Gov Sovereigns/Treasurys

Highlights Macro Outlook: Global growth is decelerating and the composition of that growth is shifting back towards the United States. Policy backdrop: The specter of trade wars represents a real and immediate threat to risk assets. Meanwhile, many of the "policy puts" that investors have relied on have been marked down to a lower strike price. Global equities: We downgraded global equities from overweight to neutral on June 19th. Investors should favor developed market equities over their EM counterparts. Defensive stocks will outperform deep cyclicals, at least until the dollar peaks early next year. Government bonds: Treasury yields may dip in the near term, but will rise over a 12-month horizon. Overweight Japan, Australia, New Zealand, and the U.K. relative to the U.S., Canada, and the euro area. Credit: The current level of spreads points to subpar returns over the next 12 months. We have a modest preference for U.S. over European corporate bonds. Currencies: EUR/USD will fall into the $1.10-to-1.15 range during the next few months. The downside risks for the pound and the yen are limited. Avoid EM and commodity currencies. The risk of a large depreciation in the Chinese yuan is rising. Commodities: Favor oil over metals. Gold will do well over the long haul. Feature I. Macro Outlook Back To The USA The global economy experienced a synchronized expansion in 2017. Global real GDP growth accelerated to 3.8% from 3.2% in 2016. The euro area, Japan, and most emerging markets moved from laggards to leaders in the global growth horse race. The opposite pattern has prevailed in 2018. Global growth has slowed, a trend that is likely to continue over the next few quarters judging by a variety of leading economic indicators (LEIs) (Chart 1). The U.S. has once again jumped ahead of its peers: It is the only major economy where the LEI is still rising (Chart 2). The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth. Chart 1Global Growth Is Slowing Again Global Growth Is Slowing Again Global Growth Is Slowing Again Chart 2U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers Such a lofty pace of growth cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48-year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows (Chart 3). For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 4). Chart 3U.S. Is Back To Full Employment U.S. Is Back To Full Employment U.S. Is Back To Full Employment Chart 4There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Mainstream economic theory states that governments should tighten fiscal policy as the economy begins to overheat in order to accumulate a war chest for the next inevitable downturn. The Trump administration is doing the exact opposite. The budget deficit is set to widen to 4.6% of GDP next year on the back of massive tax cuts and big increases in government spending (Chart 5). Chart 5The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Fed In Tightening Mode As the labor market overheats, wages will accelerate further. Average hourly earnings surprised to the upside in May. The Employment Cost Index for private-sector workers - one of the cleanest and most reliable measures of wage growth - rose at a 4% annualized pace in the first quarter. The U.S. labor market has finally moved onto the 'steep' side of the Phillips curve (Chart 6). Rising wages will put more income into workers' pockets who will then spend it. As aggregate demand increases beyond the economy's productive capacity, inflation will rise. The New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already leaped to over 3% (Chart 7). The prices paid components of the ISM and regional Fed purchasing manager surveys have also surged (Chart 8). Chart 6Wage Inflation Will Accelerate Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 7U.S. Inflation: Upside Risks (Part I) U.S. Inflation: Upside Risks (Part I) U.S. Inflation: Upside Risks (Part I) Chart 8U.S. Inflation: Upside Risks (Part II) U.S. Inflation: Upside Risks (Part II) U.S. Inflation: Upside Risks (Part II) The Fed has a symmetric inflation target. Hence, a temporary increase in core PCE inflation to around 2.2%-to-2.3% would not worry the FOMC very much. However, a sustained move above 2.5% would likely prompt an aggressive response. The fact that the unemployment rate has fallen 0.7 percentage points below the Fed's estimate of full employment may seem like a cause for celebration, but this development has a dark side. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without this coinciding with a recession (Chart 9). The Fed wants to avoid a situation where the unemployment rate has fallen so much that it has nowhere to go but up. Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle As such, we think that the bar for the Fed to abandon its once-per-quarter pace of rate hikes is quite high. If anything, the risk is that the Fed expedites monetary tightening in order to keep real rates on an upward trajectory. Jay Powell's announcement that he will hold a press conference at the conclusion of every FOMC meeting opens the door for the Fed to move back to its historic pattern of hiking rates once every six weeks. Housing And The Monetary Transmission Mechanism Economists often talk about the "monetary transmission mechanism." As Ed Leamer pointed out in his 2007 Jackson Hole symposium paper succinctly entitled, "Housing Is The Business Cycle," housing has historically been the main conduit through which changes in monetary policy affect the real economy.1 A house will last a long time, and the land on which it sits - which in many cases is worth more than the house itself - will last forever. Thus, changes in real interest rates tend to have a large impact on the capitalized value of one's home. Today, the U.S. housing market is in pretty good shape (Chart 10). Construction activity was slow to increase in the aftermath of the Great Recession. As a result, the vacancy rate stands at ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2005 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Lenders remain circumspect (Chart 11). The ratio of mortgage debt-to-disposable income has barely increased during the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. Chart 10U.S. Housing Is In Pretty Good Shape U.S. Housing Is In Pretty Good Shape U.S. Housing Is In Pretty Good Shape Chart 11Mortgage Lenders Remain Circumspect Mortgage Lenders Remain Circumspect Mortgage Lenders Remain Circumspect The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. If Not Housing, Then What? Since the U.S. housing sector is in reasonably good shape, the Fed may need to slow the economy through other means. Here's the rub though: Other sectors of the economy are not particularly sensitive to changes in interest rates. Decades of empirical data have clearly shown that business investment is only weakly correlated with the cost of capital. Unlike a house, most business investment is fairly short-lived. A computer might be ready for the recycling heap in just a few years. The Bureau of Economic Analysis estimates that the depreciation rate for nonresidential assets is nearly four times higher than for residential property (Chart 12). During the early 1980s, when the effective fed funds rate reached 19%, residential investment collapsed but business investment was barely affected (Chart 13). Chart 12U.S.: Depreciation Rate For Business ##br##Investment Is Much Larger Than For Residential Property U.S.: Depreciation Rate For Business Investment Is Much Larger Than For Residential Property U.S.: Depreciation Rate For Business Investment Is Much Larger Than For Residential Property Chart 13Residential Investment Collapsed In ##br##Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Rising rates could make it difficult for corporate borrowers to pay back loans, which could indirectly lead to lower business investment. That said, a fairly pronounced increase in rates may be necessary to generate significant distress in the corporate sector, given that interest payments are close to record-lows as a share of cash flows (Chart 14). In addition, corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. A stronger dollar would cool the economy by diverting some spending towards imports. However, imports account for only 16% of GDP. Thus, even large swings in the dollar's value tend to have only modest effects on the economy. Likewise, higher interest rates could hurt equity prices, but the wealthiest ten percent of households own 93% of all stocks. Hence, it would take a sizable drop in the stock market to significantly slow GDP growth. The conventional wisdom is that the Fed will need to hit the pause button at some point next year. The market is pricing in only 85 basis points in rate hikes between now and the end of 2020 (Chart 15). That assumption may be faulty, considering that housing is in good shape and other sectors of the economy are not especially sensitive to changes in interest rates. Rates may need to go quite a bit higher before the U.S. economy slows materially. Chart 14U.S. Corporate Sector Interest Payments ##br##At Near Record-Low Levels As A Share Of Cash Flows U.S. Corporate Sector Interest Payments At Near Record-Low Levels As A Share Of Cash Flows U.S. Corporate Sector Interest Payments At Near Record-Low Levels As A Share Of Cash Flows Chart 15Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Global Contagion Investors and policymakers talk a lot about the neutral rate of interest. Unfortunately, the discussion is usually very parochial in nature, inasmuch as it focuses on the interest rate that is consistent with full employment and stable inflation in the United States. But the U.S. is not an island unto itself. Even if a bit outdated, the old adage that says that when the U.S. sneezes the rest of the world catches a cold still rings true. What if there is a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain within the U.S. itself? Eighty per cent of EM foreign-currency debt is denominated in U.S. dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 16). Just like in that era, a vicious cycle could erupt where a stronger dollar makes it difficult for EM borrowers to pay back their loans, leading to capital outflows from emerging markets, and an even stronger dollar. The wave of EM local-currency debt issued in recent years only complicates matters (Chart 17). If EM central banks raise rates, this could help prevent their currencies from plunging. However, higher domestic rates will make it difficult for local-currency borrowers to pay back their loans. Damned if you do, damned if you don't. Chart 16EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 17EM Borrowers Like Local Credit Too EM Borrowers Like Local Credit Too EM Borrowers Like Local Credit Too China To The Rescue? Don't Count On It When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 18). Property prices in tier one cities are down year-over-year. Construction tends to follow prices. So far, the policy response has been muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 19). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approval rates are dropping (Chart 20). Chart 18Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 19China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 20China: Credit Tightening China: Credit Tightening China: Credit Tightening There is no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities will be willing to respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Rising Risk Of Another RMB Devaluation Chart 21China: Currency Wars Are Good And ##br##Easy To Win China: Currency Wars Are Good And Easy To Win China: Currency Wars Are Good And Easy To Win Even if China does stimulate the economy, it may try to do so by weakening the currency rather than loosening fiscal and credit policies. Chart 21 shows that the yuan has fallen much more over the past week than one would have expected based on the broad dollar's trend. The timing of the CNY's recent descent coincides with President Trump's announcement of additional tariffs on $200 billion of Chinese goods. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by a sufficient amount to flush out expectations of a further decline. China was too timid, and paid the price. Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a geopolitical war with the United States. The U.S. exported only $188 billion of goods and services to China, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, a currency war from China's perspective may be, to quote Donald Trump, "good and easy to win." The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Trump And Trade Needless to say, any effort by the Chinese to devalue their currency would invite a backlash from the Trump administration. However, since China is already on the receiving end of punitive U.S. trade actions, it is not clear that the marginal cost to China would outweigh the benefits of having a more competitive currency. The truth is that there may be little that China can do to fend off a trade war. Protectionism is popular among American voters, especially among Trump's base (Chart 22). Donald Trump ran on a protectionist platform, and he is now trying to deliver on his promise of a smaller trade deficit. Whether he succeeds is another story. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All of this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a current account deficit with the place where I eat lunch and they run a capital account deficit with me - they give me food and I give them cash - but I don't go around complaining that they are ripping me off. A trade war would be much more damaging to Wall Street than Main Street. While trade is a fairly small part of the U.S. economy, it represents a large share of the activities of the multinational companies that comprise the S&P 500. Trade these days is dominated by intermediate goods (Chart 23). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. Chart 22Free Trade Is Not In Vogue In The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 23Trade In Intermediate Goods Dominates Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 per cent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. Now scale that up by a factor of 100. That is what a global trade war would look like. The Euro Area: Back In The Slow Lane Euro area growth peaked late last year. Real final demand grew by 0.8% in Q4 of 2017 but only 0.2% in Q1 of 2018. The weakening trend was partly a function of slower growth in China and other emerging markets - net exports contributed 0.41 percentage points to euro area growth in Q4 but subtracted 0.14 points in Q1. Domestic factors also played a role. Most notably, the euro area credit impulse rolled over late last year, taking GDP growth down with it (Chart 24).2 It is too early to expect euro area growth to reaccelerate. German exports contracted in April. Export expectations in the Ifo survey sank in June to the lowest level since January 2017, while the export component of the PMI swooned to a two-year low. We also have yet to see the full effect of the Italian imbroglio on euro area growth. Italian bond yields have come down since spiking in April, but the 10-year yield is still more than 100 basis points higher than before the selloff (Chart 25). This amounts to a fairly substantial tightening in financial conditions in the euro area's third largest economy. And this does not even take into account the deleterious effect on Italian business confidence. Chart 24Peak In Euro Area Credit Impulse Last Year##br## Means Slower Growth This Year Peak In Euro Area Credit Impulse Last Year Means Slower Growth This Year Peak In Euro Area Credit Impulse Last Year Means Slower Growth This Year Chart 25Uh Oh Spaghetti-O Uh Oh Spaghetti-O Uh Oh Spaghetti-O If You Are Gonna Do The Time, You Might As Well Do The Crime At this point, investors are basically punishing Italy for a crime - defaulting and possibly jettisoning the euro - that it has not committed. If you are going to get reprimanded for something you have not done, you are more likely to do it. Such a predicament can easily create a vicious circle where rising yields make default more likely, leading to falling demand for Italian debt and even higher yields (Chart 26). The fact that Italian real GDP per capita is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 27). Chart 26When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 27Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy The ECB could short-circuit this vicious circle by promising to backstop Italian debt no matter what. But it can't make such unconditional promises. Recall that prior to delivering his "whatever it takes" speech in 2012, Mario Draghi and his predecessor Jean-Claude Trichet penned a letter to Silvio Berlusconi outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated Berlusconi's resignation after they were leaked to the public. One of the reforms that Draghi and Trichet demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current leaders promised to reverse that decision during the election campaign. While they have softened their stance since then, they will still try to deliver on much of their populist agenda over the coming months, much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Italy's Macro Constraints Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from an aging population that is trying to save more for retirement. Italian companies do not want to invest in new capacity because the working-age population is shrinking, which limits future domestic demand growth. Thus, the private sector is a chronic net saver, constantly wanting to spend less than it earns (Chart 28). Italy is not unique in facing an excess of private-sector savings. However, Italy is unique in that the solutions available to most other countries to deal with this predicament are not available to it. Broadly speaking, there are two ways you can deal with excess private-sector savings. Call it the Japanese solution and the German solution. The Japanese solution is to have the government absorb excess private-sector savings with its own dissavings. This is tantamount to running large, sustained fiscal deficits. Italy's populist coalition Five Star-Lega government tried to pursue this strategy, only to have the bond vigilantes shoot it down. The German solution is to ship excess savings out of the country through a large current account surplus (in Germany's case, 8% of GDP). However, for Italy to avail itself of this solution, it would need to have a hypercompetitive economy, which it does not. Unlike Spain, Italy's unit labor costs have barely declined over the past six years relative to the rest of the euro area, leaving it with an export base that is struggling to compete abroad (Chart 29). Chart 28The Italian Private Sector Wants To Save The Italian Private Sector Wants To Save The Italian Private Sector Wants To Save Chart 29Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Since there is little that can be done in the near term that would improve Italy's competitiveness vis-à-vis the rest of the euro area, the only thing the ECB can do is try to improve Italy's competitiveness vis-à-vis the rest of the world. This means keeping monetary policy very loose and hoping that this translates into a weak euro. II. Financial Markets Downgrade Global Risk Assets From Overweight To Neutral Investors are accustomed to thinking that there is a "Fed put" out there - that the Fed will stop raising rates if growth slows and equity prices fall. This was a sensible assumption a few years ago: The Fed hiked rates in December 2015 and then stood pat for 12 months as the global economic backdrop darkened. These days, however, the Fed wants slower growth. And if weaker asset prices are the ticket to slower growth, so be it. The "Fed put" may still be around, but the strike price has been marked down to a lower level. Likewise, worries about growing financial and economic imbalances will limit the efficacy of the "China stimulus put" - the tendency for the Chinese government to ease fiscal and credit policy at the first hint of slower growth. The same goes for the "Draghi put." The ECB is hoping, perhaps unrealistically so, to wind down its asset purchase program later this year. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. The loss of these three policy puts, along with additional risks such as rising protectionism, means that the outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we downgraded our 12-month recommendation on global risk assets from overweight to neutral last week. Fixed-Income: Stay Underweight Chart 30U.S. Corporate Bonds: Leverage-Adjusted Value U.S. Corporate Bonds: Leverage-Adjusted Value U.S. Corporate Bonds: Leverage-Adjusted Value A less constructive stance towards equities would normally imply a more constructive stance towards bonds. Global bond yields could certainly fall in the near term, as EM stress triggers capital flows into safe-haven government bond markets. However, if we are really in an environment where an overheated U.S. economy and rising inflation force the Fed to raise rates more than the market expects, long-term bond yields are likely to rise over a 12-month horizon. As such, asset allocators should move the proceeds from equity sales into cash. The U.S. yield curve might still flatten in this environment, but it would be a bear flattening - one where long-term yields rise less than short-term rates. Bond yields are strongly correlated across the world. Thus, an increase in U.S. Treasury yields over the next 12 months would likely put upward pressure on bond yields abroad, even if inflation remains contained outside the United States. BCA's Global Fixed Income Strategy service favors Japan, Australia, New Zealand, and the U.K. over the U.S., Canada, and euro area bond markets. Investors should also pare back their exposure to spread product. Our increasing caution towards equities extends to the corporate bond space. BCA's U.S. Corporate Health Monitor (CHM) remains in deteriorating territory. With profits still high and bank lending standards continuing to ease, a recession-inducing corporate credit crunch is unlikely over the next 12 months. Nevertheless, our models suggest that both investment grade and high yield credit are overvalued (Chart 30). In relative terms, our fixed-income specialists have a modest preference for U.S. over European credit. The near-term growth outlook is more challenging in Europe. The ECB is also about to wind down its bond buying program, having purchased nearly 20% of all corporate bonds in the euro area over the course of only three years. Currencies: King Dollar Is Back The U.S. dollar is a counter-cyclical currency, meaning that it tends to do well when the global economy is decelerating (Chart 31). If the Chinese economy continues to weaken, global growth will remain under pressure. Emerging market currencies will suffer in this environment especially if, as discussed above, the Chinese authorities engineer a devaluation of the yuan. Momentum is moving back in the dollar's favor. Chart 32 shows that a simple trading rule - which goes long the dollar whenever it is above its moving average and shorts it when it is below - has performed very well over time. The dollar is now trading above most key trend lines. Chart 31Decelerating Global Growth Tends To Be##br## Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Chart 32The Dollar Trades On Momentum The Dollar Trades On Momentum The Dollar Trades On Momentum Some commentators have argued that a larger U.S. budget deficit will put downward pressure on the dollar. However, this would only happen if the Fed let inflation expectations rise more quickly than nominal rates, an outcome which would produce lower real rates. So far, that has not happened: U.S. real rates have risen across the entire yield curve since Treasury yields bottomed last September (Chart 33). As a result, real rate differentials between the U.S. and its peers have increased (Chart 34). Chart 33U.S. Real Rates Have Risen Across ##br##The Entire Yield Curve U.S. Real Rates Have Risen Across The Entire Yield Curve U.S. Real Rates Have Risen Across The Entire Yield Curve Chart 34Real Rate Differentials Have Widened ##br##Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Historically, the dollar has moved in line with changes in real rate differentials (Chart 35). The past few months have been no exception. If the Fed finds itself in a position where it can raise rates more than the market anticipates, the greenback should continue to strengthen. Chart 35Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials True, the dollar is no longer a cheap currency. However, if long-term interest rate differentials stay anywhere close to where they are today, the greenback can appreciate quite a bit from current levels. For example, consider the dollar's value versus the euro. Thirty-year U.S. Treasurys currently yield 2.98% while 30-year German bunds yield 1.04%, a difference of 194 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.3 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.15 range over the next few months certainly seems achievable. Brexit worries will continue to weigh on the British pound. Nevertheless, we are reluctant to get too bearish on the pound. The currency is extremely cheap (Chart 36). Inflation has come down from a 5-year high of 3.1% in November, but still clocked in at 2.4% in April. Real wages are picking up, consumer confidence has strengthened, and the CBI retail survey has improved. In a surprise decision, Andy Haldane, the Bank of England's Chief Economist, joined two other Monetary Policy Committee members in voting for an immediate 25 basis-point increase in the Bank Rate in June. Perhaps most importantly, Brexit remains far from a sure thing. Most polls suggest that if a referendum were held again, the "Bremain" side would prevail (Chart 37). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The yen is likely to weaken somewhat against the dollar over the next 12 months as interest rate differentials continue to move in the dollar's favor. That said, as with the pound, we think the downside for the yen is limited (Chart 38). The yen real exchange rate remains at multi-year lows. Japan's current account surplus has grown to nearly 4% of GDP and its net international investment position - the difference between its foreign assets and liabilities - stands at an impressive 60% of GDP. If financial market volatility rises, as we expect, some of those overseas assets will be repatriated back home, potentially boosting the value of the yen in the process. Chart 36The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap Chart 37When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart 38The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish Commodities: Better Outlook For Oil Than Metals The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 39). In contrast, China represents less than 15% of global oil demand. The supply backdrop for oil is also more favorable than for metals. While Saudi Arabia is likely to increase production over the remainder of the year, this may not be enough to fully offset lower crude output from Venezuela, Iran, Libya, and Nigeria, as well as potential constraints to U.S. production growth due to pipeline bottlenecks. Additionally, a recent power outage has knocked about 350,000 b/d of Syncrude's Canadian oil sands production offline at least through July. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. Chart 40 shows that the AUD is expensive compared to the CAD based on a Purchasing Power Parity calculation. Although the Canadian dollar deserves some penalty due to NAFTA risks, the current discount seems excessive to us. Accordingly, as of today, we are going tactically short AUD/CAD. Chart 39China Is A More Dominant Consumer ##br##Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil Chart 40The Canadian Dollar Is Undervalued ##br##Relative To The Aussie Dollar The Canadian Dollar Is Undervalued Relative To The Aussie Dollar The Canadian Dollar Is Undervalued Relative To The Aussie Dollar The prospect of higher inflation down the road is good news for gold. However, with real rates still rising and the dollar strengthening, it is too early to pile into bullion and other precious metals. Wait until early 2020, by which time the Fed is likely to stop raising rates. Equities: Prefer DM Over EM One can believe that emerging market stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from overheating. But one cannot believe that both of these things will happen at the same time. As Chart 41 clearly shows, EM equities almost always fall when U.S. financial conditions are tightening. Chart 41Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Our overriding view is that U.S. financial conditions will tighten over the coming months. As discussed above, the adverse effects of rising U.S. rates and a strengthening dollar are likely to be felt first and foremost in emerging markets. Our EM strategists believe that Turkey, Brazil, Argentina, South Africa, Malaysia, and Indonesia are most vulnerable. We no longer have a strong 12-month view on regional equity allocation within the G3 economies, at least not in local-currency terms. The sector composition of the euro area and Japanese bourses is more heavily tilted towards deep cyclicals than the United States. However, a weaker euro, and to a lesser extent, a weaker yen will cushion the blow from a softening global economy. In dollar terms, the U.S. stock market should outperform its peers. Getting Ready For The Next Equity Bear Market A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year. We predicted last week that the next "big move" in stocks will be to the downside. We would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% during the next few months or if the policy environment becomes more market-friendly. Similar to what happened in 1998, when the S&P 500 fell by 22% between the late summer and early fall, a significant correction today could set the scene for a blow-off rally. In such a rally, EM stocks would probably rebound and cyclicals would outperform defensives. However, absent such fireworks, we will probably downgrade global equities in early 2019 in anticipation of a global recession in 2020. The U.S. fiscal impulse is set to fall sharply in 2020, as the full effects of the tax cuts and spending hikes make their way through the system (Chart 42).4 Real GDP will probably be growing at a trend-like pace of 1.7%-to-1.8% by the end of next year because the U.S. will have run out of surplus labor at that point. A falling fiscal impulse could take GDP growth down to 1% in 2020, a level often associated with "stall speed." Investors should further reduce exposure to stocks before this happens. The next recession will not be especially severe in purely economic terms. However, as was the case in 2001, even a mild recession could lead to a very painful equity bear market if the starting point for valuations is high enough. Valuations today are not as extreme as they were back then, but they are still near the upper end of their historic range (Chart 43). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q points to real average annual total returns of 1.8% for U.S. stocks over the next decade. Global equities will fare slightly better, but returns will still be below their historic norm. Long-term equity investors looking for more upside should consider steering their portfolios towards value stocks, which have massively underperformed growth stocks over the past 11 years (Chart 44). Chart 42U.S. Fiscal Impulse Set To Drop In 2020 U.S. Fiscal Impulse Set To Drop In 2020 U.S. Fiscal Impulse Set To Drop In 2020 Chart 43U.S. Stocks Are Pricey U.S. Stocks Are Pricey U.S. Stocks Are Pricey Chart 44Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Appendix A depicts some key valuation indicators for global equities. Appendix B provides illustrative projections based on the discussion above of where all the major asset classes are heading over the next ten years. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0194)^30=0.84 today. 4 We are not saying that fiscal policy will be tightened in 2020. Rather, we are saying that the structural budget deficit will stop increasing as the full effects of the tax cuts make their way through the system and higher budgetary appropriations are reflected in increased government spending (there is often a lag between when spending is authorized and when it takes place). It is the change in the fiscal impulse that matters for GDP growth. Recall that Y=C+I+G+X-M. If the government permanently raises G, this will permanently raise Y but will only temporarily raise GDP growth (the change in Y). In other words, as G stops rising in 2020, GDP growth will come back down. Appendix A Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Appendix B Chart 1Market Outlook: Bonds Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 2Market Outlook: Equities Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 3Market Outlook: Currencies Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 4Market Outlook: Commodities Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Global Growth: The risk to U.S. financial markets from global growth divergences and increasingly hawkish trade policy is rising, and it is unlikely to be resolved without a market riot. Credit Cycle: Valuation is expensive and indicators of monetary conditions suggest we are very late in the cycle. Both factors suggest that excess returns to corporate bonds will be meager, even if recession is avoided. Given concerns about global growth, the risk/reward trade-off favors a more defensive allocation to spread product. Corporate Leverage: Profit growth has just barely kept pace with debt growth during the past few quarters and will likely moderate as wage costs accelerate in the second half of the year. The resultant increase in leverage will pressure corporate bond spreads wider. Feature Table 1Recommended Portfolio##br## Specification Go To Neutral On Spread Product Go To Neutral On Spread Product Last week we sent a Special Report to all BCA clients advising them to cyclically reduce exposure to risk assets (equities and corporate bonds), moving from an overweight allocation to neutral.1 For U.S. bond portfolios, we recommend that investors adopt a neutral allocation to spread product versus Treasuries, while also upgrading the more defensive municipal bond sector at the expense of corporate credit. We also advise investors to maintain below-benchmark portfolio duration (Table 1). In this week's report we explain the rationale for these portfolio changes. Specifically, we run through our favorite credit cycle indicators, which we split into three categories: valuation, monetary conditions and credit quality. The message from the indicators is that it is still somewhat too soon to expect rising corporate defaults and sustained spread widening. However, the indicators also suggest that we are very late in the cycle and return expectations should be quite low. Put differently, the expected excess return from overweight corporate bond positions no longer justifies the risk of staying overweight for too long. This is particularly true given the ongoing slowdown in global growth and escalating tit-for-tat trade war. Neither of which is likely to be resolved without some market pain. Credit Cycle Indicators Valuation While value in the investment grade corporate bond space has improved somewhat since January, the sector remains expensive relative to history. Chart 1 shows the 12-month breakeven spread for each investment grade credit tier as a percentile rank for the period between 1996 and today.2 According to this measure, investment grade corporate bonds are about as expensive as they were in 2006/07, just prior to the 2008 recession and default cycle. Chart 2 shows the same valuation measure for the high-yield credit tiers. High-Yield spreads are somewhat wider than 2006/07 levels, though they are still quite low relative to the post-1996 timeframe as a whole. One critical difference between the late stages of the last credit cycle (2006/07) and the current environment is that corporate balance sheets are now in significantly worse shape. If we adjust for this by dividing the 12-month breakeven spread by our preferred measure of gross leverage we see that high-yield valuation now looks similar to 2006/07 levels, while investment grade credit looks significantly more expensive (Chart 3). Chart 1Investment Grade Valuation Investment Grade Valuation Investment Grade Valuation Chart 2High-Yield Valuation High-Yield Valuation High-Yield Valuation Chart 3Leverage-Adjusted Value Leverage-Adjusted Value Leverage-Adjusted Value These valuation measures do not suggest that spreads are about to widen. It is clear from the charts that valuation can remain expensive for long periods of time, particularly in the late stages of the credit cycle. However, the indicators do tell us that return expectations should be low relative to history and that relatively little spread widening is required before corporate bonds see losses relative to duration-matched Treasuries. All else equal, our threshold for moving out of corporate credit should be low. Monetary Conditions Chart 4Inflation Indicators Inflation Indicators Inflation Indicators We place a great deal of importance on monetary indicators for timing allocation shifts into and out of corporate bonds. The reason relates to our understanding of the Fed Policy Loop.3 When inflation is far below target, the central bank has a strong incentive to nurture economic growth. This means it will be quick to respond to any relapse in financial markets that might eventually lead to an economic slow-down. Credit spreads are unlikely to widen meaningfully in these environments of low inflation and a responsive Fed. However, as inflation approaches target the central bank's reaction function starts to change. It becomes marginally more concerned with preventing an overshoot of the inflation target and marginally less concerned with supporting economic growth. It will therefore be more willing to tolerate some widening in credit spreads before responding with a dovish policy action. With that in mind, we monitor three inflation indicators to help us determine when inflation is strong enough to significantly impair the "Fed put" on credit spreads. They are (Chart 4): Re-anchored long-dated TIPS breakeven inflation rates, within a range between 2.3% and 2.5%. The St. Louis Fed's Price Pressures Measure above 15%. Year-over-year core PCE inflation above 2%. Long-maturity TIPS breakeven inflation rates have increased significantly during the past year, but have not quite hit our target range. The 10-year TIPS breakeven inflation rate currently sits at 2.11% and the 5-year/5-year forward TIPS breakeven inflation rate currently sits at 2.17%. Similarly, the St. Louis Fed's Price Pressures Measure, an aggregate economic indicator designed to measure the percent chance that inflation exceeds 2.5% during the next 12 months, currently sits at 13%. This is only just below the 15% threshold that we have previously found to be correlated with significantly lower corporate bond excess returns (Table 2).4 Table 2Investment Corporate Bond Excess Returns* Under Different Ranges ##br##Of Price Pressures Measure** (January 1990 To Present) Go To Neutral On Spread Product Go To Neutral On Spread Product Finally, year-over-year core PCE inflation has not yet returned to the Fed's 2% target but appears to be on its way. The annualized 3-month rate of change has exceeded 2% in three of the past four months and the extreme tightness in labor markets and resultant wage pressures are likely to keep core inflation in a gradual uptrend going forward. Year-over-year core PCE inflation is very likely to reach the Fed's 2% target before the end of the year. All in all, inflation pressures suggest that investors' inflation expectations are not yet completely re-anchored around the Fed's 2% target, and probably have a bit more upside. However, we expect that all three of our inflation indicators will hit their key thresholds within the next few months. When we combine the fact that our inflation indicators are very close to sending a bearish signal for corporate bonds with our growing concerns about global growth and trade (see section titled "Global Growth Divergences: A Repeat Of 2015" below), we think it is prudent to start scaling back the credit risk in U.S. bond portfolios today. Another important indicator of monetary conditions is the slope of the yield curve. As Fed Chairman Jerome Powell explained at the last FOMC press conference, the yield curve is really about appropriate monetary policy. When it is very steep it signals that policy is currently accommodative and will tighten in the future. When it is inverted it signals that policy is restrictive and is likely to ease. Logically, when monetary conditions are close to neutral the yield curve will be very flat. The market will be uncertain about whether rates will rise or fall in the future. With that in mind we can split historical cycles into three phases based on the 3-year/10-year slope of the Treasury curve: (i) early in the recovery when the 3/10 slope is above 50 bps, (ii) the middle of the cycle when the 3/10 slope is between 0 bps and 50 bps, and (iii) late in the cycle when the 3/10 slope is inverted (Chart 5). Chart 5Corporate Bond Performance And The Yield Curve Corporate Bond Performance And The Yield Curve Corporate Bond Performance And The Yield Curve We find that corporate bond excess returns are highest early in the cycle when the yield curve is steep. Excess returns drop significantly once the 3/10 slope flattens to below 50 bps, and then turn negative once the yield curve inverts (Table 3). Table 3Risk Asset Performance In Different Yield Curve Regimes Go To Neutral On Spread Product Go To Neutral On Spread Product The 3/10 slope is currently 25 bps. We are firmly entrenched in the middle phase of the credit cycle where excess returns tend to be very low, though often still positive. Given the uncertainty surrounding when the yield curve will invert, sacrificing some small potential excess return by scaling back spread product exposure to neutral seems prudent. Credit Quality The final class of credit cycle indicators we track relates to the fundamental balance sheet health of the nonfinancial corporate sector. Chief among those indicators is our measure of gross leverage that we calculate as pre-tax profits divided by total debt. Typically, periods of rising gross leverage tend to coincide with corporate spread widening, and vice-versa. Alternatively, we can say that periods when profit growth is sustainably below the rate of debt growth tend to coincide with widening credit spreads (Chart 6). Using our most recent data, which extend only to the end of Q1 2018, profit growth has roughly kept pace with debt growth since the middle of 2016, resulting in relatively flat leverage. But this dynamic will probably not be sustained for much longer. While corporate revenue growth is strong, it cannot accelerate indefinitely. The ISM index is already peaking, and the recent bout of dollar strength will act as a headwind (Chart 7, panels 1 & 2). Chart 6Leverage Won't Stay Flat For Long Leverage Won't Stay Flat For Long Leverage Won't Stay Flat For Long Chart 7Watch Out For Rising Wages Watch Out For Rising Wages Watch Out For Rising Wages But more important is that tight labor markets are already putting upward pressure on wage costs and this wage acceleration is very likely to persist. Our Profit Margin Proxy, calculated as corporate selling prices less unit labor costs, already points to a moderation in profit growth in the second half of the year (Chart 7, panels 3 & 4). With profit growth very likely to moderate in the second half of the year, and given that it would be highly unusual for the rate of debt growth to decline meaningfully outside of recession, we expect corporate leverage to start rising again in the third and fourth quarters of this year. Bottom Line: The overall message from our credit cycle indicators is that we are very late in the cycle and expected excess returns to corporate bonds should be low. Given the risks to global growth on the horizon, it makes sense to turn more cautious on spread product. Global Growth Divergences: A Repeat Of 2015 Chart 8Global Growth Divergence Won't End Well Global Growth Divergence Won't End Well Global Growth Divergence Won't End Well From mid-2016 until a few months ago the global economy had benefited from a period of synchronized global growth, but that dynamic has now broken down. Leading indicators show that the large divergence between strong U.S. growth and weak growth in the rest of the world that was one of our key investment themes in 2014/15 has re-emerged (Chart 8). As in the 2014/15 period, the end result of divergent growth between the U.S. and the rest of the world is upward pressure on the U.S. dollar. This serves to tighten U.S. financial conditions at the margin, and exacerbates economic pain in emerging markets who have to contend with large balances of USD-denominated debt. Further, unlike in 2014/15, the global economy now has to deal with the imposition of tariffs and an escalating trade war that is unlikely to die down any time soon.5 Since the United States is a relatively large and closed economy, any moderation in global trade will be felt more acutely outside the U.S. But this only serves to increase global growth divergences and add to the upward pressure on the dollar. Eventually, as in 2015, we expect this divergence in growth and the resultant upward pressure on the dollar to culminate in a risk-off event in U.S. financial markets. At that point, the Fed will be forced to take notice and will likely pause rate hikes for a period of time. The Fed kept rate hikes on hold for an entire year following a similar market event in late 2015, but any future pause will probably not be as long. With inflation much closer to target than in 2015, the Fed will be reluctant to pause the rate hike cycle for more than a quarter or two. It is for this reason that we maintain below-benchmark portfolio duration even as we shift to a more defensive posture on spread product. The impact of divergent global growth will likely first be felt in credit spreads, and any knock-on impact to the pace of Fed rate hikes and Treasury yields could prove fleeting. Bottom Line: The risk to U.S. financial markets from global growth divergences and increasingly hawkish trade policies is rising, and is unlikely to be resolved without a market riot. Given meager expected returns in corporate bonds, it makes sense to get more defensive on spread product. Upgrade Municipal Bonds In addition to Treasuries, we also recommend allocating some of the proceeds from the corporate bond downgrade to tax-exempt municipals. As is shown in our Total Return Bond Map, municipal bonds are less risky than corporates and, depending on each investor's marginal tax rate, could offer reasonably high expected returns (Chart 9). Meanwhile, our Municipal Health Monitor remains entrenched below zero, suggesting that municipal ratings upgrades will continue to outpace downgrades, and net state & local government borrowing appears to be hooking down (Chart 10). Chart 9Total Return Bond Map (As Of June 21, 2018) Go To Neutral On Spread Product Go To Neutral On Spread Product Chart 10Municipal Health Still Improving Municipal Health Still Improving Municipal Health Still Improving In short, the current macro environment is much more negative for corporate credit quality than it is for municipal credit quality. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at www.bcaresearch.com/reports/view_report/25520/bca 2 We focus on the breakeven spread to adjust for changes in the average duration of the index over time. We calculate the 12-month breakeven spread as simply the index option-adjusted spread divided by index duration, ignoring the modest impact of convexity. 3 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2018, available at usbs.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, "Are You 'Sick Of Winning' Yet?", dated June 20, 2018, available at gps.bcaresearch.com

