial markets last week after details of the policy program for the new Five-Star Movement/League coalition government were leaked to the press. Some of the more alarming proposals included: Having the European Central Bank (ECB) "freeze" or "cancel" the €250bn in Italian government debt it holds via its asset purchase program. Revising the rules of the European Union (EU) Growth and Stability Pact, specifically its fiscal rules on debt and deficits, while also asking for Europe to, more generally, return to a "pre-Maastricht" (pre-euro?) position. These headlines were interpreted as a sign that the populists taking over Italy were looking for a way to loosen fiscal policy in excess of EU rules, if not abandon the euro currency entirely. This would be a realization of the outcome from the March election that investors feared the most. Markets responded as expected, with Italian government bond yields soaring across the entire yield curve and Italian equities and the euro selling off (Chart 7). We last discussed Italy back in February in a Special Report co-written with our colleagues at BCA Geopolitical Strategy.1 We concluded that, even though euroskepticism would continue to have appeal in Italy because support for the common currency is much weaker than in the rest of the euro area (Chart 8), none of the likely coalition partners in a new government would make noise about potentially bringing back the lira with the economy in a cyclical expansion. All of the likely winning coalitions would seek to ease Italian fiscal policy, however, which would bring back investor worries about Italian debt sustainability. Chart 7The Return Of##BR##The Italy Risk Premium The Return Of The Italy Risk Premium The Return Of The Italy Risk Premium Chart 8The Euro Is Still Less Popular##BR##In Italy Than Elsewhere The Euro Is Still Less Popular In Italy Than Elsewhere The Euro Is Still Less Popular In Italy Than Elsewhere The first part of our conclusion went in a fashion that we did not expect, with the anti-establishment Five-Star party joining forces with the far-right League in a populist coalition that could embrace euroskepticism more emphatically. The second part of that conclusion does appear to be panning out, with the new government already looking to cut taxes and ramp up fiscal spending. These outcomes would be enough for investors to begin pricing in a higher fiscal risk premium in Italian assets, thus justifying the market moves seen last week. Yet there was one other conclusion from our report that is more relevant now for fixed income investors. Italian government bonds would not begin to underperform until there were signs that Italy's economy was slowing - which is what appears to be happening now. Like the rest of the euro area, Italy saw a deceleration of economic growth in the first quarter of the year. The most cyclical components of the Italian economy, manufacturing and exports, have both shown a considerable deceleration. Exports to non-EU countries, in particular, have noticeably slowed (Chart 9), which is likely yet another sign of how slowing Chinese growth is spilling over into much of the global economy through trade channels. Domestic demand has seen some cyclical strength on the back of the surge in exports, production and employment seen in 2016/17. However, the risk now is that slowing exports feed back into slowing production and weaker hiring activity. Any sign of a slowdown would only embolden the new coalition government to aim for easier fiscal policy. That would be a logical response by any government, particularly with current budget forecasts calling for tightening fiscal policy over the next few years. The latest set of debt and deficit projections from the IMF show that Italy is expected to have a balanced budget by 2021 (Chart 10). This would imply that the primary budget balance (i.e. net of interest payments) would rise to as high as 3.6% of GDP - an enormously restrictive policy stance that no advanced economy currently runs. Chart 9Italian Cyclical Momentum##BR##Has Peaked Italian Cyclical Momentum Has Peaked Italian Cyclical Momentum Has Peaked Chart 10This Rosy Trajectory For##BR##Italian Debt Will Not Happen This Rosy Trajectory For Italian Debt Will Not Happen This Rosy Trajectory For Italian Debt Will Not Happen That degree of fiscal tightening also makes the debt dynamics of Italy look much more sustainable, with debt/GDP projected to fall by ten percentage points by 2021 according to the IMF (bottom panel). Given the leanings of the new government, and with the economy starting to lose some momentum, there is zero chance that the IMF deficit and debt projections will come to fruition. In fact, the opposite is likely to happen under the new government, with the fiscal deficit likely to widen and debt/GDP likely to increase. While a return to the "bad old" economic policies of Italy might harken back to the days of the 2011 European debt crisis, there are two major differences between then and now: Italy's borrowing costs are far lower, thanks to the hyper-easy monetary policies of the ECB (both zero/negative interest rates and outright bond purchases). The average debt on newly-issued Italian government debt has plunged from the 6-7% levels around the time of the debt crisis to less than 1% over the past three years, according to the Bank of Italy (Chart 11). This has helped substantially reduce the amount of net interest payments made by the Italian government - by one full percentage point of GDP, according to the IMF. Less Italian debt is owned by non-Italian residents than during the crisis. According to data from the Bruegel think tank in Brussels, the percentage of Italian sovereign debt held by non-Italian residents is now 36%, compared to 50% during the years before the crisis (Chart 12). As that crisis unfolded, those investors rapidly dumped their Italian bonds, cutting their ownership share by ten percentage points in less than one year. Domestic Italian banks were forced to pick up the slack, which increased the already significant fiscal exposure of the Italian banking system. Now, the ownership mix is much more balanced, including the 20% of Italian bonds owned by the ECB. This means that, today, 64% of Italy's debt is owned by those with a vested interest in Italian stability, rather than fickle foreign investors who would be much more willing to dump their bonds when the Italian news turns less favorable. Chart 11The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today Chart 12A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 This is not to say that another Italian debt crisis could not happen, especially if the Five-Star/League coalition were to more seriously discuss a potential exit from the euro. The only difference now is that Italy's debt sustainability issues are not as acute as in 2011 because of the low borrowing costs and more diverse ownership of Italian debt. Chart 13Downgrade Italian Debt To Underweight Downgrade Italian Debt To Underweight Downgrade Italian Debt To Underweight From a bond strategy perspective, however, we are more focused on the growth dynamics in Italy than the current political noise. As we also concluded in our February Special Report, the time to downgrade Italian debt was when the economy was clearly about to slow, as heralded by a decline in the OECD's leading economic indicator for Italy. That series has been highly correlated to the relative performance of Italian government debt (Chart 13) and, therefore, is a useful indicator to follow to determine Italian bond strategy. With the leading indicator now falling for four consecutive months, and with hard Italian data also starting to slow, a period of Italian bond underperformance has likely just begun - an outcome that can only be made worse by the new euroskeptic and free spending Italian government. Thus, we are downgrading Italy in our country rankings this week to underweight (2 out of 5), and cutting our recommended allocations to Italian debt in our model bond portfolio to ½ index weight. We place the proceeds of that reduction into German bonds across the yield curve. Bottom Line: Concerns over the future policies of the new Five-Star/League populist coalition government in Italy have triggered a selloff in Italian financial markets. While investors are right to be worried about the potential for greater fiscal stimulus and move vocal euroskepticism from those in charge in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns. Downgrade Italy to underweight (2 of 5) in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Geopolitical Strategy Special Report, "Italy: Growth Cures All Ills ... For Now", dated February 21st 2018, available at gfis.bcaresearch.com and gps.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Is It Partly Sunny Or Mostly Cloudy? Is It Partly Sunny Or Mostly Cloudy? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights 0 To 3 Months: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. 6 to 12 Months: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. Total Return Forecasts: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Feature Chart 1Two Milestones Two Milestones Two Milestones The U.S. bond market reached one noteworthy milestone last week and is quickly closing in on another. The first milestone is that the 10-year Treasury yield decisively broke through the 3% level that had defined its most recent peak (Chart 1). The second milestone is that the market is now close to fully pricing-in the likely near-term path for Fed rate hikes. We noted in a recent report that the Fed's "gradual" rate hike path is quite clearly defined as one 25 basis point rate hike per quarter.1 This equates to 100 bps on our 12-month Fed Funds Discounter, which currently sits at 91 bps, just below this key level (Chart 1, bottom panel). We continue to see upside in Treasury yields on a cyclical horizon. Though tactically, the likelihood of a near-term pullback in yields has increased greatly during the past few days. In this week's report we outline the case for