Highlights As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020. The labor market typically continues to improve after the economy reaches full employment, wage inflation begins to accelerate after the economy achieves full employment, while prices rise only gradually. Gold and Treasuries were the big winners and the dollar was the big loser in previous trade spats. Feature The dollar rose 1%, but gold, the S&P 500, and U.S. Treasury yields sunk last week amid a busy calendar of U.S. economic data and the Fed's new forecasts. The stats and the FOMC projections confirmed that the U.S. economy is already at full employment and that the market is underpricing the number of Fed hikes planned for this year. Meanwhile, U.S. President Trump's meeting with North Korea leader Kim Jong Un provided some relief on the geopolitical front, but there is still uncertainty on trade over impending tariffs on China. Chart 1Watch The 2.3% To 2.5% Level##BR##On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until mid-2019 and that increasing bond yields are not a threat. That said, the timing is uncertain and depends importantly on how inflation and inflation expectations shift in the coming months. Inflation is only gradually moving higher at the moment and the Fed is willing to tolerate an overshoot of the 2% target. However, some inflation hawks at the Fed are worried given that the economy is already at full employment and expected to accelerate this year. The uptrend in inflation could suddenly become steeper in this macro environment. Alarm bells will ring when inflation hits 2.5% and the central bank will switch from normalizing policy to targeting slower growth, putting risk assets under pressure. We are also on the watch for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will become more aggressive in leaning against above-trend growth and a falling unemployment rate (Chart 1). That would be an important signal to trim exposure to risk assets. Although Trump's meeting with Kim lowered geopolitical risk, BCA's strategists note that the secular decline in U.S.-China ties and the "apex of globalization"1 are more relevant subjects than what happens on the Korean peninsula. While North Korea may still stir up concern, we recommend that investors monitor U.S.-China trade tensions, the East and South China Seas, and Taiwan. Elsewhere, U.S.-Iran tensions are the key understated geopolitical risk to markets. Moreover, BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the U.S. mid-term elections in November.2 Two More In '18 As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020 (Chart 2). Chart 2FOMC And Market Mostly##BR##Aligned On Economy And Rates FOMC And Market Mostly Aligned On Economy And Rates FOMC And Market Mostly Aligned On Economy And Rates Instead of three, the Fed now expects to deliver a total of four rate hikes in 2018. For 2019, the Fed continues to project a further three rate hikes. And for 2020, the Fed now believes only one rate hike will be warranted, down from two hikes in its previous forecast. What this means is that the Fed has simply brought forward one rate hike from 2020 to 2018. It left its median projection for the level of the Fed funds rate in 2020 unchanged at 3.375%. Moreover, the Fed kept its estimate of the neutral rate unchanged at 2.875%. In other words, the Fed is forecasting a marginally faster pace to rate hikes, but it has not changed its outlook for the full extent of the tightening cycle. This minor change to the policy outlook should not disrupt financial markets. Prior to last week's FOMC meeting, Fed funds futures were already pricing a 50% probability of a fourth rate hike this year. The bigger question is whether more upward adjustments to the interest rate outlook lie ahead. On this front, there are inconsistencies in the Fed's economic projections. In terms of the long-run steady state, the Fed believes the potential growth rate of the economy is 1.8% and NAIRU is 4.5%. Yet the Fed is forecasting real GDP growth of 2.4% and 2.0% (i.e. above-trend) for 2019 and 2020, respectively, but expects both the jobless rate and core inflation to remain steady at 3.5% and 2.1%, respectively. Above-trend growth should imply a further decline in the unemployment rate. And a jobless rate that's well below NAIRU should imply an acceleration in inflation. In turn, this should mean a higher path for interest rates. But rather than higher interest rates, the inconsistency in the Fed's economic forecasts can also be resolved in other ways. First, the Fed could simply be too optimistic on growth. If growth is weaker, then unemployment and inflation forecasts could be proven right. Second, the Fed's estimates of trend growth and NAIRU may be incorrect. If trend growth is higher and NAIRU is lower, the pressures on resource utilization and inflation will be less. Bottom Line: The tweaks to the Fed's interest rate projections are too small to have a material impact on financial market pricing. However, there is a risk that the inconsistencies in the Fed's economic forecasts will be resolved with more hawkishness in 2019. This could then prove problematic for global risk assets, depending on the evolution of inflation. Are We There Yet? The U.S. economy reached full employment in Q1 2017. The unemployment rate crossed below the Fed's measure of NAIRU in March 2017, a whopping 93 months after the start of the current expansion. Chart 3 shows that in the long expansions3 in the 1980s and 1990s, the economy reached full employment sooner; 54 months in the 1980s and 72 months in the 1990s expansion. After the economy attained full employment in the 1980s and 1990s, an average of another 27 months passed before the unemployment rate troughed. This means that the trough will occur in mid-2019 and our view is that the rate will bottom at around 3.5% in mid-2019.4 Moreover, the 1980s' economic recovery lasted another 34 months once the economy hit full employment and another 47 months once full employment was breached in the 1990s. If this historical pattern holds, then the next recession will begin in late 2020. This date is consistent with our prior work5 on the start date of the next downturn. Chart 3The Economy At Full Employment In Long Cycles The Economy At Full Employment In Long Cycles The Economy At Full Employment In Long Cycles The labor market typically continues to improve after the economy reaches full employment. Initial claims for unemployment insurance, as a share of the labor force, move lower for another two years, on average, after labor market slack disappears (Chart 4, panel 2). The monthly non-farm payrolls job count follows a similar pattern and it does not turn negative for another four years (panel 3). The Conference Board's jobs easy/hard to get shows that the labor market is hotter than in the previous long expansions (panel 4). The conclusion is that the labor market will continue to tighten for another year or so, consistent with our outlook. Wage inflation begins to accelerate after the economy achieves full employment. Chart 5 shows increases in the average hourly earnings (AHE), the Employment Cost Index (ECI), and compensation per hour after the unemployment rate fell below NAIRU in the 1980s and 1990s. However, unit labor costs (ULCs) did not accelerate in those years until well after the economy hit full employment. Many of these measures of wage inflation are also on the upswing today. However, none of the indicators are rising as quickly as they did in the 1980s and 1990s (See Appendix Table 1 for more details on performance of labor market, wage and inflation metrics after the economy reaches full employment). Inflation initially remained tame even after labor market slack was taken up in the previous two long expansions. Chart 6 shows that neither headline nor core CPI accelerated sharply after the economy arrived at full employment in the '80s and '90s. However, headline CPI inflation began rising not long after full employment was reached. It took a little longer for core inflation to perk up. Moreover, inflation tends to peak as the unemployment rate troughs. This occurs, on average, about three years after the unemployment rate crosses below NAIRU. Chart 4The Labor Market When##BR##The Economy Is At Full Employment The Labor Market When The Economy Is At Full Employment The Labor Market When The Economy Is At Full Employment Chart 5Wages And Compensation When##BR##The Economy Is At Full Employment Wages And Compensation When The Economy Is At Full Employment Wages And Compensation When The Economy Is At Full Employment Chart 6Inflation When The Economy##BR##Is At Full Employment Inflation When The Economy Is At Full Employment Inflation When The Economy Is At Full Employment Bottom Line: The U.S. economy has been at full employment since early 2017, but investors should be patient if they expect a marked acceleration in inflation. Inflation is already at the Fed's target and BCA expects two more rate hikes this year and at least three more increases in 2019 as inflation moves closer to 2.5%. Stay underweight duration. The labor market is as tight as it was at this point of the previous two long expansions. Moreover, the trends in inflation and wages are similar, although from a lower level. That said, while inflation is more muted today, interest rates are much, much lower, and the Fed does not want a major overshoot. If we follow the same path as the previous two long expansions, then inflation will rise only gradually, and the next recession is a ways off. But watch for an acceleration in ULC, because in the average of the last two long expansions, an acceleration in ULC coincided with an acceleration in core CPI inflation. That would cause the Fed to become more aggressive. Trump's Focus On China The U.S. is an old hand at trade wars and economic conflicts, with an endgame of dollar depreciation and compromises on trade.6 Since 1970 there have been seven major trade disputes involving tariffs, including the one that began in March of this year. Some were brief and several of those periods overlapped. Moreover, many other factors affected investment returns, including recessions, wars, major terrorist attacks, and financial crises. As a result, these periodic trade tiffs make it difficult to discern the implications for the financial markets. During episodes of trade-related uncertainty, stocks underperform Treasuries, the dollar falls both pre- and post-dispute, and gold performs much better both during and after. Treasuries are the most consistent performer, and this asset class beat stocks during five of the six periods. Meanwhile, the dollar fell during 5 of the 6 trade spats (Table 1). Chart 7 shows the performance of a wider set of U.S. financial assets before, during, and after trade tensions erupt. Table 1U.S. Stocks, Treasuries, The Dollar, Gold And Trade Disputes The Economy At Full Employment The Economy At Full Employment Chart 7U.S. Financial Assets And Trade Spats U.S. Financial Assets And Trade Spats U.S. Financial Assets And Trade Spats We begin our discussion of trade spats and their implication for financial markets in the early 1970s. In August 1971, with the dollar steeply overvalued, President Richard Nixon abandoned the gold standard and imposed a 10% surcharge on all dutiable imports. The purpose of the tariff was to force the U.S. allies to appreciate their currencies against the dollar. Some appreciation occurred as a result of the Smithsonian Agreement, but the effects were short-lived. The U.S. could not afford to alienate its allies amid the Cold War and removed the restrictions four months later. Table 1 shows that S&P 500 increased by nearly 40% in the year prior to the 1971 trade spat, but the economy was recovering from the 1969-70 recession. Equities easily beat Treasuries (+17%), the dollar declined by 3%, and gold jumped by 22%. However, during late 1971, the S&P 500 underperformed Treasuries, the dollar dropped by 5%, and gold was little changed. In the 12 months after the trade issue was resolved, U.S. stocks beat bonds, the dollar continued to move lower, and gold surged. This occurred as inflation ramped up. In a trade dispute episode during the 1980s, then President Reagan and a Democrat-leaning Congress became concerned with trade deficits and a sharply rising dollar. The Plaza Accord in 1985 consisted of a German and Japanese promise, once again, to appreciate their currencies. From 1985-89, a U.S.-Japan trade war was waged over Japan's growing share of the U.S. market and certain unfair trade practices affecting goods such as cars, semiconductors, and electronics (Chart 8). The combination of yen appreciation, voluntary export restraints and tariffs, resulted in compromises, and in the early 1990s the U.S. removed Japan from its list of targets. Chart 8The U.S.-Japan Trade Spat In The 1980s The U.S.-Japan Trade Spat In The 1980s The U.S.-Japan Trade Spat In The 1980s During the 1985-89 dispute, the U.S. stock market crashed, economic growth surged, inflationary pressures mounted, and the Fed hiked rates. Nevertheless, stocks crushed bonds as the dollar tumbled by 40% and gold soared by 30% (Table 1). Note that gold fell in the year before the trade dispute began and in the year after it ended. In the late 1990s, a series of trade disputes erupted between the U.S. and the European Union, most significantly on a tax device that allowed companies reduced taxes on profits derived from export sales. The EU won its case against the U.S. at the WTO and the U.S. eventually repealed the offending provisions in its tax code. At the same time, from 1999-2001, the U.S. contested EU policies on banana imports. Then in March 2002, President George W. Bush imposed steel tariffs affecting Europe, but these were subsequently reversed in December 2003 in the face of retaliatory threats. Trade tension in the late 1990s and early 2000s developed alongside the tech boom, the 2001 recession and recovery, and the first Gulf War. The 10-year Treasury outperformed the S&P 500 as Bush's steel tariffs were in effect, but the early part of this period coincided with the accounting scandals that buffeted U.S. equity markets. The U.S. dollar dropped nearly 25%, although the Fed cut rates in 2002 and 2003. Gold climbed 34% in this period, outpacing both stocks and bonds. President Trump's trade positions are reminiscent of both Nixon's and Reagan's policies and his trade team includes a notable veteran of the U.S.-Japan trade war, U.S. Trade Representative Robert Lighthizer. The focus, however, is not entirely the same. True, there is still a fixation on privileged manufacturing industries like steel and autos, both in the Section 232 actions on steel and aluminum and in the NAFTA renegotiation. But there is today a heightened focus on China's abuses of the international trade system, in particular its technology theft and intellectual property violations (the Section 301 actions). For investors, the critical issue is to separate the two areas of focus. The U.S. grievances with Europe, NAFTA, and Japan will cause more volatility this year and beyond, but are ultimately more manageable than those with China. U.S.-China trade tensions are caught up in a Great Power rivalry that will likely persist throughout this century, making trade tensions a permanent feature of the relationship going forward.7 China's rapid military growth and technological acquisition threaten U.S. global dominance. China will view any imposition of tariffs by the U.S., or demands for dramatic RMB appreciation, as a strategic attempt to derail China's rise. Moreover, while Congress will not attack President Trump for retreating from the trade war with the allies, it will attack President Trump for compromising on China. Recent U.S. elections have swung on Rust Belt Midwestern states that resent America's deindustrialization. In 2020, Democrats will attempt to reclaim their credibility as defenders of American workers and "fair trade," especially against China. President Trump stole their thunder with his protectionist platform. There is unlikely to be a "trade dove," and especially not a "China dove," in the White House from 2020-24. Bottom Line: The U.S. has historically used punitive trade measures to force its allied trading partners to appreciate their currencies versus the dollar. It has also sought to protect politically sensitive industries. Today, however, the trade war with China is inextricably tied to a strategic conflict that will play out over decades. Trump will likely impose Section 301 tariffs on China after June 15 and any deal to avoid confrontation will merely delay the decision on tariffs until after November's mid-term elections. Investors should recall that bonds beat stocks, the dollar fell, and gold rose during previous periods of trade tension. We also note that shifts in correlations between key U.S. asset classes tend to occur as trade spats begin and end, especially in the past 30 years (Chart 9). Moreover, gold usually continues to climb and the dollar falters even after these disputes are resolved. Chart 9U.S. Asset Class Correlations During Trade Disputes U.S. Asset Class Correlations During Trade Disputes U.S. Asset Class Correlations During Trade Disputes John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Bank Credit Analyst Monthly Report, published March 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000," published March 30 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," published April 12, 2017. Available at gps.bcaresearch.com. 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," published March 14, 2018. Available at gps.bcaresearch.com. Appendix Appendix Table 1Key Labor Market And Inflation Indicators At Full Employment The Economy At Full Employment The Economy At Full Employment