a near-term (0-3 month) pullback in Treasury yields, but also look ahead by introducing a simple framework investors can use to make total return forecasts for all different U.S. bond sectors. The Case For A Near-Term Pullback In addition to the fact that the market is closer to fully discounting the likely near-term path of rate hikes than it has been for some time, there are two other reasons to expect a near-term, temporary pullback in yields. The first is that the below-benchmark duration trade has become the consensus position in the market (Chart 2). Net speculative short positions in 10-year Treasury futures have rarely been greater, and since the financial crisis large net short positions have correlated quite strongly with a decline in the 10-year yield during the subsequent three months. Similarly, positions reported in the JP Morgan Duration Survey are firmly in "net short" territory for both the "all clients" and "active clients" surveys. The Marketvane survey of bond sentiment has also turned bearish for only the fourth time since 2010. Each of the other three times has coincided with a near-term drop in yields. Chart 2Bond Market Looks Oversold Bond Market Looks Oversold Bond Market Looks Oversold But positioning alone would not be enough to convince us that yields might decline in the near-term. Investors also need a catalyst. An excuse to take profits on large net short positions that have been working well. That catalyst is typically a period of worse-than-expected economic data. To judge the trend in economic data relative to expectations we turn to the Economic Surprise Index. Chart 3Economic Surprise Index Economic Surprise Index Economic Surprise Index In a report from last year we demonstrated that if the Economic Surprise Index ends a month below (above) the zero line, it is very likely that Treasury yields fell (rose) during that month.2 Also, we know that the surprise index is mean reverting by its very nature. A long period of positive (negative) data surprises will certainly be followed an upward (downward) revision to investors' economic expectations. Eventually expectations become so elevated (depressed) that they become impossible to surpass (disappoint). The index will then start to mean revert. In that same report from last year we also introduced a simple auto-regressive model of the surprise index, designed to capture its average speed of mean reversion. Based on that model, which is purely a function of the index's own lags, we would expect the surprise index to dip slightly into negative territory in one month's time (Chart 3). Though given the large amount of uncertainty in the model, a fairer assessment would be that it is no longer a given that the surprise index will remain above the zero line in the near-term. Bottom Line: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. Less nimble investors are better off riding out any potential near-term volatility and maintaining below-benchmark portfolio duration on a 6-12 month horizon. The Cyclical Picture Is Unchanged On a 6-12 month investment horizon, we are sticking with the playbook of our Two-Stage Bond Bear Market.3 The first stage is characterized by the re-anchoring of inflation expectations, and here, long-maturity TIPS breakeven inflation rates are still slightly below our target range of 2.3% to 2.5% (Chart 4). We also think bond investors should maintain an overweight allocation to spread product, though the time to trim exposure is approaching. Because the Fed's support for credit markets will weaken as inflation pressures mount, we will start reducing exposure to spread product once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are within our target 2.3% to 2.5% band. The intuition that the credit cycle is long in the tooth is further supported by the fact that the 2/10 Treasury curve is close to 50 bps (Chart 4, bottom panel). In a recent report we showed that while corporate bond excess returns relative to Treasuries usually remain positive until the yield curve inverts, they decline dramatically once the slope dips below 50 bps.4 Valuation also remains tight in the corporate bond market. While investment grade corporate bond spreads have widened in recent months, the junk spread is still close to its post-crisis low, as is the differential between the junk and investment grade spread (Chart 5). Chart 4Inflation Compensation Inflation Compensation Inflation Compensation Chart 5Flirting With The Lows Flirting With The Lows Flirting With The Lows The recent widening of investment grade corporate spreads appears to simply reflect a reversion to more reasonable valuation levels, after they had been extremely expensive at the start of the year. Chart 6 shows the 12-month breakeven spread for each investment grade credit tier. We look at the breakeven spread - defined as the spread widening required to lose money versus Treasuries on a 12-month horizon - in order to adjust for the changing duration of the index over time. Chart 6 also shows the breakeven spread as a