Highlights Contagion risk from Italy to its European peers presents a buying opportunity; Italian policymakers are constrained by the bond market and avoiding brinkmanship; In a game of chicken between Berlin and Rome, Chancellor Angela Merkel is behind the wheel of a 2.5-ton SUV; Italy's ultimate constraint is its bifurcated economic system - staying in the EU helps manage this problem; Underweight Italian bonds in a global portfolio and short Italian bonds versus their Spanish equivalents. Feature Chart 1Is Contagion Warranted? Is Contagion Warranted? Is Contagion Warranted? On May 31, Italy formed the second overtly populist government in the Euro Area. The first was the short-lived SYRIZA government in Greece, which lasted from January to September 2015. Under the leadership of Prime Minister Alexis Tsipras and his colorful finance minister Yanis Varoufakis, Athens took Greece to the brink of Euro Area exit in the summer of 2015. Ultimately, Greek politicians blinked, folded, and re-ran the January election in September, transforming SYRIZA from an overtly euroskeptic party to a europhile party in just eight months. Investors are concerned that "this time will be different." We disagree. To use a poker analogy, Italian policymakers are better positioned to "bluff" their European counterparts as their chip stack is larger. But they are still holding a bad hand, and other players at the table still hold big stacks. The recent turbulence in Italian bond markets has spilled over into other Mediterranean countries (Chart 1). This contagion is unwarranted, as there has been much improvement across the region over the past few years, both politically and economically. As for Italy itself, it is positive that populists have come to power today, for several reasons. First, it will force them to actually run the country, a sobering process that often tempers anti-establishment zeal, as it did in Greece. Second, they will run the country at a time when popular support for the Euro Area and EU remains strong enough to deter an overt attempt to exit those institutions. Third, Italy remains massively constrained by material forces outside of their control, which will force compromises in negotiations with Brussels and fellow EU member states. There Will Be No Contagion From Italy Markets overreacted to the political risks emanating from Italy in recent weeks. Fundamentally, Italy's peripheral peers have emerged stronger from the Euro Area crisis. Since the onset of the Euro Area crisis, Greece, Portugal, Ireland, and Spain - the hardest-hit economies in 2010 - have seen their unit labor costs contract by an average of 8.7%. Over the same period, the rest of the Euro Area inflated its labor cost structure by around 10.9% (Chart 2). Italy remains saddled with a rigid, under-educated, and rather unproductive workforce that has seen no adjustment in labor costs.1 Meanwhile, its Mediterranean peers have practically closed their once-enormous unit labor-cost gap with Germany. Furthermore, all southern European countries now run primary surpluses, reducing the need for external funding (Chart 3). It is fair that the market should apply a fiscal premium to Italy, given the new government's plans to blow out the budget deficit. But no such fiscal plan is in the works in the rest of the Mediterranean. The cyclically-adjusted primary balance - for Italy, Spain, Portugal, and Greece - has gone from a deficit of 4.4% during the height of the debt crisis, to a surplus of 1.4% today. One can argue about whether such fiscal austerity was really necessary. The advantage, however, is that the improvement in structural budget balances has diminished the need for additional austerity measures and could also provide greater fiscal space during the next recession. Finally, household balance sheets have been on the mend for some time. Consumer debt levels as a percentage of disposable income in Spain, Portugal, and Ireland - the epicenter of the original Euro Area debt crisis - have now dipped below U.S. levels. In the case of Italy, importantly, the household sector was never over-indebted to begin with (Chart 4). Chart 2Italy Has Had No Labor-Cost Adjustment Italy Has Had No Labor-Cost Adjustment Italy Has Had No Labor-Cost Adjustment Chart 3Mediterranean Austerity Is Over Mediterranean Austerity Is Over Mediterranean Austerity Is Over Chart 4No Household Credit Bubble In Italy No Household Credit Bubble In Italy No Household Credit Bubble In Italy On the political front, Italians are clearly more euroskeptic than their Euro Area peers (Chart 5). Although only 30% of Italians oppose the common currency, in line with Greece, this is still considerably higher than in Spain and Portugal (Chart 6). Italians also feel less "European" than the Spanish or the Portuguese - i.e., they identify more exclusively with their unique nationality. Again this is in line with Greek sentiment (Chart 7). Italians were not always this way: in the early 1990s, they felt the most European. Chart 5Italy Lags In Support For The Euro... Italy Lags In Support For The Euro... Italy Lags In Support For The Euro... Chart 6...But Only 30% Of Italians Want Out ...But Only 30% Of Italians Want Out ...But Only 30% Of Italians Want Out Chart 7Italians Are Feeling More Italian Italians Are Feeling More Italian Italians Are Feeling More Italian In Portugal and Spain, parties across the political spectrum have responded to improving political and economic fundamentals. In Spain, the mildly euroskeptic Podemos is polling below its June 2016 election result. Its leadership has also abandoned any ambiguity on its support of the common currency, although it still campaigned in 2016 on restructuring Spain's foreign debt. The leading party in the Spanish polls is the centrist Ciudadanos (Chart 8), led by 38-year old Albert Rivera. Much like French President Emmanuel Macron, Rivera has a background in finance - he worked as a legal counsel at La Caixa - and presents a centrist vision for Europe, favoring more integration. The rise of Ciudadanos is important as Spain could have new elections soon. Conservative Prime Minister Mariano Rajoy resigned following a vote of no-confidence engineered by the Spanish Socialist Party (PSOE) leader Pedro Sánchez. However, PSOE only holds 84 seats of the 350-seat parliament. As such, it is unclear how the Socialist minority government will govern, particularly with the budget vote coming in early fall. But investors should welcome, not fear, early elections in Spain. With Ciudadanos set to join a governing coalition, it is clear that Spain's commitments to the Rajoy structural reforms will remain in place while no discussions of Spanish exit from European institutions is on any investment-relevant horizon. In Portugal, the minority government of Prime Minister António Costa has overseen a brisk economic recovery. Costa's center-left Socialist Party has received support in parliament from the far-left, euroskeptic Left Bloc, plus the Communists and Greens. Despite the involvement of the Left Bloc, the minority government has not initiated any euroskeptic policy. The latest polling suggests that Costa could win a majority in 2019. An election has to be held by October of that year, thus potentially strengthening the pro-European credentials of the Portuguese government (Chart 9). Finally, in Greece, the once overtly euroskeptic SYRIZA is polling well below their 2015 levels of support. Ardently europhile and centrist New Democracy (ND) is set to win the next election - which must be held by October 2019 - if polling remains stable (Chart 10). The fascist and euroskeptic Golden Dawn remains a feature of Greek politics, but has a support rate under 10%, as it has over the past decade. In fact, the rising player in Greek politics is the centrist and europhile Movement for Change, an alliance that includes the vestiges of the center-left PASOK, which polls around 10%. Chart 8There Is No Populism In Spain... There Is No Populism In Spain... There Is No Populism In Spain... Chart 9...Or Portugal... ...Or Portugal... ...Or Portugal... Chart 10...And Surprisingly None In Greece ...And Surprisingly None In Greece ...And Surprisingly None In Greece Bottom Line: Italy stands alone in the Mediterranean as a laggard on both economic and political fundamentals. Contagion risk from Italy to the rest of its European peers should be faded by investors. It represents a buying opportunity every time it manifests itself. What Car Is Italy Driving In This Game Of Chicken? The new ruling coalition in Rome has a democratic mandate for a confrontation with Brussels over fiscal spending. The coalition consists of the Five Star Movement (M5S) and the League (Lega), formerly known as the "Northern League." In his inaugural speech to the Italian Parliament, Prime Minister Guiseppe Conte emphasized that the mandate of the new coalition includes "reducing the public debt ... by increasing our wealth, not with austerity."2 So, the gloves are off! Not really. Almost immediately, Conte pointed out that "we are optimistic about the outcome of these discussions and confident of our negotiating power, because we are facing a situation in which Italy's interests... coincide with the general interests of Europe, with the aim of preventing its possible decline. Europe is our home." PM Conte subsequently focused in his speech on increasing social welfare payments to the poor, conditional on vocational training and job reintegration. Talk of a "flat tax" was replaced with an eponymous concept that is anything but a "flat tax."3 And there was no mention of overturning unpopular pension reforms, but merely "intervening in favor of retirees who do not have sufficient income to live in dignity."4 We may be reading too much into one speech. However, the time for brinkmanship is at the beginning of a government's mandate. And Conte's opening salvo suggests that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit by 5% of GDP, putting the total at 7%. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. Conte's relatively tame speech represents one of three concessions that Rome has made before it even engaged Brussels in brinkmanship. The two others were to replace the original economy minister designate - euroskeptic Paulo Savona - and to form a government in the first place. The latter is particularly telling. Polls have shown that the two populist parties would have an even stronger hand if they waited until the fall to re-run the election (Chart 11). In particular, Lega has seen its support rise by 9% since the election. It is politically illogical to form a governing coalition with less political capital when a new election would strengthen the hand of both populist parties. So why the concessions? Because Italian policymakers are not interested in brinkmanship. The populist campaign rhetoric and hints of euroskepticism were an act. And perhaps the act would have continued, but the bond market reaction was so quick and jarring (Chart 12) - including the largest day-to-day selloff since 1993 (Chart 13) - that it has disciplined Italy's policymakers almost immediately. Chart 11Lega Gave Up A Lot By Forming A Coalition Lega Gave Up A Lot By Forming A Coalition Lega Gave Up A Lot By Forming A Coalition Chart 12Bond Vigilantes Are... Bond Vigilantes Are... Bond Vigilantes Are... Chart 13...A Massive Constraint On Rome ...A Massive Constraint On Rome ...A Massive Constraint On Rome This is instructive for investors. In 2015, Greece decided to play the game of brinkmanship with Europe and ultimately lost. Our high-conviction view at the time was that Athens would back off from brinkmanship because it was massively constrained.5 Not only would an exit from the Euro Area mean a government default and the redenomination of all household saving into "monopoly money," but the level of euroskepticism in Greece was not high enough to support such a high-risk strategy. At the time, we pointed out that most investors - and practically all pundits - were wrong when they argued that brinkmanship between Greece and Brussels was "unpredictable." This conventional view was supported by an incorrect reading of game theory, particularly the "game of chicken." Game theory teaches us that a game of chicken is the most dangerous game because it can create an equilibrium in which all rational actors have an incentive to stick to their guns - to "keep driving" in the parlance of the game - despite the risks.6 In Diagram 1, we can see that continuing to drive carries the most risks, but it also carries the most reward, provided that your opponent swerves. Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. When this does not happen, the bottom-right quadrant emerges, one of chaos and deeply negative payouts for everyone involved in the crash. The problem with this analysis is that - as with most game theory - its parsimony belies deep complexity that often varies due to a number of factors. The first such factor is replayability. The decisions of Italian policymakers will be informed by the outcomes of the 2015 Greek episode, which did not go well for Athens. Another factor that obviously varies the payout matrix is the relative strength of each player; or, to stick with the analogy, the type of vehicle driven by each actor. Greece and its Euro Area peers were not driving the same car. The classic game of chicken only produces the payouts from Diagram 1 if all participants are driving the same vehicle. However, if Angela Merkel is behind the wheel of a Mercedes-Benz G-Class SUV, while Greek PM Alexis Tsipras is riding a tricycle, then the payouts are going to be much different in the case of a crash. In that case, the payouts should approximate something closer to Diagram 2. Diagram 1Regular Game Of Chicken Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? Diagram 2Greece Versus Euro Area In 2015 Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? So the crucial question for investors is what vehicle are Italian policymakers driving? We do not doubt that it is an actual car, unlike Tsipras's tricycle. But it is more likely to be a finely-crafted Italian sportscar, adept at hugging the twists and turns of Rome's policy, rather than an SUV capable of colliding with Merkel's ominous truck. Why doesn't Rome have more capability than Greece? Because of time horizons. An Italian exit from the Euro Area would undoubtedly shake the foundations of the common currency and the European integrationist project. But Rome actually has to exit in order to shake those foundations. As we have learned with Brexit, such an "exit" scenario could take months, if not years. In the process of trying to exit, the Italian banking system would become insolvent, turning household savings and retirements into linguini. This would occur immediately and would exert economic, financial, and - most importantly - political pressure on Italian policymakers instantaneously. Our colleague Dhaval Joshi, BCA's Chief European Strategist, has argued that a 4% Italian bond yield is the "line in the sand" regarding the survival of Italy's banks.7 As Dhaval points out, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). Based 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 14). Although the net NPL figure has improved much from the peak in 2015, it remains large. 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. Dhaval estimates that this equates to the 10-year BTP yield breaching and remaining above 4% (Chart 15). Chart 14Italian Banks' Equity Capital ##br##Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Chart 15Italian Banks' Solvency Would Be In ##br##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% Additionally, while Italian support for the common currency is relatively low, there is still a majority of around 60% that support the euro. This is similar to the level of support for the euro in Greece in 2015. We would suspect that the support for the currency would rise - and that populist parties would decline in popularity - if Italian policymakers set off a bond market riot that caused the insolvency of Italian banks. Does this mean that the bond market is a permanent constraint on Italian exit from the Euro Area? No. At some point in the future, after a deep recession that raises unemployment levels substantively, popular support for the common currency could tank precipitously. But we are far from that point. In fact, Italy has enjoyed a relatively robust recovery over the past 18 months. As such, any economic crisis today will be blamed on the populist policymakers themselves, yet another reason for them to moderate and seek the path of calm negotiations with the EU. Bottom Line: With regards to any potential "game of chicken" negotiations with the rest of Europe, Italian policymakers are not riding a tricycle like their Greek counterparts were in 2015. Italians are behind the wheel of a finely-crafted, titanium-chassis, Italian roadster. Unfortunately, Chancellor Angela Merkel is still in a Mercedes SUV that weighs 2.5 tons. This is a high-conviction view based on the actions of Italian policymakers over the past month. Despite an improvement in polling, populists have backed off from calling for a new election (which would have been perfectly logical) and that would have been advantageous to them and have abandoned some of the most controversial - and expensive - platforms of their coalition agreement. Unlike their peers in Greece, Italian populists have proven to have little stomach for actual confrontation. The Ultimate Constraint: Risorgimento In a report published back in 2016, we argued that Italy's original sin was its unification in 1861.8 Risorgimento brought together the North and South in a political and economic union that made little sense. The North had developed a market economy during the Middle Ages (and gave the West its Renaissance!), while the South had remained under feudalism well into the early twentieth century. Given the limited resources, governance, and technology of the mid-nineteenth century, the scope, ambition, and yes, folly of uniting Italy were probably several orders of magnitude greater than the effort to forge a common currency union in Europe in the twenty-first century. To this day, Italy remains an economically bifurcated country. Map 1 shows that the four wealthiest and most-productive regions of Europe, outside of capital cities, are the German Rhineland, Bavaria, the Netherlands, and Northern Italy. Meanwhile, the Italian South - or Mezzogiorno - is as undeveloped as Greece and Eastern Europe. Map 1Core Europe Extends Well Into Northern Italy Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? The units of analysis in Map 1 are the so-called EU "nomenclature of territorial units for statistics" (NUTS).9 These regions matter because Brussels uses them to determine how much "structural funding" - essentially development aid - each country receives from the EU. The EU "regional and cohesion" funding - totaling €351.8 billion for the 2014-2020 budget period - is not distributed based on the aggregate wealth of each country, since that would favor the new entrants into the union. The EU's discerning eye when it comes to distributing development funds is not accidental. It is a product of decades of lobbying by Italy (and Spain) to prevent a shift of structural funding to Eastern European member states. From Rome's perspective, the real European development project is not in Poland or Greece, but in the Mezzogiorno. Chart 16Italy Shares The Burden Of The Mezzogiorno With The EU Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? To this day, Italy and Spain receive the second and third largest amount of EU development aid (Chart 16). Despite contributing, in gross terms, 13% to the EU's total revenues, Italy's net contribution per person is smaller than those of the Netherlands, Sweden, Denmark, Finland, and Austria (Chart 17). Given that Italy is a wealthy EU state, its net budget contribution of approximately €3 billion, 0.2% of GDP, essentially means that it gets the benefits of EU membership for free. Chart 17Italy Gets To Join The Club For Free Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? And EU membership comes with many benefits. Membership in the Euro Area - combined with sharing the same "lender of last resort" with Germany, the European Central Bank - allows Italy to finance its budget deficits at low interest rates and to issue government debt in the world's second largest reserve currency (Chart 18). These financial benefits are even greater than the rebate it gets from Europe. Access to cheap financing allows Italy to carry the costs of Mezzogiorno on its own. Chart 18The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today It is somewhat ironic that Lega is today preaching populism and euroskepticism. In the early 1990s, its main target of angst was not the EU and Brussels, but Italy's South and profligate Rome, which funneled the North's taxes to the South. This early iteration of the party was quite pro-EU, as it saw Italy's North as genuinely European and worthy of membership in EU institutions. Some of its politicians and voters hoped that Northern Italy could meld into the EU, leaving the Mezzogiorno to fend for itself. Hence there is no deep, ideological euroskepticism in Lega's DNA. The party's evolution also illustrates how opportunistic and pragmatic Italian policymakers can be. The reality is that if Italy were to act on its threat of "exit," it would undoubtedly become far worse off economically. Not only would Northern Italy have to support the Mezzogiorno alone, but any structural reforms that could lift productivity and education in the South would become far less likely as anti-establishment forces took hold. Bottom Line: Our high-conviction view is now the same as it was in 2016. Italy is "bluffing." Leaving the EU or the Euro Area makes no sense given its economic bifurcation, which is the result of Risorgimento. Both policymakers and voters understand this. The real intention in the game of chicken between Brussels and Rome is to see an easing of austerity. We expect that Italian policymakers will ultimately succeed in getting leniency from Brussels on allowing deficit-widening fiscal stimulus, but the stimulus will be much smaller than their original plans that spooked the bond market laid out. To European and Italian politicians, Italy's economic bifurcation is well understood. Jean-Claude Juncker, the President of the European Commission, specifically referred to it when he said, "Italians have to take care of the poor regions of Italy." He was later forced to apologize for his comments, with leaders of M5S and Lega faking outrage. But given that the ideological roots of Lega are precisely in the same intellectual vein as Juncker's comments, investors should understand that politicians in Rome are well aware of their fundamental constraints. Juncker's comments were a dog whistle to Rome. The actual message was: we know you are bluffing. Investment Implications Our analysis suggests that the path of least resistance for the M5S-Lega coalition is to negotiate some austerity relief from the EU Commission, but to definitively pivot away from talk of "exit" from European institutions. PM Conte has reaffirmed that exiting the euro is off the table and that it was never on the table to begin with. The new economy minister, Giovanni Tria, followed this up with a comment that "the position of this government is clear and unanimous... there are no discussions taking place about any proposal to leave the euro." Meanwhile, Lega leader and new Italian interior minister Matteo Salvini has focused his early efforts and commentary on the party's promise to check illegal immigration to Italy. This will be a policy upon which Lega will test its populist credentials, not a fight with Brussels. Is the worst of the crisis therefore "over"? Is it time to buy Italian assets? Not yet. Both Italian bonds and equities rallied throughout 2017. Italian equities, for example, have a higher Shiller P/E ratio than both Spanish and Portuguese stocks (Chart 19). As such, a sell-off was long overdue. Chart 19Why Did Italian Equities Rally So Much? Why Did Italian Equities Rally So Much? Why Did Italian Equities Rally So Much? Chart 20Italy's Binary Future Italy's Binary Future Italy's Binary Future Furthermore, we do not expect Rome's negotiations with Brussels to proceed smoothly. It is very likely that the bond market will have to continue to play the role of disciplinarian. The government debt-to-GDP ratio could quickly become unsustainable if the current primary budget balance is thrown into a deficit (Chart 20). According to the IMF and BCA Research calculations, Italian long-term debt dynamics are stable even with real interest rates rising to 2% - from just 0.5% today - and real GDP growth remaining at a muted 1%. But this stability requires the country to continue to run a primary budget surplus of around 2% of GDP (Chart 21). Conversely, running a persistent primary deficit of 2% would result in an explosive increase in Italy's debt dynamics. Even if that stimulus produces real GDP growth of 3%, the "bond vigilantes" could protest the surge in debt and drive real interest rates to 3.5% or higher. As such, the country's fiscal space will ultimately be determined by the bond market. Rome can afford to lower its primary budget surplus, but only so far as the bond market does not riot. Our colleague Dhaval Joshi believes that the math behind an Italian fiscal stimulus would make sense if it provides enough of a sustainable boost to economic growth without blowing out the budget deficit.10 We suspect that the bond market will eventually agree, but only if Brussels and Berlin bless the ultimate fiscal package as well. While investors wait to see the outcome of Rome-Brussels budget talks, which will likely last well into Q4, we prefer to play Mediterranean politics by shorting Italian government bonds versus their Spanish equivalents. BCA's Global Fixed Income Strategy initiated such a trade on December 16, 2016, which has produced a total return of 5.8%. 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 those of Spain (Chart 22). These differences were not reflected in relative bond prices. Chart 21Three Factors Will Influence Italy's Debt Trajectory Three Factors Will Influence Italy's Debt Trajectory Three Factors Will Influence Italy's Debt Trajectory Chart 22Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Ongoing political turmoil in Italy has justified sticking with the trade. Looking ahead, there is potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth; the deficit outlook will invariably worsen for Italy with the new coalition government; and Spanish support for the euro and establishment policymakers remains far higher and more buoyant than in Italy. All these factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 23). Chart 23Stay Short 5-Year Italy Vs. 5-Year Spain Stay Short 5-Year Italy Vs. 5-Year Spain Stay Short 5-Year Italy Vs. 5-Year Spain Chart 24Stay Underweight Italian Debt Stay Underweight Italian Debt Stay Underweight Italian Debt One final critical point - the timing of any budget related uncertainty could not be worse for Italy. Economic growth is slowing and leading indicators say that this trend will continue, which suggests that Italian government bonds should continue to underperform global peers (Chart 24). Our Global Fixed Income Strategy team has argued that government debt in the European "periphery" should be treated more like corporate credit rather than sovereign debt.11 Faster economic growth leads to fewer worries about debt sustainability and increased risk-taking behavior by investors, both of which lead to reduced credit risk premiums and eventually, stronger growth. In other words, think of Italian BTPs as a BBB-rated corporate bond rather than a "risk-free" Euro Area government bond. So as long as the Italian economy continues to lose momentum, an underweight stance on Italian government bonds is justified. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 2 Please see Repubblica, "Il discorso di Conte in Senato, la versione integrale," dated June 6, 2018, available at repubblica.it. 3 Conte's exact quote was "the objective is the 'flat tax,' that is a tax reform characterized by the introduction of rates that are fixed, with a system of deductions that can guarantee that the tax code remains progressive." This is our own translation from Italian and therefore we may be missing something. However, a "flat tax" that has a number of different rates and that remains progressive is, by definition, not a flat tax. 4 In fact, the speech could be read with an eye towards some genuine supply-side reforms, particularly in bringing the country's youth into the labor force, improving governance, reforming the judiciary, cracking down on corruption and privileges of the political class, and generally de-bureaucratizing Italy. If successful, these would all be welcome reforms. 5 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," July 8, 2015, available at gps.bcaresearch.com. 6 The game derives its name from a test of manhood by which two drivers drive towards each other on a collision course, preferably behind the wheel of a 1950s American muscle car. Whoever swerves loses. Whoever keeps driving, wins and gets the girl. 7 Please see BCA European Investment Strategy Weekly Report, "Italy's 'Line In The Sand,'" dated May 31, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 The acronym stands for Nomenclature des Unités Statistiques. 10 Please see BCA European Investment Strategy Special Report, "Italy Vs. Brussel: Who's Right?" dated May 24, 2018, available at eis.bcaresearch.com. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?" dated May 22, 2018, available at gfis.bcaresearch.com.