percentile rank relative to history. In other words, it shows the percentage of time that the breakeven spread has been lower in the past. Notice that earlier in the year investment grade corporate spreads had been approaching all-time expensive levels. They are now closer to the 25th percentile, much more in line with similar spreads for the High-Yield credit tiers (Chart 7). Chart 6Investment Grade Breakeven Spreads Investment Grade Breakeven Spreads Investment Grade Breakeven Spreads Chart 7High-Yield Breakeven Spreads High-Yield Breakeven Spreads High-Yield Breakeven Spreads There is no longer a risk-adjusted opportunity in high-yield corporate bonds relative to investment grade. Bottom Line: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. A Simple Framework For Forecasting Total Returns In a recent report we observed that, using a 12-month investment horizon, the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.5 With that in mind, this week we extend that analysis to develop a simple framework for forecasting bond total returns. The framework relies on the fact that the "12-month rate hike surprise" described above is correlated with the 12-month change in Treasury yields. The Appendix to this report shows the historical correlation between the 12-month rate hike surprise and the 12-month change in several different par-coupon Treasury yields. Unsurprisingly, the correlation is very strong for short maturity yields, and gradually weakens as we move further out the curve. This is important because it means that the total return forecasts we generate from this exercise will be more accurate for bond sectors with low duration than for those with high duration. Table 1 shows the total return forecasts we generated for the Bloomberg Barclays Treasury Master Index and for several of its maturity buckets. The results are presented in such a way that readers can impose their own forecasts for the number of Fed rate hikes that will occur during the next 12 months, and then map that forecast to a reasonable expectation for Treasury total returns. Table 1Treasury Index Total Return Forecasts Pulling Back And Looking Ahead Pulling Back And Looking Ahead For example, in a scenario where the Fed lifts rates four times (100 bps) during the next year, given current market pricing the rate hike surprise will be modestly negative.6 Using the historical correlations shown in the Appendix, we map that rate hike surprise to changes in the par-coupon Treasury curve and then use the duration and convexity attributes of each individual index to determine how that shift in the Treasury curve will impact index returns. In the scenario described above we would expect the Treasury Master Index to return +2.13% during the next year. While this is a slightly positive number, it is close enough to zero that it does not provide much insulation from changes in long-dated yields that are unrelated to the near-term path for rate hikes. Further, in the four rate hike scenario, investors moving from the Treasury Master Index to the 1-3 year index need only sacrifice 12 bps of expected return to reduce their duration risk by a factor of three. Such a risk/reward trade-off clearly favors a below-benchmark duration stance on a 12-month investment horizon. Table 2 repeats the same exercise but for the major spread sectors of the U.S. bond market. To estimate spread sector total returns we need to forecast both the shift in the Treasury curve and whether spreads will widen, tighten or remain constant. Specifically, we assume that spreads either widen or tighten by the standard deviation of annual spread changes for each index, calculated using a post-crisis interval. Table 2Spread Product Total Return Forecasts Pulling Back And Looking Ahead Pulling Back And Looking Ahead The results show that, in a four rate hike scenario, we should expect 12-month investment grade corporate bond total returns of approximately 3.4%, assuming also that spreads stay flat. In a scenario where the average index spread widens by 42 bps, we should expect total returns of only 1%. Bottom Line: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Spread product returns should continue to beat Treasuries for the time being, but the window for outperformance is starting to close. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix Chart 8Change In 1-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Pulling Back And Looking Ahead Pulling Back And Looking Ahead Chart 9Change In 2-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Pulling Back And Looking Ahead Pulling Back And Looking Ahead Chart 10Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Pulling Back And Looking Ahead Pulling Back And Looking Ahead Chart 11Change In 5-Year Yield Vs.12-Month ##br##Fed Funds Rate Surprise Pulling Back And Looking Ahead Pulling Back And Looking Ahead Chart 12Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Pulling Back And Looking Ahead Pulling Back And Looking Ahead Chart 13Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Pulling Back And Looking Ahead Pulling Back And Looking Ahead Chart 14Change In 30-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Pulling Back And Looking Ahead Pulling Back And Looking Ahead 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", dated May 8, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 6 The 12-month rate hike surprise is defined as the 12-month Fed Funds Discounter less the actual change in the fed funds rate during the following 12 months. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? A Breakdown In The Making? A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator bca.ems_wr_2018_05_17_s1_c4 bca.ems_wr_2018_05_17_s1_c4 Chart I-5China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits bca.ems_wr_2018_05_17_s1_c8 bca.ems_wr_2018_05_17_s1_c8 Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels ...At Low Levels ...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Brazil: Exports Are Slowing Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Global Volatility Vs. Inflation: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Feature Chart of the WeekThe Comeback Kids The Comeback Kids The Comeback Kids After a lengthy period of convalescence following the February VIX spike, some calm has been restored to financial markets. Global equities are staging a recovery from the correction seen earlier this year, with major indices like the U.S. S&P 500 and the MSCI All-Country World Index breaking out above key technical levels last week (Chart of the Week). Volatility in developed economy credit has also died down a bit, although corporate bond spreads still remain above the lows of the year in most countries. The resiliency of risk assets is even more impressive when viewed against the continuing climb of oil prices, fueled further by President Trump's announcement last week that the U.S. was pulling out of the Iran nuclear deal. With the benchmark Brent oil price now within hailing distance of $80/bbl, developed market government bond yields remain under upward pressure through higher inflation expectations (bottom panel). Yet as been the case for the past several months, the greatest upward pressure on global bond yields has been seen in the U.S., where the benchmark 10-year Treasury yield is once again knocking on the door of the 3% level. Global growth has lost some momentum in the first few months of the year, but not by enough to cause any loosening of capacity pressures through rising unemployment rates. Until the latter occurs, central banks will remain focused on the slow-but-steady rise in inflation pressures. This will limit any material decline in government bond yields as markets must price in both higher inflation expectations and some degree of interest rate increases. Not every central bank will deliver on what is currently discounted in terms of rate hikes, however, which continues to create more attractive relative fixed income country allocation opportunities now than have been seen in the past few years. We continue to recommend an overall below-benchmark portfolio duration stance, favoring corporate credit over sovereign debt. Within dedicated government bond portfolios, we favor underweight exposures in the U.S., Canada and core Europe while overweighting Australia, the U.K. and Japan. Lower U.S. Volatility Does Not Necessarily Mean Greater Global Stability The surge in market volatility earlier in the year began in the U.S. following the "wage inflation scare" in early February. The idea that dormant U.S. wage inflation could finally have awakened shook markets out of their slumber, driving the VIX index sharply higher (with some nudging from volatility-linked ETFs and other leveraged vehicles). Yet other markets saw a surge in vol, like currencies and the MOVE index of U.S. Treasury option prices (Chart 2). The latter development underscores one of our key investment themes for 2018, which is that the low market volatility environment will end through higher bond volatility.1 Faster U.S. inflation was expected to be trigger for that pickup in U.S. bond volatility, which would lead to a more aggressive path of Fed rate hikes and more uncertainty about the U.S. growth outlook beyond 2018. We did not expect that inflation-driven surge in bond volatility until the latter half of this year, but what happened in early February showed how the investing backdrop can turn ugly once inflation makes a comeback. Looking ahead, the subdued readings from the Chicago Board Options Exchange VVIX index, which measures the implied volatility of VIX options, indicate that the VIX can continue to head lower in the coming weeks (top panel). Combined with some easing of pressures seen in funding markets through the wider LIBOR-OIS spread (bottom panel), the backdrop is in place for continued recovery in U.S. equity and credit markets. It's a different story in non-U.S. markets, however. Softening global growth in the first quarter of the year, combined with steady increases in U.S. interest rate hike expectations, has resulted in the U.S. dollar staging a recovery after the pounding it took in 2017 (Chart 3). That combination of higher U.S. bond yields, a stronger dollar and weaker growth is a classic toxic brew for Emerging Market (EM) assets, which have been underperforming under the weight of investor outflows. None of those factors looks set to reverse in the near term, and we continue to recommend underweight allocations to EM fixed income (especially corporate debt). Chart 2The VIX Storm Has Blown Over The VIX Storm Has Blown Over The VIX Storm Has Blown Over Chart 3Not All Risk Assets Have Been Stabilizing Not All Risk Assets Have Been Stabilizing Not All Risk Assets Have Been Stabilizing Within the major developed markets, the most important factor at the moment is diverging inflation trends rather than growth. While U.S. inflation continues to drift higher, inflation in the euro area and U.K. has lost momentum (Chart 4). Surprisingly, Japanese inflation has finally started to show a bit of life - even after a period of yen appreciation - but perhaps that is because domestic inflation is finally awakening with annual wage growth hitting a 15-year high of 2.1% in March (3rd panel). Core inflation remains well below the Bank of Japan's 2% target, however. Meanwhile, last week's release of the April U.S. CPI data showed that inflation was still moving higher despite the outcome being slightly worse than expected (Chart 5). Importantly, some large and important elements of the CPI, like Shelter costs (33% of the total CPI index) and core goods prices (20%), saw a pickup in year-over-year inflation in line with our models and leading indicators. Given that U.S. real GDP growth leads core CPI inflation by about five quarters (top panel), this suggests that all of our inflation indicators are pointing to additional increases in U.S. inflation in the next 3-6 months. Chart 4Diverging Trends In Global Inflation Diverging Trends In Global Inflation Diverging Trends In Global Inflation Chart 5U.S. Inflation Momentum Still Trending Higher U.S. Inflation Momentum Still Trending Higher U.S. Inflation Momentum Still Trending Higher With U.S. inflation heading higher and non-U.S. developed market inflation languishing, there is still much more upside risk for U.S. Treasury yields than for the other government bond markets, mostly via higher U.S. inflation expectations. Stay underweight the U.S. within global hedged bond portfolios and remain long U.S. inflation protection by favoring TIPS over nominal Treasuries. Bottom Line: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: Outperformance To Continue Under New RBNZ Leadership Chart 6Good Timing On Our Bullish NZ Call Good Timing On Our Bullish NZ Call Good Timing On Our Bullish NZ Call One of the more successful trade recommendations we have made over the past year was to go long New Zealand government bonds versus U.S. Treasuries and German government debt in May 2017.2 Our call was predicated on a simple premise. The Reserve Bank of New Zealand (RBNZ) would maintain a dovish policy bias far longer than markets were expecting because of subdued inflation, at a time when the Fed would be hiking interest rates and the markets would begin to discount an end to the ECB's asset purchase program. Since we initiated that recommendation one year ago, headline New Zealand CPI inflation has slowed from 1.9% to 1%, while the RBNZ has kept policy rates unchanged. The spread between 5-year New Zealand government debt and 5-year U.S. Treasuries has collapsed from +74bps to -56bps, while the 5-year New Zealand-Germany spread has tightened from 292bps to 234bps. The overall New Zealand government bond index has outperformed the Barclays Global Treasury index by 120bps, currency hedged into U.S. dollars (Chart 6). Looking ahead, it may prove difficult to repeat those numbers from current levels. Yet it is even more challenging to construct a bearish case for New Zealand debt - the economy still looks sluggish, inflation is languishing well below the RBNZ target, and there have been changes at the central bank that will likely keep a dovish bias to New Zealand monetary policy. A Big Shakeup At The RBNZ There are several major moves that have just taken place at the RBNZ that should ensure that the central bank will not be raising rates anytime soon. First, Adrian Orr took over as RBNZ Governor back in March, replacing Graeme Wheeler. Orr was the Chief Executive of the New Zealand government pension (superannuation) fund, but was also a former RBNZ Chief Economist and Deputy Governor. He has stated an intention to make the RBNZ a more open, communicative central bank than Wheeler, who shunned media interviews and limited the number of on-the-record speeches by RBNZ officials. This will make the central bank a more transparent entity and limit the ability of the central bank from doing unexpected policy moves, as it has done in the past. The transparency will increase next year when the RBNZ moves to a full policy committee approach, where interest