Highlights Fed: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. Credit Cycle: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Emerging Market Debt: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Feature The Federal Reserve meets this week and will deliver the second rate hike of the year, bringing the target range for the federal funds rate up to 1.75% - 2%. With that hike already fully discounted, investors will be more concerned with parsing the post-meeting statement, Summary of Economic Projections, and Chairman Powell's press conference for clues about the future path of rates. We expect only minor changes to the statement, though the Committee could decide to tweak its promise that "the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run". Such a change would simply acknowledge that if gradual rate hikes continue, then the federal funds will move close to most estimates of its neutral (or equilibrium) level within the next 12 months. This touches on an important question for bond investors. Would the Fed actually start to slow the pace of rate hikes once the funds rate reaches its estimated neutral level? Or will it need to see some evidence of decelerating economic growth before slowing the pace of rate hikes below its current 25 bps per quarter pace? Chart 1 shows why this question is important. The shaded boxes in that chart outline a "gradual" rate hike path of 25 bps per quarter. The Fed has been lifting rates at this pace since late 2016. The "x" markings denote the median expected fed funds rate from the Fed's Survey of Primary Dealers, and the "F" markings denote the Fed's own median projections. Notice that there are two "F"s shown at the end of 2018. This is because an equal number of FOMC participants (6) expect a fed funds rate of 2% - 2.25% as expect one of 2.25% - 2.5%. We expect the median will coalesce around the 2.25% to 2.5% range by the end of tomorrow's meeting. Chart 1The Outlook For Rate Hikes The Outlook For Rate Hikes The Outlook For Rate Hikes Notice in Chart 1 that both primary dealers and the Fed expect to deviate from the quarterly rate hike pace around the middle of next year. This would be consistent with the pace of hikes starting to slow as the fed funds rate approaches its currently anticipated neutral level near 3%. But how confident is the Fed in its estimate of that neutral rate? We would argue that its confidence should be quite low. We are not alone in this assessment. In one of Janet Yellen's final speeches as Fed Chair she warned against placing too much confidence in estimates of the neutral rate.1 [T]he neutral rate changes over time as a result of the interaction of many forces, including demographics, productivity growth, fiscal policy, and the strength of global demand, so its value at any point in time cannot be estimated or projected with much precision. We expect that the current FOMC will heed this warning, and if there are no signs of economic deterioration by the middle of next year, then the Fed will continue to hike rates at a pace of 25 bps per quarter and estimates of the neutral rate will be revised higher. We examined what could potentially make the Fed deviate from its 25 bps per quarter rate hike pace, by hiking either more quickly or more slowly, in a recent report.2 Crucially, Chart 1 shows that not only is the market priced for the Fed to slow its pace of rate hikes as we reach the middle of next year, it is also priced for a slower pace of rate hikes than is expected by the Fed or the primary dealers. This divergence means that below-benchmark portfolio duration continues to make sense on a 6-12 month horizon. Bottom Line: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. A Quick Update On Our Tactical Long Position On May 22 we advised clients with a short-term (0-3 month) horizon to position for lower U.S. bond yields in the near term.3 This call was premised on two catalysts. First, bond market positioning had become excessively net short. That picture now looks more mixed (Chart 2). Net speculative positions in 10-year Treasury futures remain deep in "net short" territory and the Marketvane survey of bond sentiment is still "bearish", but the JP Morgan Duration Surveys for both "all clients" and active clients" have moved somewhat closer to neutral. The second catalyst was that our auto-regressive model pointed to strong odds of a negative reading from the U.S. Economic Surprise Index during the next month (Chart 3). This remains the case, but the reading from our model has moved much closer to the zero line. Chart 2Positioning Now Closer To Neutral Positioning Now Closer To Neutral Positioning Now Closer To Neutral Chart 3Surprise Index Still Low Surprise Index Still Low Surprise Index Still Low Taken together, our two indicators no longer send a resounding "buy bonds" signal. But given the deeply net short Treasury futures positioning and the low level of the surprise index, we are inclined to maintain our tactical buy recommendation for another week. We will re-assess again next week based on trends in the surprise index and the positioning data. The Fed & The Credit Cycle The Powell Fed has so far not been kind to credit spreads. Since February our index of financial conditions has tightened considerably, driven by a combination of falling equity prices, wider quality spreads and a stronger dollar (Chart 4). Yet, the Fed seems relatively unconcerned and is broadly expected to lift rates this week. All in all, the Powell Fed seems less concerned with responding to tighter financial conditions than was the Yellen Fed. Chart 4How Much Pain Can The Fed Take? How Much Pain Can The Fed Take? How Much Pain Can The Fed Take? There is some truth to this observation, though we think the difference has more to do with recent trends in inflation than with any change in approach between the two Fed Chairs. As inflation pressures mount, the Fed is marginally less concerned with responding to weakness in financial markets and marginally more concerned with preventing an inflation overshoot. This is why we will reduce our allocation to corporate bonds once our monetary indicators tell us that inflation expectations are well anchored around the Fed's target. Monetary Indicators Long maturity TIPS breakeven inflation rates are the primary indicators we are monitoring in this regard. When both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%, that will be consistent with past periods of well-anchored inflation expectations and we will start reducing exposure to corporate credit (Chart 5). But we should not rely solely on one indicator. It is conceivable that the financial crisis ushered in a structural shift (possibly due to stricter banking regulations) and that the level of TIPS breakevens consistent with well-anchored inflation expectations is now slightly lower.4 For this reason we also pay attention to the St. Louis Fed's Price Pressures Measure (Chart 5, bottom panel). This model is designed to output the percent chance that inflation will exceed 2.5% during the next 12 months, and we have found that corporate bond excess returns decline significantly when it exceeds 15%.5 It currently sits at 13%. Finally, it's also a good idea to pay attention to core PCE inflation itself. The year-over-year rate of change in core PCE inflation jumped sharply in recent months, but it has not yet returned to the Fed's 2% target (Chart 6). It is therefore still reasonable to expect that inflation expectations are not consistent with target inflation. It is likely that many investors still have doubts about whether inflation will recover to the Fed's target. Chart 5Credit Cycle: Monetary Indicators Credit Cycle: Monetary Indicators Credit Cycle: Monetary Indicators Chart 6The Fed's Inflation Model The Fed's Inflation Model The Fed's Inflation Model Those doubts would probably fade if the year-over-year rate of change in core PCE inflation actually rose to 2% and stayed there for several months. At that point we would have to conclude that inflation expectations are well anchored, whatever the level of TIPS breakeven rates. Incidentally, the recent bounce in core inflation brought it back in line with the reading from Janet Yellen's Phillips Curve model that she presented in a speech from 2015.6 In the context of this model, a continued decline in the unemployment rate will pressure inflation slowly higher, meaning that we expect to receive a signal from our monetary indicators sometime this year. We will pare exposure to corporate bonds at that time. It will be very interesting to hear from Chair Yellen herself when she visits the BCA Conference in September, and we hope to gain insight not only about her inflation forecast but also about how the Fed thinks about its responsiveness to financial markets, and most importantly, about how the Fed is likely to manage the tightening cycle as the funds rate approaches its estimate of neutral. Credit Quality Indicators Outside of Fed policy and the inflation outlook, we are also closely monitoring the relationship between profit growth and debt growth for the nonfinancial corporate sector. Leverage rises whenever debt growth exceeds profit growth and rising leverage tends to coincide with widening credit spreads (Chart 7). Nonfinancial corporate debt grew at an annualized rate of 4.4% in the first quarter, while pre-tax profits actually contracted at an annualized rate of 5.7%. As a result, our measure of gross leverage ticked higher from 6.9 to 7.1. More broadly, profits grew 5.8% in the four quarters ending in Q1 2018, only slightly faster than the 5.2% increase in corporate debt. This does not provide much of a buffer, and it will not take much to send profit growth below debt growth on a sustained basis. In fact, we expect that if labor compensation costs continue to accelerate we will see leverage start to rise more meaningfully in the second half of this year. Our overall Corporate Health Monitor improved noticeably in the first quarter (Chart 8). But this large move will almost certainly reverse in Q2. The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart 8, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (Chart 8, bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. Chart 7Leverage Is Poised To Head Higher Leverage Is Poised To Head Higher Leverage Is Poised To Head Higher Chart 8Tax Cuts Helped Balance Sheets In Q1 Tax Cuts Helped Balance Sheets In Q1 Tax Cuts Helped Balance Sheets In Q1 Bottom Line: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Still No Opportunity In Emerging Market Debt We pointed out in a recent report that a persistent divergence between U.S. and non-U.S. economic growth was the most likely catalyst that could cause the Fed to slow its pace of rate hikes.7 A divergence between strong U.S. growth and weaker growth in the rest of the world puts upward pressure on the U.S. dollar, and this is a particular problem for many emerging markets that carry large balances of U.S. dollar denominated debt. Our Emerging Markets Strategy service published a Special Report last week that explains in detail this particular problem faced by emerging markets and shows which countries face the most pressing debt concerns.8 For U.S. fixed income investors another important question is whether the recent strength in the U.S. dollar, and weakness in emerging market currencies, has resulted in an opportunity to shift out of U.S. corporate credit and into USD-denominated emerging market sovereign debt. On that note, Chart 9 shows that the average option-adjusted spread for the Baa-rated U.S. Corporate bond index recently dipped below the average spread for the investment grade USD Emerging Market (EM) Sovereign index. However, we think it is still too soon to move into emerging market debt. After adjusting for differences in duration and spread volatility between the two indexes, we come up with a measure of "Months-To-Breakeven". This indicator shows the number of months of spread widening required for each index to lose money relative to U.S. Treasuries. By this measure, U.S. Corporate bonds still look attractive compared to investment grade EM Sovereigns. At the country level, Chart 10 shows the 12-month breakeven spread for the USD-denominated sovereign debt of several major EM countries. It also shows each country's foreign funding requirement, a measure of the foreign capital inflows required in the next 12 months for each country to cover any shortfall in current account transactions and service its foreign currency debt. Chart 9EM Sovereigns Are Still Expensive EM Sovereigns Are Still Expensive EM Sovereigns Are Still Expensive Chart 10USD-Denominated Emerging Market Debt: Risk/Reward At The Country Level Threats & Opportunities In Emerging Markets Threats & Opportunities In Emerging Markets For the Baa-rated countries, Colombia, Mexico and Indonesia all offer spreads similar to what can be found in the Baa-rated U.S. Corporate bond market. The Philippines looks quite expensive, but Russia looks cheap compared to U.S. Corporates and has one of the lowest foreign funding requirements of any EM country. In High-Yield space, Turkey is fairly priced relative to Ba-rated U.S. junk, while Brazil and South Africa both look expensive. Argentina also looks expensive relative to B-rated U.S. junk. Bottom Line: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20170926a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 We explored some possible reasons for such a shift in the U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 7 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Special Report, "A Primer On EM External Debt", dated June 7, 2018, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Risks To The Bond Bear Market Risks To The Bond Bear Market Risks To The Bond Bear Market Two weeks ago we flagged that large net short positioning and elevated growth expectations left the Treasury market primed to benefit from any disturbance in the economic outlook. Since then the 10-year yield fell from a peak of 3.06% to 2.77%, before climbing back to 2.92%. With positioning still deeply net short and strong odds of a further decline in the economic surprise index (Chart 1), we continue to see an elevated risk that yields move lower on a 0-3 month horizon. But beyond that, less nimble investors should remain positioned for higher yields on a 6-12 month timeframe. The major risks in the global economy - Eurozone sovereign credit concerns and a strong dollar weighing on emerging market demand - are unlikely to put the Fed off its "gradual" pace of one rate hike per quarter unless they lead to a significant risk-off event in U.S. financial markets. Absent that sort of shock, the Fed will continue to lift rates "gradually" toward a neutral level near 3%, and eventually into restrictive territory. This rate hike path is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to -122 bps. Value has improved considerably since the start of the year. The 12-month breakeven spread for a Baa-rated corporate bond is back up to its 29th percentile relative to history (Chart 2). Market-derived inflation expectations also ebbed during the past month, with the 10-year and 5-year/5-year forward TIPS breakeven inflation rates now at 2.09% and 2.12% respectively. This is below the target range of 2.3% to 2.5% that would trigger a downgrade to our corporate bond allocation. The combination of more attractive value and a somewhat more supportive monetary environment (as evidenced by the decline in TIPS breakeven rates) increases the odds of near-term corporate bond outperformance, and we would not be surprised to see spreads tighten during the next few months. However, the longer run outlook for corporates remains negative. First quarter data showed a 5.7% annualized decline in pre-tax corporate profits, dragging the year-over-year growth rate down to 5.8% (bottom panel). As employee compensation costs accelerate in the second half of the year, we expect that corporate profit growth will fall sustainably below the pace of corporate debt growth leading to rising leverage (panel 4). Strong oil prices have caused the energy sector to outperform the overall index considerably since the middle of last year. Now, many energy sub-sectors no longer appear cheap on our model. We take this opportunity to downgrade a few energy sub-sectors from overweight to neutral, and adjust some other sector recommendations as well (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Bond Bear Still Intact Bond Bear Still Intact Table 3BCorporate Sector Risk Vs. Reward* Bond Bear Still Intact Bond Bear Still Intact High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +36 bps. The average index option-adjusted spread widened 24 bps on the month, and currently sits at 356 bps. High-yield spreads are increasingly at odds with Moody's default rate projections. The latter call for the 12-month speculative grade default rate to fall to 1.5% by next April. The current 12-month trailing default rate is 3.7% (Chart 3). Using the Moody's default rate projection, and our own forecast for the recovery rate, we calculate the excess spread available in the Bloomberg Barclays High-Yield index to be 284 bps (after accounting for expected default losses). This is somewhat higher than the historical average of 248 bps. The current excess spread means that in an unchanged spread environment we would expect a High-Yield excess return (relative to duration-matched Treasuries) of +278 bps during the next 12 months. If the index spread were to tighten by 100 bps, we would expect an excess return of +675 bps. If the index spread were to widen by 100 bps we would expect an excess return of -120 bps (panel 3). If the excess spread were to simply revert to its historical average, then it would imply an excess High-Yield return of +427 bps. At the sector level, Moody's expects that most defaults during the next 12 months will come from the Media: Advertising, Printing & Publishing sector, followed closely by the Durable Consumer Goods and Retail sectors. Much of the projected improvement in the overall default rate results from a continued decline in Oil & Gas sector defaults compared to the past few years. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in May, dragging year-to-date excess returns down to -27 bps. The conventional 30-year zero-volatility MBS spread widened 4 bps on the month, driven entirely by a 4 bps increase in the compensation for prepayment risk (option cost). The option-adjusted spread held flat at 32 bps. Value in the MBS sector is by no means exciting. The nominal spread on a conventional 30-year MBS is near its all-time low, the option-adjusted spread is close to one standard deviation below its pre-crisis mean (Chart 4) and MBS no longer look very attractive compared to investment grade corporate credit (panel 3). The most compelling reason to hold agency-backed MBS is that mortgage refinancings are likely to remain very low, owing both to rising interest rates and the large number of homeowners that have already refinanced. Depressed refi activity should keep MBS spreads near historically low levels (bottom panel), even as stresses emerge in other spread product sectors, notably corporate bonds. We recently presented a method for calculating expected total returns for all different bond sectors, only using assumptions for the number of Fed rate hikes during the next 12 months and the expected change in spreads.1 Our results showed an expected total return of 2.9% for conventional 30-year MBS in a scenario where the Fed lifts rates by 100 bps and where spreads remain flat. The same scenario corresponds to 3.4% total return for the investment grade corporate index. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 33 basis points in May, dragging year-to-date excess returns down to -40 bps. Sovereign debt underperformed the Treasury benchmark by 158 bps on the month, dragging year-to-date excess returns down to -242 bps. Foreign Agencies underperformed by 37 bps on the month, dragging year-to-date excess returns down to -56 bps. Local Authorities underperformed by 22 bps on the month, dragging year-to-date excess returns down to +37 bps. Supranationals underperformed by 2 bps on the month, dragging year-to-date excess returns down to +2 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to +7 bps. Global growth divergences and a stronger U.S. dollar weighed on Sovereign bond returns in May (Chart 5). While value in the sector improved somewhat as a result, it remains expensive relative to investment grade corporate credit (panel 2). With dollar strength likely to persist in the near-term, we remain underweight Sovereign bonds. Conversely, we reiterate our overweight recommendations on Foreign Agency and Local Authority bonds. Those sectors still offer compelling valuations and are less sensitive to a strong U.S. dollar than the lower-rated Sovereign sector. Supranationals and Domestic Agency bonds are low risk but do not offer sufficient spread to warrant much attention. Better low-risk spread product opportunities are available in the Agency CMBS and Consumer ABS sectors. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +110 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% on the month and, at 86%, it is very close to its post-crisis low (Chart 6). It remains somewhat elevated compared to the average level of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Technically, yield ratios have been supported by robust fund flows and subdued issuance (panels 2 & 3), while fundamentally our Municipal Health Monitor suggests that ratings upgrades will continue to outpace downgrades for the time being (not shown). The message from our Health Monitor is confirmed by the trend in state & local government net borrowing (bottom panel). First quarter data, released last week, showed a sizeable drop in net borrowing as state & local governments managed to grow revenues by $46 billion while growing expenditures by only $25 billion. This is consistent with governments working hard to repair their budgets, raising taxes and slowing spending growth, as we showed in a recent report.2 Given tight municipal valuations, we continue to see better opportunities in the corporate bond space than in municipal bonds. But we will look to upgrade munis at the expense of corporates as we approach the end of the credit cycle. Hopefully, from a more attractive entry point. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in May. The 2/10 Treasury slope flattened 3 bps to end the month at 43 bps. The 5/30 slope held steady at 32 bps. The short-end of the Treasury curve is still not adequately priced for the Fed's likely pace of one 25 basis point rate hike per quarter. Such a pace translates to a level of 100 bps on our 12-month discounter, which currently sits at only 73 bps (Chart 7). Similarly, the long-end of the Treasury curve is not adequately priced for the likely trend in inflation. The 10-year TIPS breakeven inflation rate is at only 2.09%, below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. We anticipate that higher TIPS breakevens at the long end of the curve will be roughly offset by loftier rate expectations at the short end of the curve, leaving the slope of the Treasury curve close to current levels during the next few months. In a recent report we introduced a framework for identifying the most attractively valued butterfly trades across the entire yield curve.3 The results, shown in Table 4, identify the 7-year bullet over the 1-year/20-year barbell as the most attractively valued butterfly trade that is geared toward curve steepening. According to our model, that trade is priced for 56 bps of 1/20 flattening during the next six months (panel 4). That seems excessive given the low level of long-maturity TIPS breakevens. Table 4Butterfly Strategy Valuation (As Of June 4, 2018) Bond Bear Still Intact Bond Bear Still Intact TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +95 bps. The 10-year TIPS breakeven inflation rate fell 10 bps on the month and currently sits at 2.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 13 bps and currently sits at 2.12%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.4 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. Recent trends show that inflation is steadily making progress toward the Fed's 2% goal. The 12-month rate of change in the core PCE deflator is back up to 1.8%, from 1.5% in February. However, the core PCE deflator has only increased by 0.15% in each of the past two months. Consistent monthly prints above 0.165% are required to reach the Fed's 2% target (Chart 8). We expect tight labor markets and strong pipeline pressures (panel 3) to drive inflation higher in the months ahead. Although, as we discussed last week, the risk of a significant overshoot of the Fed's inflation target during the next 6-12 months is low.5 ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -3 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp on the month and now stands at 41 bps, 7 bps above its pre-crisis low. While consumer ABS offer reasonably attractive expected returns relative to other low-risk spread product (Agency CMBS, Domestic Agency bonds and Supranationals), credit risk is slowly starting to build in the sector. The New York Fed's Household Debt and Credit report showed that the 90+ day credit card delinquency rate rose above 8% in Q1 for the first time since 2015. Meanwhile, the overall consumer credit delinquency rate continues to increase alongside a rising debt service ratio (Chart 9). On the supply side, banks reported tightening credit card lending standards for the fourth consecutive quarter in Q1, while auto loan lending standards were tightened for the eighth consecutive quarter. Periods of tightening lending standards tend to coincide with rising delinquencies and wider spreads (bottom panel). In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect Aaa-rated credit card ABS to return 2.3% and Aaa-rated auto loan ABS to return 2.4%.6 Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month and currently sits at 70 bps, close to one standard deviation below its pre-crisis mean. Banks eased lending standard on nonfarm nonresidential loans in Q1 for the first time since 2015, and continued easing could signal lower delinquencies in the future (Chart 10). Easier lending standards could also support commercial real estate prices, which have decelerated recently and currently pose a risk for spreads (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +13 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 48 bps. In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect non-agency Aaa-rated CMBS to return 2.8% and Agency CMBS to return 2.6%.7 Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.54%. The drop in the model's fair value compared to last month stems from a decline in the global PMI from 53.5 to 53.1, and a rise in dollar bullish sentiment from 60% to 67%. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. As resource slack dissipates, inflationary pressures mount and the same pace of global growth should be associated with a higher Treasury yield. This means that as we approach the end of the cycle, the 2-factor model will start producing fair value readings that are consistently too low. We can attempt to correct for this by incorporating a measure of resource slack into our model, in this case the employment-to-population ratio. A model for the 10-year Treasury yield based on the employment-to-population ratio and the Global PMI produces a fair value of 3.29% (Chart 11). As we move further toward the end of the cycle, and away from the zero-lower bound on the fed funds rate, we expect the regression coefficients shown in the bottom three panels will revert to their pre-crisis levels and Treasury fair value will revert closer to the one shown in the second panel. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@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 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

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

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

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 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