rates will be decided by a vote rather than a decision solely made by the Governor. Second, the New Zealand government has altered the RBNZ's monetary policy mandate following a review after the victory by the Labour party in last year's election. The central bank must now not only target price stability, but also seek to "maximize sustainable employment" in the New Zealand economy, not unlike the dual mandates of the U.S. Federal Reserve or Reserve Bank of Australia. This marks a major shift for the RBNZ, which was the first central bank to introduce an official inflation target in 1989. This change fulfils the new Labour-led government's campaign promise to promote job creation, which also includes restricting immigration. New Zealand Finance Minister Grant Robertson did state last November that the government would only consider candidates for RBNZ Governor that would be "willing and ready to adopt the new processes" of its review of the RBNZ's policy mandate.3 Robertson also noted that the new framework might result in monetary policy staying more accommodative from time to time. This smacks of increased government pressure on the RBNZ to keep policy as loose as possible to boost economic growth. Governor Orr has already had to go on the defensive, publicly stated that the central bank had "always" been considering short-term swings in employment when making its interest rate decisions. At a minimum, the case for future interest rate increases would have to be very strong under the new policy framework, focused on inflation seriously threatening the upside of the RBNZ's 1-3% target band. Economy Looking Sluggish After last week's monetary policy meeting, where the central bank kept the Overnight Cash Rate at 1.75% and downgraded its growth projections, Orr noted that the markets had "finally seemed to listen" to the RBNZ's message that policy rates would be on hold for a long time. He pointed to the decline in the New Zealand dollar (NZD) to a six-month low following the meeting as a "good thing for a trading nation" like New Zealand.4 His blunt, yet cautious, tone fits with developments in the New Zealand economy of late. Growth slowed over the course of 2017, with real GDP expanding at a 2.9% year-over-year rate in the fourth quarter after averaging 3.5% growth since 2014. The two major drags on growth were consumer spending and residential investment, both of which decelerated from unsustainably high growth rates in the prior few years that were fueled by high rates of net immigration (Chart 7). In the May 2018 Monetary Policy Report (MPR) released last week, the RBNZ noted that it expects net immigration to fall for three reasons: a strengthening Australian labor market, tighter visa requirements and the departure of those with temporary visas.5 The RBNZ is projecting immigration levels will steadily decline over the next four years, returning to levels last seen in 2011 in 2020, which will cause consumer spending growth to slow from over 4% to 2% by the end of the projection period (middle panel). That will also act as a major drag on housing activity, with no significant growth in real residential investment expected until 2020 (bottom panel). This will come on top of other regulatory changes introduced in 2016 to cool an overheated housing market (limiting loan-to-value ratios on mortgage lending). The RBNZ now expects real GDP growth to slow to 2.8% in 2018, a pace below its estimate of potential GDP growth of 3.2%. Not only is consumer spending and housing expected to slow, but the business sector is also projected to remain sluggish. Business confidence and capacity utilization are both well off the 2017 peak, thanks mainly to the slump in the dairy sector, which remains a critical part of the New Zealand economy (Chart 8). The fall in dairy prices and milk production was reportedly caused by poor weather conditions and falling demand from China, but the declines may be bottoming out (bottom panel). Besides the agricultural sectors, manufacturing and service sectors are still in decent shape, with the PMIs for both still above 50 even after last year's declines (top panel). The softer China demand story is not just about dairy, however. Growth in overall export demand from China has slowed dramatically over the past year, from 50% year-on-year down to -4.3% in March (Chart 9, 2nd panel). Australian export demand has also decelerated, which is critical given that those two countries represent 40% of total New Zealand exports. The RBNZ export survey, which has been a reliable leading indicator for New Zealand export growth, shows that exports are likely to continue falling over the next 6-8 months (top panel). With the overall commodity price index have clearly slowed (bottom panel), it is likely that the terms of trade will remain a drag on New Zealand economic growth, and the NZD, through a deteriorating current account deficit (now -3% of GDP) in the coming months. Chart 7Immigration-Fueled Growth Set To Reverse In NZ Immigration-Fueled Growth Set To Reverse In NZ Immigration-Fueled Growth Set To Reverse In NZ Chart 8Dairy Still Matters For NZ Dairy Still Matters For NZ Dairy Still Matters For NZ Chart 9NZ Exports Getting Hit NZ Exports Getting Hit NZ Exports Getting Hit Where's The Inflation? Despite the recent cooling of growth, the New Zealand unemployment rate is well below the OECD's estimate of the full employment NAIRU. Unlike other developed market countries with low unemployment rates, however, New Zealand's labor force participation rate is currently close to an historical high near 71% (Chart 10). While a high participation rate should mean that New Zealand is truly at full employment, wage growth remains anemic even with booming levels of job vacancies (3rd panel). The growth in average hourly pay for overall workers is still below the rate of headline CPI inflation, although this will get a bump with a 4.8% minimum wage increase being adapted last month. Overall, New Zealand's headline CPI inflation reached the RBNZ's target rate only once in Q1 2017, after several years of staying below that 2% benchmark, then started to slow down again over the rest of last year (Chart 11). Currently, headline and core CPI inflation are only 1.1% and 0.9%, respectively. This is now at the lower bound of the RBNZ's 1-3% target band, justifying the central bank's dovish bias. Chart 10Low Unemployment With No Wage Growth Low Unemployment With No Wage Growth Low Unemployment With No Wage Growth Chart 11No Inflation Problems For The New RBNZ Governor No Inflation Problems For The New RBNZ Governor No Inflation Problems For The New RBNZ Governor Within the main components of the index, non-tradables (i.e. domestically based) inflation has maintained stable growth near 2%, but tradables (i.e. globally based) prices are in outright deflation. This remains the biggest source for the undershoot of the RBNZ's inflation target over the past year - shockingly, a period when oil prices surged higher and the trade-weighted NZD softened. Yet the low levels of inflation are not filtering though into household expectations, with survey data showing that inflation is expected to stay above 2% next year, and even rise to 3% over the next five years. Policy To Stay On Hold For A Lot Longer The RBNZ is not as optimistic as households on inflation, however. The central bank is projecting that the headline CPI index will only rise by 1.1% in 2018 and will not return to the 2% target until 2021. On the back of this, the RBNZ is also projecting that the Overnight Cash Rate will remain at 1.75% until the end of 2020. Chart 12NZ Bonds Will Continue To Outperform NZ Bonds Will Continue To Outperform NZ Bonds Will Continue To Outperform The market is still pricing in one 25bp rate hike over the next 12 months, according to our calculations from the Overnight Index Swaps market (Chart 12). We see no reason for the RBNZ to not be taken at its word about holding rates steady, especially given the new dovish elements of the RBNZ's revised mandate. With price and wage inflation still so surprisingly low, the RBNZ can go for its maximum employment mandate and maintain highly accommodative monetary conditions. This includes both low policy rates and keeping the currency as weak as possible. We would recommend leaning against the mild increase in New Zealand bond yields, and the modest flattening of the yield curve, currently priced into the forwards (3rd and 4th panels). That suggests maintaining an above-benchmark duration stance for dedicated New Zealand fixed income investors. It also means adapting a bullish stance on New Zealand government bonds from a relative perspective to other developed markets. We are maintaining our current recommended spread trades for 5-year New Zealand bonds versus 5-year U.S. Treasuries and 5-year German debt. We have maintained the U.S. trade on a currency-hedged basis, as we typically do with all our recommendations. For the New Zealand-Germany spread trade, however, we made a rare exception and entered that trade on an unhedged basis. This was because we had a strong view that the euro would depreciate against most major currencies last year, including the NZD. That did not occur last year as the euro surged higher, which meant that our New Zealand-Germany trade took losses as NZD/EUR declined. For now, we are keeping that trade on an unhedged basis given the depressed level of NZD/EUR, but we will keep a tight stop going forward in the event of a broader breakdown in the NZD. Bottom Line: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 https://www.reuters.com/article/us-newzealand-economy-finmin/new-zealand-finance-minister-says-new-rbnz-governor-must-take-on-dual-mandate-idUSKBN1DG0EY?il=0 4 https://www.reuters.com/article/us-newzealand-economy-rbnz-orr/rbnz-governor-says-markets-finally-getting-the-hint-on-low-rates-idUSKBN1IC0LS 5 https://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement/mps-may-2018 Recommendations The GFIS Recommended Portfolio Vs. 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